3.5 Permanent and temporary working capital
3.5.6 Factors influencing working capital investment
The management 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, credit terms and policies, payables management, the production process and cycle, the firm’s investment policy and the corporate governance of the firm. External factors include the political climate, the availability of short term credit, interest rates, inflation, industry working capital policies, technology etcetra.
3.5.6.1 Leverage
Previous studies have found that leverage and working capital investment have an inverse relationship (Erasmus, 2010, Chiou et al., 2006, Raheman and Nasr, 2007). Two factors have been cited to explain why leverage has a negative association with working capital investment.
First, external capital is more costly than internal resources; therefore firms with creeping leverage levels closely monitor working capital levels in order to minimise resources which could invested in other valuable projects being tied-up in its operating cycle (Nazir and Afza,
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2009c, Wasiuzzaman and Arumugam, 2013). Second, it does not make business and economic sense to hold large volumes of low-earning assets financed by high-cost funds (borrowed capital) (Baños‐Caballero et al., 2010).
3.5.6.2 Firm Size
Firm size influences the amount of resources a firm commits to working capital. Larger businesses require larger current assets investment because of their larger sales levels and the larger scale of their operations (Kieschnick et al., 2006). Firm size is also used as a proxy for capital markets access (Hill et al., 2010). Large firms have fewer borrowing constraints and enjoy easier access to capital than small firms due to less information asymmetry because they are closely monitored by analysts. Therefore, large firms can pursue flexible working capital investment policies. Chiou et al. (2006) assert that large firms can use their superior access to capital markets to maintain low cash balances. On the other hand, larger firms can use their size to build relationships with suppliers which enable them to hold low working capital investments (Baños‐Caballero et al., 2010, Nwankwo and Osho, 2010). Large firms have better capacity to manage their CCCs (Moss and Stine, 1993). Empirical evidence on the firm size-working capital investment relationship has produced mixed results. Three proxies for firm size have been used; the natural logarithm of sales or total assets (Chiou et al., 2006, Wasiuzzaman and Arumugam, 2013, Baños‐Caballero et al., 2010) and the natural logarithm of market capitalisation (Hill et al., 2010).
3.5.6.3 Economic conditions
The state of the economy affects a firm’s investment in current assets. Carpenter et al. (1994) state that the Gross Domestic Product growth rate affects firms’ level of working capital investment. For example, inventory holdings fall drastically during recessions because most firms run down their inventory to generate cash (Lamberson, 1995, Blinder and Maccini, 1991).
Firms experience challenges in expanding smoothly, turning over inventory quickly and collecting receivables during recessions (Chiou et al., 2006), consequently the level of working
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capital investment may be maintained at high levels in order to ensure that the operations of the firm are run without disruptions.
The level of business during expansion is usually high; therefore working capital needs during such periods are also high. Wasiuzzaman and Arumugam (2013) argue that during economic expansion, it is easier for firms to access financing; as a result, they may pay less attention to working capital investment levels or cash locked-up in the cash cycle. Recessions are characterised by relatively tight cash supply and as a result firms try to mine cash from wherever possible and shorten their cash-to-cash cycle (Chiou et al., 2006, Baños‐Caballero et al., 2010). Sathyamoorthi and Wally-Dima (2008) argue that firms manage their working capital in line with macroeconomic fundamentals, pursuing aggressive and conservative policies in times of low and high business volatility, respectively.
3.5.6.4 Sales growth
Working capital investments support operational activities which generate sales. Working capital needs increase with a growth in sales and the expansion of the business. According to Hill et al. (2010), “the direction of influence of sales growth on working capital investment is difficult to determine with precision because of potential endogeneity problems. For example, liberal credit and inventory policies can stimulate sales, causing reverse causality when using contemporaneous sales growth as an independent variable”. Firms may accumulate inventory in anticipation of future sales growth (Nwankwo and Osho, 2010, Kieschnick et al., 2006).
3.5.6.5 Nature of business
The type of business activity determines a firm’s working capital investments and level; for example, manufacturing firms invest large amounts of working capital in inventory and spare parts and may have a large receivables’ book. A grocery store will generally have large inventory levels but low or no accounts receivables. The nature and amount of the current assets investment of a manufacturing firm is different from service firms, information technology firms and public utilities. It is evident that a manufacturing company needs a well-
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defined receivables management policy, unlike a grocery store which may not extend credit at all to customers. Public utilities tend to make huge investments in fixed assets and less investment in current assets. Empirical evidence suggests that the working capital policies adopted by firms are a function of the industry the firm is operating in (Hawawini et al., 1986, Filbeck and Krueger, 2005a). Trade receivables and payables and inventory policies tend to be different across industries, but tend to be the same within an industry (Smith, 1987, Niskanen and Niskanen, 2006, Ng et al., 1999).
3.5.6.6 Internal resources
The capacity of a firm to generate internal resources from the normal course of its operations influences its ability to fund its working capital investment. Firms with high operating cash flows can pursue flexible working capital investment policies because they have more resources to finance their working capital investment and internal resources with lower costs than external funds (Hill et al., 2010, Fazzari and Petersen, 1993). Firms with low and negative operating cash flows require financial resources from additional sources to support their working capital;
hence, such firms face constraints in their working capital investments (Mathuva, 2013).
Appuhami (2008) found that firms with an increasing in operating cash flow tend to reduce their working capital investment.
3.5.6.7 Seasonality of operations
In industries such as agriculture and food processing, production is seasonal. Investment in working capital for such companies will be cyclic, increasing during the peak season and declining when operations are off-peak. In cases where the supply of raw materials is seasonal, the firm has to buy and stock-pile raw materials because buying them during peak-season might be costly. Firms with operations that are not affected by seasons have stable working capital investments (Nwankwo and Osho, 2010).
60 3.5.6.8 Fixed investment
The level of a firm’s fixed investment influences its working capital investment because, for a financially constrained firm, there is competition for a limited pool of funds between capital expenditure and working capital investment (Fazzari and Petersen, 1993). Mathuva (2013) states that an increase in inventory holdings may be followed by additional investment in tangible and/or intangible assets such as warehouses and technology. On the other hand, increasing inventory investment may also result in a decline in fixed investment. When fixed investment opportunities arise, firms reduce their demand for working capital requirements and increase their liquidity in order to avoid issuing securities in the capital markets at short notice (Appuhami, 2009, Palombini and Nakamura, 2012).
3.5.6.9 Supply chain
If the supply of goods for production or resale is reliable and certain, the firm can commit fewer funds to inventory investments. However, if the supply is erratic, unreliable or seasonal, more financial resources have to be invested in inventory in order to ensure uninterrupted production.
3.5.6.10 Corporate governance and Management ability
The ability of management to co-ordinate the activities of the firm from the procurement of goods to distribution to customers as sales significantly influences the firm’s working capital investment. Poor co-ordination of the production and distribution of goods may increase the need for working capital, as more funds will be tied up in inventory and trade debtors.
Other important factors include the firm’s production policy, cycle and plans, credit availability and credit policy.
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