Trade Credit: The “Glue” Holding Supply Chains Together

Aug. 19, 2024

In the complex and interconnected world of global supply chains, resilience is constantly tested by disruptions ranging from natural disasters to geopolitical tensions and economic volatility. Amid these challenges, one financial mechanism is proving crucial in maintaining the stability of these intricate networks: trade credit.

Trade credit, a key aspect of business transactions, allows firms to receive goods and services with deferred payment. A recent study by Swedish House of Finance’s Mariassunta Giannetti, along with Cox School of Business’ Nuri Ersahin and Ruidi Huang, reveals how supply chain interdependencies affect trade credit during operational shocks. By examining how companies manage payments and extend credit before and after natural disasters, the study underscores trade credit's essential role in maintaining supply chain stability.

While trade credit's role in sustaining business relationships might seem straightforward, this study extends the focus beyond simple supplier-customer relationships to explore entire supply chain networks. It highlights how interconnected firms influence trade credit flows during disruptions, emphasizing the vital role suppliers play in supporting both their direct customers and other firms within the network.

Firms Facing Shocks Extend Trade Credit…

Operating shocks—such as natural disasters, cyberattacks, or geopolitical instability—can severely impact a firm’s ability to deliver goods on time and at the expected quality. In response, affected firms often extend more trade credit to their customers to maintain crucial relationships and prevent business losses, the study shows.

The simultaneous increase in both accounts payable and receivable for firms facing operational difficulties suggests that trade credit serves as a buffer, helping firms absorb the shock and prevent a complete breakdown of the supply chain.

“Trade credit could, therefore, be used as a glue to enhance the stability of the production network when negative operating shocks occur,” the authors say.

This “glue” effect is particularly strong in industries where switching suppliers is costly, making customers more likely to accept extended payment terms rather than seek alternative sources.

… and their Suppliers Extend Trade Credit to Them too

The study reveals that the strategic use of trade credit is not limited to firms directly impacted by disruptions. Suppliers to these firms also play a critical role. They often extend more trade credit to help the affected firm manage customer relationships, motivated by their dependence on the affected firm for their own sales and revenue. This collective effort ensures that the entire supply chain remains intact.

"The suppliers of affected firms have a stake in the stability of the whole supply chain and want to avoid the breakup of the relationships between the affected firms and their customers,” the authors say. “Thus, the suppliers may extend more trade credit in order to facilitate the extension of the affected firms’ trade credit.”

Impact of Financial Constraints

However, when financial constraints prevent firms from extending additional trade credit, the relationships with their customers are more likely to break down, the study shows. This breakdown leads to a decrease in sales for both the affected firm and its suppliers, underscoring the crucial role of trade credit in maintaining supply chain stability.

“Customers that do not receive more trade credit in turn become more likely to terminate their relationships with the affected firms and start new relationships. Consequently, the affected firms’ and their suppliers’ sales decrease,” the authors explain. “Thus, pervasive financial constraints over the supply chain limit trade credit usage and imperil the stability of supply chains.”

Substitutability, Reputation, and Geographic Distribution

The amount  of trade credit extended by a firm is influenced by several factors, including the substitutability of the firm’s products, its reputation, and the geographic distribution of its operations. For instance, firms with easily substitutable products often need to offer more trade credit to keep customers from switching to competitors.

“Affected firms that produce easy to substitute products indeed extend more trade credit to their customers,” the authors say.

Similarly, a firm’s strong reputation and wide geographic distribution can reduce the need for trade credit, as these factors help mitigate disruptions and maintain customer loyalty. Firms operating in multiple locations can continue production and shipping from unaffected areas, thereby reducing potential disruptions.

Implications for Production Network Relationships

The study also highlights that the importance of a customer to a firm influences how much trade credit is extended. Firms that are more dependent on a major customer are more likely to offer trade credit to maintain that relationship during challenging times.

“Affected firms and their suppliers are expected to be particularly inclined to extend trade credit to major customers,” the authors say.