Trade credit and the speed of leverage adjustment

Abstract

Purpose

The purpose of this paper is to examine the impact of trade credit on the speed of adjustment (SOA) of short-term leverage. Bankruptcy cost is higher for over-levered firms, generating a good incentive to use trade credit as a lower cost substitute; hence, firms adjust capital more quickly.

Design/methodology/approach

Firm-level data are used from five countries, in two different economic orientations, during the period 2000–2017: bank-oriented economies include France, Germany and Japan, and market-oriented economies include the UK and the USA. First, using the two-step GMM the study estimates the target short-term leverage ratio. Then, it examines the impact of trade credit on the SOA of the actual leverage towards the target leverage ratio.

Findings

It finds a positive impact of a low amount of trade credit (high capacity) on the SOA for over-levered firms. This is in line with the substitution effect, where the bankruptcy cost is higher for over-levered firms, which leads them to substitute bank loans with trade credit.

Research limitations/implications

The study uses data from publicly traded firms; data from non-listed and small firms may be considered as a good opportunity for future research.

Practical implications

The policy implication that can be derived from the empirical results is that firms’ management should recognise the relationship between trade credit and deviation from target short-term leverage. During periods of high short-term leverage firms should use trade credit as a source of finance when adjusting the short-term leverage towards the target ratio.

Originality/value

This study is the first to examine the influence of trade credit on the SOA.

Citation

Abuhommous, A.A. (2021), "Trade credit and the speed of leverage adjustment", Management Decision, Vol. 59 No. 8, pp. 1915-1928. https://doi.org/10.1108/MD-04-2019-0530