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Asian Review of Financial Research Vol.32 No.2 pp.309-349
Effects of Financial Vulnerability and Macroeconomic Shock on Firms' Working Capital Management : Empirical Analysis of Business Operations and Trade Credit Financing in Korea
Yong-Jun Cho* Ph.D. Candidate, Department of Business Administration, University of Seoul Director of Research Center, Hana Financial Investment
Byung-Uk Chong Professor of Finance, College of Business Administration, University of Seoul
Key Words : Financial Vulnerability,Macroeconomic Shocks,Working Capital Management,Short-Term Debt Financing,Trade Credit Financing


Trade credits are offered by suppliers in the form of allowances for buyers to postpone their payments. Trade credits are non-market-based bilateral debt contracts between buyers and sellers, and these contracts incur higher costs of debt than market-based short-term financing sources such as bank financing and commercial paper. Trade credit financing is generally assumed to be more expensive than bank financing, as trade credit is commonly requested by credit-constrained borrowing firms. Another prevailing assumption is that reliance on trade credit financing tends to increase with the degree of credit rationing on financially constrained firms following adverse macroeconomic shocks. In the fields of corporate finance and financial intermediation, the question of how firms choose their financing sources has become increasingly important for researchers. Clearly, different sources involve different kinds of risk, and choices are made under conditions of information asymmetry in financial markets. In line with traditional research in this area, this paper examines how firms conduct trade credit financing in response to both macroeconomic and microeconomic factors, and it tests the substitutability and complementarity of bank financing and trade credit financing. The existing literature on trade credit financing suggests two main views on trade credit channels, namely the “substitution view” and the “complementarity view.” The substitution view posits that trade credit is a substitute for market-based, short-term financing sources such as bank revolving lines or commercial paper. Reliance on trade credit is more likely when the borrowing firms are constrained in their access to these market-based, short-term financing sources. Under such constraints, firms commonly turn to substitute sources of financing, such as trade credit. In this sense, trade credit and market-based financing are substitutes, and we can expect that trade credits will be more commonly used by firms under financial distress or in times of economic shocks, e.g., financial crises. The complementarity view holds in situations where the supply of trade credit and the access to bank financing or capital market funding are linked. When financial intermediaries are more effective in screening and monitoring the borrowing firms, financial intermediaries can provide financing directly to firms operating in capital markets. However, when the suppliers are more efficient in screening and monitoring, or in enforcing debt contracts, it may be optimal for these financial intermediaries to offer financing to the suppliers, who then relend to the purchasing firms. Such efficiency may arise if the suppliers have proprietary information about the purchasing firms, if they can threaten to suspend future deliveries, or if their opportunity costs for any repossessed inventory are higher than the costs of financial intermediaries. In some sense, non-financial suppliers act as “agents” for financial intermediaries. The main question raised in this paper is why financially vulnerable firms rely more on trade credit financing, even when seemingly cheaper sources of financing (such as bank revolving lines and commercial paper) are available in the short-term debt markets. In particular, our paper investigates how financial vulnerabilities and macroeconomic shocks operate in both separate and combined ways to affect firms' choices for trade credit financing. This paper uses CP spread as a measure of credit crunches in short-term debt markets. In addition, the 2008~2009 global financial crisis is used as a natural event study factor, which represents an example of an extreme macroeconomic shock to both domestic and overseas financial markets. The effects of both CP spreads and macroeconomic shocks on trade credit financing are estimated. The empirical results show that adverse macroeconomic shocks increase trade credit financing, which is measured by accounts payable relative to sales. These results imply that trade credit financing may offset the contraction of bank financing, which can be triggered by adverse macroeconomic shocks and credit crunches in the Korean economy. In other words, trade credit financing can function as a financing instrument that can absorb macroeconomic shocks, thereby serving to maintain business operations and enable the management of working capital. Our paper also examines the effects of various firm-level financial vulnerabilities on trade credit financing. Following previous studies, we consider financial vulnerability factors, including the Whited-Wu index and the dividend payout ratio, both of which indicate the degrees of financial constraint. We also consider the modified Altman Z score and the default likelihood Indicator, both of which indicate the degree of financial distress. The empirical results show that financial vulnerability factors increase firms' reliance on trade credit financing. Overall, our paper's findings indicate that under conditions of macroeconomics shock, financially vulnerable borrowing firms are inclined to increase their reliance on trade credit financing. This evidence supports the hypothesis that trade credit financing serves as an alternative source of short-term corporate debt financing for financially vulnerable firms that are facing credit crunches. Our results suggest that trade credit financing plays a key role in helping firms to flexibly maintain their business operations and manage working capital under conditions of financial constraint or distress, such as those following macroeconomic shocks. Moreover, this paper provides evidence that the interactive effects of macroeconomic shocks and financial vulnerabilities tend to stimulate trade credit borrowing (i.e., accounts payable relative to sales). This pattern implies that firms are commonly forced into reliance on trade credit financing when adverse macroeconomic circumstances render them financially vulnerable.
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