long-term financial planning, though in reality they are taken as independent of the former or they are subsumed under long-term financial planning. The way a firm manages its working capital therefore can significantly influence its long-term financial planning and in particular how it copes with financial constraints.
Financially constrained firms only undertake investments when they have ample internal resources and will be compelled to reduce their investment when they experience a reduction in their cash flow. When a financially constrained firm experiences a negative cash flow shock it may decide against forgoing long-term investment in the short run instead of working capital investment (Rao, 2005). Rao (2005) states that financially constrained firms do not divert long- term funds; they reduce their working capital investment and forgo short-term profits. Thus, efficient working capital management may be crucial for financially constrained firms in order to maintain relatively high and smooth fixed investment levels. However, the degree by which working capital can facilitate fixed investments smoothing depends on the firm’s level of working capital. This means that a decline in working capital negatively impacts fixed investment directly, since it implies a fall in internal resources, and indirectly raising the cost of external funds, while huge investments in working capital capacitate the firm to smooth fixed investments(Fazzari and Petersen, 1993).
Using the example of the financially constrained Chinese firms, Ding et al. (2013) posit that efficient management of working capital could be very important for such firms to maintain relatively high and smooth levels of fixed investment and can provide an important avenue to mitigate the impact of financing constraints.
According to Chan (2010), “working capital represents a significant component of firms’
financial needs, especially in developing countries; therefore, it is likely to be an important mechanism by which financial constraints can affect firm behaviour”. Appuhami (2009) states
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that uncertainty in capital markets has made working capital an important determinant of capital investments. Working capital represents both a source and a use of short-term financial resources, and is a readily reversible store of liquidity, which a firm can use to smooth its fixed investment if it experiences a cash flow shock or becomes financially constrained (Ding et al., 2013). Fazzari and Petersen (1993) emphasised working capital’s high reversibility, stating that working capital investment can temporarily be negative (when raw materials consumption is faster than its replacement) and can be improved by intensifying collections efforts and tightening credit policies on new sales. More efficient management working capital mean less requirement for external financing and better financial performance (Shin and Soenen, 1998).
Fazzari and Petersen (1993) found that United States firms used their working capital to smooth fixed investments. Since adjusting fixed capital investment has huge costs, firms benefit from maintaining smooth fixed investment. When they experience negative cash flow shocks and face financing constraints firms that maintain high working capital levels can absorb such shocks without cutting their fixed investment. Their regression analysis results showed that working capital investment as an independent variable had a negative coefficient; they concluded that working capital and fixed assets investment compete for limited funds. In addition, working capital is more sensitive to cash flow than fixed investment.
Ding et al. (2013) used a panel of 121 237 firms in China to study the fixed and working capital investment relationship in the presence of financial constraints. Their study found that firms characterised by high working capital displayed high sensitivities of investment in working capital to cash flow and low sensitivities of investment in fixed capital to cash flow. According to Ding et al. (2013), “despite binding external financing constraints, firms with low fixed capital to cash flow and high working capital to cash flow have the highest fixed investment rates, suggesting that sound working capital management may help firms to ease the impact of financing constraints on fixed investment”.
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Non-financially constrained firms have better capacity to finance their net working capital than financially-constrained firms. Therefore the optimal level of a non-financially constrained firm will be higher than that of financially constrained firms. Ding et al. (2013) state that the effects of financial constraints on cash flow investment sensitivity can be ameliorated by maintaining high working capital levels. However, it should be borne in mind that high net working capital has to be financed (Hill et al., 2010). On its own high net working capital represents a good liquidity position but it might also mean poor utilisation of resources. Therefore, when testing how working capital alleviates financial constraints, consideration must also be given to the profitability of the firm. In the true sense, working capital makes a difference in alleviating financial constraints when one considers high working capital firms that are delivering value to shareholders.
Bushman et al. (2007) explored the effect of working capital on fixed investment from a slightly different perspective. Unlike other studies’ analysis of investment-cash flow which use cash flow as accounting earnings before depreciation, they decomposed cash flow into a cash component, cash flow from operations (CFFO), and a non-cash component, working capital accruals (WCACC). They argued that working capital accruals principally reflect the net investment in non-cash working capital like trade debtors and stocks. Working capital accruals measure changes in non-cash working capital and directly represent near-term investment in working capital, which is in turn directly related to fixed investment rather than financing constraints. Bushman et al. (2007) concluded that, “the documented pattern in investment- cash flow sensitivities is driven by the working capital investment component, not the cash component (CFFO)”.
The amount of working capital holdings that ensure the smooth flow of production and the implementation of investment plans depends on the firm’s reputation in the financial markets, among other factors. Calomiris et al. (1995) state that firms that are considered to have high long-term and short-term credit quality have lower stocks of inventories and financial working capital. Such firms do not need to accumulate working capital as a buffer against fluctuations in
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cash flow as they can easily obtain external funds at favourable terms like the commercial paper market.
Luo (2011) presented an argument that financial constraints have a brighter side in influencing how managers spend cash. Luo (2011) argued that, in the absence of financial constraints, management of cash-rich firms are likely to use it for projects that do not create value.
Financial constraints force managers to spend cash on value adding projects. In the same manner, financial constraints force managers to set optimal working capital at levels that are not too high.