Martin H. Seiden

English

Research Papers in Economics

This PDF is a selection from an out-of-print volume from the National Bureau
of Economic Research
Volume Title: The Quality of Trade Credit
Volume Author/Editor: Martin H. Seiden
Volume Publisher: UMI
Volume ISBN: 0-87014-401-4
Volume URL: http://www.nber.org/books/seid64-1
Publication Date: 1964
Chapter Title: Trends and Cycles in Trade Credit Quality
Chapter Author: Martin H. Seiden
Chapter URL: http://www.nber.org/chapters/c1866
Chapter pages in book: (p. 93 - 98)8
Trends and Cycles in Trade Credit Quality
Trend of Quality
All but one of the qualitative measures employed indicate that the
underlying quality of trade credit was declining between 1947 and 1957
(Table 43). There was a decline in the ability of firms to repay debt,
as indicated by the drop in the firms' financial ratios. Credit standards,
as measured by the turnover of trade debt, went down, perhaps as a
consequence of the decline in the repayment capacity of business.1 The
rising share of trade debt owed by small unprofitable firms also indicates
that a qualitative decline was under way. Only the increase in the average
age of firms suggested some improvement in the quality of trade credit,
the assumption being that the average age of trade debtor rose with the
average age of all firms. The age factor alone, however, cannot account
for more than a token offset to the decline in the over-all quality of trade
credit. On balance, it may be concluded that the quality of trade credit
declined in 1947-57. Supplementary data indicate that this long-run
1The turnover of trade debt is used here in place of the turnover of trade
credit discussed earlier. The latter suggests changes in credit standards as seen
from the trade creditor's viewpoint, while the former looks at credit standards from
the recipient's or debtor's viewpoint. In addition, the turnover ratio used here
(SITD) is the reciprocal of the one employed in Chapter 4, so that its change will
move in the same direction as changes in credit quality.
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.Trends and Cycles in Trade Credit Quality
decline has persisted into the 1960's. More research is required to
determine the implications of this trend for, general business conditions.
Some tentative conclusions are cited below.
Ranking the Measures
The several measures of the ex ante quality of trade credit are not of
equal importance. 'Since the greater part of the risk inherent in lending to
small, young, or unprofitable firms is their chronically poor financial
position, the four financial ratios stand out as the most important meas-
ares. The distribution of trade debt (Table 43, cols. 1, 5-7) is useful
principally for the perspective it provides for judging the relative impor-
tance to the economy of changes in the financial position of different
groups of firms.
Changes in the turnover of trade debt (Table 43, column 4), used
here as a rough measure of changes in credit standards, lie between the
financial ratios and the distribution of trade debt in importance for
qualitative analysis. Although a tightening of terms or a greater selec-
tivity in the choice of customers could maintain the quality of trade
credit despite a decline in the financial position of the universe of firms,
if the measure of credit standards (sales/trade debt) declines at about
the same rate as the other financial ratios, it may be assumed that the
decline in the financial ratios describes the declining repayment capacity
of trade debtors.
Turning Points in Trade Credit Quality
Trade credit quality, as defined by the four financial ratios (see Chart
13), improves in business contractions and deteriorates in expansions.
The quality of trade credit, a function of the ability to repay debt,
is inversely related to the degree of indebtedness measured by the
financial ratios. Thus credit quality is at its lowest at or near the peak
of business activity, when the degree of indebtedness is highest, and
at its height at or near the trough of business activity, when the
degree of business indebtedness is lowest.2
2lndebtedness and liquidity are not, alternatives. A firmmayhave zero debt
and yet not be liquid. Conversely, a firmmaybe greatly in debt but be highly liquid,
as may be the case if the borrowed funds are held in the form of demand deposits
or government securities.
95The Quality of Trade Credit
CHART13
Turning Points in Financial Ratios and Related Series, 1947-61
(seasonally adjusted)
Interval in months
37 11 45 13 35 25 9
Reference cycle
Worth-to-Debt
Current Ration
Quick Ratio°iiiiiiiiii it" lilt
Working CapLtQI
illiltiF I' rtlititII"i'j4
Failure LiclbiUtiesb
II il itt
Profit Marginsb
1947'48'49'50'51'52'53'54'55'56'57'58'59'60'61
FTC-SEC Quarterly Financial Report for Manufacturing Corporations.
bGeoffrey H. Moore (ed.), Business Cycle Indicators, Princeton for NBER,
1961, Vol. I, Appendix B.
Shaded areas represent business contractions; unshaded areas, expansions.
96Trends and Cycles in Trade Credit Quality
The sequence of change in some of the measures of ex ante and
ex post quality can be seen in relation to one another and to general
business conditions in Chart 13, which shows the turning points of each
of the four financial ratios. These ratios are for manufacturing corpora-
tions and are computed from seasonally adjusted quarterly data pub-
lished jointly by the Federal Trade Commission and the Securities and
Exchange Commission.3 Also shown are the turning points in failure
liabilities for all nonfinancial firms and a series measuring the profit
margins of manufacturing corporations.
The four financial ratios are all inversely rejated to general business
conditions, although their turning points have not always coincided
closely with opposite turns in the business cycle.4
Failure liabilities are inversely related to the financial ratios,
usually with a lag. This suggests that the least-liquid firms tend to be
eliminated with the increasing indebtedness associated with periods of
prosperity. Profit margins (ratio of profits to sales) are shown to decline
before the peak of the general business cycle, but after the peaks in the
financial ratios. The decline in. profit margins adds to the pressure of
the mounting debt burden during the business expansion, and con-
tributes to the rise in failures. Similar relationships appear to hold
during the business contraction. Hence these variables are related to
one another in a fashion that suggests a fairly cohesive system.
The Cycle of Credit Quality: A Hypothesis
Although the data analyzed in this study permit only tentative generali-
zations, a hypothesis about the cycle of trade credit quality may be
formulated.
Apparently the sensitivity of the business sector to a decline or
even to a stabilization of demand and profit margins increases with the
increased indebtedness of the business sector accompanying general
economic expansions. Thus, while prosperity is still under way, illiquidity
3See Appendix Table B-7.
4 turnoverof trade debt (not shown in the chart) does not conform to
general business conditions. It had only two turning points in 1947-60, and the
variations were slight: a peak in the second quarter of 1950 and a trough in the
third quarter of 1952. Otherwise the sales-to-trade-debt ratio, though possessing a
negative trend, was comparatively stable from 1952 through 1960. As noted in
Chapter 4, this ratio or its alternative, the collection period, is useful only as a
to long-run, not to short-i-un, changes in credit standards.
97The Quality of Trade Credit
and potential insolvency begin to grip an increasing proportion of
business. As profit margins decline in the late stages of the boom, further
increases in indebtedness are discouraged, thereby halting the deteriora-
tion in the quality of credit. The decline in sales, which begins at the
peak of the general business cycle and continues throughout the conk
traction, contributes to the elimination of the least liquid firms whose
solvency was based on the cash flow generated by the high sales volume
of the expansion. The process of improvement in the quality of credit
follows.
It has been found that, during the downturn in general business
conditions, the cutback in production and the reduction in inventories
and outstanding receivables yield excess receipts on operations.5 The
sharper the downturn and the higher the preceding level of indebted-
ness, the greater the accumulation of excess receipts. As a result, the
need for new credit is reduced and a reversal of the credit flow is
facilitated.
Thus during the downturn the reduction in debt accumulation and
the partial liquidation of outstanding debt bring about an improvement
in the quality of current and potential credit. The stage is set for the
next business expansion.
5Wilson F. Payne, Industrial DemandsUponthe Money Market, 1919-1957:
A Study in Fund-Flow Analysis, NBER Technical Paper 14, New York, 1961, p. 10.
Thomas M. Stanback, Jr., Postwar Cycles in Manufacturers' Inventories, Princeton
for NBER,, 1962.
98

The Quality of Trade Credit

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