Research reveals new insights into trade credit lending decisions

Suppliers don’t always give the best terms to their biggest customers

Carolyn Crist | Jan. 06, 2020


  • Trade credit theories suggest that suppliers extend more trade credit to important customers in order to preserve the sales relationship.
  • However, a new dataset shows that suppliers limit trade credit exposure to major customers. 
  • Suppliers being monitored by their bank, in particular, tend to follow more conservative trade credit practices with their larger customers.  

Contrary to common expectation, suppliers might not bend to the bargaining power of their biggest customers and offer them more generous trade credit to sweeten the relationship, according to a new study from the University of Georgia. In fact, they often do the opposite and restrict the terms to reduce their risk exposure.

The research, which won the Best Paper in Corporate Finance Award at the Financial Management Association’s annual meeting in October, analyzes trade credit at the customer-supplier level to understand important lending decisions that haven’t been examined before.

Trade credit allows businesses to purchase supplies without immediate payment and is commonly used as short-term financing. Explaining its importance to commerce, Terry College of Business finance professor Kayla Freeman said it’s the largest financial asset and second-largest liability (second only to commercial loans) on the U.S. aggregate balance sheet for non-financial firms. But little is known empirically about how trade credit lending decisions are made.

“Testing trade credit theories is difficult because we usually only have data on aggregate trade credit given to all of a supplier’s customers. We need data on trade credit between an individual customer and supplier in order to understand lending decisions,” said Freeman, the paper’s author, who conducted the research as part of her Ph.D. dissertation at Indiana University.

Freeman found a different way in to observe thousands of discrete customer-supplier data points and analyze trade credit lending decisions more effectively.

Theory predicts that the importance of the customer to the supplier’s sales and operations would play a major role. However, Freeman found that wasn’t necessarily the case.

“We read news reports about large customers like Amazon and Walmart that have a network of small suppliers who depend heavily on them,” she said. “My paper suggests that often, smaller suppliers are making decisions in their own best interest, not simply succumbing to what their customer wants.”

While researching data on supply chain relationships from firm financial statements for another project, Freeman saw that many suppliers disclosed trade credit balances with their customers, and she realized the data could provide a fascinating way to analyze the individual relationships that influence trade credit decisions. The data wasn’t organized in an easily accessible way, though, so she curated a dataset for herself from the financial statements.

Based on more than 6,500 available supplier-customer observations, she found that suppliers avoid credit concentrations with their major customers. In fact, the proportion of sales made on credit declined as the size of the sale increased. She also discovered that when a supplier had a significant customer dependence, the supplier extended more trade credit to their network of smaller customers, which could indicate that suppliers use trade credit to diversify their sales base.

In Freeman’s opinion, current trade credit theory models lack a critical piece — suppliers face higher risk when they extend a large amount of credit to a major customer. If the supplier isn’t paid or if the relationship goes awry, the consequences could be devastating. 

“A building block in finance is that diversification is valuable,” she said. “You don’t put all of your eggs in one basket because if something goes wrong, you’re going to lose everything.”

On top of that, Freeman found that the results were even stronger for suppliers with an outstanding bank loan. In essence, suppliers with a bank monitoring them tend to use more conservative trade credit policies and resist overextending credit to a major customer.

In addition, customers with riskier balance sheets and cash-to-debt ratios are less likely to receive large trade credit allowances. Interestingly, when the supplier and customer have the same lender for a bank loan, trade credit is more likely to be extended, perhaps because the bank is less concerned about heavy credit exposure to their own client.

“These conclusions make sense, but it’s not what we expected based on prior theoretical work,” Freeman said. “It’s interesting to know that small suppliers aren’t being completely bullied by their largest customers.”

The Best Paper in Corporate Finance Award was sponsored by the Association of International Certified Professional Accountants, or AICPA. Freeman is revising the paper based on peer feedback and submitting it for publication. Next, she plans to use the same dataset to test other theories about trade credit and supply chain relationships.