Like working capital investment, the financing of working capital is influenced by several quantitative and qualitative, internal and external factors. Among others, firm-specific factors include; the nature of the business, the size of the business, the cash cycle, the firm’s access to capital and financial markets, the production process and the firm’s investment policy. External factors include the political climate, interest rates, inflation and technology.
3.11.1 Market power or size
Market power influences the terms of both purchases and sales. Firms with significant market power have the capacity to negotiate and secure more liberal credit terms with suppliers.
Suppliers are likely to give trade credit to large firms as they consider them to be low risk customers (Delannay and Weill, 2004). Small firms find contracts with industry leaders very valuable. Industry leaders can use their market power to stretch the credit terms extended by suppliers with minimal negative consequences (Hill et al., 2010).
86 3.11.2 The working capital cycle
As measures of operational efficiency, the Operating Cycle and the Cash Cycle significantly influence a firm’s working capital financing. A negative CCC means that firm is receiving cash from its customers faster than it is paying its suppliers, while a positive CCC means that the firm is paying its suppliers faster than it is collecting from its customers and has to borrow as it awaits payments from its debtors. The CCC provides management with a good indication of the duration the company must fund its operating cycle with non-spontaneous sources of finance of either debt or equity capital.
For example, if a firm has an accounts receivables period of 45 days, inventory turnover period of 50 days and pays its trade creditors in 35 days, then its CCC is 60 days (45 days + 50 days – 35 days). In other words, this firm will need to fund its inventory and receivables from its own resources for a period of 60days. Firms with longer CCCs are expected to hold large working capital investments (inventories and receivables) and require more external financing to maintain their operations, which bear more financing costs than firms with shorter CCCs. A short CCC put the firm in a better position to generate cash flows than a long CCC.
3.11.3 Business cycle
The business cycle refers to changes in general economic performance in the long-term development of an economy. During periods of economic expansion, businesses expand, resulting in a need for more working capital due to increased investment opportunities. During periods of recession or depression less working capital finance may be required because of low business activity. On the other hand, a recession may result in the firm experiencing challenges in generating internal resources from its operations, thereby increasing its accounts payable as it struggles to pay its trade credits. Furthermore, during recessions, the ability of the firm to raise funds is restricted. For example, one of the major consequences of the recent global economic crisis of 2008 – 2009 was limited access to short term finance for most firms. During times of rapid price increases, the working capital financing required to support current assets also increases.
87 3.11.4 Operating Cash flow
Working capital financing is also influenced by management decisions in line with profit projections. Adequate profit aids in the generation of cash which enables finance managers to retain some of the profits in the firm and gather considerable internal financial resources.
These internal financial resources enable businesses to finance working capital needs and adopt a more flexible working capital policy which facilitates the future growth of sales (Hill et al., 2010). Myers (1984) and Myers and Majluf (1984) Pecking Order Theory has been used to explain managers’ financing preferences. The theory states that managers prefer internal funds, followed by safe debt, then risky debt and equity is issued as a last option (Wasiuzzaman and Arumugam, 2013). Following the Pecking Order Theory, firms are expected to use retained earnings to finance their working capital first, then safe debt (trade credit and bank credit) and risk debt (long-term debt) and equity. Firms that generate more internal resources will require less external resources, especially supplier financing (Hill et al., 2010, Deloof and Jegers, 1999).
Firms with limited or no internal financial resources must finance their working capital needs using other sources.
3.11.5 Sales growth
A growth in the level of sales creates financing pressures and is a major determinant of the demand for short-term finance. Firms experiencing high sales growth are likely to employ more short-term debt as spontaneous sources may not be sufficient to meet the new current asset requirements (Delannay and Weill, 2004). As the sales volumes increase there is need for an increase in working capital to finance both inventory and receivables.
3.11.6 Creditworthiness
Creditworthy and larger firms are subjected to fewer borrowing constraints, have better access to capital markets and have better capacity to finance the working capital gap from external sources (Hill et al., 2010, Whited, 1992). A firm’s reputation in the capital markets affects the amount of working capital it will hold in order to ensure that its investment plans are not
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interrupted. Calomiris et al. (1995) found that highly-rated firms in both long-term and short- term credit markets have low inventories and financial working capital. High credit quality firms have no need to accumulate working capital as a cushion against fluctuations in cash flow because they can easily access external finance at favourable terms. Calomiris et al. (1995) show that, given a high (long term) bond rating, only large firms with low earnings variance, high cash flows and/or cash flows and/or large stocks of liquid assets have access to the commercial paper market. Large firms are expected to be more creditworthy and less of a risky investment (Delannay and Weill, 2004).
3.11.7 Term structure of interest rates
Interest is tax deductible expense; this creates an interest tax shield and enhances firm value.
An upward sloping term structure encourages the use of short term debt (Gitman et al., 2010).
Brick and Ravid (1991) contend that firms employ less short-term bank borrowing when the term structure is upward sloping and vice-versa; consistent with the tax liability argument which states that an upward sloping yield curve favours long-term debt usage so that they benefit from the higher tax shield generated by a higher tax liability (thereby increasing the value of the firm).
3.11.8 Non-debt tax shields
These are measured by depreciation and amortization and reduce the amount of debt financing that a firm employs because they reduce the expected interest tax shield the debt will generate. Non-debt tax shields serve as a substitute for interest expenses, which are deductible in the calculation of corporate tax and have a negative correlation to the debt capital employment in a firm’s capital structure.
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