Efficient working capital management, financial constraints and firm value: A text-based analysis

Highlights

• We show that firms with efficient working capital management are less likely to be financially constrained in the future.

• We show that financially constrained firms with efficient working capital management have higher valuations.

• We use a novel text-based measure of financial constraints for a sample of Australian firms.

Abstract

In this paper we examine the association between efficient working capital management and financial constraints for a sample of Australian firms. Using a text-based measure of financial constraints, we show that efficient working capital management is associated with lower financial constraints in firms in the next two to three years. Ours is the first study to use a text-based measure of financial constraints for Australian firms. We also show that the negative association between financial constraints and future share price is significantly weakened for firms with efficient working capital management, suggesting that such firms have higher market valuations despite being financially constrained. Finally, analysts seem take into account working capital management of firms when setting the one year ahead target price.

Introduction

There is increasing scrutiny of financial performance that's associated with managing working capital. And, even though it does not appear on an income statement, working capital can amount to significant revenue for a company.¹

In this paper, we study the importance of working capital management in reducing the likelihood of future financial constraints and signalling higher firm value. Working capital management is important because it enables firms to free up cash and improve liquidity. Deloof (2003) shows that efficient management of the cash conversion cycle can improve corporate profitability significantly. Baños-Caballero et al. (2012) show that an optimal level of working capital is associated with higher profitability of Spanish SMEs. Aktas et al. (2015) also find that an optimal level of working capital improves operating performance. These studies highlight the importance of good working capital management.

The importance of working capital management is highlighted by the fact that firms often struggle to manage their working capital effectively, and thereby lose significant opportunities to create value. Indeed, a recent survey by PriceWaterhouseCoopers revealed that 203 companies in Australia and New Zealand saw deteriorations in their working capital performance by more than 5% in 2017.² The survey further revealed that Australian and New Zealand firms could unlock

$90.60 billion by improving their working capital management practices. Given the importance of working capital, we ask whether efficient working capital reduces the likelihood of firms being financially constrained in the future and, whether financially constrained firms with more efficient working capital management have higher future prices.

There is anecdotal evidence of the benefits of efficient working management. In 1994, Dell, Inc. turned to the management of its cash conversion cycle in order to reverse its recent losses. That strategy contributed to Dell growing its return on invested capital to 167%, 10 times the industry average, in the second quarter of 1997.³

Working capital management involves both choosing the amount to invest and managing the cash conversion cycle (the time it takes to convert working capital into cash). It is not enough for companies to invest in working capital. Deciding the amount to invest in working capital is important because over-investment in working capital may increase idle investment and therefore be value-reducing. This is consistent with the results of some prior research (Kieschnick et al., 2013; and de Almeida and Eid Jr, 2014) that incremental investment in working capital are could be value reducing. To manage working capital effectively, it is also important for firms to manage the cash conversion cycle, because that creates liquidity. Given the importance of both level of working capital and the cash conversion cycle, we focus on both these aspects of working capital management in this study. This is an important feature of our study. Specifically, extant research on working capital management usually focuses on only one aspect of working capital management (for example, Ding et al., 2013 define working capital management in terms of investment in working capital, whereas Baños-Caballero et al. (2014) define it in terms of the cash conversion cycle). By focusing on both the level of investment and cash conversion cycle, we provide a more comprehensive analysis of the importance of working capital.

We focus on whether efficient working capital management affects the likelihood of future financial constraints. Campello et al. (2010) and Almeida and Campello (2007) argue that financial constraints negatively affect future performance. Financially constrained firms often pass up po- tentially profitable investment opportunities, and the ability of firms to avail external financing. Given the adverse consequences of financial constraints, prior research has identified factors that reduce the likelihood of financial constraints. For instance, Erel et al. (2015) show that financially constrained target firms experience financial relief after being acquired. Ratti et al. (2008) show that bank concentration could reduce financial constraints, and Love (2003) shows that financial liberalisation could reduce financial constraints. These studies thus show that some external factors could reduce financial constraints. Internal capital markets could also reduce the likelihood of financial constraints, as Shin and Park (1999) and Desai et al. (2007) argue. Using a sample of Australian firms and a text-based measure of financial constraints developed by Bodnaruk et al. (2015), we show that efficient working capital management reduces the likelihood of the firm facing financial constraints up to three years into the future.

We next examine the valuation implications of working capital, by studying whether the negative effect of financial constraints on future share prices is less for firms with more efficient working capital management. Our research is based on findings in prior research (Denis and Sibilkov, 2009) that cash holdings enable financially constrained firms to make (value increasing) investments. We find that, while there is a negative association between financial constraints and one-year ahead share price, this negative association becomes weaker for firms with more efficient working capital management. In important additional analysis, we show that analysts seem to recognise the importance of working capital management for financially constrained firms, as evidenced by higher target prices for such firms.

We focus on Australian firms for the following reasons. First, Australia has a developed capital market with strong investor protection laws (Leuz et al., 2003). Since firms operating in capital markets with strong investor protection laws tend to manage earnings less (Leuz et al., 2003) and have more informative earnings announcements (DeFond et al., 2007), financial statements of Australian firms are of high quality and useful for analysis. Second, despite the fact that Australia has a developed capital market, it has a significant number of small firms, which are more likely to be affected by financial constraints (Belghitar and Khan, 2013). Indeed, the mean total assets for our sample of firms is AUD 45.90 million. This contrasts with USD 7270 million for US firms (Glendening et al., 2019). The fact that a significant number of small firms is listed on the Australian Stock Exchange (ASX) and the fact that Australia has a developed capital market makes it an interesting institutional setting to study financial constraints.

Further, (poor) working capital management is an issue of relevance for Australian companies. Indeed, as discussed above, the 2018 working capital survey of Pricewaterhouse Coopers finds that about 50% of the surveyed Australian and New Zealand companies saw their working capital performance deteriorate by more than 5% between 2017 and 2018, and that these companies could unlock $90.6 billion in value by managing their working capital more effectively. These survey results make our research setting of particular relevance.

Our study relates to Ding et al. (2013) and Baños-Caballero et al. (2014). However, in our opinion, our study differs significantly from these studies. Ding et al. (2013) is more closely related to our study, because they analyse the association between financial constraints and working capital investment. They argue that high investment in working capital allows firms to invest more during periods of financial constraint. Ding et al. (2013) focus only on the investment in working capital; they do not study the importance of the efficiency of working capital management. In contrast, we consider both the level of working capital (through measures like cash to asset ratio, and current ratio) and also the efficiency of working capital management (cash conversion cycle). Investment in working capital, by itself, does not measure the efficiency of working capital management. Indeed, high level of working capital could suggest that the firm has idle investment or poor cash conversion issues, as it is not able to generate enough cash from its working capital. Second, Ding et al. (2013) study how investment in working capital allows financially constrained firms to make investments in the current period. This research question is fundamentally different from ours, since we study whether current working capital management is associated with future financial constraints, and whether more efficient working capital management allows financially constrained firms to enjoy relatively higher valuations. Ding et al. (2013) do not study the valuation implications of working capital management. Finally, unlike Ding et al. (2013), who measure financial constraints by the ratio of current cash flow to capital stock, we use a novel text-based measure of financial constraints that detects financial constraints more accurately than other measures (Bodnaruk et al., 2015).

Our study also differs from Baños-Caballero et al. (2014). Baños-Caballero et al. (2014) primarily analyse the association between net trading cycle (working capital efficiency) and firm performance. They find a U-shaped relation, which suggests that there is a certain level of working capital efficiency that improves firm performance. They also find that financial constraints make the inflection point lower, i.e., a shorter trade cycle is associated with superior firm performance. In other words, financial constraints is a moderating variable in Baños-Caballero et al. (2014). In contrast, it is one of the main variables of analysis in our paper – we focus explicitly on the association between working capital management and financial constraints. Thus our research objective is different from Baños-Caballero et al. (2014). Second, while net trade cycle is an important measure of working capital management, it does not describe the level of investment in working capital. A more complete description of working capital management considers both the efficiency and level of working capital. Our paper considers both aspects. Third, unlike Baños-Caballero et al. (2014), whose financial constraint measure is based on financial statement variables, we use a more recent text-based measure, as described above.

We make the following contributions to extant literature. First, we provide a more complete analysis of the effect of working capital management on future financial constraints. Most extant literature (for example, Ding et al., 2013; Baños-Caballero et al., 2014) focus on either working capital investment or the trade cycle. By studying both the cash ratio and the cash conversion cycle, we present comprehensive evidence on the importance of working capital management in reducing the likelihood of financial constraints and improving firm value. This analysis is important as in- creasing working capital investment (or reducing trade cycle) by itself is not always optimal (as the results of Kieschnick et al., 2013 show).

Ours is also the first study to use a text-based measure of financial constraints for Australian firms. As Bodnaruk et al. (2015) note, this measure has several advantages over other commonly used measures, as it captures financial constraint more accurately by focusing specifically on the language used by financially constrained firms in their annual reports.

We also contribute to the literature by demonstrating that financially constrained firms with efficient working capital management have higher market valuations than those with less efficient working capital management. While prior studies (for ex- ample, Denis and Sibilkov, 2009) allude to the importance of cash holdings to finance investment, ours is the first study, to our knowledge, to demonstrate the valuation benefits of efficient working capital management for financially constrained firms.

The paper is organised as follows. We discuss prior literature, build our hypotheses and de- scribe our research methodology in Section 2; we describe the data in Section 3, and present the results of our empirical estimation in Section 4. We describe our robustness tests in Section 5, and conclude the paper in Section 6.