How Inventory Is (Should Be) Financed: Trade Credit in Supply Chains with Demand Uncertainty and Costs of Financial Distress

Abstract

A new substantially revised version of this paper under the title of "Trade Credit, Risk Sharing, and Inventory Financing Portfolios" is available for download at: http://ssrn.com/abstract=2746645.

As an integrated part of a supply contract, trade credit has intrinsic connections with supply chain contracting and inventory management. Using a model that explicitly captures the interaction of firms’ operations decisions and financial risks, this paper attempts to develop a deeper understanding of trade credit from an operational perspective. Revolving around the question of what role trade credit plays in channel coordination and inventory financing, we demonstrate that with demand uncertainty, trade credit enhances supply chain efficiency by serving as a risk-sharing mechanism. When offering trade credit, the supplier balances its impact on operational profit and costs of financial distress. Facing a trade credit contract, the retailer finances inventory using a portfolio of cash, trade credit, and short-term debt, where the structure of this inventory financing portfolio depends on the retailer’s financing need and bargaining power. Additionally, our model suggests that financial diversification, that is, employing multiple financing sources, provides an alternative explanation for the use of factoring in accounts receivable management and the decentralization of some supply chains. Finally, using a sample of firm-level data from Compustat, we find that the inventory financing pattern our model predicts exists in a wide range of firms.

Keywords: trade credit, supply chain management, inventory management, newsvendor model, supplier financing, costs of financial distress, debt structure, financial constraint