DETERMINANTS OF ACCOUNTS RECEIVABLE AND ACCOUNTS PAYABLE: A CASE OF PAKISTAN TEXTILE SECTOR

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1 DETERMINANTS OF ACCOUNTS RECEIVABLE AND ACCOUNTS PAYABLE: A CASE OF PAKISTAN TEXTILE SECTOR MUBASHIR ALI KHAN (Corresponding Author) MS Scholar Sukkur Institute of Business Administration Airport Road Sukkur, Sindh, Pakistan GHULAM ABBAS TRAGAR MS Scholar Sukkur Institute of Business Administration Airport Road Sukkur, Sindh, Pakistan NIAZ AHMED BHUTTO Associate Professor Sukkur Institute of Business Administration Airport Road Sukkur, Sindh, Pakistan Abstract The objective of this study is to analyze the determinants of Pakistani listed companies accounts receivable and accounts payable focusing the textile sector. It is evident from the findings that accounts receivable are strongly affected by the firm s incentive to use trade credit as a means of price discrimination and level of internal financing. Additionally, the size of the firm also affects the level of accounts receivable a firm maintains. Whereas, most significant determinants of accounts payable are size of the firm, level of purchases and market interest rate. Keywords: Trade Credit, Price Discrimination, Accounts Payable, Textile Sector 1. INTRODUCTION In corporate finance trade credit has been supposed to be a nonissue for a long time, at least in the context of perfect markets (Sartoris and Hill, 1988). Nevertheless, it is observed that a significant quantity of cash is invested in accounts receivable and an enormous amount of accounts payable, as a source of financing in nearly all non-financial firms (Deloof and Jegers, 1999). Significance of trade credit differs among the countries and it is expected to be higher in the countries which produce more manufacturing products, although there is substantial difference across them (Marotta, 1998). Rajan and Zingales (1995) compared non-financial companies in the G7 countries and found that relative part of accounts receivable differs between 29% Italy and 13% Canada, on the other hand, the respective limits for accounts payable were 17% France and 11.5% Germany. Mian and Smith (1992) reported that in 1986 US manufacturing firms had 21 percent of accounts receivable of their total assets and about 40% of account payable of their total liabilities. Deloof and Jegers, (1999) reported that in 1995 Belgian non-financial firms accounts receivable were 16% of total assets, and 240

2 accounts payable 12% of total liabilities. Several studies have been conducted to simply analyze the existence of trade credit (see a.o. Schwartz, 1974; Feriss, 1981; Frank and Maksimovic, 1998; Long, Malitz and Ravid, 1993; Brennan, Maksimovic and Zechner, 1988; Brick and Fung, 1984; and Emery, 1984 and 1987), but very few studies have discussed the reason behind the trade credit is offered or which corporations use it or delivers it most (Petersen and Rajan, 1997). Storey (1994) analyzed earlier work on the financing patterns of UK small companies and found that for small firms trade credit is more valuable than for large firms. Whereas Walker (1991) investigated the US small firms and found that US small firms are also relying on trade and bank credit and these two financing sources are being used as substitutes. Furthermore, it is always argued that borrowing at rational rates is an issue for corporate decision makers. Berger and Udell (1998) suggested that when borrowing outside the firm, small firms face particular restrictions. Borrowing a small amount of capital from external capital markets becomes their obstacle, which is usually called as Macmillan gap, and for this reason they are being offered higher interest rates (Storey, 1994). While market imperfections, just as, agency costs and asymmetric information, are the reasons of these issues as proposed by several economic theorists. Even risky debt has a preference when information asymmetries are not favorable. Mayers (1984) pointed out this situation as pecking order theory of financing in which a firm first raises capital internally by reinvesting its net income and selling off its short-term marketable securities. When that supply of funds is exhausted, the firm will issue debt and perhaps preferred stock. Only as a last resort will the firm issue common stock. Whereas, it has also been reported by several studies that close bank-borrower association improves credit accessibility (Niskanen and Niskanen, 2006). Other studies propose that the availability of credit is affected positively by bank-borrower relationship (Petersen and Rajan, 1994). 2. LITERATURE REVIEW Danielson and Scott (2004) investigated the effect of bank loan availability on the trade credit and credit card demand of small firms and found that firms increase their demand for trade credit and credit card debt when facing credit constraints are imposed by banks. Deloof and Jegers (1999) investigated the role of trade credit as source of financing for Belgian firms focusing accounts payable and found that trade credit plays a significant role in the corporate financing policy. They found that the amount of trade credit a customer takes is determined by the need for funds and by the internally available funds. Finally they found that trade credit can act as a vital substitute for short term as well as long term financial debt. Atanasova (2007) tested for the existence of credit 241

3 constraints and their effect on the corporate financing policies and found that credit constrained firms substitute trade credit to institutional finance especially during tight money periods. Huyghebaert (2006) tested hypothesis that why firms use trade credit on business start-ups and find that more trade credit is used when firms face financial constraints and suppliers have a financing advantage over banks in financing high risk firms. Niskanen and Niskanen (2006) analyzed credit policies of Finnish small firms functioning in bank dominated environment. Creditworthiness and access to capital markets were found as important determinants of trade credit extended by the sellers. Firm s age, size and level of internal financing were found to be negatively correlated to the trade credit usage, whereas level of current assets to total assets and loan availability were found negatively correlated with the trade credit usage. In addition to it, the level of purchases was found positively correlated with level of accounts payable. Niskanen and Niskanen (2000b) analyzed the accounts receivable and accounts payable of Finnish listed firms and found that accounts receivable are most likely to be influenced by the firms incentive to use trade credit as a means of price discrimination. Through increased demand for the trade credit level of accounts receivable increases with the increase in the interest rate level. Additionally, they found that the level of accounts payable is affected by the firm size, supply of trade credit, interest rate level, the ratio of current assets to the total assets, and insufficient internal financing. Blasio (2005) tested the Meltzer (1960) trade credit bank credit substitution hypothesis on Italian manufacturing firms inventory behavior and found that during money tightening Italian manufacturing firms are more constrained than normal macroeconomic conditions. 3. THEORIES AND EMPIRICAL EVIDENCES ON TRADE CREDIT Various theoretical studies have tried to investigate the reason of providing intermediary services by suppliers to their customers and to find out the rationale to use trade credit as a substitute of less costly bank debt Transaction Costs Transaction Costs have been declared to be one rationale to sustain credit sales. Transaction costs theory describes that paying at once for several shipments collectively saves transaction costs and permits flexibility in payments (Ferris, 1981).Furthermore, money can be saved by keeping smaller cash balances Financial Models Financial models are based on capital market imperfections concerning information asymmetries. These imperfections lead to the phenomena in which firms, with lower cost of financing due to their better access to capital markets, tender trade credit to other financially constrained firms (Schwartz, 1974). Furthermore, trade 242

4 credit facilitates firms to support the growth of their clients. It is also believed that trade credit can serve to alleviate credit rationing problems as trade credit plays as a signal on the buyers good quality to the financially intermediary (Frank and Maksimovic, 1998; Biais and Gollier, 1997). Financial theory proposes that the seller has a lead over financial institutions in information gaining and controlling the consumer. In European countries, all these gains speak about the nearer and greater relationship between buyer and seller than between the financial institutions and buyers. That is supplier have a threatening tool to stop future supplies when consumer does not pay in time. On the other hand a financial institution may not have a device like this to have power over consumers, while warning to depart future lending may not have instant consequence on the consumers attitude (Petersen and rajan, 1997) Price Discrimination Price discrimination is a possibility of charging dissimilar prices for dissimilar consumers. This can happen in a situation when credit conditions include discounts on paying before time. These conditions are mostly presented by leading firms in the industry (Brennan et al., 1988; Mian and Smith, 1992). These firms have an advantage to collect extra sales to existing clients without decreasing price. As a result these firms extend high priced trade credit which is not acceptable for creditworthy customers. While for low rating companies this credit may be acceptable as it might be less costly than borrowing from financial intermediary (Brennan et al., 1988; Petersen and Rajan, 1997). Additionally, trade credit offers a facility to gauge the quality of products earlier than paying for it so this becomes an inherent guarantee for the seller s manufactured goods (Lee and Stowe, 1993). For small and less reputable sellers this facility of trade credit may have a great importance (Frank and Maksimovic, 1998) Macroeconomic Conditions Macroeconomic conditions have also an effect on trade credit usage and conditions which cannot be ignored and has been highlighted by many researches. Kashyap et al., (1993) investigated the effect of macroeconomic factors on trade credit and found that under restrictive monetary policy and controlled money supply smaller firms are ready to extend trade credit on the given conditions as increasing borrowing rates create trade credit a supplementary viable type of short term funding. Petersen and Rajan (1997) highlighted the same issue and found that firms extend trade credit when loan from financial intermediaries is not present. They further added that, in this scenario, the role of financial intermediary will be performed by larger suppliers as firms having no access to institutionalized financial markets will borrow from these larger firms. 243

5 4. DATA DESCRIPTION AND DEPENDANT VARIABLES The data sample of this study comprises of financial accounting information of the firms listed at Karachi Stock Exchange during 2004 to 2009.This accounting data is extracted from the Balance Sheet Analysis published by the State Bank of Pakistan. After excluding missing firm year data from analysis 891 observations were analyzed from 151 firms. 5. RESULTS 5.1. DETERMINANTS OF ACCOUNTS RECEIVABLE Carrying receivables has both direct and indirect costs but it also has an important benefit that is increased sales. Receivable management begins with the credit policy, but a monitoring system is also important. Corrective action is often needed, and the only way to know whether the situation is getting out of hand is with a good receivables control system Demand for Trade Credit A firms decision on how much to lend to its customers is determined from the level of firms accounts receivables. Still the quantity of trade credit, a firm offers, is influenced by a demand component (Petersen and Rajan, 1997). This demand on the whole is not possible to compute directly as approaches of nearly all firms consumers to trade credit varies. This is due to the reason that, just for example, a retail company can contain thousands of credit consumers which can be either persons or other firms. Whereas, the accounts payable of a particular company, can be similar in greater part as they are payable to the other companies which are comparatively little in number in any particular industry. As the demand curve for trade credit is not identified, interpretation of estimated coefficients can help in understanding this problem. Petersen and Rajan (1997) found that large firms maintain higher accounts receivables. One reason for this result can be, the greater access of larger firms to capital markets which makes them less capital reserved. Second reason can be the demand component from capital rationed firms that causes the accounts receivable of larger firms higher than average Creditworthiness and Access to Capital Markets Firm size and age are used to compute the firm s creditworthiness and access to capital markets. The natural log of firm age (Ln(1+ firm age)) is used as proxy for creditworthiness and natural log of total assets (Ln(book value of assets)) is taken to proxy the suppliers access to external capital. The results in the Table 1 show that size is 244

6 significant variable with (p = ). These results are consistent with earlier studies like Petersen and Rajan s(1997) Internal Financing The study uses operating cash flow (earnings before depreciation and interest minus taxes) divided y assets to gauge the firm s capability to produce cash from internal sources to fund the trade credit which it extends to its customers. The results indiate that internal financing effects positively to the level of accounts receivables. The variable is positive and significant at (p= ) which indicates that the larger the positive cash flow the supplier has, the higher the trade credit he is ready to offer to its customers. The results are consistent with findings of Niskanen and Niskanen (2000) and are contradictory to the findings of Petersen and Rajan (1997). Model I: AR = β0 + β1cf + β2cm + β3gr + β4kib + β5size Table 1: Dependant Variable: Accounts Receivable/Assets β 0 β 1 β 2 β 3 β 4 β 5 Coefficient * * * S.E P-Value (0.110) (0.000) (0.000) (0.766) (0.596) (0.000) R-Square F-Value * Adjusted-R (0.000) DW *Significant at α = ** Significant at α = Price Discrimination Price discrimination is an act of billing the same product to different clients with different prices, even when the costs of supplying them are same. This practice is mostly observed by monopolists as they exploit their leading power for discrimination. This study uses ratio of contribution margin (sales minus variable costs) to assets to 245

7 proxy for monopoly power to carry out price discrimination. In our sample of all textile firms existing on Karachi Stock Exchange, it is found that a significant but a negative relationship exist between price discrimination and accounts receivable management policies which is validated by a p value of (p= ). These results are contradictory to the findings of Niskanen & Niskanen (2000) Cost Of Alternative Capital The study uses annual average three month KIBOR rate to compute the basic cost of capital. A positive relationship is expected between accounts receivable level and level of interest rate. The reason behind this can be the demand for trade credit which can be expected to be high when the cost of alternative capital is increased. An insignificant coefficient is found in the results Table 1 with value of (p= ) Growth Normally firm s target growth rates are attached with its trade credit policies. Generally, credit conditions just as discounts and duration of payments play a role of competitive instruments. In order to increase sales, firm may select a policy of offering trade credit with delayed due periods than its competitors are offering. This proposes that there is a positive relationship between growth and the level of accounts receivable. Though, trade credit may be used to boost sales of those firms which could not maintain a smooth rise in their sales. Even in conditions of declining sales a firm may offer more trade credit than an average company in the industry (Petersen and Rajan, 1997).This study computes growth by the annual sales growth percentage. Empirically, it is found that sales growth is insignificant (p= ) which can be interpreted as the sales growth does not affect the level of trade credit offered DETERMINANTS OF ACCOUNTS PAYABLE (TRADE CREDIT) Firms generally make purchases from other firms on credit, recording the debt as an account payable. Accounts payable, or trade credit, is the largest single category of operating current liabilities, representing about 40% of the current liabilities of the average US nonfinancial corporations. The percentage is somewhat larger for smaller firms. Because small companies often do not qualify for financing from other sources, they rely especially heavily on trade credit. Table 2 presents the outcome of proposed determinants on which the accounts payable is regressed. This model uses the same variables (including the control variables) used for accounts receivable model. Besides these variables, two more variables are added in this model. First, to determine the 246

8 asset maturity RATIO OF CURRENT ASSETS (INVENTORIES AND FINANCIAL ASSETS) TO TOTAL ASSETS is used. Second, to assess the supply of trade credit PURCHASES TO TOTAL ASSETS is used Supply of Trade Credit Niskanen and Niskanen (2000) use the annual purchases as a proxy for the supply of trade credit making an assumption that all purchases are on credit. They believe that this assumption is not very restrictive, as large companies normally do not pay their purchases in cash. This study also uses the purchases as proxy to supply of trade credit and considers the same assumption. The result relating the supply of trade credit is same as expected: a significant and positive coefficient is obtained (p= ) which indicates that an increase in the supply of trade credit increases the level of its use Creditworthiness and Access to Capital Markets Result concerning asset size is quite significant in explaining the accounts payable level. The coefficient is positive and significance level is also quite high (p= ). This positive sign shows that financing of larger firms is comprised of more trade credit than smaller firms. This may be due to their greater access to capital markets. This finding is consistent with Niskanen and Niskanen (2000) where as Petersen and Rajan (1997) found a weak positive relationship between the firm size and accounts payable. Model No II: AP = β0 + β1gr + β2ca + β3size + β4kib + β5cf + β6pur Table 2: Dependant Variable: Accounts Payable β 0 β 1 β 2 β 3 β 4 β 5 β 6 Coefficient S.E P-Value (0.0000) (0.0015) (0.0002) (0.0000) (0.0001) (0.0066) (0.0005) R-Square F-Value * Adjusted-R (0.000) DW *Significant at α = ** Significant at α =

9 Growth Theory suggests that healthier investment opportunities are available to the firms which are growing and these firms require increased financing for these new investment opportunities. It is assumed that trade credit may be used as fractional source of financing for these growing firms. However, opposite is found from empirical results. Sales growth is found to have a negative but significant coefficient (p= ) which implies that faster a firm is growing the less it uses trade credit in its financing. Hence, firms growing slowly or not growing at all utilize the trade credit most. Furthermore, these results are consistent with Niskanen and Niskanen (2000) and contradictory to the findings of Rajan and Zingales (1997) Internal Financing The results reveal that operating cash flow is a significant variable in explaining the accounts payable level with p-value of (p= 0066) Asset Maturity In explaining the level of accounts payable the asset maturity, measured by the ratio of current assets to the total assets, is found to have a greater proportion with a significant positive variable (p= 0002). This finding is consistent with the view that firm s assets are financed with funds having same maturities. This is carried out to plan repayments of the funding to match with the decline in the value of firm s assets (Diamond, 1991). As a result, short-term assets are usually financed with short-term debt just as accounts payable, while long-term assets are financed with long-term debt or equity Cost of Alternative Capital Market interest rate, measured as average 3 month KIBOR rate, is appeared to be quite significant explanatory variable in explaining accounts payable (p= 0001). Positive coefficient of market interest rate shows that higher the interest rates the higher the demand for trade credit will be. As it is vivid from the results that market interest rate is not significant in accounts receivable model, this may support the idea that demand side is more affected by the fluctuations in the market interest rate. 6. CONCLUSION This study empirically analyzed the determinants of Pakistani listed firms accounts receivable and accounts payable management policies. The results show that accounts receivable are strongly affected by the firms incentive to use trade credit as a means of price discrimination and level of internal financing. Furthermore, size 248

10 of the firm also affects the level of accounts receivable a firm maintains. The results of the accounts payable model show that all the variables, which were taken to determine the level of accounts payable, were statistically significant. Additionally, most significant determinants of accounts payable were size of the firm, level of purchases and market interest rate. Dissimilarity in the results of this study to earlier studies may greatly be due to the variation among Pakistani, U.S., UK and Finnish capital markets. As it is evident, that ban-borrower relationship, when analyzed as financial intermediaries, is supposed to be a substitute source of capital for trade credit. This relationship can be studied as further research line in this area. But the unavailability of data on this relationship makes it bit a difficult task as statistics regarding relationship between banks and firms are not publicly available. 249

11 References Atanasova, C. (2007). Access to Institutional Finance and the Use of Trade Credit. Financial Management, 36(1), Blasio, G. (2005). Does Trade Credit Substitute Bank Credit? Evidence from Firm level Data. Economic notes, 34(1), Brennan, M. J., Miksimovic, V., & Zechner, J. (1988). Vendor financing. The Journal of Finance, 43(5), Brick, I. E., & Fung, W. K. H. (1984). Taxes and the theory of trade debt. Journal of Finance, Danielson, M. G., & Scott, J. A. (2004). Bank loan availability and trade credit demand. The Financial Review, 39(4), Deloof, M., & Jegers, M. (1999). Trade credit, corporate groups, and the financing of Belgian firms. Journal of Business Finance & Accounting, 26(7 8), Diamond, D. W. (1991). Monitoring and reputation: The choice between bank loans and directly placed debt. Journal of Political Economy, Emery, G. W. (1984). A pure financial explanation for trade credit. Journal of financial and quantitative analysis, 19(3), Emery, G. W. (1987). An optimal financial response to variable demand. Journal of financial and quantitative analysis, 22(02), Ferris, J. S. (1981). A transactions theory of trade credit use. The Quarterly Journal of Economics, 96(2), 243. Frank, M., & Maksimovic, V. (1998). Trade credit, collateral, and adverse selection. Unpublished manuscript, University of Maryland. Hill, N. C., & Sartoris, W. L. (1988). Short-term financial management: Macmillan. Huyghebaert, N. (2006). On the Determinants and Dynamics of Trade Credit Use: Empirical Evidence from Business Start ups. Journal of Business Finance & Accounting, 33(1 2), Kashyap A.K., J.C. Stein and D.W. Wilcox (1993). Monetary policy and credit conditions: Evidence from the composition of external finance. American economic review, 83, Lee, Y. W., & Stowe, J. D. (1993). Product risk, asymmetric information, and trade credit. Journal of financial and quantitative analysis, 28(02), Long, M. S., Malitz, I. B., & Ravid, S. A. (1993). Trade credit, quality guarantees, and product marketability. Financial Management,

12 Marotta, G., & politica, U. d. M. D. d. e. (1997). Does trade credit redistribution thwart monetary policy? Evidence from Italy. Applied Economics, 29(12), Meltzer, A. H. (1960). Mercantile credit, monetary policy, and size of firms. The Review of Economics and Statistics, 42(4), Mian, S. L., & Smith Jr, C. W. (1992). Accounts receivable management policy: Theory and evidence. Journal of Finance, Myers, S. C. (1984). Capital structure puzzle: National Bureau of Economic Research Cambridge, Mass., USA. N. Berger, A., & F. Udell, G. (1998). The economics of small business finance: The roles of private equity and debt markets in the financial growth cycle. Journal of banking and finance, 22(6-8), N. Berger, A., & F. Udell, G. (1998). The economics of small business finance: The roles of private equity and debt markets in the financial growth cycle. Journal of banking and finance, 22(6-8), Niskanen, J., Niskanen, M. (2000). Accounts Receivable and Accounts Payable in Large Finnish Firms Balance Sheets: What Determines Their Levels? The Finnish Journal of Business Economics, Niskanen, J., & Niskanen, M. (2006). The Determinants of Corporate Trade Credit Policies in a Bank dominated Financial Environment: the Case of Finnish Small Firms. European Financial Management, 12(1), Petersen, M. A., & Rajan, R. (1994). The effect of credit market competition on lending relationships: National Bureau of Economic Research Cambridge, Mass., USA. Petersen, M. A., & Rajan, R. G. (1997). Trade credit: theories and evidence. Review of Financial Studies, 10(3), 661. Rajan, R. Zingales (1995) What do we know about capital structure? Some evidence from international data. Journal of Finance, 50(5), Schwartz, R. A. (1974). An economic model of trade credit. Journal of financial and quantitative analysis, 9(04), Storey, D. J. (1994). Understanding the small business sector: Thomson Learning Emea. Walker, D. (1991). An empirical analysis of financing the small firm. Advances in Small Business Finance,

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