Inventory, Risk Shifting, and Trade Credit

Abstract

This article has two objectives. First, it shows how debt financing distorts the inventory decision of a retailer who orders multiple items that differ in cost, revenue, or demand parameters. Taking advantage of limited liability, a debt-financed retailer will favor items with a low salvage value, those with a high profit margin, and those that represent a large proportion of the total inventory investment. Second, we argue that this distortion is mitigated when financing is provided by the supplier(s) who can observe the actual order quantities before determining the credit terms. “Borrowing goods” rather than “borrowing cash” limits the retailer’s ability to deviate from the first-best inventory decision. This benefit of trade credit financing is most significant when sourcing multiple differentiated items from a single supplier, and when bankruptcy risk and, thus, the limited liability effect are considerable.