A note on the price of trade credit

Abstract

Purpose

In contrast to common literature that suggests that trade credit is an extremely expensive source of financing with annual interest rates exceeding 40 percent, this paper seeks to argue that the average interest rate of trade credit does not exceed the cost of alternative funds, thereby explaining why trade credit constitutes a substantial part of the optimal financing mix of large, liquid, and capital market listed firms.

Design/methodology/approach

Besides providing a formula for estimating a firm's actual trade credit interest rate, this paper is mainly based on a descriptive analysis of trade credit use as well as on survey results of a broad range of prior studies.

Findings

The paper finds that highly liquid firms use substantial amounts of trade credit, thus indicating that trade credit use per se cannot be as expensive as literature supposes. In line, estimated average interest rates are about 4 to 6 percent.

Originality/value

By arguing that actual cost of trade credit use is far from being as high as literature supposes, this paper provides important implications for optimal short‐term financing strategies as well as for the assessment of trade credit use in credit worthiness analyses.

Citation

Chludek, A.K. (2011), "A note on the price of trade credit", Managerial Finance, Vol. 37 No. 6, pp. 565-574. https://doi.org/10.1108/03074351111134754