Journal OfBusincss Finance &‘Accounting, zyxwvu 13(4), zyxwv Winter 1986, 0306 686X f2.50 zyx USING FINANCIAL MARKET DATA TO MAKE TRADE CREDIT DECISIONS JAMES A. MILES AND RAJ VARMA’ INTRODUCTION Most firms sell on credit to other firms. The buyer promises to make a future cash payment in exchange for receiving the goods immediately. Credit analysis consists of evaluating the promise to pay and comparing its value with the incremental costs of providing those goods. As is the case with any financial decision, the trade credit decision should be evaluated in a wealth maximiza- tion framework. This is done by computing the decision’s Net Present Value (NPV), which is simply the present value of the benefits less the present value of the cost. In case of the trade credit decision NPV would equal the market value of the buyer’s promise-to-pay minus the incremental cost to the seller for pro- viding credit. The purpose of this paper is to show how financial market data can be used to compute the NPV of the above credit decision. Practitioners have developed models using various accounting ratios (such as coverage ratio, debt to equity ratio, etc.) to assess credit-worthiness. Almost all these models have been derived by some statistical search using various com- binations of all kinds of accounting ratios until one that works is found. Although fairly successful in predicting credit-worthiness, most accounting ratio models have little theoretical foundation. Also a major problem with these models is that they do not provide a method by which an explicit market value estimate of the buyer’s promise can be made. Thus, although these models can provide an indication of the buyer’s credit-worthiness, they cannot assign a market value to the buyer’s promise. This makes it impossible to view the trade credit decision in a NPV context. In this paper a method is developed to find the value of a buyer’s promise. It is shown that the correct measures of a buyer’s promise are the market value of equity (share price multiplied by number of shares outstanding) and the variance of equity value. In a single-period model, default occurs at the end of the period only if the buyer’s equity value is zero. Intuitively, if current equity value is ‘high’ and the variability of equity value is ‘low’ for a particular buyer, then it is unlikely that equity market value will fall to zero by the end of the period and the buyer is a good credit risk. This intuition is exploited here by using an option pricing equation and the observed market value of equity to value the buyer’s promise. z ’ The authors are from the Department of Finance, College of Business Administration, The Pennsylvania State University. (Paper received April 1985, revised January 1986) zy 505