These large companies effectively borrow from their smaller vendors via trade credit, the bridge financing that manufacturers extend to retail buyers to cover the gap between acquiring goods in inventory and the final sale of the goods. Large retailers often demand longer payment terms—for example, taking 60 days to pay instead of 30 days—and smaller vendors usually comply with the demands from their important buyers. The study, “The Implicit Costs of Trade Credit Borrowing by Large Firms,” finds that even a small delay in payment days has a significant effect on the operations of these smaller manufacturers.
“When a firm like Walmart, Target, or Costco pays more slowly, their small suppliers can’t just borrow more money, so they cut back on spending,” says study co-author Justin Murfin, assistant professor of finance at the Yale School of Management. “They invest less, they cut overhead, they do whatever they can to support their much bigger buyers. That causes a big distortion in the economy because firms that potentially have good projects to invest in can’t invest in them because they’re allocating their scarce capital to support these big buyers who don’t face any financing constraints.”
Murfin and co-author Ken Njoroge of the Lundquist College of Business at the University of Oregon studied how delays in buyers’ payments changed the spending behavior of suppliers by matching pairs of buyers and suppliers. They identified a sample of 1,063 unique buyer-seller pairs, with 40 big retail buyers and 723 sellers that supply them. The median supplier had a market capitalization of one-tenth of 1% of the size of the median buyer, at $29 million and $23 billion, respectively, and faced interest rates more than six times higher.
The authors found that, on average, when a large buyer pays one month more slowly, constrained suppliers cut back their capital expenditures by 1.2% of their lagged assets. “If you do 80% of your sales to Walmart and Walmart pays you even a little bit slower, it drains your cash by a lot,” explains Murfin. “Suppliers have to make that up from somewhere, and we show that one of the ways they do that is by cutting back on their spending.”
Buyers face a tradeoff when they demand more favorable payment terms. The authors show that as payable days grow, so does the price markup that suppliers place on their goods as compensation for being squeezed by financing.
To confirm that the effect of suppliers investing less when buyers pay more slowly is due to constrained access to financing, the authors studied a shock to financing constraints. They compared suppliers whose major lender was CIT, which went into bankruptcy during the financial crisis, to suppliers that were not banked by CIT. Murfin and Njoroge found that firms that had less access to financial capital because their major lender failed were the most impacted by the payment terms of their major buyers.
The authors also found something unexpected: during the financial crisis, buyers seemed to understand that suppliers were constrained and paid them more quickly. “Suppliers that had been banked by CIT and therefore had been damaged were the most appreciative and responded by investing more or not cutting back their investment by as much. They took the faster payment as a liquidity shock and invested the money,” says Murfin.
Murfin says that the paper offers a simple message for CFOs who have the bargaining power to squeeze their suppliers. “Paying your supplier more slowly damages your supplier. In order for your supplier to withstand that, they have to be compensated somehow. So if you’re the bigger company that can borrow more cheaply, then you should do the financing, and, of course, you can pay your supplier lower prices. They’ll be willing to accept that because it means they’re not getting squeezed on the financing.”
“The Implicit Costs of Trade Credit Borrowing by Large Firms” is forthcoming in the Review of Financial Studies.