ARTICLE

PRESENTATION
Working capital management, corporate performance,
and financial constraints
GROUP MEMBERS
HAJIRA RIAZ
ZAHARA JAVAID
KHADIJA SHAREEF
JAWERIA KHAN
SONIA KANWAL
Contents
1.Introduction
2.Working capital, corporate performance and financing
Working capital and corporate performance
Investment in working capital and financial constraints
3.Model and data
4.Empirical evidence
5.Conclusions
Introduction
• The literature on investment decisions evolved through many theoretical
• and empirical contributions. A number of studies show a direct
• relation between investment and firm value.
• Studies on working capital management fall into two competing views of
working capital investment.
• The hypothesis in this paper is that an inverted U-shaped relation may result
if both effects are sufficiently strong.
Discussion
• Authors like Schiff and Lieber , Smith , Kim and Chung suggest that
working capital decisions affect firm performance.
• Their results show that, on average, an additional dollar invested in net
• Operating working capital is worth less than a dollar held in cash.
• Market imperfections increase the cost of outside capital relative to internally
generated funds.
• Our paper examines the functional form of the relation between investment
in working capital and corporate performance.
Discussion
This study contributes to the working capital management literature
In a number of ways.
1. Evidence on the effect of working capital management on corporate
performance.
2. The paper investigates the relation between investment in working capital
and firm performance.
3. Estimate the models by using panel data methodology in order to eliminate
the unobservable heterogeneity.
4. The generalized method of moments (gmm) to deal with the possible
endogeneity problems.
Working capital & Corporate performance
• Investment in Receivables & Inventories represents firm
assets while trade credit is source of funds.

• Under perfect financial markets trade credit decision do

not increase Firm value.
 Incentives to hold positive working capital.
• Higher investment in extended trade credit & inventories might increase
corporate performance for several reasons
1. Larger inventories can reduce supply costs, price fluctuations , prevent
interruptions in production process & loss of business
2. It also allow better service for customers & avoid high production cost
which arise from high fluctuations
3. Granting trade credit might also increase sales because it encourages
customers to acquire merchandize when demand is low, it strengthens long
term supplier-customer relationship, it allows buyers to verify product
quality before payment, it reduces asymmetric information between buyer
and seller .Indeed trade credit is an selection criteria when it is hard to
differentiate products.
4. Trade credit is more profitable then short term investment then marketable

securities .

5. Working capital may also act as as stock of precautionary liquidity

providing insurance against future shortfalls in cash.

6. Finally from the point of view of accounts payable firm obtain discounts for

early payments when its reducing its supplier financing .

Adverse effects of investment in working capital which
lead to negative impact on firm value
1. Warehouse rent, insurance & security expense tend to increase as a level of
inventories increases.
2. Greater working capital level indicates a need of additional capital which firm
must finance it involves financing cost and opportunity cost.
3. Companies which holds more working capital level also face more interest
expense as a result more credit risk as working capital increase mostly the firms
will experience financial distress & face the threat of bankruptcy.
4. Keeping high working capital level means money is locked up in working capital
,so its reduces the ability of firm to take up other value enhancing projects.
INVESTMENT IN WORKING CAPITAL
AND FINANCIAL CONSTRAINTS

Modigliani and Miller argue that in a

frictionless world,compnies can always obtain
external financing without problem.
Investment in working capital and financial
constraints
Fazzari and Petersen(1993) suggest that investment in working capital are
more sensitive to financial constraints than investment in fixed capital.
Investment in Working Capital and financial
constraints

To test the effect of financial constraints on the optimal level of working

capital, Researcher estimate the optimal working capital investment for
various firm subsamples.
Proxies for the existence of financing
constraints

Researcher consider that firms with a dividend payout ratio

above the sample median are less financially constrained &
Vice versa.
Proxies for the existence of financing
constraints

Firms with a cash flow above the sample median are

assumed to be less likely to face financing constraints.
Proxies for the existence of financing
constraints
Size
Many studies use this variable as an inverse proxy of financial constraints.
Cost of external financing
Companies with cost of external financing above the sample median are
more likely to be financially constrained.
Proxies for the existence of financing
constraints
• Whited and Wu index
A linear combination of six factors:
Cash flow, a dividend payer dummy, Leverage,
firm size, industry sales growth, and firm sales growth.
Measures for bankruptcy risk
Interest coverage.
Greater this ratio, the fewer problems the firm would have in repaying its
debt and the firm’s EBIT would cover the interest payments.
Z-score.
Firms with below-median scores are financially constrained while above-
median firms are financially unconstrained.
MODEL AND DATA

Researcher analyze the quadratic model.

Researcher use the net trade cycle as a
measure of working capital management.
Model and data
Qi;t = β0 + β1NTCi;t + β2NTC2i;t + β3SIZEi;t + β4LEVi;t+ β5GROWTHi;t +
β6ROA + λt + ηi+ εi;t.
where Qi,t is the corporate performance.
Net trade cycle (NTC) and its square(NTC2).
NTC comes from:
NTC=(accountsreceivable/sales)∗365+(inventories/sales)∗365−(accountspay
able/sales)∗365.
Model and data
The parameter λt is a time dummy variable
• ηi is the unobservable heterogeneity or the firm's unobservable individual effects,
• Finally, εi,t is the random disturbance.
Model and data
• Researcher use panel data methodology.
• Researcher estimated model by using two steps generalized method of
moments(GMM).
Data and summary statistics
• Data collect from the Osiris database. The sample comprises non-financial quoted
firms for the period 2001–2007.
• A t test confirms that there are no significant differences between the mean NTC of
our sample.
Data and summary statistics
• Specifically, we calculated the variance inflation factor (VIF) for each independent
Variable there is no multicollinearity problem in our sample, because it is far from
5.
 EMPIRICAL EVIDENCE
1-Effects of working capital management on firm
performance:

A. Results confirmed a large and statistically significant inverted U-shaped

relation between corporate performance and working capital.
B. working capital has a positive impact on firm’s performance.
C. working capital has a negative impact on firm’s
performance.
2-Financial constraints and optimal working capital level:

Aim to explore the possible effect of financing on optimal level

of W.C.
A- The results indicated the existence of a concave
relation between working capital and firm performance for less
financially constrained firms.
B- F-test was also done(F1, F2 test).
However, the optimal investment in working capital
depends on
the financing constraints borne by firms. When
financing conditions
are present in the analysis, the results indicate that the
optimal
level of working capital is lower for those firms more
likely to be
financially constrained. This may be mainly because of
the higher
financing costs of those firms and their greater capital
rationing,
since the lower the investment in working capital, the
lower the
need for external financing.