The JSE is a key part of the South African financial landscape. It has been and continues to be the magnet for foreign investment in South Africa, with more than half of the trading at times attributed to foreign investors (Firer et al., 2012). This study of the working capital investment and financing decisions of listed firms at a time when finance managers are under pressure to deliver more value to their shareholders by attaining high company valuations (Poirters, 2004, Weston and Copeland, 1992) is important in order to ensure that the investment magnet status of the JSE is enhanced.
Despite the strong relationship between working capital management and firm value, this subject has received less attention in empirical research and has therefore not been fully explored. According to Brealey et al. (2008) little is known about working capital investment that maximises firm value. This study contributes to the short-term financial management debate by presenting a new perspective on how the management of working capital affects firm value. The few previous studies on this subject present two conflicting views on working capital management and do not agree on which working capital approach maximises shareholder value. These studies did not take into account the positive effects (benefits) and negative effects (costs) of holding working capital investments. One view is that low levels of working capital investment enable the firm to create value by reducing investments in non- productive assets and by quickly turning over its working capital to generate more revenue.
However, low working capital levels may result in lost revenue due to stock-outs, disruption of
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the production process and technical insolvency. Another view is that high levels of working capital investment enable the firm to minimise shortage costs but the firm incurs huge opportunity costs. These two conflicting views clearly show that any level of working capital investment has benefits and costs and these have to be taken into account when analysing the relationship between working capital management and firm value. This study presents an analysis of the relationship between firm value and working capital investment, with costs and benefits in mind; as a result this relationship is hypothesised to be non-linear. No studies reviewed have tested this relationship using quadratic equations. Testing the existence of an optimal point justifies the pursuit of an optimal working capital level. Thus this study uses econometric analysis to show how low and high levels of working capital impact on firm value, taking into account that firms have target levels of working capital investment. The existence of benefits and costs of holding working capital means that there is an optimal point that maximises shareholder value and that when firms are on either side (below optimal level and above optimal level) of the optimal point, this reduces firm value. In analysing working capital management, there is a need to consider that firms have target working capital investment levels which they believe will help to maximise shareholder value.
Through efficiently managing their working capital, Chinese firms have recorded phenomenal growth despite financial constraints (Hale and Long, 2011). South Africa presents an ideal case for investigating the role of working capital management in alleviating financial constraints because of its unique setting. South Africa is an emerging market economy with a sophisticated financial system, yet neither the country nor South African firms have been able to produce high growth rates. Developed financial systems make it easier to access funding. Furthermore, while there is a growing literature on cash flow-investment sensitivities (Pawlina and Renneboog, 2005, Guariglia, 2008), very few studies (Fazzari and Petersen, 1993, Ding et al., 2013) have analysed the impact of working capital in alleviating cash flow investment sensitivities. The role of working capital in alleviating cash flow investment sensitivities is important; Ding et al. (2013) found that the growth of Chinese firms can largely be attributed to their working capital management practices.
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In South Africa, working capital management as a corporate finance subject is generally not talked about and has very limited empirical research. A search of the literature found only three working capital management and profitability studies (Erasmus, 2010, Smith and Begemann, 1997, Ngwenya, 2012). There is a paucity of research on firms’ practices relating to working capital financing in emerging markets (Zapalska et al., 2004) and it is virtually non-existent in South Africa; to the best of our knowledge, no empirical work has been carried out in South Africa. Therefore, to contribute to the literature on access to finance in emerging economies, this study examines working capital finance sources in an economy that has a well-developed capital market and financial services sector. Furthermore, given the South African financial landscape, there is a need to analyse the determinants of working capital financing. The extensive use of trade credit by listed companies (which are supposedly big firms likely facing few financial constraints) while there is an abundant supply of bank credit in South Africa make this matter worthy of investigation.
Most finance managers plan their operations with gross working capital in mind. Working capital represents a large portion of firms’ total assets. Although current assets levels differ from one sector to another and differences also exist within an industry, they generally constitute more than half of the total assets for most firms (Appuhami, 2008, Moyer et al., 1995, Raheman and Nasr, 2007). The literature on firm value and gross working capital relationship is very sparse. Most previous studies evaluated the relationship between firm value and the individual components of working capital which considers both the benefits and costs of holding such assets; inventory, receivables (Martínez-Sola et al., 2013b) and cash holdings (Martínez-Sola et al., 2013a).
The estimation of the appropriate working capital investment level is fraught with many challenges and consequently, the firm’s working capital investment level may not always be at the desired level. Most existing studies on working capital management assume a static approach; that is, firms can instantaneously adjust their levels of working capital investment.
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This study employs a partial adjustment model because the adjustment process towards the real or desired target of working capital management involves both time and costs. It involves a trade-off between being in disequilibrium and the cost of adjusting towards the target. In terms of methodology, this study contributes to the short-term financial management discourse by employing a dynamic approach and uses the Generalised Method of Moments (GMM) as a way of controlling possible endogeneity problems. The highly integrative nature of working capital management means that regression analysis must take into account the problem of endogeneity.