metadata: authors: 0: author: Klapper, Leora
1: author: Laeven, Luc
2: author: Rajan, Raghuram
count: World
docna: 0: docna: Trade credit contracts
docty: Policy Research Working Paper
subtopic: Human Rights,Construction Industry,Common Carriers Industry,Food & Beverage Industry,General Manufacturing,Pulp & Paper Industry,Plastics & Rubber Industry,Financial Regulation & Supervision,International Trade and Trade Rules,Business Cycles and Stabilization Policies,Access to Finance
teratopic: Macroeconomics and Economic Growth,Finance and Financial Sector Development
abstracts: cdata!: The authors employ a novel dataset on
            almost 30,000 trade credit contracts to describe the broad
            characteristics of the parties that contract together; the
            key contractual terms, such as the discount for early
            payment; and the days by when payment is due. Whereas prior
            work has typically used information on only one side of the
            buyer-seller transaction, this paper utilizes information on
            both. The authors find that the largest and most
            creditworthy buyers receive contracts with the longest
            maturities from smaller suppliers, with the latter extending
            credit to the former perhaps as a way of certifying product
            quality. Discounts for early payment seem to be offered to
            riskier buyers to limit the potential nonpayment risk when
            credit is extended for non-financial reasons.
repnme: repnme: Trade credit contracts
display_title: Trade credit contracts
listing_relative_url: /research/2011/07/14594558/trade-credit-contracts
topicv3: Manufacturing Sectors m1326521 1281,Trade m1326924 698,Access to Finance m1327464 1249,Trade Guarantees m1505111 3906,Discrimination m1505707 3379
publishtoextweb_dt: 2011-07-01T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Finance and Financial Sector Development
no_of_pages: 40
model_extractions: WPS5726 Policy Research Working Paper 5726

# Trade Credit Contracts

_Leora Klapper Luc Laeven Raghuram Rajan_ The World Bank Development Research Group Finance and Private Sector Development Team July 2011
Policy Research Working Paper 5726

# **Abstract**

The authors employ a novel dataset on almost 30,000 trade credit contracts to describe the broad characteristics of the parties that contract together; the key contractual terms, such as the discount for early payment; and the days by when payment is due. Whereas prior work has typically used information on only one side of the buyerseller transaction, this paper utilizes information on both.

The authors find that the largest and most creditworthy buyers receive contracts with the longest maturities from smaller suppliers, with the latter extending credit to the former perhaps as a way of certifying product quality. Discounts for early payment seem to be offered to riskier buyers to limit the potential nonpayment risk when credit is extended for non-financial reasons.

This paper is a product of the Finance and Private Sector Development Team, Development Research Group. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at lklapper@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Trade Credit Contracts**

Leora Klapper, Luc Laeven, and Raghuram Rajan* _JEL Classification_ : G32 _Keywords_ : Trade Credit; Capital Structure; Contract Theory; Risk Management

* Klapper is Lead Economist at the World Bank. Laeven is Deputy Division Chief at the International Monetary Fund and Research Fellow at CEPR. Rajan is the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago and Research Associate at NBER. We thank PrimeRevenue for generously sharing the trade credit contract data, Alexander Ljungqvist (the Editor), two anonymous referees, Stijn Claessens, Shane Maine, John Sculley, and Chris Woodruff for useful comments or suggestions, and Teresa Molina and Douglas Randall for excellent research assistance. This paper‘s findings, interpretations, and conclusions are entirely those of the authors and do not necessarily represent the views of the World Bank, the IMF, their Executive Directors, or the countries they represent.
# **1. Introduction**

Trade credit is an important source of external financing for firms of all sizes (Demirguc-Kunt and Maksimovic, 2005). For instance, suppliers often offer working capital financing to their buyers, reported as accounts receivables, some of whom may be small or credit constrained (McMillan and Woodruff, 1999; Marotta, 2005; and Van Horen 2005). Trade credit has also been shown to act as a substitute for bank credit during periods of monetary tightening or financial crisis (see, for example, Himmelberg et al., 1995; Choi and Kim, 2005; and Love et al., 2007).

Trade credit, however, is not used for financing purposes alone. Trade credit, it has been argued, is a way for a supplier to engage in price discrimination, giving favored or more powerful clients longer terms (see, for example, Wilner, 2000; Fisman and Raturi, 2004; Van Horen, 2005; and Giannetti, Burkart, and Ellingsen, 2011). Furthermore, trade credit may simply be customary in an industry, with customs driven by economic rationales such as allowing buyers time to assess the quality of the supplied goods (Lee and Stowe, 1993).

Studies have explored the supply and demand of trade credit around the world (for instance, Petersen and Rajan, 1997; Johnson, McMillan and Woodruff, 2002; Boissay and Gropp, 2007; and Fabbri and Klapper, 2009). Yet, in part due to the lack of detailed contract-level data on trade credit terms, little is known about how the contract terms of trade credit vary across buyer and supplier characteristics. For example, what is the typical contract period of trade credit? Which buyers receive longer net days (days before payment is due)? Which firms are offered early payment discounts?

This paper addresses these questions using a unique database that includes contract information for about 30,000 supplier transactions for 56 large buyers in the United States and Europe. The data includes detailed information on contract terms: the contract size (the amount in trade credit to spend in U.S. dollars), net days (days within which the buyer has to pay the amount owed), discount days (days within which the buyer has to pay to get the full discount), discount rate (the size of the discount if the amount is paid by the discount date), and the currency of the transaction.

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What really sets our dataset apart from the earlier survey based work, however, is that our data has bilateral contract information, allowing us to control both for buyer and supplier firm characteristics and analyze both sides of the buyer-seller transaction, whereas earlier work only analyzed one side of the buyer-seller transaction. An equally important distinction with previously used survey data is that we have multiple contracts for the same buyer and supplier firms, rather than a firm-average response. This allows us to include firm fixed effects in our empirical analysis, thereby correcting for time-invariant firm characteristics that might determine the choice of credit terms.

The limitations of our data set are that the number of buyers is small (a total of 56), which limits our analysis of buyer characteristics, and that we have relatively little information about the sellers in our sample. For example, we do not have information on the industry of the seller. Unfortunately, we have no way of getting more data. Because our buyers are mostly large firms we are less likely to pick up the financing motive as strongly as in earlier work (although we do have a mix of investment and non-investment grade buyers), but this allows us to focus on other non-financing motives.

We start by summarizing typical trade credit contracts terms, such as number of discount days, discount rate, and net days, and analyze how they relate to buyer and seller characteristics. We then turn to analysis. We argue that while it seems hard to conclude that trade credit is primarily a cheap way for suppliers to provide buyers financing in our sample (most of our buyers are larger and better rated than our suppliers, and still get credit), non-financing motives seem to be operative. In particular, large, investment-grade buyers get long terms from small suppliers. We believe this is consistent with relatively untrusted suppliers extending longer terms to buyers to guarantee product quality. However, this leaves suppliers exposed to riskier credits. This is where discounts help. Riskier buyers are offered discounts to repay early so that suppliers can offer warranties about the quality of the product supplied even while containing the credit risk in their trade credit portfolio.

The paper continues as follows. In section 2 we review theories of trade credit, and we describe our data set in section 3. In section 4, we present the empirical results, and we conclude in section 5.

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# **2. Theories of Trade Credit**

Before we present the data, it might be useful to outline various theories of trade credit. Much of the work on trade credit has seen it as a _form of financing_ that can overcome traditional impediments in financing. In particular, the seller may know more about, and have more clout over, the buyer than other arm‘s length financiers (see, for example, Smith, 1987; Brennan et al., 1988; Petersen and Rajan, 1997; Biais and Gollier, 1997; and Burkart and Ellingsen, 2004). Therefore trade credit may be available when other forms of financing are not. Much of this literature argues that large, high credit quality suppliers have a comparative advantage in obtaining outside finance and pass on this advantage to small, credit constrained buyers (e.g., Boissay and Gropp, 2007). Similarly, large suppliers may act also as liquidity providers, insuring buyers against liquidity shocks that could endanger their survival (see, for example, Cunat, 2006). They may also be better able to extract value from the liquidation of assets in default, generating demand for trade credit from credit constrained buyers (Petersen and Rajan, 1997; and Fabbri and Menichini, 2010). Or, as in Burkart and Ellingsen (2004), receivables may be used as collateral for bank credit, improving the buyer and supplier‘s combined access to finance.

Nevertheless, previous studies and our own also suggest that trade credit is not only used to finance credit constrained firms.<sup>1</sup> For instance, large, listed, multinational firms around the world, which are unlikely to face financing constraints in the market, hold large volumes of accounts payable on their balance sheet (e.g., Demirguc-Kunt and Maksimovic, 2005). Globally, it is estimated that trade credit financed 90% of world merchandise trade in 2007, valued at about US$ 25 trillion dollars.<sup>2</sup> Why might large, investment grade buyers choose to use trade credit financing? Perhaps their suppliers have even cheaper access to financing, and a comparative advantage in passing it on (see Ng et al., 1999). However, many suppliers in our data set are much smaller than their buyers, and are unlikely to have access to cheaper financing.

> 1 In fact, Schiff and Lieber (1974) argue that risk management and inventory management decisions are often taken separately from financing decisions and by different units of the firm, and that consequently trade credit cannot be solely explained on financing grounds.

> 2 ―World Bank urged to lift trade credit finance,‖ _Financial Times_ , November 11, 2008.

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An alternative explanation is that large buyers have the _market power_ to extract favorable contract terms, which reduce their overall borrowing costs (see, for example, Giannetti, Burkart, and Ellingsen, 2011; and Fabbri and Klapper, 2009). Why small suppliers may want to borrow at high cost in order to provide such cheap financing seems less clear – could they not simply offer more of a price discount up front, without incurring the deadweight costs of intermediation? One reason may be that a country‘s laws may not allow a vendor to offer different prices to different clients.<sup>3</sup> To the extent that price discrimination is prohibited, variations in trade credit terms also offer opportunities for sellers to offer better terms to more important suppliers (e.g., Brennan et al., 1988). The market power explanation does suggest possible variation in contractual terms also: To the extent that a buyer is more creditworthy than a supplier and enjoys lower financing costs, he should prefer to obtain discounts for early payment (effectively, a price discount) rather than longer term financing.

Another non-financial reason for the use of trade credit is for the supplier to _warranty product quality_ to the buyer. To the extent that the buyer does not have to pay for a good until he has used or sold it satisfactorily, it allows him time to verify the quality of the good before deciding whether or not to make payment and accept the merchandise (see, for example, Lee and Stowe, 1993; Long et al., 1993; and Antras and Foley, 2011). The time that buyers need to verify quality may then determine the duration of trade credit. For instance, perishable goods bought by small suppliers may take a relatively short time to verify. In contrast, durable goods bought by cross-border large buyers, who take more time to distribute to their outlets, may require longer payment terms.<sup>4</sup> Finally, given non-financial reasons for extending trade credit, _financial risk management_ might dictate at the margin what terms are set. For instance, suppliers may be more willing to trust large investment grade buyers with longer terms. Trade credit terms can also be set by suppliers as a screening mechanism to gauge buyer default risk (see, for example, Mian and Smith, 1992; and Frank and Maksimovic, 2005). In particular, sellers can reduce payment risks

> 3 For example, the Clayton Act in the US prohibits price discrimination across customers for the same good.

> 4 Of course, a supplier who is in a repeated relationship with a buyer may have incentives to deliver quality. Even so, trade credit could save on transactions costs, with the buyer paying only for what meets the quality hurdle (or the time specified for sales as in consignment sales).

5
through two-part payment terms, such as early payment discounts to incentivize buyers to pay early (e.g., Ng et al., 1999).

In sum then, we see three important factors driving trade credit: 1) As a way for suppliers with cheaper access to credit to finance buyers; 2) As a means for the buyer to exercise market power and obtain favorable price discrimination; and 3) As a warranty assuring buyers of product quality. Given these three factors, terms may be influenced by the supplier‘s need to contain financial risks.

Our data set is unique in that we know some characteristics of the parties on either side of the contract. So we can take a closer look at these rationales for trade credit, focusing on how contract terms vary with characteristics of the parties to the contract. The limitations of our data set are that we do not have detailed characteristics on the firms, and we have no way of getting more data. Therefore our tests are reduced-form in nature, allowing us to document associations but not identify causality. Nevertheless, what we can tease out is intriguing.

# **3. Data, Summary Statistics, and Variance Decomposition Analysis**

We use a novel database of trade credit contracts for nearly the universe of suppliers of 56 large buyers.<sup>5</sup> The data are provided by PrimeRevenue, an online network that links large, global companies, their suppliers, and third-party financial institutions, via the Internet. PrimeRevenue provides software and an IT platform for buyers to post their invoices directly. Suppliers choose whether to be paid at the maturity of the contract or to have the contract ―factored out‖ and be paid immediately at a discount. PrimeRevenue is a leading provider of such ―open platform supply-chain finance (SCF)‖ solutions, allowing multiple banks to participate directly in a buyer‘s SCF program.

The buyers in our dataset are PrimeRevenue‘s clients. The data on the suppliers is collected from the buyers, who hold extensive information on their suppliers, including detailed information on their trade credit contracts. The suppliers sell mostly final goods (only 1% of

> 5 Because purchasing history is proprietary information, we do not know the identity of buyers in our sample. However, as discussed in this section, PrimeRevenue provided us with buyer characteristics (such as size, sector, and location) and informed us that almost all buyers in our sample are Global Fortune 500 companies.

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contracts are from sellers that produce intermediate goods), indicating that the buyers are mostly at the end of the value chain.

Our data is a snapshot of outstanding receivables as of December 1, 2005. Importantly, this snapshot is before PrimeRevenue started factoring the receivables.<sup>6</sup> Also, PrimeRevenue allows firms to post whatever trade credit contract they choose, and does not limit the choice to a set of standardized options for firms. Buyers generally post invoices for all ̳important‘ suppliers, which is estimated by PrimeRevenue to capture over 90% of total inputs to the buyer. Our database includes information for 29,019 contracts, the full set of contracts in PrimeRevenue at the time, which includes 56 large buyers and 24,140 suppliers. The data includes complete information on contract terms: the contract size, net days, discount days, discount, and currency in which the contract is denominated. Most buyers interact with most sellers only once, though there is a fraction of repeat buyers and sellers who have multiple buyers.

For buyers, we can control for firm size using buckets based on their total sales<sup>7</sup> , location (North America or Europe), sector, and whether the buyer is investment grade. For suppliers, we know their size (sales buckets) and whether the supplier is investment grade. Information is not provided on supplier location or sector, since 95% of buyers purchase inputs via local distribution centers to avoid any import duties, such as tariffs and taxes. Apart from missing information about net days for 832 out of 29,019 contracts, we have complete information on contract terms.

Empirical work on trade credit thus far has been hampered due to a lack of firm-level data on trade credit contract terms. Most studies have used the Federal Reserve‘s Survey of Small Business Finances (SSBF) database of U.S. firms, which has only limited data on credit terms and firm characteristics (e.g., Petersen and Rajan, 1997; and Giannetti et al., 2011). Ng et al. (1999), instead, uses survey level data on 950 listed U.S. firms to study the determinants and characteristics of trade credit contracts.

> 6 Unfortunately, we were unable to obtain repeated cross-sections or panels of data from Prime Revenue, because these are proprietary data. We obtained a single snapshot of data for the year 2005, prior to Prime Revenue starting factoring the receivables in 2006.

> 7 Buyer and supplier size buckets based on total sales are (in U.S. dollars): less than $0.1 billion; $0.1-2 billion; $2-7 billion; $7-10 billion; larger than $10 billion.

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Our dataset differs from ones used in the earlier survey based work by Ng et al. (1999), Giannetti et al. (2011) and others in several important ways. First, we use data from actual trade credit contracts rather than data based on survey responses, thereby mitigating the usual misreporting concerns associated with survey based data. Importantly, our dataset consists of trade credit contracts signed, while papers using the National Survey of Small Business Finance (NSSBF) database use trade credit contracts offered. Our dataset also covers a broader set of industries that includes technology firms, allowing for an analysis of trade credit contract terms across a broader range of industries, and includes trade credit terms not only for U.S. firms but also for international firms, allowing for a comparison of trade credit terms across different jurisdictions. Moreover, our dataset covers suppliers of all sizes, and not just small firms as in the SSBF. This is an important difference because the credit terms offered by large firms could be very different than those by small firms.

We begin by summarizing the main characteristics of buyers, suppliers, and contracts. Panels A and B of Table 1 show summary statistics of buyer and supplier characteristics. First, the buyers in our sample are very large – 33 out of 56 (or 59%) of buyers have over US$ 10 billion in sales and only one buyer has less than US$ 2 billion in sales.

The buyers are also creditworthy as measured by whether or not they are investment grade – about 75% of buyers in the dataset are investment grade. That we have mostly large, investment-grade buyers will make it harder to find evidence in this dataset of a financing motive for trade credit. We should, therefore, treat our results with appropriate caution.

Buyers are active in a range of industries, with the majority in retail industries. The sectoral distribution of buyers is: 16% in auto manufacturing, 13% in diversified retail, 29% in diversified manufacturing, 7% in retail groceries, 16% in retail hard goods, 11% in retail soft goods, 5% in technology, 4% in food and beverages, and 2% in the utility sector. The data encompasses only one firm in the utility sector and two firms in the food and beverages sector. Approximately 77% of buyers are from North America (the U.S. or Canada) and 23% of buyers are from Europe.

In comparison to the buyers, our suppliers are relatively small: 56% of suppliers have less than US$ 100 million in sales and only 11% of suppliers have more than US$ 2 billion in sales.

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Creditworthiness is also an issue for many suppliers, given that almost two-thirds of suppliers are not investment grade (meaning their credit rating is below investment grade or they do not have a rating).

In Table 1, Panel C, we present summary statistics of contract characteristics. We have a wide distribution of contract amounts (contract size) varying from about US$ 400 dollars to over US$ 4 billion dollars, with a median of about US$ 3.5 million dollars.<sup>8</sup> Contracts in our sample are generally very long in duration – the average net days is 59.2 and the median is 60 net days. About 75% of contracts in our sample have net days longer than 30 days, which is longer than the ̳typical‘ contract of 30 days previously shown in the literature (Ng, Smith and Smith 1999), possibly because our buyers are relatively large. For example, 20% of contracts have net days of exactly 30 days, 28% have net days of exactly 60 days, and 17% have net days of exactly 75 days.

About 60% of contracts in our sample are denominated in U.S. dollars, followed by almost 40% in euros; this is in line with the distribution of contracts among buyers in Europe and North America (41% and 59%, respectively, as shown in Table 1, Panel A).

In our sample, 13% of contracts (or 3,707 in total) offer early payment discounts.<sup>9</sup> We also examine the discount terms, including the discount and discount days (the number of days within which the buyer has to pay to obtain the discount). Almost two-thirds of discount days are 30 days or less, while 27% are between 30 and 60 days, and 9% are more than 60 days. Some terms seem very common; 20% of discount days are 10 days, 20% are 30 days, and 16% are 60 days. The most common spreads of net days less discount days are 1 day (34% of contracts with discounts), 30 days (29% of contracts), and 20 days (16% of contracts), with the majority (or 63%) of contracts having a spread of net days less discount days equal to or less than 20 days. The mean spread of net days less discount days equals 17 and the mean ratio of discount to net days is 63%.

> 8 The largest contract in our dataset is for a large, diversified U.S. retailer.

> 9 This is a comparable figure to that obtained using SSBF survey data on U.S. firms, indicating that 20% of firms that use trade credit are offered an early payment discount from their suppliers.

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That 30% of contracts have a spread of exactly one day might suggest that discounts can be used simply to encourage prompt payments, or as an implicit price discount, i.e. an alternative to a cut in list prices.<sup>10</sup> The mean and median discount rate is equal to 2%. Of contracts with discounts, 36% have a discount equal to 1% or less, 56% have a discount of 2% or less but exceeding 1%, and the remaining 8% have a discount greater than 2%.

Trade credit appears expensive for most buyers. The effective interest rate, defined as the implied interest rate if the buyer does not pay on the discount date, foregoes the discount, and pays on the due date, is  1 1(  _discount rate_ )  360/( _net days_  _discountdays_ )  1. The average effective interest rate is high at 53%, though effective interest rates vary from a low of 2% to a high of 100%.

In Table 2, we show the distribution of contracts and buyers across buyer and supplier characteristics, indicating that the sample is well distributed across firms of different sizes and investment grade ratings. For example, while the majority of buyers are investment grade, there are still 14 (out of 56) firms that are not investment grade.

In Table 3 we present the distribution of contract terms by buyer and supplier characteristics. Larger buyers tend to make purchases with a wider range of contract size, including more frequent relatively small purchases of less than US$ 1 million in size. Across industries, auto manufacturing and retail hard goods have relatively larger average contract size, especially relative to technology, where almost 75% of contracts are less than US$ 1 million in size. We find no notable differences in contract size across buyer location or investment grade. In addition, large suppliers appear to make large sales, while whether a supplier is investment grade or not does not seem related to average contract size.

Contracts to the largest and most creditworthy buyers also entail longer maturities (net days). We find strong sectoral effects in the net days offered: 85% of contracts in retailing of soft goods have a maturity of 30 days or less, while other sectors have longer average maturities. Contracts to firms in Europe are on average longer than contracts in North America (although the sectoral distribution is relatively even across regions).

> 10 Anecdotally, large buyers do not pay late fees to their suppliers.

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Next, we focus on the decision to extend early payment discounts (Table 4). Statistics refer to the subsample of contracts that offer an early payment discount. Overall, 34 out of the 56 buyers (or 63% of buyers) are offered at least one early payment discount. In general, the buyers receiving a discount are small and non-investment grade, while suppliers offering a discount tend to be larger and are roughly equally likely to be investment or non-investment grade. Suppliers are also most likely to offer discounts to buyers that retail in hard goods. 22 buyers are never offered discounts (including all buyers in the food and beverages, technology, and utility sectors). In the empirical analysis of this paper we therefore also check how the results look if we drop the firms who never report discounts.

Discounts do not appear strongly related to buyer or supplier characteristics, with the exception that higher discounts (>2%) are more common in the auto industry and among grocery firms. Discount days, the number of days the buyer has to pay and receive a discount, appears strongly related to buyer size – 78% of firms with less than US$ 10 billion in total sales have discount days of 30 or less, while only about 64% of firms larger than US$ 10 billion in size receive a short discount window. The mean of net days is 60 days for contracts without discounts and 44 days for contracts with discounts, suggesting that suppliers offer trade discounts in association with shorter net days.

Importantly, our database also allows for both supplier and buyer fixed effects. About 25% of suppliers (or 7,273 suppliers) sell to multiple buyers. Of these, 3,126 suppliers sell to 2 buyers and 4,147 suppliers sell to 3 or more buyers. In addition, 16% of suppliers (or 4,557 suppliers) have more than one contract with the same buyer. Specifically, 2,685 suppliers have exactly 2 contracts with a buyer, and 1,872 suppliers have 3 or more contracts with a buyer. In general, we find variation in net days and the decision to extend an early payment discount across contracts of a single supplier.

The summary statistics and correlation matrix of the main regression variables are presented in Tables 5 and 6. We find that the correlation between supplier investment grade and supplier large size is not high at 0.2, and that the correlation between buyer investment grade and buyer large size is close to zero (these calculations treat unrated firms as non-investment grade firms because the data do not allow us to distinguish between non-investment grade and unrated).

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These low correlations reduce concerns about potential multicollinearity problems in our regressions.

Next, we conduct a variance decomposition analysis of our main outcome variables of interest: log of net days, the discount dummy (equal to one if a discount is offered), and the effective interest rate. In earlier work, Ng et al. (1999) argue that most of the determinants of trade credit contracts are sector driven. The variance decomposition results presented in Table 7, Panel A confirm this: net days and discounts (and to lesser extent interest rates) are mainly driven by buyer industry characteristics.

Of course, the supplier characteristics we have are coarse, and do not include the supplier industry. Because the suppliers are smaller and hence likely to be more narrowly focused, their industry is likely to carry more information about trade credit terms. One way to explore the effect of inclusion of detailed supplier characteristics is to include supplier fixed effects. This will allow us to check whether credit terms of a given seller vary across buyers. Specifically, we compute the contribution of buyer characteristics in explaining the variance of contract characteristics that remain after controlling for supplier fixed effects, for the sellers with multiple contracts. The results are in Table 7, Panel B.

They show that buyer characteristics explain only a small fraction of the variation in net days and interest rates once the variation in credit terms from supplier characteristics has been fully accounted for, indicating that the credit terms offered by a given seller do not vary much across buyers (and that the narrower seller‘s industry probably subsumes much of the variation in the buyer‘s industry). However, buyer industry characteristics remain an important determinant of the variation in discounts of a given seller across buyers, even after controlling for supplier fixed effects. The results suggest that a seller may offer discounts selectively across buyers, even if other terms like the duration of credit may be largely determined by the seller‘s characteristics. This willingness to be selective in discounts will be important in our explanation of its purpose.

# **4. Characteristics of Contracting Parties and Regression Analysis**

Let us now examine the determinants of contract terms more explicitly, starting first with the explicit duration of contracts, that is, net days.

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of contracts. The second columns in each of these pairs excludes credit contracts with discounts, so as to correct for the possibility that net days on two-part contracts vary systematically from those of simple contracts without discounts – however, the estimates excluding contracts with a discount do not seem to be qualitatively different.

Our industry classifications are very broad. Nevertheless, we find buyers in industries with substantial turnover and where goods are more likely to be perishable (groceries, soft goods), tend to have shorter net days. This is consistent with trade credit as a warranty of quality. Utilities also tend to have lower net days, which would be consistent with trade credit as a warranty if utilities primarily buy fuel, whose quality is easily assessed.<sup>11</sup> Consistent with Figure 1, we find that longer net days are offered to significantly larger, investment grade buyers (Table 8, Columns 1-2). The magnitude of these effects is sizeable. For example, from the estimates in Column 2, a buyer who is large gets 9.8 longer days than the mean of 59 days. Similarly, a buyer who is investment grade gets 7.5 longer days than the mean net days.

We also find that net days are shorter for buyers located in North America (the majority of which are located in the US) relative to buyers located in Europe. One potential explanation for this result is that sales in Europe are often cross-border in which case buyers may demand longer days to protect against damaged goods and avoid having to challenge suppliers in foreign courts.

When we include buyer fixed effects (Table 8, Columns 3 and 4), we find that longer net days are significantly more likely to be extended by smaller suppliers and by investment grade suppliers, again consistent with Figure 1. When we include supplier fixed effects (thus focusing on the subsample of suppliers with multiple contracts within or across buyers), we continue to find that larger and investment grade buyers get longer net days (Table 8, Columns 5 and 6).

The evidence thus far is consistent with trade credit as a way to warranty product quality – the easier verifiability of the quality of supplies to buyers running high turnover businesses

> 11 We should be cautious about over-interpreting the effect found for the utility sector because it is based on observations from only one firm.

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with perishable inputs would justify the short duration credit extended to these businesses, while the long time period before cross-border buyers get to use shipped goods justifies the longer terms extended to them.<sup>12</sup> That investment grade suppliers, who presumably have greater access to finance, extend longer net days is consistent with the financing explanation. However much of the evidence cannot be reconciled with the financing explanation. We have seen that large, investment grade buyers get longer net days, while the financing argument would suggest that smaller, higher credit risk buyers should get longer term financing. Also small suppliers tend to offer longer term credit, which again is inconsistent with the financing story. These results may be more consistent with the market power rationale for trade credit – large, investment grade buyers would typically have more power over small suppliers and be able to demand better terms from them. They are also consistent with the warranty rationale – small suppliers may be relatively unknown, and have to offer longer term credit to persuade buyers to take their products.

Finally, given some underlying rationale for extending credit (such as its value as a warranty of product quality) the evidence is also consistent with a risk management explanation. Suppliers are willing to trust larger investment grade buyers with longer-term credit because they are less likely to default.

# **_4.2 Buyer-supplier Pairs_**

Perhaps we can shed more light on the alternative explanations for trade credit by looking more closely at buyer-supplier pairs more carefully, correcting for buyer fixed effects. The financing explanation would suggest that large investment grade suppliers should extend longer terms to small non-investment grade buyers than should small non-investment grade suppliers. The bargaining power explanation would suggest that small suppliers should extend longer terms than would large suppliers, especially to large buyers. To the extent that the primary factor driving trade credit is its use as a warranty of quality, and to the extent that larger buyers take longer to use a product and test its quality, while small suppliers have a greater need to establish

> 12 It could also be argued that buyers may have to raise the money needed to pay for shipped goods by selling them, so they need to be financed until that happens. However, this would not explain why the largest buyers, who presumably have the easiest access to financing, get the longest term credit.

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product quality, this is another reason why small suppliers should extend longer term credit to large buyers. Finally, whatever the reason suppliers extend credit, small non-investment grade suppliers have the least ability to sustain credit losses, and would have the greatest preference for mitigating risk by reducing the length of credit, especially to small, non-investment grade buyers. Of course, these theories need not be mutually exclusive.

In Table 9, we explore these possibilities by including buyer fixed effects, and various interaction effects in the regression explaining log net days. In column 1, we include interactions between the supplier‘s size and the buyer‘s rating. Large- and medium-sized suppliers offer significantly shorter terms than small suppliers (the omitted category) to non-investment grade buyers, while their terms are longer, but still less than those offered by small suppliers, for investment grade buyers. Thus small suppliers offer relatively the longest duration credit, especially to low credit quality buyers.

In column 2, we see that medium-sized suppliers are significantly less likely than small suppliers to extend credit to small buyers, while large-sized suppliers are significantly less likely than small suppliers to extend credit to large buyers. Small suppliers seem therefore to extend longer credit than larger suppliers, no matter what the size or investment rating of the buyer.

In column 3, we see that investment grade suppliers offer shorter terms to non-investment grade buyers than do non-investment grade suppliers, while they offer longer terms to investment grade buyers than do non-investment grade suppliers. Again, it seems that non-investment grade suppliers are forced to provide longer terms to less creditworthy buyers.

In sum, small suppliers offer the longest terms, which is consistent with them being squeezed by more powerful buyers for more credit, or with them having to post a stronger performance bond. That small, non-investment grade suppliers offer relatively more credit to non-investment grade buyers than to investment grade buyers suggests they are forced to extend credit to risky buyers, even when suppliers with greater access to finance are not.

Not all the evidence goes against the financing explanation though. When the supplier is investment grade and therefore has greater access to financing, it seems to be willing to lend longer, except to non-investment grade buyers. For instance, investment grade suppliers do lend 16
longer to investment grade buyers than do non-investment grade suppliers (column 3). Also, investment grade suppliers offer longer terms to small buyers than do non-investment grade suppliers, while the differences narrow for larger buyers (column 4).

In column 5, we include all the explanatory variables in the previous columns, and while the coefficient estimates of the interaction terms are typically smaller, the signs are unchanged.

We have to recognize the dangers of drawing overly strong conclusions, given that our buyers are, for the most part, billion dollar companies. This is likely to be a sample where the financing motive for trade credit is least likely to be operative. Nevertheless, it is telling that our strongest finding runs against the grain of the financing theory: Even after correcting for buyer fixed effects, small suppliers extend the longest credit, even to small, non-investment grade buyers. Perhaps then, our sample allows us to highlight the non-financial motives for trade credit; the need to offer better terms to powerful buyers, and the need to signal product quality.

Interestingly, though, given a non-financial motive to extend credit, credit is naturally longest when the cost of giving it is low – when the buyer is investment grade and the supplier is investment grade.

# **_4.3 Discounts_**

To throw further light on the motivations behind trade credit, we examine the sample of contracts that include an early payment discount. The view that discounts are used as a screening mechanism to reduce buyer default risk would suggest that smaller and non-investment grade buyers, where default risk tends to be higher, would more likely receive discounts. To the extent that it is easier for large rated suppliers to diversify or otherwise absorb default risk, this view would also suggest that small unrated suppliers are more likely to extend discounts.

Discounts also allow us to shed more light on the bargaining power explanations. If trade credit is a means for large powerful buyers to effectively extract better prices, we should also see the following: Because it is costly for small unrated suppliers to extend long term trade credit, and because longer term credit is of least value to large rated buyers, who can get financing elsewhere, we should see the large buyers translate their bargaining power into shorter terms and a discount for early payment.

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Finally, to the extent that longer trade credit is a way for the supplier to guarantee product quality, we should see small young suppliers, who might suffer the greatest distrust of the quality of their product, most reluctant to offer discounts for early payment. Thus the data on early payment discounts might shed light on the relative merits of the non-financing explanations.

We start by charting the average number of contracts with discounts for suppliers and buyers of different characteristics. We only consider the 34 buyers who receive at least one discount (it may be that the remaining buyers do receive discounts but do not report them, and therefore we do not consider the data reliable for them).<sup>13</sup> Suppliers offer discounts for early payment more frequently to small buyers (Figure 2a and 2c) as well as to non-investment grade buyers (Figure 2b and 2d), consistent with the use of discounts as a way to mitigate the risk of default. Unlike the predictions of the bargaining power theory, however, small suppliers are least likely to offer early discounts to large buyers. Instead, they seem to conserve discounts and offer relatively more to small and non-investment grade buyers (Figures 2a and 2c). A similar pattern can be seen for non-investment grade suppliers – discounts are targeted at riskier buyers.

> 13 Our main results are robust to the inclusion of these buyers in the model that includes supplier fixed effects and adjusts standard errors for clustering at the buyer level. Buyers who never offer discounts are dropped from the model that includes buyer fixed effects.

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We turn next to regression analysis. In Table 10, we present logit regressions of determinants of early payment discounts for the subsample of contracts that offer early payment discounts. The dependent variable takes value 1 if the contract includes a discount (two-part contract), and 0 otherwise. We focus on the regressions for buyers who have at least one discount (columns 2, 3, and 5), though for completeness, we also present regression results for the complete sample of buyers (in columns 1 and 4).

Let us focus first on the regression estimates with supplier fixed effects in column 5. Large buyers get significantly fewer contracts with discounts, and investment grade buyers are also less likely to get discounts for early payment. Discounts also tend to be industry-specific, with discounts being more common for buyers in the groceries sector, where goods tend to be perishable. These findings are consistent with the theory that trade credit is a way to guaranty product quality. Turning next to the estimates with buyer fixed effects in column 3, we find that large and medium-sized suppliers give significantly fewer discounts than small suppliers.

That early payment discounts are more common from small suppliers is consistent with the market power hypothesis, except that these discounts go more to small and non-investment grade buyers **.** The finding is more consistent with the risk management view that stipulates that smaller suppliers are more likely to offer discounts to risky buyers as a way to encourage early payment and prevent default because it is more difficult for these firms to absorb and diversify default risk.<sup>15</sup>

# **5. Concluding Remarks**

The bilateral, multi-contract nature of our dataset is truly unique and is a major improvement on (generally survey based) datasets that have previously been used to study the determinants of credit terms used in trade credit. This multi-contract structure of our dataset allows us to abstract from unobserved buyer and supplier firm characteristics, something previous empirical work has not been able to do.

> 15 We could also examine buyer-seller pairs as in Table 9, but the smaller number of observations on discounts renders much of the analysis statistically inconclusive.

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We find that the largest and most creditworthy buyers receive contracts with the longest maturities, as measured by net days, from smaller suppliers. This is consistent with a market power explanation (smaller suppliers are squeezed more by large buyers) as well as the view that credit may be a means for small suppliers to warranty quality to their large buyers. However, if the buyer‘s bargaining power is the primary rationale for trade credit, it is puzzling that the large rated buyers do not swap the credit (which the supplier can ill afford and the buyer does not need) for a discount. Instead, it is the small unrated buyer who typically gets the discount. One explanation is that there may be non-financial intrinsic value in trade credit – for example as a warranty of product quality – that is lost when the buyer is offered and takes a discount. Nevertheless, trade credit discounts may still be offered to the riskiest buyers in order to reduce the overall risk of the supplier‘s credit portfolio, and achieve an optimal mix of warranty and risk.

Clearly, more work is needed to put these conjectures on firmer footing. Nevertheless, our work provides more evidence that the motivations for trade credit are both intriguing and suggestive of the richness of financial contracting.

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