Reducing Risk through Trade Credit: Theory and Evidence from Dual-Channel Suppliers

<p>Trade credit is traditionally viewed as increasing supplier risk, because delayed payments expose suppliers to buyer uncertainties.&nbsp;</p> <p>Using a stylized game-theoretic model, we show that this conventional wisdom can be overturned when a supplier is dual-channel: operating a direct channel that sells to end customers in addition to an indirect channel that sells to an industry peer who serves the same market. Compared with zero trade credit provision where the supplier requires cash on delivery (COD), we observe empirically that high trade credit provision can lead to lower risk for the dual-channel supplier.&nbsp;</p> <p><span>We propose a possible mechanism for this risk mitigation effect--pooling: When the market overlap between the supplier and its peer buyer is sufficiently high, the random split of the overlapping market creates negative association between the supplier's direct channel sales and the buyer's trade credit payment. Trade credit does not always mitigate risk for dual-channel suppliers. If the supplier's debt level is high, our theory predicts that trade credit exacerbates risk.&nbsp;</span></p> <p>We find empirical evidence consistent with our theoretical predictions using data on U.S. manufacturing firms that sell to their industry peers. The positive association between trade credit provision and bankruptcy risk is dampened or even reversed once a supplier begins selling to peer firms. This risk mitigation effect is stronger among suppliers with lower leverage and greater market overlap with their buyers. For highly financially constrained suppliers, trade credit provision is associated with an increase in bankruptcy risk after the supplier becomes dual-channel.</p>