Inventory, Risk Shifting, and Trade Credit

This paper has two objectives. First, we show how debt financing distorts a retailer’s inventory decision when the retailer orders multiple items that differ in cost, revenue, or demand parameters. Taking advantage of limited liability, a debt-financed retailer favors 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 the financing is provided by the supplier 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. On the flip side, few suppliers can access capital at the same low cost as banks. We study a combination of bank and supplier financing that allows the retailer to get the best of both worlds.