The Impact of Working Capital Financing Costs on the Efficiency of Trade Credit

Abstract

One of the arguments given to explain the widespread use of costly trade credit in supply chains is that trade credit enhances efficiency by resolving moral hazard problems. In this paper, we consider the impact of demand shocks on this efficiency role of trade credit. We show that as the probability of a negative demand shock increases, the amount of trade credit necessary to resolve moral hazard also increases. In other words, as economic conditions weaken (i.e. as the probability of low demand increases), more trade credit is required to coordinate the supply chain. The working capital financing costs associated with trade credit can impose a burden that makes it infeasible to coordinate the supply chain. We show that an appropriately designed reverse factoring program can provide suppliers with access to inexpensive credit necessary to finance the working capital associated with trade credit and restore supply chain efficiency.