Financial Leverage and Product Quality: Evidence from the Supermarket Industry

Abstract:     
This paper examines whether debt financing can undermine a supermarket firm's incentive to provide product quality. In the supermarket industry, product availability is an important measure of quality. Using U.S. consumer price index microdata to track inventory shortfalls, I find that limited corporate liquidity and financial constraints are associated with more frequent shortfalls. Taking on high leverage increases shortfalls by about 10 percent. Highly leveraged firms appear to be degrading their products' quality in order to preserve current cash flow for debt service. Although reducing quality can erode both current sales and customer loyalty, firms appear to be willing to risk these outcomes in order to achieve benefits associated with debt finance.

Keywords: debt, financial constraint, inventory management, stockout, leveraged buyout

JEL Classifications: D21, G31, G32, G34, L81, M31

Working Paper Series