The Effect of Trade Credit on Leverage Adjustment Speed

Capital market imperfections make a linkage between the firms’ leverage and its value. In other words, there is a level of leverage at which the entity achieves its maximum value. It is generally assumed that the actual leverage is close to the optimal (target) leverage and when firms deviate from the optimal leverage or their optimal leverage changes, the actual leverage ratio is rapidly approaching the optimal leverage. However, several factors such as financing frictions in the capital market, macroeconomic shocks, as well as financial constraints and agency costs slow down the adjustment speed. Among the theories related to firms’ leverage (including trade-off, pecking order, agency and market timing theory), the concept of target (optimal) leverage has a key role in trade-off theory. According to trade-off theory, optimal leverage is achieved via balancing the tax shield of debts and bankruptcy costs, and if adjusting the leverage does not impose cost on a firm; the company will minimize any deviation from the target leverage rapidly. The dynamic version of trade-off theory highlights the role of adjustment costs in firms’ financing decisions. In this version, if there is a deviation between the actual and the optimal leverage, firms balance the benefits and costs of adjustment. If the adjustment costs are high, the firm may not adjust the leverage. On the other hand, using trade credit is one of the ways to firms’ short-term financing. This research investigates the effect of trade credit on firms’ actual leverage adjustment speed to achieve the target (optimal) leverage. 

This research is applied. In terms of research purpose, it is analytical, quasi-experimental and correlational, and in terms of time dimension, it is retrospective and post-event. The research sample includes 143 firms listed in Tehran Stock Exchange (TSE) during the period 2005-2019. In order to determine the type of firms’ leverage (over-leveraged or under-leveraged), our static models are estimated using panel data approach and fixed effect modes. In addition, to test the research hypotheses, we use dynamic models using the difference generalized method of moment’s estimator (Difference-GMM), and the system generalized method of moments estimator (System-GMM) is used in our robustness tests. 

Overall, the results show that in over-leveraged firms, the leverage adjustment speed is faster for those firms which have lower trade credit than other firms. Furthermore, our results indicate that in under-leveraged firms, the leverage adjustment speed is slower for those firms which have lower trade credit. Findings from robust tests that confirm our initial results are consistent with trade-off theory. 

Findings show that in sub-sample of firms where debts are more (less) than the optimal amount, more use of trade credit and reducing its capacity, reduces (increases) the speed of correcting the actual leverage to achieve the target leverage. In addition, our findings indicate that in sub-sample of firms where debts are less than the optimal amount, more use of trade credit and reducing its capacity increases the speed of correcting the actual leverage to achieve the target leverage.