Trade Credit Use as Firms Approach Default

• Published date: 01 August 2020
• Author: EMILIA GARCIA‐APPENDINI,JUDIT MONTORIOL‐GARRIGA
• Date: 01 August 2020
• DOI: http://doi.org/10.1111/jmcb.12618

DOI: 10.1111/jmcb.12618

EMILIA GARCIA-APPENDINI

JUDIT MONTORIOL-GARRIGA

Trade Credit Use as Firms Approach Default

Using a sample of distressed firms with information about suppliers, we doc-

ument an average fall in the use of trade credit as firms approach bankruptcy

compared to a control sample of nonbankrupt firms. However,we uncover a

large degree of heterogeneity across suppliers. Suppliers facinghigh switch-

ing costs maintain their business ties with the distressed firms as they ap-

proach bankruptcy, and provide them more trade credit. Suppliers in con-

centrated markets provide temporary support to their clients. Overall, the

findings of this paper suggest that switching costs are fundamental to explain

whether suppliers provide liquidity to their distressed clients or not.

JEL codes: G01, G30, G32

Keywords: trade credit, bankruptcy, switching costs.

THE SINGLE LARGEST EXPOSURES TO the bankruptcy of an in-

dustrial firm take the form of trade credit, that is, the credit offered by suppliers in

exchange for an anticipated delivery of inputs (Evans and Koch 2007, Jorion and

Zhang 2009). Theoretically, this finding has been usually justified with models that

claim that suppliers have an implicit stake in their clients’ business. According to

these models, which we shall henceforth refer to as “liquidity provision” theories,

suppliers have strong incentives to provide trade credit to clients in distress, because

in this way they maintain their future earnings and protect a valuable client (Wilner

2000, Cu˜

nat 2007).

An early version of this paper circulated with the title “Trade credit and financial distress.” Many

thanks to Marco Forletta, Yannic Hegers, and Constantin Charles for research assistance, and to Mike

Jacobs Jr. for making the LOC data for bankrupt firms available for this project. We are also grateful to

two anonymous referees, as well as to Martin Brown, Breck Robinson, Emiliano S´

anchez, and to seminar

participants at the 2014 IBEFASummer conference,the 2014 European Economic Association Meetings,

the XXII Spanish Finance Forum, the XI Winter Conference in Financial Intermediation (Lenzerheide),

Innsbruck University,and the University of Neuchatel for useful comments. Garcia-Appendini gratefully

acknowledges financial support from the European Research Council (ERC) under the European Union’s

Horizon 2020 research and innovation programme ERC ADG 2016—GA: under grant agreement No.

740272: lending.

EMILIA GARCIA-APPENDINI is a Senior Research Fellow in the Department of Banking and Finance,

University of Zurich at Zurich (E-mail: emilia.garcia@uzh.ch). JUDIT MONTORIOL-GARRIGA is a Senior

Economist, CaixaBank Research (E-mail: montoriol@gmail.com).

Received August 2, 2017; and accepted in revised form December 27, 2018.

Journal of Money, Credit and Banking, Vol.52, No. 5 (August 2020)

C

2019 The Ohio State University

1200 :MONEY,CREDIT AND BANKING

In contrast to the liquidity provision theories, other authors argue that suppliers

withdraw their support as they progressivelylose confidence in their distressed clients

(Smith 1987). Relative to other creditors, suppliers havestrong incentives to withdraw

their financial support to firms in distress well before a bankruptcy, because trade

credit lacks contractual seniority and formal collateral. Due to the absence of these

protective features, recovery rates for suppliers are potentially low in case of default.

Moreover, suppliers have an information advantage relative to other creditors that

can facilitate an early exit from a distressed relationship (Biais and Gollier 1997).

The ability of suppliers to assess their clients’ financial situation better than banks

derives from the soft information that they obtain from dealing in person with their

clients on a periodic basis, and the possibility to compare them with other firms in

the same industry. We shall refer to these theories as the “loss of confidence” theories

hereafter.

In this paper, we investigate the above two streams of the literature with opposing

implications, examining whether suppliers of firms in financial distress increase or

withdraw their financial support to the failing firms. In order to empirically identify

changes in the supply of credit, rather than changes in the demand for credit, we

follow a sample of firms that eventually filed for bankruptcy (treated firms) and their

suppliers several years prior to bankruptcy,and compare them to a sample of matched

control firms in the same industry that did not file for bankruptcy.

In line with the theories of loss of suppliers’ confidence, we find that the use of

trade credit falls, on average, as firms approach bankruptcy,consistently with a lower

supply of credit by the firms’ suppliers. We also find that several suppliers reduce

their sales to the distressed firms. These findings are consistent with suppliers losing

confidence on distressed firms, and consequently, reducing their business ties with

distressed firms well before bankruptcy.

However,our analysis uncovers a large degree of heterogeneity in supplier behavior

across different supplier–client relationships. In fact, we find that several suppliers

continue selling large amounts to distressed firms until bankruptcy or shortly before.

In line with the theories of liquidity provision, we find that these suppliers provide

liquidity to their distressed clients during the distress period. Further analyses reveal

that these suppliers are those facing high switching costs for replacing their clients:

They sell differentiated goods, are located closer to their clients, and sell them

large fractions of their products. In all these cases, the supplier has an important

implicit stake in its customer’s business and hence the value to continue a long-term

relationship is high.

It is important to note that it is challenging to find suitable nonbankrupt control

firms for our sample of bankrupt firms according to one important dimension: The

importance of the firm to its suppliers (measured as the average ratio of supplier sales

to the firm divided by total supplier sales). Six to 10 years before the bankruptcy, the

average importance of the firm to its suppliers is 15.7% for treated firms and 20.6%

for control firms. Tofind control firms that are more comparable to the treated firms in

this dimension, we need to go as back as 15 years prior to the bankruptcy. On the one

hand, the difficulty of finding a suitable control group closer to the bankruptcy date