affect firm value, namely, cash flows, liquidity risk and operations. Damodaran further argues that increasing working capital investment involves a trade-off between the negative effects on cash flows against the positive effects of reducing liquidity risk and potentially increasing sales.
To examine the effects of working capital investment on the three key impact areas, CATA and CATA2 was regressed against cash flows, liquidity risk and operations.
Working capital investment affects the cash flows operations of the firm. It was hypothesised operating cash flows to total assets, OCFTA has positive and negative relationships with CATA and CATA2 respectively. The reasoning is that at low working capital investment, the firm is able to turn over its working capital faster and generate more cash flows, while at higher levels the firm will have more funds invested in working capital, hindering its ability to generate more cash flows.
CATA was hypothesized to have negative relationship with the proxy of liquidity risk, while CATA2 was expected to have a negative association with liquidity risk. At lower levels of working capital investment, the firm faces high liquidity risks (resulting in difficulties in paying liabilities on time) and at higher levels there is low risk. The study uses current liabilities to current assets; CLCA as a measure of liquidity risk. Gupta (2003) used current liabilities to current assets; CLCA (the inverse of the current ratio), to measure the risk of financing working capital.
180
Working capital investment affects the operations of the firm. Profitability (as measured ROA) was therefore hypothesised that CATA is positively related to profitability (reflecting the positive effect of a tight credit policy and keeping low inventory levels) while CATA2 was hypothesised to be negatively related to profitability (reflecting the negative effect of a generous credit policy and holding high inventory levels).
The estimation results of the relationship between working capital investment and its three impact areas namely; operating cash flows, liquidity risk and profitability are presented in Table 23.
In Column 1 the coefficients of both CATA and CATA2 have expected signs that are statistically significant. Low levels of working capital investment create value because, as noted by Damodaran (2001), working capital investment impacts on cash flows. Working capital investment represents money that is tied up and cannot be used. Therefore a reduction in working capital investment means more cash flows are available which can be deployed to more productive uses. Jose et al. (1996) support this line of thought by arguing that a shorter CCC is associated with a high valuation of cash flows from the firm’s assets. Reducing investments in current assets also enables firms to free up more funds from daily operations and channel them to other expansion projects because it generates savings and reduces financing costs for the firm through less reliance on expensive external funds, resulting in a lower required return on capital and higher firm value (Filbeck and Krueger, 2005b, Nazir and Afza, 2009a, Poirters, 2004).
Consistent with expectations, in Column 2 CATA and CATA2 have respective negative and positive coefficients. Both coefficients are statistically significant at 1%. Low working capital investment levels mean low liquidity levels and therefore higher liquidity risk. Low working capital investment levels, in particular, low cash levels hamper the firm’s ability to pay maturing obligations on time (Firer et al., 2012, Damodaran, 2001). Increasing working capital
181
investments (in particular cash and marketable securities) enables the firm to meet its obligations more easily, thus reducing its liquidity risk.
TABLE 23: IMPACT AREAS OF WORKING CAPITAL INVESTMENT LEVEL
(1) (2) (3)
OCFTA CLCA ROA
CATA 0.378*** -2.476*** 0.618***
(2.77) (-9.47) (4.15)
CATA2 -0.213** 0.988*** -0.284***
(-2.25) (9.45) (-5.28)
SIZE (LNMCAP) 0.034*** -0.102*** 0.044***
(2.96) (-7.74) (5.50)
SGR 0.007 0.036** -0.0228**
(0.87) (2.88) (-2.85)
LEVERAGE - 0.272*** -0.026*
- (13.84) (-2.10)
m2 0.655 0.604 0.387
Hansen 43.33 38.26 35.24
df 36 43 43
p-values 0.216 0.677 0.794
t statistics in parenthesis. *, ** and *** denote significance at 10%, 5% and 1%, respectively Time dummies’ coefficients not reported for brevity.
Source: Own calculations using a balanced panel over the period 2001 to 2010. Data obtained from the McGregor BFA library.
As expected, in Column 3 the coefficient of CATA is positive and CATA2 is negative which is consistent with the argument that aggressive working capital management may yield more returns while a conservative approach compromises profitability. Holding low inventory levels and a tight credit policy may lower carrying costs and this may increase profitability. However, it may lead to the inability to serve customers and a loss of value. A liberal inventory and credit policy may increase carrying costs (increasing inventory levels and accounts receivable) which negatively affects revenues (Damodaran, 2001).
These findings also demonstrate the trade-offs associated with investing in working capital. At lower levels of working capital investment, South African firms enjoy positive effects on cash
182
flows, but suffer the negative effects of increased liquidity risk and the potential of losing sales while at higher levels they suffer the negative effects on cash flows, but enjoy the positive effects of reducing liquidity risk and potentially increasing sales.
The increase in working capital investment has a negative effect on cash flows, but a positive effect on liquidity and operations; managers should increase working capital investment when the positive effect on liquidity and operations outweighs the negative effect on cash flows. In cases where the negative effect on cash flows exceeds the positive effect on liquidity and operations, working capital investment should be reduced.
The interdependence of the effects of either increasing or decreasing working capital investment makes the job of the finance manager more challenging (Poirters, 2004). In addition, the effect of some working capital increases cannot be observed directly, but manifest themselves in several ways. For example, one of the operational effects of increasing accounts receivable is that the firm incurs administration costs and collection costs; this influences the liquidity risk of the firm by increasing the cash locked-up in the firm’s working capital cycle.