Can Trade Credit serve as a Cushion against the Financial Setbacks

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1 Can Trade Credit serve as a Cushion against the Financial Setbacks in a Developing Economy? 1 Jaleel Ahmed, * 2 Hui Xiaofeng, and 3 Jaweria Khalid 1,*2 Corresponding Author, 3 School of Management, Harbin Institute of Technology, Harbin , P.R. China, jaleelahmed11@yahoo.com Abstract This research paper attempts to investigate the effect of 2008 financial crisis on performance of non-financial firms listed at Karachi Stock Exchange. After using the data from 2005 to 2011 fixed-effect model confirms the hypothesis that non-financial firms of Pakistan increase use of trade credit supply during financial crisis and continue this process in succeeding periods. As expected, firms also increase trade credit demand during tight economy conditions but reduce in succeeding periods. Non-financial firms which can arrange financing from their suppliers and those which grant goods on credit enhance their value during financial crisis. We have also found that large firms are willing to grant trade credit but they are not interested in receiving goods on credit. Keywords: Trade credit, Financial crisis, Firm performance, Non-financial firms, KSE 1. Introduction Trade credit is a contract where firms purchase goods on account. Trade credit is a general term that is used for either goods are purchased or sold on account. Trade credit supply is a term that is used to demonstrate those firms which sell goods immediately but payment is made on some future date, in this transaction seller write the transaction in its book of accounts as account receivables. On the other hand trade credit demand is written in accounts books as accounts payables. Management of account receivables and account payables is very important for any firm. According to Giannetti [9] on average account receivables are quarter of total assets in European countries. The 2008 financial crisis had casted a shadow on the financial standings of both the developed as well as the developing economies. One of the major consequences of the crisis is that non-financial firms have lost their confidence on the financing mode via financial instruments. Different firms have different sources of financing. Regardless of the discussion of short term and long term financing, so it is considered as an alternate to bank financing. Thus research on trade credit has taken into account and its role in lessening the financial frictions in the tough days of the crisis and had come up with some astonishing results. Financial institutions were the major contributors of 2008 financial crisis. Bank lending decreased during this time period and hence, non-financial firms were unable to find credit from financial institutions. As suggested by Meltzer [16], creditworthy firms may increase their sales by granting goods on credit by adopting redistributive policy. This outcome becomes more prominent in the time of financial crisis. As every firm tries to increase its market share, firms which have better access to capital markets may increase their market share after granting trade credit during the times of financial frictions. Smaller firms could also increase their market share via different channels. During the time of financial crisis small can generate more profit after adopting trade credit policy. On the other hand, less credit worthy firms which are unable to find any credit from financial institutions may focus on supplier financing in such times. The trade credit suppliers have an edge over banks as they can recapitalize their goods and sell them in case of having bad debts and hence, recover the loss [20]. In the context of a developing economy such as Pakistan, no study till date have investigated the impact of financial crisis on the use of trade credit and none have discussed the performance of nonfinancial firms when they participate in credit transactions during the times of financial crisis. This research focuses on the performance of non-financial firms during the crisis period and brings in consideration the redistributive role of the non-financial firms. Main question to be addressed is that if the non-financial firms opt to play the role of an intermediary firm, what benefits they get and what costs they incur during financial crisis. This is a significant dimension to study because research proved that Journal of Convergence Information Technology (JCIT) Volume 9, Number 6, November

2 the management of account receivables and payables greatly affect the value of shareholders and more importantly, in a crisis period, it may become decisive to a company s existence in a developing economy. As per the research question, the objective of this study is to investigate the effect of financial crisis on trade credit patterns in industrial sectors of Pakistan. Moreover, the objective is to investigate the performance of non-financial firms during the financial crisis as compare to before crisis period. Literature review and hypotheses are discussed in section 2. Data description, model and methodology are given in section 3. Section 4 discuses the results and then conclusion of the study is presented in section 5. Lastly, limitations of the study and implications for the firms are discussed in section Literature Review and Hypotheses 2.1. Financial crisis and trade credit The 2008 financial crisis carried liquidity issues as financing was not available via banks. Whenever firms find any kind of financing problem from the banks they increase their trafficking towards trade credit [1][20]. But this flexibility in changing financing mode is not true for every firm. The large firms might not get involved in credit transactions no matter what are the scenarios at work regarding the financial frictions because they do not face liquidity issues [4] and neither they opt for the reputation building channel via credit transaction as they simply don t need it [13]. However, small firms try to increase their market share by granting more trade credit to their customers [25] and also solve their liquidity issues via this channel [4]. When we look at the demand side we can also observe that less creditworthy firms try to get credit during the tight monetary conditions either from formal or informal channels of financing [19]. Another study regarding the effects of 1994 and 1997 Asian financial crisis on firm s trade credit policy has been conducted by Love et al. [14]. By analyzing the large firms data they have found a decrease in trade credit during the days of financial crisis. Based on the above mentioned arguments we have a mix of arguments regarding the impact of financial crisis on trade credit supply and demand. So we can formulate our first hypothesis that is related to the effect of financial crisis on trade credit. H1: As compared to before financial crisis, non-financial firms will increase the use of trade credit supply and demand during the time of financial crisis Financial crisis, trade credit and firms performance Under the assumptions of certainty and competition, model of Lewellen et al. [12] states that the firms value remains unaffected due to change in credit policy. By relaxing these assumptions they have suggested that credit policy could have an impact on firms value and market imperfections lead towards the optimal trade credit policy. During the time of financial crisis an economy might face a downturn in its performance. Liquidity is known as the back bone of any business and its shortage ends up in the declined operating performance. During the times of liquidity shortages, trade credit aids to strengthen the relation between seller and purchaser [7]. According to Biais and Gollier [3] when firms are unable to arrange financing from either of the channel, they might face a drop in sales. At this point there is a motivation for suppliers to become a helping hand and increase their market share by involving further in credit transactions. Ban os- Caballero et al. [2] Brennan et al. [6] and Nadiri [18] have made an identical argument that firms can increase their sales by increasing their trade credit supply which will result in higher profitability. According to Martinez-Sola et al. [15] firms can increase their sales by offering trade credit to their customers; this would lead to increase in profitability. Process of granting goods on credit leads to increase investment in current assets [11][22]. Molina and Preve [17] postulate that the firms which do not get involved in trade credit transaction during the times of financial crisis can face a severe problem for their sales. Permitting trade credit supply in the course of financial crisis enables a firm to regulate the effect of financial crisis on firm s profitability [10]. This discussion leads us to postulate two hypothesis regarding investment in trade credit supply/demand and firms performance. H2a: During the financial crisis non-financial firms enhance their value by increasing the amount of trade credit supply. 144

3 H2b: During the financial crisis non-financial firms enhance their value by increasing the amount of trade credit demand. 3. Data Analysis and Methodology 3.1. Data analysis Like many other countries (United Kingdom, Netherlands and Germany) it is not obligatory for Pakistani non-listed firms to report their financial statements. Hence the study has a limitation to use data from those non-financial firms which are listed at Karachi Stock Exchange (KSE). Data has been extracted from the Balance Sheet Analysis (BSA) and Financial Statement Analysis (FSA) published by The State Bank of Pakistan (SBP) from 2005 to Data have been divided into three sub samples: before, during and after financial crisis. We have depicted years as before crisis period and used as a benchmark for this study. We used year 2008 as during financial crisis and year as after financial crisis period. Figure 1 a and b is showing the usage pattern of trade credit supply (TCS) and trade credit demand (TCD) in the above mentioned time periods. Before During After Before During After Figure 1. Trade credit use in before, during and after financial crisis In figure 1a, b vertical line columns are used to identify the period of before financial crisis. Dotted columns are representing during financial crisis period and horizontal line columns are used to differentiate after financial crisis period from other two time periods. Graph 1a is clearly depicted that trade credit supply has increased during the financial crisis period as compared to before crisis period and this pattern continues after it. As figure 1b is showing that trade credit demand also increases during financial crisis as compared to before crisis and it is decreased after financial crisis. TCS TCD Table 1. ANOVA During crisis vs. before crisis (0.0000) (0.0000) After crisis vs. before crisis (0.0000) (0.0000) To compare means an ANOVA test has been conducted. TCS and TCD were significantly increased in the periods of financial crisis as compare to before financial crisis period. As compare to before crisis period TCS significantly increase in after crisis period. On the other hand TCD decreased in after crisis period as compare to before crisis period. Difference in means reported in table 1 has been figured out by using Boneferroni adjusted significance level (see Love et al. [14]). We have used two dependent variables, trade credit supply that is ratio of accounts receivables to total assets and trade credit demand that is measured as accounts payables divided by total liabilities [14]. To investigate the effect of net trade credit on firm value we have used the approximation for Tobin s Q which is measured as market value of assets divided by book value of assets [6]. During crisis and after crisis are dummy variables that are used to capture the effects of financial crisis during and after the crisis period as compare to before crisis period. These variables have been derived by taking one for specific year and zero otherwise. Some control variables are also used to capture the effect of firm 145

4 specific variables on use of trade credit. Control variables are collateral, sales growth and size of the firm. Collateral is the ratio of fixed assets to total assets. Literature has reported an inverse relationship between collateral and trade credit as Vaidya [23] have suggest that the firms having access to banking and other financing channels have less tendency towards credit transactions. Sales growth is measured as change in sales divided by previous year sales. Firms having growth in sales are more motivated to get financing from their suppliers but not willing to grant goods on credit. The finding of Garcia-Teruel and Martines-Solano[8] and Petersen and Rajan [21] suggest a positive relationship between sales growth and trade credit demand and an inverse relationship between sales growth and trade credit supply [8]. Size is calculated as by taking natural logarithm of sales. Firms in large size have more ability to arrange financing to facilitate their sales and they always try to get involve in credit transactions [8][21]. Hence the above mentioned studies suggest a positive relationship between trade credit and size of the firm. To check the impact of trade credit on firm value we have used net trade credit variable to measure whether a firm is net trade credit receiver or giver. Net trade credit is defined as account receivables minus account payables divided by sales. If a non-financial firm have a positive net trade credit (PNTC) it means its account receivables are more than its account payables. On the other hand, negative net trade credit (NNTC) stand for a firm which has account receivables less than its account payables. PNTC and NNTC are dummy variables for positive net trade credit and negative net trade credit respectively. PNTC has been extracted by using one in front of those firms which were net trade credit giver during the time of financial crisis and NNTC has been extracted by placing one in front of those firms which were net trade receiver zero otherwise. Table 2 is representing summary statistics. Some prominent effects can be traced out of it. Mean values are showing the participation rate in overall assets and liabilities of non-financial firms of Pakistan. Reported mean values of TCS and TCD are significantly depicting that their magnitude is less than one and there is no extreme value in the data. Importantly, it is evident from the table 1 that average trade credit supply and demand has increased during the financial crisis period as compared to before crisis period. This is in line with the figure 1 which is markedly representing the rise in trade credit during the crisis period. Standard deviation of the variables is showing that none of the variable has greater variation in it Methodology and Model As cross sectional and time series data posed some problems, in order to overcome some problems panel data estimations tries to capture these problems. By using a large number of observations make a researcher able to acquire more efficient inferences [24] and help in to reduce the problem of multicollinearity. According to Wang et al. [24] panel data allow us to seize the variation in time and cross section components. Love et al. [14] have mentioned that to capture the effects of financial crisis on trade credit, fixedeffect model can be used to analyze the data because of the common practice to take hold of the unnoticed heterogeneity in firm specific level data. Moreover it helps us to segregate the behavior of during and after crisis from before crisis period. Following fixed effects model 1 is used to capture the effect of financial crisis on trade credit. TC it=α i+β 1DuringCrisis t+β 2AfterCrisis1 t+β 3AfterCrisis2 t+β 4AfterCrisis3 t+β 5X it+ε it (1) where, TCit is a general term that is used for trade credit supply and demand of ith firm at time t. During crisis and after crisis are dummy variables that are used to capture the effect of financial crisis on trade credit. We have derived during crisis variable by using one for the year 2008 and zero otherwise. After crisis period is then divided into three categories namely, after crisis 1 that is derived by using 1 for year 2009 and zero otherwise. After crisis 2 and 3 are dummy variables which are used for the year 2010 and 2011 respectively. A vector (Xit) of firm specific factors is used to estimate the level of trade credit and is representing collateral, size and sales growth. Whereas, collateral is fixed assets over total assets and SIZE is measured as by taking natural logarithm of gross sales. Sales growth is annual sales growth percentage. Lastly, Ɛit is an error term. Following model 2 is used to estimate the impact of net trade credit granting or receiving on firm value during the times of financial crisis. 146

5 FV it =α i +β 1 PNTC it +β 2 NNTC it +β 3 COL it +β 4 SG it +β 5 SIZE it +ε it (2) where, FVit is value of ith firm at time t. Proxy for Tobin Q has been used to measure firm value. αi is constant for ith firm. Positive net trade credit (PNTC) and negative net trade credit (NNTC) are dummy variables which are used to notice the effect of net trade credit when it is positive or negative during financial crisis. COL, SG and SIZE are other control variables which are used as independent variables. Collateral (COL) is measure as fixed assets over total assets. SG is annual sales growth. SIZE is measured as taking natural logarithm of sales. Ɛit is an error term. TCS TCD Tobin s Q NTC Collateral Sales Growth SIZE Table 2. Descriptive statistics Time Period Mean Range St. Deviations Before Crisis During Crisis After Crisis Overall Before Crisis During Crisis After Crisis Overall Before Crisis During Crisis After Crisis Overall Before Crisis During Crisis After Crisis Overall Before Crisis During Crisis After Crisis Overall Before Crisis During Crisis After Crisis Overall Before Crisis During Crisis After Crisis Overall We have applied Wald test and Hausman test to check whether fixed effect model is more appropriate as compared to pooled ordinary least square model and random-effect model respectively. Significant values of F-statistics and Hausman test indicate that fixed effect model should be applied. 4. Results Table 3 is showing the results of estimated models. Column 1 and 3 are representing the results of elementary effects of financial crisis on trade credit supply and demand. Column 2 and 4 are representing the results of effect of crisis on trade credit demand and supply after including the control variables. Column 5 is linked to the results of model 2. Most of our results are in line with hypotheses made in section 2 and with previous findings regarding trade credit use and financial crisis. Coefficients of dummy variables are showing a significant difference in pattern of trade credit during crisis against before crisis period. Apparently study has found the same pattern of trade credit use as it has been hypothesized. Trade credit supply significantly increased during the financial crisis period. In column 1 positive and significant coefficients of after crisis variables are indicating that pattern of granting goods on account remain continue after the financial crisis. In column 3 positive and significant coefficient of during crisis for trade credit demand is demonstrating that nonfinancial firms in Pakistan have increased the pattern of purchasing goods on account as compare to 147

6 before crisis period. After the financial crisis variables have significant and negative signs. It means nonfinancial firms has changed their behavior of receiving financing from trade credit channel after the financial crisis and the magnitude of trade credit demand decreased in after crisis period. Table 3. Fixed effects model estimation TCS TCD Tobin s Q During Crisis *** ** ** ** After Crisis *** *** *** *** After Crisis *** *** *** *** After Crisis *** *** *** *** COL *** *** SG *** *** SIZE *** *** PNTC *** NNTC *** Constant *** *** *** *** Adjusted R Standard errors are reported in parentheses. *** and ** are showing the significance at 1% and 5% level of significance respectively. After including the control variables in first model all financial crisis dummy variable remains same in signs and significance. In column 2, collateral is significantly and negatively related to trade credit supply. It means investment in fixed assets keep non-financial firms far from investment in current assets. In column 4 coefficient of collateral for trade credit demand is positive and significant which is suggesting that firms with higher amount of collateral can get financing from any channel easily. Results for sales growth is also showing that firms which have greater sales growth they have no need to grant goods on credit. On the other hand small firms which are trying to increase their market share they receive goods on credit and try to sell them. Hence sales growth is positively related to trade credit demand. Large firms are capable to arrange financing from any source so they are able to get involved in credit transactions. As the result of SIZE is concerned, positive and significant sign of coefficient is indicating that large firms in Pakistan are keen to grant goods on credit and they are not ready to receive goods on credit. Finally, results of the second model depicts that firms which were able to deliver goods on credit and those firms which were capable to receive financing from their suppliers were able to enhance their value during the time of financial crisis. As positive net trade credit and negative net trade credit both have positive and significant effect on firm value. Positive and significant effects of these variables allow us to accept our second hypothesis. When firms will invest in current assets it means they are increasing their total assets. On the basis of increase in total assets they might be able to increase their number of shares and it would lead to increase in firm s value. On the other hand when firms are able to receive financing from their suppliers they will carry out their practices in a smooth way. This would lead to increase in sales and finally increase in market value of firm, which confirms the second hypothesis. Moreover results are also signifying that investment in fixed assets during the financial crisis is not a sensible decision because non-financial firms can enhance their value by investing in current assets during financial crisis. Overall the results of this study suggests that in times of financial crisis nonfinancial firms have better option to get involved in credit transactions. By doing this they can perform well and can boost their value. 148

7 5. Conclusion Study has focused on behavior of trade credit during and after financial crisis 2008 as compared to before crisis period. Study finds an increase in use of trade credit supply and demand during the crisis period. Also an increase in the use of trade credit demand followed by a decrease in subsequent periods. But on the other hand behavior of granting goods on credit remains same in succession periods. Study has find some other useful evidence, that non-financial firms which have enough amount of collateral and positive sales growth they have no need to grant trade credit. On the other hand firms which have lesser amount of collateral to get financing from banking channel are more willing to get financing from trade credit channel. Firms which have positive sales growth try to maintain this and so they are more willing to arrange financing from trade credit channel. Large non-financial firms of Pakistan are willing to grant goods on credit but they are less willing to purchase goods on credit. Non-financial firms either they have granted or received trade credit during financial crisis were able to enhance their value. It is hence concluded that for better survival during the financial crisis firms should increase the magnitude of their current assets and current liabilities by increasing credit transactions. 6. Limitations and Implications of the study This study has certain limitations which should be kept in mind while generalizing its results. First, it has studied the data of only one country and hence, cultural patterns may limit its use for other countries. Secondly, in 2008, effect of financial crisis was not alone to affect Pakistan s economy. There were other problems as well, like increase in oil price and political transition from Military rule to democratic government. These factors were also responsible for any unusual behavior of firms during Due to data limitations we cannot address these issues. Third, it has only taken the listed firms in its sample which may have different pattern of business than the non-listed firms. This suggests that the results of this study could be used with caution by non-listed firms in Pakistan unless any further study reveals similar patterns regarding credit transactions in such firms. This study significantly implies that the managers in non financial firms may involve in policy making for their trade credit usage. It gets extra importance when there comes any financial crunch in the economy. Trade credit transactions proves to be a cushion against the financial setbacks in the economy and also, are an important tool to enhance firm s value. 7. References [1] Atanasova, C.V. and N. Wilson, 2004, Disequilibrium in the UK corporate loan market, Journal of Banking and Finance 28, [2] Baños-Caballero, S., García-Truel P.J., Martínez-Solano P Working Capital Management in SMEs, Accounting & Finance, 50 (2010) [3] Biais, B., & Gollier, C. (1997). Trade credit and credit rationing, Review of Financial Studies, 10, [4] Bougheas S, Mateut S & Mizen P, Corporate trade credit and inventories: new evidence of a trade-off from accounts payable and receivable, Journal of Banking and Finance 33 (2), [5] Brennan, B., Maksimovic, V., & Zechner, J. (1988). Vendor financing, Journal of Finance, 43, [6] Chung, K. H., and S. W. Pruitt, 1994, A simple approximation of Tobin s Q, Financial Management 23, [7] Cun at, V., 2007, Trade credit: suppliers as debt collectors and insurance providers, Review of Financial Studies 20, [8] Garcia-Teruel PJ & Martinez-Solano P, 2010a. Determinants of trade credit: a comparative study of European SMEs, International Small Business Journal 28 (3), [9] Giannetti, M., 2003, Do better institutions mitigate agency problems? Evidence from corporate finance choices, Journal of Financial and Quantitative Analysis 38, [10] Kestens, K., P. Van Cauwenberge, and H. V. Bauwhede, 2012, Trade credit and company performance during the 2008 financial crisis, Accounting and Finance 52,

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