Predicting a company’s stock return, through trade credit links

According to new research from Saïd Business School, Oxford and Católica Lisbon Business School, businesses that extend high levels of trade credit to their customers and engage in foreign sales have stock returns that are strongly predictable based on the stock returns of their associated international customers. This means that firms that extend high levels of trade credit may be more vulnerable to shocks to their customers, especially during financial crises.

Sumudu W. Watugala said: ‘The implications of these findings are that during a financial crisis, investors and policy makers should monitor the economic links between supplier and customer firms across countries, especially the use of trade credit. Extending high levels of trade credit may make firms more vulnerable to shocks to their customers. This paper sheds light on a source of firm risk that may lead to cross-border financial contagion.’

Trade credit, or the credit extended by suppliers to their customers, represents a significant source of financing for many firms. In the study, the use of trade credit was measured via the relative levels of accounts receivables on a firm’s balance sheet. Financing with trade credit is particularly important for firms that are bank credit-constrained or operate in emerging markets with underdeveloped legal systems and capital markets.

The findings were launched in a publication in the Journal of Financial Economics titled, ‘Trade Credit and Cross-Country Predictable Firm Returns’ which was authored by Professor Tarun Ramadorai and Sumudu W. Watugala at Saïd Business School, University of Oxford, and Professor Rui Albuquerque, Boston University and Católica Lisbon.

During financial crises, stock market movements across the globe appear synchronised. To explain this observation, many have highlighted the role of direct economic links. Recent domestic evidence from the US shows that economic links not only explain contemporaneous correlations between firms' stock returns, but also provide useful information for predicting future firm-level stock returns. The paper specifically focuses on the role of an important economic connection between suppliers and customers that leads to return predictability across borders.

The report analysed data from 43 countries from 1993 to 2009 and the authors developed an asset pricing model to better understand the effect in which firms in different countries are connected by trade credit links. Suppliers who extend trade credit have an implicit stake in the future prospects of their customers. The model offers further predictions about this phenomenon, for which the authors find empirical evidence, including stronger predictability during periods of high credit constraints and low uninformed trading volume.