Research Highlight Why some businesses prefer cash over credit lines
Businesses need cash – or its equivalent – to remain afloat, and liquidity management choices are key financing decisions. But how do firms trade off between their own cash reserves and bank credit lines to meet their needs? One overlooked determinant of this financing choice is customer risk, according to a new study by Prof. Thomas David.
Money makes the world go round, and it's particularly true of businesses. They need liquidity to ensure the continuity of their business, for example to purchase inventory, maintain the payroll in the off-season or just face an emergency that can't be addressed by selling off the family jewels or turning to financial markets.
So how do firms face their liquidity needs? Mainly, through cash (what's in the company's vaults/treasure chests) and credit (in the bank's vaults). Internal cash reserves and bank credit lines are two essential components of firms' liquidity management choices.
But how do they arbitrate between these two sources of liquidity? Academic studies have highlighted a number of determinants, including performance, risk and cost of financing, but remain silent on the effect of buyer-supplier relationships. Assistant professor of finance Thomas David addressed this gap in a recent paper focusing on customer risk.
Traditional predictors of happiness and their limits A trade-off between cash and lines of credit
While cash is a traditional answer to immediate financial needs, bank lines of credit appear to be a “credible and potentially valuable substitute for cash as a source of liquidity,” as Thomas David writes. The use of revolving credit facilities (i.e. that remain open as long as necessary, within the set credit limit) provides borrowing firms with both greater financial flexibility and capacity to meet their needs. “Lines of credit allow firms to seize investment opportunities without burning cash or raising external capital in good states of nature,” writes the professor, adding that “borrowing firms can use lines of credit as insurance against liquidity shocks (...) especially to ensure the continuity of their activities in the midst of a financial crisis.”
However, credit lines come with strings attached, in the form of covenants. Violating them decreases a firm's ability to obtain raise debt in the future.
So, there is a cost associated with relying on credit lines. According to existing literature, “these costs are higher for riskier firms either directly through tighter contractual terms (...) or indirectly through a higher implied threat of covenant violation”. But there are numerous ways a firm can be exposed to risk which affect a firm's financing decisions.
Customer risk as a determinant of cash-holding choices
Thomas David identified one under-documented source of risk exposure: supplier-customer relationships. Indeed, one of the major determinants of customer quality is the ability of a customer firm to honor its debts on time, if at all. In other terms, if customers fail to settle their bills, supplier firms face a higher operating risk through the potential loss of cash flows, which in turn for them means trouble meeting debt repayment deadlines.
Hence the professor's main hypothesis: Firms facing higher customer risk rely less on lines of credit as a source of liquidity (as opposed to relying on cash). To test it, he built a comprehensive sample of corporate loans for more than 8,000 US industrial firms covering more than a quarter of a century, then created a matched buyer-supplier sample. His results indeed exhibited a negative and significant correlation between customer risk and the relative reliance on credit lines.
Protecting the future availability of liquidity
Thomas David then took a look at another factor: the hedging needs of firms. Firms with high hedging needs are those most sensitive to a decrease in the expected future availability of funds for investment opportunities.
How do they hedge against low future cash flows? Notably, through precautionary reserves of liquidity. However, the cost of relying on bank-monitored liquidity insurance is increased, as banks are more likely to tighten the purse strings (through restrictive covenants, for example) when cash flows are low.
Therefore, firms with high hedging needs tend to shy away from external reserves of cash to maximize the probability of being able to draw from their liquidity reserves when needed. The results of the study did support this negative effect of customer risk on relative reliance on bank credit lines for firms with high hedging needs (though the effect was relevant, albeit marginal, for firms with low hedging needs).
Customer risk and stricter credit line covenants
Finally, another direct channel through which customer risk can affect the demand for lines of credit is the effect of the threat of covenant violations on decision-making, namely the fact that banks may impose stricter contractual terms on future credit lines if borrowers violate performance covenants. Alternatively, capital covenants may also be included in debt contracts, with lenders relying on some underlying collateral in order to ensure repayment.
Notably, asset-based credit facilities most commonly use accounts receivable as a borrowing base. Indeed, the empirical study confirmed that borrowing base credit lines, which require highly intensive monitoring from lending institutions, mechanically increase the threat of reduced access to external liquidity reserves for borrowing firms that face a potential decrease in the sufficiency of the receivables they pledged as collateral, a situation most likely to arise when customer risk is high. Consistent with this, the study shows that banks are more prone to including borrowing base provisions in credit line agreements signed with firms with riskier customers, instead of increasing the number and strictness of financial covenants.
These insights on corporate financial decisions are relevant to a broader set of firms than the US sample from the study. Managing supply-chain risk and meeting liquidity needs are indeed key aspects of all businesses, especially SMEs like small subcontractors. Indeed, as of 2019, 55% of US and 51% of European small businesses reported a significant reliance on bank credit lines as a source of external funding.