Do Working Capital Strategies Matter? Evidence from Small Business Data in Japan

• Author: Daisuke Tsuruta
• Published date: 01 December 2018
• Date: 01 December 2018
• DOI: http://doi.org/10.1111/ajfs.12239

Do Working Capital Strategies Matter?

Evidence from Small Business Data in

Japan*

Daisuke Tsuruta**

College of Economics, Nihon University, Japan

Received 12 September 2017; Accepted 6 October 2018

Abstract

Previous studies show that a high level of working capital is harmful to firm performance.

Using data from over 100,000 small businesses in Japan, we show that a high level of

working capital has a positive effect on default risk and sales growth. Therefore, this activ-

ity has both positive and negative effects. Additionally, the relationship between working

capital and firm performance is negative over a 1-year period, but positive over longer

periods, implying that a high level of working capital is ultimately not harmful for small

businesses.

Keywords Working capital; Firm performance; Trade credit; Inventory; Small businesses

JEL Classification: G31, G32, G33

1. Introduction

We investigate whether the cost of working capital is significant for small busi-

nesses. In general, working capital consists of trade receivables, inventories, and

trade payables. As Preve and Sarria-Allende (2010) argue, working capital manage -

ment is one of the most strategic issues in corporate finance. Many studies investi-

gate the relationship between firm performance and working capital management

and note that a conservative working capital strategy (which involves a high level of

*The author thanks the CRD Association, which has given permission for the use of its data.

The views expressed in this paper do not necessarily reflect those of the CRD Association.

This study is supported by a Grant-in-Aid for Scientific Research (C) #16K03753 from the

Japan Society for the Promotion of Science.

**Corresponding author: College of Economics, Nihon University, 1-3-2 Kanda-Misaki-cho,

Chiyoda-ku, Tokyo 102-8360, Japan. Tel: +81-3-3219-3606, Fax: +81-3-3219-3606,

email: tsuruta.daisuke@nihon-u.ac.jp.

Asia-Pacific Journal of Financial Studies (2018) 47, 824–857 doi:10.1111/ajfs.12239

824 ©2018 Korean Securities Association

working capital) reduces firm value.

1

Kieschnick et al. (2013) argue that firms with

large working capital requirements need larger amounts of external finance, which

leads to a higher probability of bankruptcy and lower firm value. Opler et al.

(1999) and Bigelli and S

anchez-Vidal (2012) show that firms with high levels of

working capital need large cash holdings, which have a high opportunity cos t. Faz-

zari and Petersen (1993) focus on the underinvestment problem under financial

constraints. As financial constraints are severe for borrowers, working capital has

negative effects on fixed investment because working capital plays the role of both a

use and a source of funds. This implies that higher levels of working capital induce

undervaluation of fixed investment. As a result, firm value decreases by increasing

the level of working capital (de Almeida and Eid, 2014; Zeidan and Shapir, 2017).

2

Some studies empirically investigate optimal working capital. For example,

Aktas et al. (2015) show the nonlinear effects of w orking capital on stock perfor-

mance. They show that firms with positive excess working capital enhance their

stock performance by decreasing their working capital. These results imply the exis-

tence of an optimal level of working capital. Ba~

nos Caballero et al. (2012, 2014)

and Ben-Nasr (2016) also show an inverse U-shaped relationship between invest-

ment in working capital and firm performance. These studies also imply that a high

level of working capital is suboptimal for maximization of firm value.

However, a high level of working capital is not necessarily suboptimal and

harmful to firm value. First, the optimal working capital level is firm-specific, that

is, a high level of working capital is harmful for some firms, but not all firms. Hill

et al. (2010) argue that optimal working capital depends on internal financing

resources, external financing costs, and capital market access because some firms

need to finance credit demand from a high level of working capital. Chen and

Kieschnick (2018) show that availability of bank credit decreases cash holdings and

investment in inventory. This implies that firms with less severe credit constraints

can invest in more working capital.

Second, some studies argue that a high level of working capital increases firm

value. Long et al. (1993) note that trade receivables promote sales because these

enable customers to evaluate the quality of products. Petersen and Rajan (1997) also

argue that trade credit provision promotes firm sales. As a result, and as Deloof

(2003) shows, increases in trade receivables increase firm profitability, which leads to

1

A conservative working capital strategy is one that involves a high level of working capital.

Firms with this strategy have an adequate stock of current assets as protection against a sud-

den change in economic conditions. However, they have to finance the high level of working

capital. An aggressive working capital strategy is one with a lower level of working capital,

such that firms only have a small stock of current assets (such as inventories). The risk of

this strategy is high because firms do not have adequate inventories to respond to sudden

changes in the level of production or sales.

2

Nobanee et al. (2011) show the negative relationships between working capital and firm per-

formance using data from Japanese listed firms.

Do Working Capital Strategies Matter?

©2018 Korean Securities Association 825

higher firm values.

3

Ding et al. (2013) argue that firms with high levels of working

capital have low sensitivity to cash flows on fixed investment, suggesting that these

firms alleviate financial constraints using working capital. Some studies (e.g., Blinder

and Maccini, 1991) argue that large inventory holdings can increase a firm’s sales by

hedging the risk of stock-outs and high input prices from business cycle fluctuations.

Third, if a high level of working capital is suboptimal, firms adjust their work-

ing capital level to the optimal level. Ba~

nos Caballero et al. (2013) estimate the

adjustment speed of working capital requirements using a partial adjustment model.

They show that firms can easily adjust their working capital level to the target level.

This implies that the level of working capital has significant effects on firm perfor-

mance over short periods, but the effects are insignificant over longer periods

because firms adjust the level of working capital to mitigate the negative effects.

In this paper, we investigate the relationship between the level of working capital

and firm performance for small businesses. Although an optimal level of working

capital exists, a very high level of working capital is observed. In our databas e of

small businesses in Japan (Credit Risk Database), the median of net working capital

(trade receivables +inventories –trade payables) normalized by total sales is 0.133

and the third quartile is 0.231. Furthermore, the interquartile range of working capi-

tal is 0.162, which suggests that the distribution has a wide range. If a very high level

of working capital is not optimal for firms, they should reduce their working capital

level. As a result, the distribution of working capital levels should become narrower.

However, the distributions of working capital levels are similar each year. Therefo re,

we predict that a high level of working capital is not suboptimal for all firms.

We investigate the effects of a working capital strategy using small business data

in Japan. As Berger and Udell (1998) argue, small businesses face financial constraints

because they are informationally opaque. The costs of external finance for sma ll busi-

nesses are higher than those for large firms, so the costs of a high level of working

capital can be serious (Ba~

nos Caballero et al., 2012). Therefore, a sample of small

businesses is appropriate for investigating the effects of a working capital strategy.

Japanese data are suitable for investigating the effects of a working capital strategy.

First, Japanese firms are large users of trade credit, whichis a maincomponent of work-

ing capital. Accordingto C^

ot

e and Graham (2007), trade credit to total corporate liabil-

ities in Japan’s nonfinancial sector is the largest among the G7 countries plus Australia.

Therefore, the costs and benefits of a high level of working capital through trade credit

can be observed. Second, according to Hoshi and Patrick (2000), the Japanese financial

system is bank-centered. Therefore, the availability of bank loans for firms is high com-

pared with other developed countries.

4

This implies that firms finance high levels of

3

As Kieschnick et al. (2013) empirically show, stock returns increase with profitability, which

enhances firm value.

4

International comparisons by C^

ot

e and Graham (2007) indicate that total corporate liabili-

ties (less equity) to nominal GDP are the highest among the G7 countries plus Australia,

implying that Japanese firms can access bank loans easily.

D. Tsuruta

826 ©2018 Korean Securities Association