Suppliers have an information advantage over financial institutions when extending trade credit to customers. This information advantage generates significant return predictability. Firms that rely more on trade credit than debt financing tend to have higher stock returns. The return predictability is more evident for firms with lower borrowing capacity or profitability and for firms with higher information asymmetry.
What’s Inside?
Suppliers extending trade credit to customers have an information advantage over financial institutions. The authors find that the suppliers’ information advantage extends from credit markets to well-developed stock markets. Using the trade credit ratio as a proxy of this advantage, the authors can predict future sales growth and stock returns after adjusting for firm characteristics. A zero-cost long–short portfolio strategy that bets on the trade credit ratio would have achieved an information ratio of 0.62 over the study period. But the suppliers’ information advantage is more evident for firms with lower borrowing capacity or profitability and is more significant for firms with a greater degree of information asymmetry.
How Is This Research Useful to Practitioners?
The authors extend the work of previous researchers who have investigated the information content of trade credit. They show that a portfolio strategy based on the trade credit ratio (accounts payable/sum of accounts payable and financial credit) has the potential to generate significantly positive alphas and high reward/risk ratios. Using the information advantage, suppliers are more willing to extend credit to customers with high sales potential to capture future profitable business. Therefore, suppliers may be ready to take customer credit risk after they have favorable information on the buyer’s future sales growth.
The trade credit ratio is found to have the ability to predict wide variation in firms’ sales growth in the US market, even after the authors control for the effects of lagged level and growth of sales, stock returns, market capitalization, book/market ratio, and accruals. They note that the annualized information ratio of a trade credit ratio portfolio would have exceeded the Sharpe ratios of many popular US factor portfolios during the study period. But the use of the trade credit ratio may not reflect suppliers’ favorable information about sales growth when the firms have easy access to credit and are profitable. The information advantage is also stronger among firms with larger information asymmetries.
Portfolio managers and equity analysts will find the conclusions of this research useful. It would seem that firms with a higher trade credit ratio tend to realize higher subsequent stock returns and that this relationship is stronger among firms with lower borrowing capacity or profitability. Because the stock market does not always do a good job of incorporating the information advantage of the trade credit ratio into stock prices, the trade credit ratio could soon become an important tool used in the financial analysis of companies (excluding financial firms and utilities).
How Did the Authors Conduct This Research?
The authors examine a sample of US firm years that has accounting data, stock price/return data, and historical standard industrial classification codes. Accounting data are obtained from Compustat; stock price/return data come from CRSP. All data are collected from 1969, with each firm needing at least two years of accounting data in Compustat to be included in the sample. As a result, the analysis covers the period 1971–2009. Financial firms and utilities are excluded. Furthermore, all firms with negative total assets, capital stock, sales, and book equity are removed. Overall, a US panel of 68,013 observations is examined.
The trade ratio (i.e., proportion of accounts payable to total debt obligations) is used as a proxy to assess the supplier’s information advantage. The average trade credit to total borrowing is 44.5%, which implies that trade credit accounts for nearly half of total borrowing of US firms. The authors carry out empirical tests to confirm that the trade credit ratio predicts one-year-ahead sales growth significantly after they neutralize for such variables as lagged level and growth of sales, stock returns, size of companies, book/market ratio, and accruals. They find that a zero-cost long–short portfolio strategy betting on the trade credit ratio would have achieved an information ratio of 0.62 during the study period.
The authors also note that the information advantage from trade credit is more salient for firms with lower borrowing capacity or profitability and with an opaque information environment.
Abstractor’s Viewpoint
Suppliers tend to have an information advantage over financial institutions when providing trade credit to customers. The authors find strong evidence that the trade credit ratio can predict future sales growth significantly beyond the stock market valuation and even after adjusting for various return predictors. The results are interesting.
Although I have concerns that the research may be a bit outdated (the data are through 2009) and that the findings apply more to firms with lower borrowing capacity or profitability and to those with higher information asymmetry than other firms, the authors’ findings nonetheless highlight the possibility of obtaining superior stock returns through monitoring the trade credit ratio. This ratio could thus become an important tool used in the financial analysis of companies (other than financial entities and utilities).