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«WORKING CAPITAL MANAGEMENT, CORPORATE PERFORMANCE, AND FINANCIAL CONSTRAINTS Sonia Baños-Caballero Profesora Ayudante Dep. Management and Finance ...»

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WORKING CAPITAL MANAGEMENT, CORPORATE PERFORMANCE, AND

FINANCIAL CONSTRAINTS

Sonia Baños-Caballero

Profesora Ayudante

Dep. Management and Finance

Faculty of Economics and Business

University of Murcia

Murcia (SPAIN)

Pedro J. García-Teruel

Profesor Titular

Dep. Management and Finance

Faculty of Economics and Business

University of Murcia

Murcia (SPAIN)

Pedro Martínez-Solano

Profesor Titular Dep. Management and Finance Faculty of Economics and Business University of Murcia Murcia (SPAIN) Área Temática: b) Valoración y Finanzas Keywords: working capital; corporate performance; financial constraints.

JEL classification: G30; G31; G32.

Acknowledgements: This research is part of the Project ECO2008-06179/ECON financed by the Research Agency of the Spanish government. The authors also acknowledge financial support from Fundación CajaMurcia.

WORKING CAPITAL MANAGEMENT, CORPORATE PERFORMANCE, AND

FINANCIAL CONSTRAINTS.

Abstract This paper examines linkage between working capital management and corporate performance for a sample of non-financial UK companies. Our findings provide strong support for an inverted U-shaped relation between investment in working capital and firm performance, that is, companies have an optimal working capital level that maximizes their performance. Additionally, we also analyze whether this optimum is sensitive to alternative measures of financial constraints. Our findings show that the optimal level of working capital is lower for firms more likely to be financially constrained.

Keywords: working capital; corporate performance; financial constraints.

JEL classification: G30; G31; G32.

GESTIÓN DEL CAPITAL CIRCULANTE, VALOR DE LA EMPRESA Y

RESTRICCIONES FINANCIERAS

Resumen Este trabajo estudia el efecto que la gestión del capital circulante tiene sobre el valor de las empresas. Para ello, se ha utilizado una muestra de empresas no financieras del Reino Unido. Los resultados obtenidos ponen de manifiesto que existe una relación cóncava entre la inversión en capital circulante y el valor de la empresa, lo que implica que existe un nivel de inversión en capital circulante en el que se maximiza dicho valor. Adicionalmente, también se ha estudiado si este nivel óptimo de inversión está afectado por la existencia de restricciones financieras. En este caso, encontramos que aquéllas empresas con mayor dificultad para obtener financiación presentan un nivel de inversión óptimo menor.

Palabras clave: capital circulante; valor de la empresa; restricciones financieras.

Clasificación JEL: G30; G31; G32.

1. Introduction The literature on investment decisions has been developed through many theoretical and empirical contributions. A direct relation between investment and firm value has been demonstrated by a number of studies (see, for example, McConnell and Muscarella, 1985; Chung, Wright and Charoenwong, 1998; Burton, Lonie and Power, 1999). Additionally, since the seminal work by Modigliani and Miller (1958) showing that investment and financing decisions are independent, extensive literature based on capital-market imperfections has been published that supports the relation between these two decisions (Fazzari, Hubbard and Petersen, 1988; and Hubbard, 1998).

Finally, there is a large and growing literature documenting the sensitivity of investment to cash flow (Pawlina and Renneboog, 2005; Guariglia, 2008; among others).

However, empirical evidence on the valuation effects of investment in working capital and more specifically the possible influence of financing on this relation is scant, despite the importance of taking into account the interrelations between the individual components of working capital when evaluating their influence on corporate performance (Schiff and Lieber, 1974; Sartoris and Hill, 1983; Kim and Chung, 1990).

Previous studies on working capital management fall into two competing views of working capital investment. Under one view, higher working capital levels allow firms to increase their sales and obtain greater discounts for early payments (Deloof, 2003) and, hence, may increase firms’ value. Alternatively, higher working capital levels need to be financed and, consequently, firms face additional financing expenses that increase their probability of going bankrupt (Kieschnick, LaPlante and Moussawi, 2009). Combining these positive and negative working capital effects leads to the prediction of a nonlinear relation between investment in working capital and firm value.

We hypothesize an inverted U-shaped relation may result if both effects are sufficiently strong.

Authors like Schiff and Lieber (1974), Smith (1980) and Kim and Chung (1990) suggested that working capital decisions affect firm performance. In this line, Wang (2002) finds that firms from Japan and Taiwan with higher values hold a significantly lower investment in working capital than firms with lower values. Recently, Kieschnick et al., (2009) studied the relation between working capital management and firm value.





The last of these take Faulkender and Wang (2006) as their baseline valuation model and analyze how an additional dollar invested in net operating working capital is valued by shareholders of US corporations by using a stock’s excess return as proxy for firm value. Their results show that, on average, an additional dollar invested in net operating working capital is worth less than a dollar held in cash. Additionally, they find that an increase in net operating working capital, on average, would reduce the excess stock return and show that this reduction would be greater for those firms with limited access to external finance. Since market imperfections increase the cost of outside capital relative to internally generated funds (Jensen and Meckling, 1976; Myers and Majluf, 1984; and Greenwald, Stiglitz, and Weiss, 1984) and may result in debt rationing (Stiglitz and Weiss, 1981), Fazzari, Hubbard and Petersen (1988) suggest that firms’ investment may depend on financial factors such as the availability of internal finance, access to capital markets or cost of financing. Moreover, Fazzari and Petersen (1993) suggest in their analysis that investment in working capital is more sensitive to financing constraints than investment in fixed capital.

However, while that study focuses on the influence of an additional investment in working capital on firm value, our paper examines the functional form of the relation between investment in working capital and corporate performance. In addition, and taking into account that financing conditions might play an important role in this relation, we also study whether the above-mentioned relation is affected by firms’ financing constraints. To our knowledge, our paper is the first to carry out these analyses.

We use non-financial companies from United Kingdom. The UK is considered to have well developed capital markets (Schmidt and Tyrell, 1997), and it is estimated that more than 80 per cent of daily business transactions in the UK corporate sector are on credit terms (Summers and Wilson, 2000). In fact, Cuñat (2007) indicates that trade credit represents about 41% of the total debt and about half the short term debt in UK medium sized firms.

This study contributes to the working capital management literature in a number of ways. First, we offer new evidence on the effect of working capital management on corporate performance, by taking into account the possible non-linearities of this relation. Second, the paper investigates the relation between investment in working capital and firm performance depending on the financing constraints of the firms. Third, we estimate the models by using panel data methodology in order to eliminate the unobservable heterogeneity. In addition, we use the Generalized Method of Moments (GMM) to deal with the possible endogeneity problems.

Our results indicate that there is an inverted U-shaped relation between working capital and firm performance. That is, investment in working capital and corporate performance relate positively at low levels of working capital and negatively at higher levels. In addition, we find that the results obtained are maintained when firms are classified according to a variety of characteristics that are designed to measure the level of financial constraints borne by firms. The findings show that the optimum is sensitive to financing constraints of the firms and that under each of our classification schemes optimal working capital level is lower for those firms that are more likely to be financially constrained.

The remainder of this paper is organized as follows. The next section develops the predicted concave relation between working capital and corporate performance and outlines the possible influence of financing conditions on this relation. In section 3 we describe our empirical model and data. We present our results in section 4. Moreover, we also analyse how the optimum changes between firms more or less likely to face financing constraints. Finally, section 5 concludes the paper.

2. Working capital, corporate performance and financing.

2.1. Working capital and corporate performance The investment in receivable accounts and inventories represents an important proportion of a firm’s assets, while trade credit received is an important source of funds for most firms. In fact, Cuñat (2007) indicates that trade credit represents about 41% of the total debt and about half the short term debt in UK medium sized firms.

There is substantial literature on credit policy and inventory management, but few attempts have been made to integrate both credit policy and inventory management decisions, even though Schiff and Lieber (1974), Sartoris and Hill (1983), and Kim and Chung (1990) do show the importance of taking into account the interactions between the various working capital elements (i.e. receivable accounts, inventories and payable accounts).

Lewellen, McConnel, and Scott (1980) demonstrate that under perfect financial markets, trade credit decisions cannot be used to increase firm value. However, capital markets are not perfect and, consequently, several works have demonstrated the influence of trade credit and inventories on firm value (see, for instance, Emery, 1984;

Bao and Bao, 2004). The idea that working capital management affects firm value also seems to be generally accepted, although the empirical evidence on the valuation effects of investment in working capital is scarce.

Various explanations have been offered for the incentives of firms to hold a positive working capital. Firstly, a higher investment in trade credit extended and inventories might increase corporate performance for several reasons. According to Blinder and Maccini (1991), larger inventories can reduce supply costs and price fluctuations and prevent interruptions in the production process and loss of business due to scarcity of products. Moreover, it allows firms better service for their customers and avoids high production costs arising from high fluctuations in production (Schiff and Lieber 1974).

Granting trade credit, on the other hand, might also increase a firm’s sales, because it is used as an effective price cut (Brennan, Maksimovic, and Zechner 1988; Petersen and Rajan 1997), it encourages customers to acquire merchandise at times of low demand (Emery 1987), it strengthens long-term supplier-customer relationships (Ng, Smith, and Smith 1999; Wilner 2000), and it allows buyers to verify product and services quality prior to payment (Smith 1987; Long, Malitz and Ravid 1993; and Lee and Stowe 1993). Hence, it reduces the asymmetric information between buyer and seller. Indeed, Shipley and Davis (1991), and Deloof and Jegers (1996) suggest that trade credit is an important supplier selection criterion when it is hard to differentiate products. Emery (1984), moreover, suggests that trade credit is a more profitable shortterm investment than marketable securities. Secondly, working capital may also act as a stock of precautionary liquidity, providing insurance against future shortfalls in cash (Fazzari and Petersen, 1993). Finally, from the point of view of accounts payable, Ng et al., (1999) and Wilner (2000) also demonstrate that a firm may get important discounts for early payments when it reduces its supplier financing.



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