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How do market imperfections affect
working capital management?
Sonia Baños-Caballero, Pedro J. García-Teruel and Pedro Martínez-Solano
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Edita / Published by: Instituto Valenciano de Investigaciones Económicas, S.A.
Depósito Legal / Legal Deposit no.: V-283-2010 Impreso en España (enero 2010) / Printed in Spain (January 2010) WP-EC 2009-14 How do market imperfections affect * working capital management?
Sonia Baños-Caballero, Pedro J. García-Teruel and Pedro Martínez-Solano** Abstract This paper examines whether Working Capital Management (WCM) is sensitive to market imperfections such as asymmetric information, agency conflicts or financial distress. We find that firms have a target investment in working capital and that they take decisions in order to achieve this. In addition, the results appear to support the hypothesis that the working capital competes with investment in fixed assets for the funds of the firms when they have financial constraints. Finally, we also find that WCM depends on bargaining power and other financial factors such as the availability of internal finance, cost of financing and access to capital markets.
Keywords: net trade cycle, working capital management, market imperfections, panel data.
JEL classification: G30, G31, G32.
Resumen Este artículo analiza si la gestión del capital circulante está afectada por las imperfecciones de mercado tales como la asimetría informativa, los conflictos de agencia o las dificultades financieras. Los resultados muestran que las empresas tienen un nivel de inversión en capital circulante objetivo y toman decisiones con el fin de alcanzarlo. Además, los resultados parecen apoyar la hipótesis de que el capital circulante compite con los activos fijos por los fondos de las empresas cuando éstas tienen restricciones financieras. Finalmente, la gestión del capital circulante depende del poder de negociación y otros factores financieros tales como la disponibilidad de financiación interna, el coste de financiación y el acceso a los mercados de capitales.
Palabras clave: ciclo de efectivo, gestión del capital circulante, imperfecciones de mercado, datos de panel.
* This research is part of the Project ECO2008-06179/ECON financed by the Research Agency of the Spanish government. Sonia Baños-Caballero was in receipt of a FPU grant from the Spanish Government. The authors also acknowledge financial support from Fundación Caja Murcia.
** S. Baños-Caballero, P.J. García-Teruel and P. Martínez-Solano: University of Murcia. Contact author: email@example.com.
1. Introduction Since the seminal work by Modigliani and Miller (1958) showing that a firm´s financial structure is irrelevant to investment, the literature on investment decisions has been enlarged by many theoretical and empirical contributions. It has shown that in the presence of market imperfections, firms may prefer one source of funds over another because of a wide cost-wedge between internal and external funding sources. Myers and Majluf (1984) show that firms present a preference for internal over external funds, and in the case of external funds, a company prefers debt before equities. In fact, Fazzari, Hubbard and Petersen, (1988) test the financing hierarchy hypothesis and suggest that the firms´ investment may depend on financial factors such as the availability of internal finance, access to capital markets or cost of financing.
The investment that firms make in current assets, as well as the current liabilities used, represents an important share of items on a firm´s balance sheet. Decisions about how much to invest in receivable accounts and inventories, and how much credit to accept from suppliers, are reflected in the management of firms’ working capital. This may have an important impact on the profitability and liquidity of the firm (Shin and Soenen, 1998), so firms have to evaluate the trade-off between expected profitability and liquidity risk before deciding the working capital policy to adopt.
Despite the importance of working capital management for the profitability of the firms (Smith, 1980; Soenen, 1993; Jose, Lancaster and Stevens, 1996; Shin and Soenen, 1998; Deloof, 2003; and Garcia and Martinez, 2007), there has been little work on the empirical determinants of the working capital management. Chiou, Cheng and Wu (2006) analyze firm characteristics and macroeconomic factors that might affect working capital management for companies from Taiwan. Kieschnick, Laplante and Moussawi (2006) also study the determinants of WCM, in this case, for a sample of US companies. However, these studies have several limitations. First, they do not control for endogeneity. Second, none of these existing empirical studies has shown the possible existence of a target level of the measures of working capital management, even though its existence appears to be evident. Several previous studies (Nadiri, 1969;
Emery, 1984: Blinder, 1986, among others) have shown that firms have target or optimal levels for their individual components such as accounts receivable, inventories and accounts payable. Moreover, under imperfect capital markets, firms have to evaluate the trade-off between costs and benefits of maintaining a larger investment in working capital.
In this paper we attempt to extend the empirical research on working capital management in a number of ways. First, in contrast to the existing empirical studies, this paper adopts a dynamic framework, which assumes that firms have a target investment in working capital and that they adjust their current investment gradually over time because of adjustment costs. Second, we use panel data because it allows us to control for unobservable heterogeneity, making it possible to exclude biases deriving from the existence of individual effects. Third, we use two-step GMM estimator to avoid the problem of possible endogeneity. For example, several studies have shown how the measures of the working capital management affect profitability and firms´ sales. Finally, we present empirical evidence for a sample of Spanish firms in the context of the continental model, which is characterised by less-developed capital markets (La Porta, Lopez de Silanes, Shleifer and Vishny, 1997, 1998), low investor protection and high concentration of ownership. It allows our results to be compared with others obtained for companies with different financial systems.
Following Shin and Soenen (1998), we use the Net Trade Cycle (NTC) as a measure of working capital management. NTC indicates the number of “days sales” the firm has to finance its working capital under ceteris paribus conditions. Our findings indicate that firms have a target Net Trade Cycle and they adjust their current Net Trade Cycle to their target gradually over time because of adjustment costs. Moreover, the speed of adjustment is relatively quick, which may be because being in disequilibrium is costly for this sample. On the other hand, the results reported in this study suggest that firms that are capable of generating more internal funds have a longer cycle. The results also lend support for Fazzari and Petersen´s (1993) argument that working capital competes with the investment in fixed assets for the funds of the firms when they suffer financial constraints. The hypothesis that companies with a greater bargaining power follow a more aggessive working capital policy is also supported by the findings of this paper. Finally, our results suggest that Net Trade Cycle also depends on other financial factors such as the cost of financing and access to capital markets. Thus, we obtain that growth opportunities, probability of financial distress and cost of external financing negatively affect NTC. However, we do not find support for the hypothesis that leverage influences the measures of working capital management.
The remainder of this paper is organized as follows. The next section develops the hypotheses and reviews the previous studies on working capital management. In section 3 we describe the empirical model and data. We present our results in section 4 and relate them to earlier findings. Finally, the main conclusions are presented in Section 5.
2. Theoretical framework and hypotheses
In perfect capital markets, investment decisions of a firm are independent of its financial situation (Modigliani and Miller, 1958). Since there is no capital rationing, firms can always obtain external financing without problem, so the firms´ investment should be driven only by expected future profitability and, therefore, should not be affected by the availability of internal funds. However, in imperfect markets, the firms´ investment may depend on financial factors such as the availability of internal finance, access to capital markets or cost of financing (Fazzari, Hubbard and Petersen, 1988).
Under this situation, the working capital level held by companies may also be sensitive to these financial factors.
The Net Trade Cycle (NTC) and Cash Conversion Cycle (CCC) are the most popular measures of working capital management used in previous works, due to the criticism of static measures (Gitman, 1974; Kamath, 1989). Both of these measures are a dynamic measure of ongoing liquidity management, and they are closely correlated.
The CCC is calculated as (accounts receivables/sales)*365 + (inventories/cost of sales)*365 - (accounts payable/purchases)*365 and shows the time lag between expenditure for the purchase of raw materials and the collection of sales of finished goods (Deloof, 2003). So, the longer this time lag, the larger the investment in working capital. The Net Trade Cycle (NTC) is basically equal to the CCC, but the three components (accounts receivable, inventories and accounts payable) are expressed as a percentage of sales, so indicating the number of “days sales” the firm has to finance its working capital (Shin and Soenen, 1998).
Increasing these cycles may positively affect firms´ profitability for two reasons.
First, it may increase firms´ sales (Blinder and Maccini,1991; Smith, 1987; Emery, 1987; Deloof and Jegers, 1996; Petersen and Rajan, 1997; and Ng, Smith and Smith, 1999). These works show that firms´ sales increase when they increase their investment in inventories or trade credit granted. Second, Ng et al., (1999) and Wilner (2000) also demonstrate that firms may get important discounts for early payments when they reduce their supplier financing. However, this benefit has to offset the costs of a larger investment in working capital when firms operate under imperfect capital markets. First, firms have a financing cost. Second, the main cost of holding a higher working capital level is the opportunity cost, because a firm may forgo other more productive investments in order to hold that level. Finally, and according to Soenen (1993), longer cycles might also lead companies to bankruptcy.
Hence, under imperfect capital markets, companies may have an optimal Net Trade Cycle that balances the costs and benefits of maintaining it and which maximizes their value. In addition, since a longer cycle indicates a need for additional capital, it may depend on agency costs, asymmetric information and financial distress, because these lead to a higher cost of financing external and credit rationing.
Asymmetric Information and Agency conflicts
Asymmetric information and agency costs could lead to either underinvestment or overinvestment. On the one hand, given the limited liability of shareholders, they might carry out riskier investment projects (problem of overinvestment), because shareholders would benefit from the firm’s higher value, while creditors would suffer the possible losses (Jensen and Meckling, 1976). On the other hand, the conflict between shareholders and creditors, according to Myers (1977), can also lead to a problem of underinvestment, because given the priority of creditors in case of bankruptcy, shareholders may decide not to carry out or to abandon investment projects with a positive net present value when the net present value of the investment is less than the amount of debt issued. Consequently, firms have to pay a risk premium, which results in a higher cost for external sources of funds. In this sense, the pecking order theory of Myers (1984) states that firms give priority to resources generated internally over debt and new equity. This idea has been supported by several earlier studies that have demonstrated that the amount of corporate investment is affected by its internal financing (Fazzari et al., 1988; Carpenter, 1995; Kadapakkam, Kumar and Riddick, 1998; Hoshi, Kashyap and Scharfstein., 1991; Hadlock, 1998; Cleary, 1999; Moyen, 2004). Greenwald et al., (1984), on the other hand, suggest that asymmetric information may also result in credit rationing in competitive markets, which might also affect the level of firms´ investment. Hence, and taking into account these hypothesis, internal funds should also positively influence the firms´ working capital investment, as is demonstrated by Fazzari and Petersen (1993).