- 06 Sep 2012
- Working Paper Summaries
FIN Around the World: The Contribution of Financing Activity to Profitability
Overview — A basic premise of financial economics is that financial markets aid the flow of capital to its best use. In a frictionless world, every firm's return on equity (ROE) would equal the firm's cost of equity capital. However, numerous frictions at the firm and country level cause return on equity to vary considerably within and across countries. In this paper, the authors study one prominent friction―the availability of domestic credit from banks―and investigate how differences in the availability of domestic credit across countries influences the resulting leverage, spread, and the net financing contribution to firms' return on equity. Results show that the influence of domestic credit in a country, the rate that trade credit and financial credit substitute for each other, and how operating performance flows through to the financial performance, all depend critically on the relative size of the firm in its home economy. Key concepts include:
- Where a firm resides, and its relative size in that country, has a major impact on how the firm's profitability is affected by its financing activities.
- Large firms in countries with well-developed banking systems enjoy the largest financing contributions to ROE. This occurs despite the fact that they lower their leverage as their operating profit increases.
- The largest firms also come the closest to a perfect substitution between trade credit and financial credit, and this financial flexibility is not limited to the most well-developed countries.
- In contrast, the smallest firms gain the least from financing activities, regardless of the development of their home country's banking system.
We study how the availability of domestic credit influences the contribution that financing activities make to a firm's return on equity (ROE). Using a sample of 51,866 firms from 69 countries, we find that financing activities contribute more to a firm's ROE in countries with higher domestic credit. The higher contribution of financing activities is not driven by firms taking greater leverage in these countries, but by firms realizing a higher spread (i.e., a greater difference in operating performance and borrowing cost) when more domestic credit is available. Also, we find that firms partially substitute trade credit for financial credit, with large firms exhibiting the greatest rate of substitution. For small firms, the rate of substitution improves with the country's available domestic credit, while large firms are insensitive to this friction. The findings suggest that both country and firm-level factors have a significant impact on how financing activities contribute to corporate performance.