Running head: IMPACT OF TRADE CREDIT ON THE PROFITABILITY OF FIRMS 1

IMPACT OF TRADE CREDIT ON THE PROFITABILITY OF FIRMS

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IMPACT OF TRADE CREDIT ON THE PROFITABILITY OF FIRMS 2

ABSTRACT

The amount of the accounts receivables denote a large segment of the company’s

investment. Therefore, the intent of this work is to evaluate the association between investing in

the accounts receivable and the profitability of firms and also discuss the effects of the trade

credit motives, in terms of financial, operational, and commercial, on the association between the

profitability of companies and the accounts receivable. The findings indicate that companies can

enhance their profitability by investing in the accounts receivable; the impact is greater in

companies with a significant volatile demand. Besides, the study reveals that companies that

invest more compared to the average companies in the industry tend to be more profitable.
IMPACT OF TRADE CREDIT ON THE PROFITABILITY OF FIRMS 3

1.0 INTRODUCTION

The manner in which firms act when pursuing financial assistance for their operations

depends on the economic environment that is distinguished by, among other aspects, fiscal and

monetary policies. Finances are required in the establishment of an enterprise and in the running

and development of the same. In the initial stage of the firm lifecycle, the individual

contributions of the entrepreneur plays a critical role. Nevertheless, in the later stages, external

sources of funding are inherent in the provision of the financial leverage impact. However, as a

result of low credit worthiness, the significant cost of banks or capital restrictive lending

regulations, most enterprises find it challenging to acquire bank loans. Firms pursuing bank loans

are quite large, less liquid, less profitable, and young. Companies in industries with a great

historical start-up failure rates employs reduced bank debt. The establishment of trust between a

company and a banking organization enhances the accessibility of loans. The interactive nature

of collaboration is a tool to reduce the rationing of bank financing to enterprises. In relation to

the start-ups, challenges to the use of bank financing include inadequate credit history, the

commitment to pat loan interests and instalments within the stipulated deadlines, low

creditworthiness, the need to spend the finances as reported to the bank, and also the collateral

needs. The main objective of this essay is to analyze the effects of trade credits to the

profitability of enterprises.

2.0 Literature Review

Trade credit is established when the buyer delays making payments to their supplier for

goods. Trade credit exists once the buyer defers payments to their suppliers for the products

bought. According to Martínez-Sola et al. (2014), investment in terms of trade credit is likened to

capital assets, in which both play a role in molding the value of the firm by increasing the market
IMPACT OF TRADE CREDIT ON THE PROFITABILITY OF FIRMS 4

share. Besides, providing trade credit can increase the sales volume of the firm (Wilson &

Summers, 2002). Hypothetically, Martínez-Sola et al. (2014) posit that the performance of

companies is directly affect by the amount of trade credit offered to buyers. Companies utilize

trade credit to enhance their sales and revenue. Companies in a good financial position opt to

increase their market share by providing trade credit to its clients, particularly the buyers whose

credit rating is low. Also, companies utilize trade credit as a tool in price discrimination to

enhance the volume of their sales to buyers in a poor financial condition. Therefore, companies

tend to enhance the implicit price of the commodities to the buyers without conflicting the law of

price discrimination. Wilson & Summers (2002) are of the view that trade credit can enhance the

volume of sales and profitability by minimizing the asymmetric data between the sellers and the

buyers. Therefore, the seller can provide the buyer with time to inspect and evaluate the quality

of the merchandise before making payments. Trade credit is essential as it facilitates operating

and functioning efficiencies as it splits the processes of supplying the commodities from the

process of acquiring money from buyers, particularly in the seasons of irregular demand. It is

quite expensive for companies to change or adjust the rate of production; during a period of low

demand, the operation of a firm remains idle. Notably, during the season of high demand, a

company requires additional investment in capital resources; else, it loses its sales.

3.0 METHOD

To evaluate the effects of trade credit on the profitability of a firm, this work utilizes the

standard model of company’s profitability applied by Deloof (2003). By paying attention to

Martínez-Sola et al. (2014), the work modifies the model and examines if the investment in the

trade credits has any impacts on the profitability of a firm. Consequently, it examines if the

association is impacted by the characteristics of a company. The profitability of the firms acts as
IMPACT OF TRADE CREDIT ON THE PROFITABILITY OF FIRMS 5

the dependent variable to the study. The study uses the return on assets (PROF) that is obtained

as the ratio of earnings before interest and taxes over all resources (Lemmon, Roberts, & Zender,

2008). The investment in accounts of receivables is used as the primary independent variable for

the study. By adhering to Martínez-Sola et al. (2014), we obtain it as the ratio of accounts of

receivable to all resources. The study projects a positive correlation between the profitability of

firms and the accounts receivable. Companies ought to adhere to the industry norms in providing

trade credit; hence, the profitability of a company can be adversely affected in instances where

the firm provides less trade credit compared to its rivals. Therefore, the study projects that the

firm ought to be more profitable in case the investment in the accounts receivable is greater

compared to the average investment of the companies in the industry.

4.0 DATA

In the study, we incorporate a number of control variables together with their projected

effects on the profitability of firms. Size is one of the variables included. Large companies have a

greater advantage compared to small organizations since they produce in large volumes. We also

included growth. Companies with a higher rate of growth are projected to have more investment

chances in the future. Debt has also been included as a control variable. Companies use debt to

reduce the taxes paid. Nevertheless, the agency cost as well as the asymmetric data concern can

increase the expenses of debt. Lastly, GDP has also been employed as a control variable. The

economic conditions are likely to impact the demand for the products from the firm that impact

the profitability of companies. To assume control over the economic cycle, the GDP is inherent.

5.0 RESULTS

The study starts by evaluating the effect of trade credit regulation on the profitability of

firms. The outcomes are a confirmation of the projections that investing in the accounts
IMPACT OF TRADE CREDIT ON THE PROFITABILITY OF FIRMS 6

receivable imparts a positive effect on the profitability of firms. The results imply that companies

enhances its profitability once they make more investments in trade credit. In the stiffly

competed markets, companies employ trade credit as a tool of promotion and differentiating their

client financing to enhance their market share and sales volume, which consequently improves

on the profitability. Additionally, the outcomes confirm that the expenses of relaxing the trade

regulation like collection, financing, as well as bad debt are much less compared to the benefits

gained from trade credit. The outcomes gathered greatly align with the results of Hill et al.

(2012) and MartínezSola et al. (2014). Therefore, the findings indicate that companies that tend

to put more investments compared to the averages of the industry can enhance their revenue

generation. The findings of the control variables indicate that the profitability of companies is

positively affected by the size and growth of the firm and the growth in GDP. However, it is

adversely affected by the debts accrued by the firms.

The results gathered through the study show that companies have the capacity of

enhancing their profitability by enhancing their investments in the accounts receivable. In this

case, we can get a better comprehension of the correlation between the accounts receivable and

the firm’s profitability if the study divides the companies on the basis of their features. Hence,

the study assesses the effect of dividing the sample into two subsamples as per the characteristics

of the company, such as the size of the firm, its liquidity, market share, and sales volatility. The

strategy utilized in the study entails the subdivision of companies above and below the median

and run the regression individually for every subsample. Hence, the variation of the noted

coefficient ought to offer a clear image on the effect of trade credit objects on the profitability of

the firm such as commercial motives, operating motives and the financing motivates.
IMPACT OF TRADE CREDIT ON THE PROFITABILITY OF FIRMS 7

Companies that have high volatility in the demand of products can significantly minimize

the expenses that come with volatility by smoothing the demand. Therefore, they can increase

their profitability in instances where they relax trade credits in the peak seasons and tighten the

credit regulations in the seasons of low demand. In testing the functional intents of using trade

credit can enhance the profitability of firms, the study splits the samples into two categories:

companies with a higher volatility of sales and companies that have a lower volatility of sales.

6.0 DISCUSSION

Suppliers can provide trade credit to companies that experience challenges in accessing

financial support, due to their comparative advantage in acquiring data regarding their debtors,

greater ability to liquidate the assets subject to trade credit, as well as the greater concealed share

in the survival of the buyer over an extensive duration of time. Besides, trade credit enables the

reduction of the transaction expenses through the separation of the supply chain from the

payment cycle.in their trade receivable model, Abuzayed (2012) believe that bigger companies

tend to provide more trade credit. The relationship between the age of the firm and the trade

credit provided is of a non-linear nature. The credit supply develops and advances together with

the age of the company originally, to indicate a gradual downturn afterwards. Bigger companies

tend to provide more trade credit. The supply of trade credit is positively correlated to the

maximum credit line accessible. The demand for the trade credit indicates a weak positive

association to the size and age of the company. According to Baum, Schäfer & Talavera, (2011),

companies tend to minimize their recourse to the financing of trade credit since their profitability

tends to increase in the Eastern and Central Europe regions except for Lithuania and Hungary.

However, bigger and more profitable companies have a more likelihood of extending the trade

credit, while the companies under the threat of bankruptcy-least (Bougheas, Mateut and Mizen
IMPACT OF TRADE CREDIT ON THE PROFITABILITY OF FIRMS 8

2009), despite that the latter category is more aligned to using the trade credit. (Couppey-

Soubeyran i Hericourt, 2011). With regards to the adverse value of the variable evaluating the

length of the banking association, Lee & Mahmood (2009) observe that the trade credit goes

below the bank credit in the pecking order financial framework.

The objectives and roles for the trade credit can encompass: the reduction of the

informational asymmetry between non-financial and the financial market, improving the

functional effectivenss, minimizing any forms of inefficiencies on the financial market, attaining

the investment chances or enhancing the competitive edge of the company. According to Cheng

and Pike (2003), companies that operate in competitive markets are compelled to provide their

customers with trade credit. The decision of extending the trade credit denotes any plans in

maintaining and developing associations and ties with the buyers, hence enhancing the image of

the company.

7.0 CONCLUSION

Investments in the trade credit denotes a crucial volume of the balance sheet item of a

firm. Trade credit is established in instances where companies allow their clients to delay or

defer payments on the commodities bought. With a significant amount invested in the accounts

receivables, it can be projected that the management of such investment by the organization

imparts an effect on the profitability of the company. Hence, companies aim at taking full

advantage of the investment in the accounts receivables on the profitability of firms.

Additionally, the essay aimed at examining and evaluating if the profitability of an investment is

impacted by the characteristics of a company. The study uses the percentage of accounts

receivable to all assets as the investment in the trade credit.

The study uses the return on assets as the measure of the profitability of the firm. The

study documents a positive correlation between the investments in the profitability and accounts

receivable, and goes further to determine that organizations attain high profit in instances where

they invest in the accounts receivable at a greater degree compared to the industry average. The

study also finds that the attributes of a company can impact the profitability from investments in

accounts receivable, where we note that companies with greater volatility in demand tend to be

more profitable after investing in the accounts receivables. Generally, the results indicate that

investments in accounts receivable is crucial and integrating the routine trade credit regulation is

essential to the profitability of a firm. Hence, companies ought to take to considerations the

management of accounts receivable in their financial plan and planning course.

REFERENCES

Abuzayed, B. (2012). Working capital management and firms’ performance in emerging

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on firms’ financial constraints. Journal of International Money and Finance, 30(4), 678–

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