The Journal of Accounting and Management, Vol 6, No 1 (2016)

Determinants of Working Capital Requirements: Evidence from Selected Non-financial Firms Listed on the Johannesburg Securities Exchange

Emmanuel OSEIFUAH ¹

Abstract: Working Capital is an important aspect of corporate financial management because it affects profitability, liquidity and firm value (Smith, 1973; Deloof, 2003; Nazir and Afza, 2008).For this reason, firms try to keep an optimal (desirable) level of working capital that maximizes their value. In essence, working capital management is vital for the survival of businesses, regardless of their size.Previous studies suggest that working capital requirement of an enterprise is influenced by numerous factors such as firm size, GDP growth rate, inflation, foreign exchange rates, among others.

The study analysed the key endogenous (internal) and exogenous (external) factors influencing working capital requirements and WCM of a sample of 5large non-financial firms listed on the JSE. Data for the study was collected using a semi-structured questionnaire. The result revealed that sales growth, capital expenditure and debtors’ management are the three most important endogenous factors influencing working capital requirement of the sampled firms. Other factors identified are inventory ordering efficiency, board requirements, centralization of supply, operating expenditure and products offered. The study further revealed that interest rates, foreign exchange rate, economic growth and inflation rate are the four key exogenous factors influencing working capital requirements of the sampled firms. Additionally, 40% of the sampled firms indicate that sales affect WCM to a very high extent while 60% indicate that capital expenditure affect WCM to a high extent. Finally, 60% indicate that debtors’ terms affect WCM to a high extent. 60% of respondents indicate that economic growth some extent to a very high extent affect WCM while 80% indicate that interest rates affects WCM from to some extent to a high extent. 20% are of the view that exchange rates affect WCM to a very high extent.

Keywords: Johannesburg Securities Exchange, Non-financial firms, South Africa, Working Capital Management.

1 Introduction

Corporate finance theory contends that the primary objective of the firm is shareholders’ wealth maximization (SWM) (Fabozzi and Drake, 2010). An often ignored mechanism by which shareholder wealth can be realized is working capital management (Smith, 1980; Chan, 2010).This neglect exists, in spite of the fact that working capital comprises a significant portion of total assets and managers spend more than half of their time in managing working capital (Richards and Laughlin, 1980; Laux, 2012). More importantly, inefficient working capital management (WCM) has been cited as a major cause of business failure (Altman, 1968; Altman; Shin and Soenen, 1998).

Working capital management involves the application of economic and management principles to managing short-term assets and short-term liabilities, as well as the management of all the relationships that exist between them in order to enhance liquidity, profitability and concomitantly firm value. Generally, WCM entails two vital decisions. The first focuses on determining the optimum (desirable) level of investment in short-term assets, while the second entails determining the appropriate mix of short-term and long-term financing needed to finance this investment in short-term assets (Jain, 2004; Moyer; Brigham and Ehrhardt, 2006; Chandra, 2007; Parrino and Kidwell, 2009; McGuigan and Kretlow; 2009; Mole, Parrino and Kidwell, 2011). Despite its vital role in the success of businesses, most studies addressing the key factors affecting working capital requirements (WCR) tend to focus on developed economies with a dearth of research on emerging economies. This study attempts to fill this gap by examining the key factors that influence working capital requirement and WCM of a sample of JSE-listed non-financial firms..

1.1 Research questions

The following research questions were addressed in the study:

• What are the endogenous (internal) factors that influence working capital requirement of JSE listed firms?

• What are the exogenous (external) factors that influence working capital requirement of JSE listed firms?

• To what extent do both endogenous and exogenous factors influence WCM of JSE listed non-financial firms?

1.2 Objectives

The objectives of the present study are:

• To determine the endogenous factors that influence working capital requirement of JSE listed firms

• To determine exogenous factors that influence working capital requirement of JSE listed firms

To analyse the extent to which both endogenous and exogenous factors influence WCM of JSE listed non-financial firms.

2. Literature review

Previous studies suggestthe existence of endogenous and exogenous factors that affect a company’s working capitalrequirements and their effect on working capital management. Theinternal (firm-specific) factors include, but not limited to, company size and growth rates, organizational structure, and borrowing and investing positions/activities/capacities. The exogenous factors include banking services, inflation, interest rates, new technologies and new products, state of the economy, and competitors, among others. According to Moussawi, LaPlante, Kieschnick and Baranchuk (2006) there is strong evidence that industry practice, firm size, future firm sales growth, proportion of outside directors on a board, executive compensation, and CEO share ownership significantly influence the efficiency of large non-financial listed US firms. In another study, Chiou and Cheng (2006) analysed the effect of the key factors influencing working capital management in Taiwanese firms. The results show that factors such as type of industry, operating cash flow, growth opportunitiesand firm size have effect on working capital management. The results further show that leverage and operating cash flow has significant relationship with net liquidity balance and working capital requirement.

Using data from a panel of U.S. corporations from 1990 to 2004, Kieschnick, Laplante and Moussawi (2006) found that industry practices, company size, future sales growth, number of outside directors on the board, executive compensation (current portion), and CEO share ownership have a significant impact on the efficiency of working capital management of companies.

In a recent study, Zariyawati et al. (2010) examined important factors, which affect working capital management in Malaysian firms. The results suggest that firm size, debt ratio, and sales growth have a negative relationship with working capital management (represented by the cash conversion cycle). In addition, the study revealed that firms with more debts have less working capital since the cost of external financing is higher for these firms. A negative relationship was found to exist between CCC and sales growth indicating that firms use short-term financing to supply future demands. The positive relationship that was reported between economic growth and working capital indicated that firms expanded their investment on working capital during the economic boom. Finally, the study found no evidence for the impact of corporate governance variables on working capital management.

Hill, Kelly, & Highfield (2010) examined the key factors which affect working capital management in US firms. The results show that Working Capital Requirement (WCR) is positively related to the operating cash flow, and negatively correlated to financial distress and market-to-book ratios. The study found no evidence for relationship between gross margin profit, market share, and WCR. Manoori and Muhammad (2012) use panel data analysis including Pooled OLS, random effects and fixed effects estimations, to determine the determinants of WCM in Singapore. The findings revealed that firm size, operation cash flow, capital expenditures, and gross domestic products are negatively correlated to working capital management. Moreover, they found that firms with more profitability have longer cash conversion cycle. The study, however, did not find any significant relationship between cash conversion cycle and debt ratio.

Valipour, Moradi and Farsi (2012) used correlation and multiple regression technique to determine the effect of company characteristics on working capital management. The sample comprised 83 firms listed on Tehran Stock Exchange for the period of 2001 to 2010. Company characteristics include profitability, operating cash flow, company size, sale growth, current ratio, quick ratio and debt ratio. The analysis was conducted in two stages. In the first stage the relationship between the company characteristics with cash conversion cycle were assessed in all companies and the result indicated that profitability, operating cash flow, company size, sale growth and debt ratio affect the company’s working capital management. In the second stage, the companies were divided into 3 categories: large, medium and small. Then the relationship between company characteristics with cash conversion cycle was assessed separately. The results indicated that the effective factors in large firms were profitability, operating cash flow, debt ratio and sale growth. In medium firm, the effective factors were profitability, company size, sale growth and debt ratio, and small firms were affected by profitability, sale growth, current ratio, quick ratio and debt ratio. This study clearly reveals that, in Tehran, profitability, sales and debt are the key factors that affect WCR for firms regardless of their size.

Smith and Fletcher (2009) use net liquid balance (NLB) and working capital requirements as proxies for working capital management to examine the factors influencing working capital management in South African industrial companies. These proxies were tested for influence of industry, turnover, debt ratio, cash flow and return on assets on the measures. The study found no significant industry effect on working capital management.

In a recent study, Gill (2011) use panel data, OLS regression and correlational techniques to analyse a sample of 166 Canadian firms listed on Toronto Stock Exchange for the period 2008-2010 to determine the factors that influence the working capital requirements. The results indicate that operating cycle (OC), return on assets (ROA), internationalization of firm, firm’s growth, and firm size influence the WCR in Canada. The study also found that OC, ROA, leverage, internationalization of the firm, Tobin's Q, and firm size influence the working capital requirements in the Canadian manufacturing industry, while OC, ROA, sales growth, and firm size affect the WCR in the Canadian service industry. In a similar study, Nazir and Afza (2008) used regression analysis on panel data for 204 non-financial firms over a span of nine years. Researchers found evidence that operating cycle, leverage, return on assets and Tobin’s q significantly influence working capital requirements.

Chiou, Cheng and Wu (2006) explored the key factors of working capital management, using 19,180 company-quarter data from Taiwan Stock Exchange in the period from 1996 to 2004. Their study suggested that debt ratio and operating cash flow affected the working capital of companies. On the other side, no evidence was found to support the impact of business cycle, industry effect, company growth, company performance and company size on working capital management. Nazir and Afza (2008) studied the key factors on the requirements of working capital management, using 204 manufacturing companies from 16 industrial groups listed at Karachi Stock Exchange, Pakistan, in the period from 1998 to 2006. The authors found that operating cycle, leverage, ROA and Tobin’sQ had a significant impact on working capital requirements. Appuhami (2008) investigated the impact of corporate capital expenses on working capital management, using data collected from listed companies in the Thailand Stock Exchange, from 2000 to 2005. The study found a negative relation with capital expenses, suggesting that companies tended to manage working capital efficiently when they could find opportunities to grow by investing in fixed assets. The study also found a positive, significant relation between working capital requirements and operating and finance expenses, suggesting that companies tended to increase their working capital levels as debt and interest expenses increased.

2. Methodology

A semi-structured questionnaire was used to collect data on a sample of non-financial firms listed on the main market of the JSE Securities Exchange over the period, 2003 to 2012. A combination of Likert scale and open-ended questions were asked to elicit respondents’ view. The questionnaire is a 7-page document that contains 31 questions, divided into three major parts: A, B and C. Part A focused basically on company information. Part B asked questions related to aggregate working capital management with emphasis placed on working capital policy, the use of technology in managing working capital, and factors determining working capital requirement. Lastly, Part C dealt with inventory (supply chain) management, accounts receivable (revenue) management, and accounts payable (expenditure) management. Data was collected on a sample of 5 non-financial firms.

2. Data analysis

The first question addressed here is: What are the internal factors influencing WC requirements of non-financial listed firms?Table 1 shows the key internal factors (by rank).

Table 1. endogenous factors affecting WCR of JSE-listed non-financial firms

According to table1, the sampled firms ranked sales (1^st), capital expenditure (2^nd) and debtors (3^rd) as the three most important internal factors affecting their WC requirements.

Table two presents results of the analysis regarding the second research question: What are the external factors affecting WC requirements? The rankings given by the sampled firms are shown in table 2.

Table 2. Exogenous factors affecting WCR of JSE-listed non-financial firms

The four key exogenous factors (by rank order) are interest rate (1^st), exchange rates and GDP (both 2^nd), inflation rate (4^th) positions respectively.

Table 3 and 4 provide further analysis to answer the third question: What are the effects of the endogenous and exogenous factors on WCM?

Table 3. Impact of endogenous factors on WCM

Table 3 shows that 40% of the sampled firms indicate that sales affect WCM to a very high extent while 60% indicate that capital expenditure affect WCM to a high extent. Also 60% indicate that debtors’ terms affect WCM to a high extent.

Table 4. Impact of exogenous factors on WCM

According to table 4, 60% of respondents indicate that economic growth affects WCM from to some extent to a very high extent, while 80% indicate that interest rates affects WCM from to some extent to a high extent. 20% are of the view that exchange rates affect WCM to a very high extent.

2. Conclusions

The study analysed the key endogenous (internal) and exogenous (external) factors influencing working capital requirements and WCM of a sample of 5 large non-financial firms listed on the JSE. The result revealed that sales growth, capital expenditure and debtors’ management are the three most important endogenous factors influencing working capital requirement of the sampled firms. Other factors identified are inventory ordering efficiency, board requirements, centralization of supply, operating expenditure and products offered. The study further revealed that interest rates, foreign exchange rate, economic growth and inflation rate are the four key exogenous factors influencing working capital requirements of the sampled firms. Additionally, 40% of the sampled firms indicate that sales affect WCM to a very high extent while 60% indicate that capital expenditure affect WCM to a high extent. Finally, 60% indicate that debtors’ terms affect WCM to a high extent. 60% of respondents indicate that economic growth some extent to a very high extent affect WCM while 80% indicate that interest rates affects WCM from to some extent to a high extent. 20% are of the view that exchange rates affect WCM to a very high extent.

6. References

Aberdeen Group (2007). Working Capital Optimization: Improving Performance with Innovations and New Technologies in Inventory Management and Supply Chain Finance. www.aberdeen.com. Accessed: 11 April 2014.

Al-Shubiri, FN (2011). Analysis the Relationship between Working Capital Policy and Operating Risk: An Empirical Study on Jordanian Industrial Companies. Hebron University Research Journal. Vol. 6, No.1, pp. 287 – 306.

Alexander, L (1999). Determining board effectiveness: A handbook for directors and officers.Conference Board.

Allen, DS (1995). Changes in Inventory Management and the Business Cycle.Review.Federal Reserve Bank of St. Louis.July/August 1995.

Arnold, JRT (1998). Introduction to Materials Management. Prentice Hall, USA, 1998.

Arrow, K. J., Harris, T. and Marschak, J (1951).Optimal Inventory Policy. Econometrica, Vol. 19, pp. 250-272.

Altman, E. (1968). Financial ratios, discriminant analysis and the prediction of corporate bankruptcy.The Journal of Finance, Vol. 23 No. 4, pp. 589-609.

Appuhami, BAR (2008). The Impact of Firms’ Capital Expenditure on Working Capital Management: An Empirical Study across Industries in Thailand. International Management Review Vol. 4 No. 1 2008

Arnold G (2010). Financial Times Handbook of Corporate Finance: A Business Companion to Financial Markets, Decisions and Techniques

2nd Edition. Pearson.

Asaf S (2004). Executive corporate finance: the business of enhancing shareholder value. Pearson Education Limited. UK.

Atrill, P (2009). Financial management for decision makers.Pearson Education Limited. UK. 5th Edition.

Beaumont-Smith, M (1991). Financial management techniques of manufacturing firms in South Africa.MCOM thesis.University of South Africa. Pretoria.

Berger, S (2007). Fundamentals of health care financial management: A practical guide to fiscal issues and activities / Steven Berger. — 3rd Edition. Jossey-Bass Publishing.

Berman, H. J., Weeks, L. E., and Kukla, S. F. (1994).The Financial Management of Hospitals (8th ed. ) Ann Arbor, Mich.: Health Administration Press, 1994.

Block SB, Hirt GA, and Danielsen BR (2011). Foundations of Financial Management (14th ed.). Boston: McGraw-Hill.

Brealey, R.A., Myers SC and Allen F (2008).Principles of corporate finance, 9th ed. Boston/Irwin: McGraw-Hill.

Brigham EF and Daves PR (2007).Intermediate Financial management.Ninth Edition.Thomson/South-Western.

Colina J (2001). REL Consultancy Group presentation on Working Capital Trends [www2.financialexecutives.org/download/REL-Presentation-6-14-2k1.ppt‎] [Accessed 23 December, 2013].

Dobson, J. (1999). Is shareholder wealth maximization immoral? Financial Analysts Journal, Vol. 55, pp. 69-76.

Eiteman DK, Moffett MH, and Stonehill AI (2001). Multinational Business Finance, Ninth Edition.

Eljelly, AMA (2004). Liquidity - profitability trade-off: An empirical investigation in an emerging market. International Journal of Commerce and Management, Vol. 14, No. 2, pp.48 – 61.

Ehrhardt MC and Brigham EF (2010). Corporate Finance: A Focused Approach. 4/e. South-Western, a part of Cengage Learning

Erlenkotter, D. (1989) “An Early Classic Misplaced: Ford W. Harris’s Economic Order Quantity Model of 1915,” Management Science 35:7, pp. 898–900.

Eun CS and Resnick BG (2004). International Financial Management.Third Edition.The McGraw−Hill Companies.

Fernandez-Corugedo E, McMahon M, Millard S, and Rachel L (2011).Understanding the macroeconomic effects of working capital in the United Kingdom.Bank of England Working Paper No. 422. Electronic copy available at: http://ssrn.com/abstract=1814987. Accessed on 17 December 2013.

Fess, PE (1966): The Working Capital Concept. The Accounting Review, Vol. 41, No. 2, p. 266–270.

Filbeck, G, Krueger, T, and Preece, D. (2007). CFO magazine’s ‘working capital survey’. Do selected firms work for shareholders? Quarterly Journal of Business & Economics. Spring2007, Vol. 46 Issue 2, p3-22.

Fourcans A and Hindelang TJ (1974). Working capital management for the multinational firm: A simulation model. WSC ’74.Proceedings of the 7th conference on winter simulation – volume 1, pp 141 -149.

Freeman RE (1984).Strategic Management: A Stakeholder Approach (Boston: Pitman, 1984).

Friedman M (1962). Capitalism and Freedom.

Friedman M (1970). “The social responsibility of business is to increase its profits,” New York Times Magazine, September 13, 1970, pp. 122-126.

George, D., and Mallery, P (2003).SPSS for Windows step by step: A simple guide and reference. 11.0 update (4th ed.). Boston: Allyn & Bacon.

Gordon, J. N (2007). The rise of independent directors in the United States, 1950-2005: Of

shareholder value and stock market prices. Stanford Law Review, 59(6): 1465.

Guerard, JB and Schwartz e (2007).Quantitative corporate finance.Springer.

Guthmann HG and Dougall HE (1948).Corporate Financial Policy.Second edition, Prentice-Hall, 1948.

Greenberg L (2009). Liberating Cash: Reducing working capital levels. Association for Financial Professionals.www.AFPonline.org.

Hackett-REL (2006). ‘Book of Numbers Research Series: 2005 Performance Metrics and Best Practices in Total Working Capital’. Business Wire, May 31, 2006.

Harris, F. M. (1913) “How Many Parts to Make at Once,” Factory, The Magazine of Management 10:2, 135–136, 152. Reprinted in Operations Research 38:6 (1990), 947–950.

Hofmann E, Maucher D, Piesker S, and Richter P (2011). Ways Out of the Working Capital Trap: Empowering Self-Financing Growth Through Modern Supply Management. Springer-Verlag Berlin Heidelberg.

Institute of Management Accountants (1997).Measuring and Managing Shareholder Value Creation. Statements on Management Accounting

Jensen, M. C. (2001). Value maximization, stakeholder theory, and the corporate objective function. Journal of Applied Corporate Finance, 14: 8–21.

Jensen, M.C. (1972). Capital Markets: Theory and Evidence. Bell Journal of Economics and Management Science 3: 357–398.

Jensen, M.C. (1983). Organization Theory and Methodology. Accounting Review (April): 319–339.

Jensen, M.C. (1986). Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers. American Economic Review (May): 323–329.

Jones TM and Felps W (2013).Shareholder Wealth Maximization and Social Welfare

A Utilitarian Critique. Business Ethics Quarterly; April 2013, Vol. 23 Issue 2, pp 207-238.

Korn/Ferry International (2000).27th Annual Board of Directors Study 2000.

Laux J (2012). Topics in Finance Part IX—Working Capital Management.American Journal of Business Education – November/December 2012 Volume 5, Number 6.

Luo MM, Lee JJ-Y, and Hwang Y (2008). Cash Conversion Cycle, Firm Performance and Stock Value.

Lough, W. H. (1917): Business Finance: A practical study of financial management in private business concerns. New York.

Moyer RC, Mcguigan JR and Kretlow WJ (2006).Contemporary Financial Management.Thomson/South-Western.

McMenamin J (1999). Financial Management: An introduction. Routledge

Muckstadt JA and Sapra A (2010). Principles of Inventory Management: When You Are Down to Four, Order More. Springer Series in Operations Research and Financial Engineering Series Editors: Thomas V. Mikosch, Sidney I. Resnick, and Stephen M. Robinson.

Nellis, JR (1986). Public enterprises in Sub-Saharan Africa.World Bank discussion papers.http://www.pwc.co.uk/strategy/issues/working-capital-management-cash-for-growth.jhtml

Norton G M (2003). Valuation: maximizing corporate value. John Wiley and Sons.

Nunnally, J. C. (1967). Psychometric theory (1st ed.). New York: McGraw-Hill.

Opler, T., Pinkowitz, L., Stulz, R. and Williamson, R. (2001).‘Corporate cash holdings.' Journal of Applied Corporate Finance, 14: 55–67. doi: 10.1111/j.1745-6622.2001.tb00320.x

Pandey, I.M. (2005). Financial Management (9th edition).New Delhi; Vikas Publishing House PVT LTD.

Park C and Gladson JW (1963). Working Capital. The Macmillan Co, New York, 1963.

Payne S M (2006). How Low Can It Go? The 2006 Working Capital Scorecard.CFO Magazine September 01, 2006. CFO Magazine. Hackett-REL.

Payne SM (2002). “The Keys to Unlocking Hidden Cash”: A Treasurer’s Guide to US Cash Management.

Poitras G (1994). Shareholder Wealth Maximization, Business Ethics and Social Responsibility, Journal of Business Ethics, 13:2 (1994:Feb.) p.125.

Priester C and Wang J (2010).Financial Strategies for the Manager.Tsinghua University Press, Beijingand Springer-Verlag Berlin Heidelberg.

Pye, A (2002). The changing power of “explanations”: Directors, academics and their sense making from 1989 to 2000. Journal of Management Studies, 39(7): 907–925.

Ross, S.A., Westerfield RW, and Jaffe, JF (2002).Corporate finance, 6th ed. New York: McGraw-Hill.

Sagner JS (2011). Essentials of working capital management. John Wiley & Sons, Inc

Salek, JG (2005). Accounts receivable management best practices.John Wiley & Sons, Inc., Hoboken, New Jersey.

Say, J.-B (1803). A Treatise on Political Economy or the Production, Distribution and Consumption of Wealth, A.M. Kelley Publishers, New York.

Sathyamoorthi, C. R., and Wally-Dima, L. B. (2008). Working Capital Management: The Case of Listed Retail Domestic Companies in Botswana. The Journal of Management Research, 6(5), 7-24.

Sherman R (2012). Working Capital Optimization - What’s It All About? http://www.capgemini.com/blog/capping-it-off/2012/09/working-capital-optimization-whats-it-all-about. Accessed on 11 April 2014.

Shleton, F (2002). Working Capital and the Construction Industry.Journal of Construction Accounting and Taxation.November/December.

Siame, C (2012). The Relationship Between Profitability and Liquidity in South African Listed Firms. Master of Commerce (Financial Management) Dissertation, University of Cape Town.

Silva, SMSFN (2011).Effects of working capital management on the profitability of Portuguese manufacturing firms. Master’s thesis, Universidad do Minho, Portugal.

Smith KV and Sell SB (1980). “Working Capital Management in Practice,” in Readings in the Management of Working Capital, 2nd ed., Keith V. Smith, ed. St. Paul: West Publishing Company.

Smith MB and Begemann E (1997).Measuring associations between working capital and return on investment.South African Journal of Business Management. Vol. 28, No. 1, pp.1-5

Sundaram AK and Inkpen AC (2004). “The Corporate Objective Revisited,” Organization Science, vol. 15, no. 3 (May/June, 2004): pp. 350-363.

Taffler, R. (1982), Forecasting company failure in the UK using discriminant analysis and financial ratio data. Journal of Royal Statistical Society, Vol. 145, No. 3, pp. 342-58.

Tirole, J (2006). The theory of corporate finance.Princeton University Press.

Tully, S (1994). “American Standard: Prophet of Zero Working Capital”, Fortune, June 13, 1994. Tully, S (1994). “Raiding a Company’s Hidden Cash”, Fortune, August 22, 1994. Van Horne, JC and Wachowicz JM (2008).Fundamentals of financial Management.13th Edition.Prentice Hall/Financial Times.

Vernimmen P, Quiry P, Dallocchio M, Le Fur Y and Salvi A (2005).Corporate Finance: Theory and Practice. John Wiley & Sons Ltd. UK.

Supply & Demand Chain Executive, June/July, 2006. [http://www.sdcexec.com/article/10289863/running-the-numbers-june-july-2006; accessed: 21 December, 2013]

Walker EW (1974).Essentials of Financial Management.Second edition, Indian reprint, Prentice-Hall India, New Delhi.

Watson, D and Head A (2010). Corporate Finance Principles & Practice.Fifth edition.Pearson Education Limited.

Zheng, Y. S. (1992) “On Properties of Stochastic Inventory Systems,” Management Science 38:1, 87–103.

Zipkin, P. (2000) Foundations of Inventory Management, McGraw-Hill Higher Education, New York, New York..

Refbacks

• There are currently no refbacks.