Government contracts and trade credit
Introduction
Government spending and the provision of goods or services to the government have received special attention over the past decade. In the fiscal year 2018, the U.S. federal government spent more than $550 billion in contracts for goods and services, an increase of $100 billion from the fiscal year 2015's purchases.1,2 This leads to the question of how such large spending influences the business environment. A growing number of studies investigate the impact of government contracts on firm behavior. Prior research reveals that firms with a government customer are more conservative (Hui, Klasa, & Yeung, 2012), have a lower level of tax avoidance (Huang, Lobo, Wang, & Xie, 2016), provide less earnings guidance (Cao, Hsieh, & Kohlbeck, 2013), make fewer investments in corporate social responsibility (Habib, Hasan, & Bhuiyan, 2015), and obtain equity financing at a lower cost (Dhaliwal, Judd, Serfling, and Shaikh (2016). Nevertheless, the relation between government contracts and firms' financing decisions remains unclear.
Trade credit refers to buyers' deferment of payment to their suppliers (Huyghebaert, 2006). Recent empirical studies on corporate financing have shown that firms have increasingly used trade credit as an important source of short-term financing (e.g., Abdulla, Dang, & Khurshed, 2017; Chen, Liu, Ma, Martin, & X., 2017; El Ghoul & Zheng, 2016). For example, nonfinancial U.S. businesses finance with trade credit relative to bank loans in a 3:1 ratio (Barrot, 2016). Trade credit accounts for 13% of total liabilities for U.S. manufacturing companies (Cao, Ye, Zhang, & Li, 2018). The increasing use of trade credit to finance operations highlights the importance of understanding the determinants of trade credit. In this study, we examine the association between a firm having government contracts and the firm's level of trade credit.
Theoretically, the association between government contracts and firms' level of trade credit is ambiguous. On the one hand, firms with government contracts may have lower demand for trade credit because of their (1) lower operational risk, (2) better firm performance, and (3) easy access to other cheaper sources of financing (e.g., Dhaliwal et al., 2016). Government contractors' low risk level is the result of the fact that their customer (i.e., the government) has a lower likelihood of bankruptcy than other customers. The long-term nature of government procurement contracts leads to a low probability of the government switching to a different contractor, which also lowers the risk level of government contractors (Dhaliwal et al., 2016). In addition, some government contractors have lower operational risk because cost-plus government contracts assign operational risk to the government rather than the government contractor. Moreover, the knowledge gained from government contracts enables firms to achieve better corporate performance (Anderson & Lee, 2016). Indeed, government contractors can obtain valuable knowledge through organizational learning and alliances with other parties during the process of producing products or providing services to the government. Furthermore, government contractors have a higher level of credibility than other firms (Al-Thaqeb & Harper, 2016). Coupled with lower firm risk, better firm performance and higher credibility will contribute to government contractors' higher capacity to generate internal funds and easy access to financing. Taken together, the above factors can lower government contractors' demand for supplier financing.
Alternatively, government contractors may have a higher demand for trade credit. This is because contractor firms have a higher level of litigation risk (Rainey & Bozeman, 2000) and lower investments in physical and intellectual capital over time (Cohen & Malloy, 2016), which influences their cost of debt and equity financing. In addition, supplier firms may be more willing to offer trade credit to government contractors. In fact, supplier firms assess the customers' creditworthiness and default risk when they decide to offer trade credit (Petersen & Rajan, 1997). In this sense, the lower operational risk, better firm performance, and higher credibility will provide government contractors an advantage over other firms in obtaining more trade credit.
Using a sample of 52,680 firm-year observations covering the period from 2000 to 2016, we document a negative association between government contractors and the firms' level of trade credit. The results suggest that government contractors use less trade credit than firms without government contracts. In a supplemental test, we examine the possibility that government contractors remit payments more quickly to take advantage of low-cost short-term financing within the discount period. Specifically, we use trade credit turnover as a measure of how quickly government contractors pay trade creditors. We find that compared to noncontractors, government contractors have higher trade-credit turnover.
To further explore the mechanisms through which government contracts are negatively associated with trade credit, we conduct the following additional tests: (1) the association between government contracts and operational risk and (2) the relation between government contracts and firm performance. The results show that the level of operational risk is lower for government contractors than non-contractors. We also find that government contractors perform better than non-government contractors. These results are consistent with the argument that government contractors can generate less risky cash flows and adequate internal funds for their operations. The results support our assertion that government contractors may have better access to other sources of financing.
We perform several tests to check the robustness of our results. We use the proportion of government sales to total sales as an alternative measure to identify government contractors. We find that firms with a greater ratio of sales to the government to total sales tend to use less trade credit. In other tests, we find our results are robust to alternative measures of trade credit. Next, we examine the association between government contractors and trade credit by controlling for potential endogeneity problems. Specifically, to correct for endogeneity, we employ the propensity score matching (PSM) method, in which we construct a control group similar to treatment firms (government contractors) in the same industry-year. We find that our results are qualitatively similar to our primary findings.
Our study makes several contributions. First, our results extend the growing field of empirical studies that focus on firms' use of trade credit as an important form of short-term financing. Prior studies have suggested that customer firm-related and supplier firm-related characteristics determine a firm's level of trade credit. Incremental to prior studies, our study shows that the type of customer is an important determinant of firms' use of trade credit. Second, prior research reveals that good customer relationship management helps firms to improve performance and profitability (Patatoukas, 2012; Payne & Frow, 2005). Extending this line of research, our findings suggest that the customer relationship (herein, the relationship with governmental customers) also influences firms' financing policies. Third, in the current study, we not only examine the relation between government contracts and firms' use of trade credit but also, to fill the gap in prior literature, investigate the mechanisms for the negative association between government contracts and the level of trade credit.
Dhaliwal et al. (2016) finds that firms that have the government as a major customer can obtain equity financing at a lower cost. Our study adds to this result by showing that government contractors use less trade credit. Different from Dhaliwal et al. (2016), our study does not focus on firms with government customers as a major customer. Instead, we examine all firms that have contracts with the government.
The remainder of the paper is organized as follows. Section 2 reviews the literature and develops our hypothesis. Section 3 describes our research design and the sample selection procedure. We present our empirical findings in Section 4. Section 5 presents our conclusions.
Section snippets
Prior research on government contractors
Prior research on government suppliers has documented the association between a contractor's characteristics and the government's purchasing decisions. For example, Flammer (2018) finds that only firms with a high reputation and other credible signals of trustworthiness can gain the government's trust and thus obtain government contracts. Burke, Convery, and Skaife (2015) find that government contractors are less likely to receive going concern audit opinions. Green, Tian, and Xia (2017) find
Model specification
We investigate whether government contractors have a higher level of trade credit using an ordinary least squares (OLS) regression as follows:
Following Chen et al. (2017), we use the ratio of accounts
Descriptive statistics
Panel A of Table 2 provides the descriptive statistics for the 52,680 firm-year observations included in the trade credit regressions. All the continuous variables are winsorized at the 1% and 99% levels to reduce the effect of outliers. The ratio of accounts payable to the book value of total assets (TRADECREDIT) has a mean of 0.1123 and a median of 0.0613. These values are consistent with those in prior studies that use the same measure of trade credit. For example, Chen et al. (2017) report
Government contractors and the turnover of trade credit
In this additional test, we investigate whether government contractors take advantage of early payment discounts of trade credit contracts. In trade credit contracts, there are two important dates: the discount date and the due date. Trade credit can be a cheap form of short-term financing if firms pay within the discount period. However, trade credit can become an expensive form of financing when firms make payments beyond the discount period. Given that government contractors have a high
Robustness tests
To ensure the robustness of our results, we conduct the following tests: an alternative measure of government contractors, alternative measures of trade credit, alternative estimations and standard errors, and the propensity score matching method to address potential endogeneity problems.
Conclusion
In this study, we investigate whether the provision of goods and/or services to the government influences firms' use of trade credit as a source of short-term financing. Government contractors may use more or less trade credit. On the one hand, government contractors may demand less trade credit for three main reasons. First, government contractors have a lower level of operational risk because cost-plus pricing contracts shift risk from the contractor to the government. Second, government
Declaration of Competing Interest
None.
Acknowledgments
We gratefully acknowledge helpful comments from Dennis Caplan (editor), the Associate Editor and the two anonymous reviewers.
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