The Insurance Value of Trade Credit

Abstract

The extensive use of trade credit in all manufacturing sectors, despite its high cost, is an apparent puzzle that economists explain in terms of asymmetric information problems affecting financial markets. The financial constraints arising from credit rationing and limited access to stock markets suffice to induce firms to resort to trade credit as a supplemental source of funding. Nonetheless, empirical evidence shows that also large and liquid firms facing no binding financial constraints use substantial amounts of trade credit. We address this issue by modelling the financial policy of a firm that does not face a binding liquidity constraint but the risk of being constrained in the future. We characterise the optimal amount of trade credit held by such a firm, and we show that a positive probability of facing a liquidity constraint leads the firm to fund its inventories with trade credit, even if cheaper sources of funds are available. The rationale is that trade credit provides implicit coverage against liquidity risk. Therefore, the optimal amount of trade credit grows with the expected size of a possible liquidity shock and with the likelihood of its occurrence.