Trade Credit, Collateral, and Adverse Selection

Abstract

We show how trade credit use depends on the value of collateral in a repossession, as well as the extent to which firms face adverse selection problems when dealing with an outside investor. If a buyer defaults, then the seller is in a better position than is the investor to reclaim value from the repossessed good. Offsetting this is a concern on the part of the investor about the prudence of the seller's trade credit policy. In equilibrium sellers extend full trade credit to their creditworthy buyers and partial trade credit to their creditworthy buyers. The amount of credit extended to a more creditworthy buyer, is an increasing function of seller creditworthiness. Trade credit also induces a spillover from adverse selection in the financing, to the pricing and sales of goods. The results include the following. First, the theory explains why trade credit is short term credit. Second, the theory accounts for firms simultaneously taking and extending credit to other firms with similar levels of creditworthiness. Third, the conventional advice that firms should collect early and pay late, is shown to be questionable general advice. Fourth, the theory explains why firms whose prospects start to deteriorate, often respond by increasing the extent to which they offer trade credit to their buyers.