Exploring the Determinants of Working Capital Management: Evidence across East Asian Emerging Markets.

• Author: Bin, Leo

1. Introduction

   Corporate finance can be divided into three main domains of decision makings: capital budgeting, capital structure, and working capital management. While the former two domains cover the sources and uses of long-term corporate capital, the domain of working capital management focuses on the short-term financing sources (i.e., "current liabilities") and short-term investment uses (i.e., "current assets") of corporate capital. The time-consistent importance of working capital decisions to firm performance, risk and value has been theoretically summarized (e.g., Smith, 1973; Smith, 1980) and empirically supported by prior researchers (e.g., Nunn, 1981; Aktas et al., 2015), who emphasize the potential jeopardy of insolvency due to the lack of capable working capital maintenance and control. When compared with capital-budgeting and capital-structure research, however, the publications regarding the relevance of working capital management are relatively much fewer in quantities and less known in citations. Even less attention has been paid to a systematic investigation of working capital determinants, especially outside the range of developed economies.

   Recognizing the lack of empirical studies that examine the determinants of working capital and the importance of its management on firm value in global emerging markets, we conduct this research in attempt to partially fill the gap, focusing on East Asian emerging markets. In line with Shulman and Cox (1985), we employ the net liquid balance (NLB) and the working capital requirements (WCR) as proxies to measure the firm's working capital management, more effective than using traditional liquidity variables such as current ratio, quick ratio or net working capital, particularly in the cases of forecasting corporate liquidity around financial turmoil.

2. Literature Review

   Along with long-term fixed capital and the associated capital budgeting and structure decisions, short-term working capital and its relevant decision makings can also add value to the firm, let alone keeping the firm financial afloat. Smith (1973) compares the pros and cons across a variety of corporate working capital management approaches, whereas Smith (1987) focuses on that working capital management has specific importance in affecting firm value through two factors: liquidity and profitability. As for liquidity, illiquidity leads to bankruptcy risk that undermines firm value. On the other hand, abundant liquidity means inefficient use of corporate fixed resources and the cost of capital that the firm must bear for financing its short-term assets thus can also be harmful to the firm's profitability. Therefore, it is a key issue for corporations to maximize their values by balancing the tradeoff between liquidity and profitability. To implement such working capital component optimization with maximum efficiency, researchers need to investigate across various possible determinants, then identify the most influential factors, and then try to capture likely variations in such influences across economies (e.g., developed and emerging) and/or across business cycles (e.g., before and after recession).

   With regard to developed economies, Nunn (1981) finds that averagely 38.6% of assets in a US manufacturing firm is tied up in working capital (which include cash, inventory and receivable, etc.), demonstrating the importance of efficient working capital management. With current liabilities also being added into the calculation, working capital reflects both the sources and the uses of short-term capital; and the aim of working capital management is to ensure that the firm's short-term obligations are met (on liquidity side), and that its on-going operation is working properly (on profitability side). Therefore, it is essential to determine an appropriate level for each component of working capital to create an efficient mix, which will thus not only facilitate the on-going operation of the firm, but also minimize the carrying cost of working capital resources. As the ideal level of a firm's inventory is "just in time" in which the supply meets the demand so as to optimize the cost-benefit trade-off of total inventory over time (Blazenko and Vandezande, 2003), the ideal amount of a firm's working capital is "just sufficient" in which the risk-return trade-off can be optimized between liquidity and profitability, so as to maximize the firm value. As such, the relation between the various measures of working capital management and firm value in developed economies has been examined by several researchers (Deloof and Jegers, 1996 and 1999; Deloof, 2003; Cunat, 2007; Martinez-Sola et al., 2013; Lyngstadaas and Berg, 2016).

   Firms in emerging markets have some characteristics that make them differ from those in developed countries on practicing working capital management. The first is relatively smaller firm size. Banos-Caballero et al. (2010) state that efficient working capital management is especially essential for survival and growth of small and medium-size firms, in which "the average investment in tangible fixed assets in the sample used in this paper [small and medium-size enterprises, SME] is only 23.6% of their total assets, which demonstrates the importance of an efficient management of current assets" (Banos-Caballero et al., 2010: 512). As a result, for relatively small firms in emerging markets, managers need to spend considerable amounts of time and efforts in making decisions relating to working capital.

   Financial constraint is the second limitation for those firms in emerging markets. Small size and less developed capital market make the corresponding firms more difficult and/or costly to raise long-term external capital, and they are more reliant on short-term financing such as trade credit from their suppliers and operating loans from local banks (Deloof and Jegers, 1996; Petersen and Rajan, 1997; Banos-Caballero et al., 2010).

   There are various known measures for working capital management effectiveness. Current ratio, quick ratio and net working capital are three of the widely and traditionally used in the area; but they draw some criticisms (e.g., Shulman and Cox, 1985). The current and quick ratios are useful to show the liquidity of the firm, but they give no indication about the robustness of the on-going operation of the firm. On the other hand, net working capital (subtracting current liabilities from current assets) accounts for both the firm's operations and its short-term financial decisions, but it is not a suitable indicator for liquidity. Noting such a dilemma, several studies thus employ the approach suggested by Shulman and Cox (1985), of dividing the net working capital into NLB and WCR portions, which proves to outperform traditional indicators when evaluating firm liquidity and predicting financial crises (Hawawini et al., 1986). Therefore, in this study we adopt WCR and NLB as indicators of working capital management, even though these two measurements are negatively related to each other (Shin and Soenen, 1998).

   Concerning specific factors that might materially affect the working capital of a firm, an earlier empirical research by Nunn (1981) uses both correlation analysis and factor analysis to discover the determinants of working capital management for US sample firms. He identifies a set of 19 variables, which are categorized into five groups (production-related, sales-related, accounting-related, competitive positions, and industry types), to be the long-term strategic determinants of working capital. Later, several more-recent studies also attempt to determine the key determinants of corporate working capital management for different countries or regions, thus finding some influential exterior factors including general economic conditions and industry features, along with firm-specific interior factors including firm leverage, financial performance and capital expenditure. For example, some of such findings in developed markets include Howorth and Westhead (2003) on UK firms, Garcia-Teruel and Martinez-Solano (2007) on Spanish firms, Hill et al. (2010) on US firms, Pais and Gama (2015) on Portuguese firms, and Lyngstadaas and Berg (2016) on Norwegian firms. Putting multiple developed markets together, Koralun-Bereznicka (2014) studies nine EU member nations over the period 2000-2009, finding that country-specific factors, industry types and firm sizes are the most influential to the working capital management of those EU sample firms.

   Some similar evidence is also observed in emerging markets, such as by Ding et al. (2013) on Chinese firms, Wasiuzzaman (2015) on Malaysian firms, and Mielcarz et al. (2018) on Polish firms. Among these, Mielcarz et al. (2018) extend their investigation time horizon beyond the international credit crunch of 2008. It is also notable that Mongrut et al. (2014) conduct a multinational comparative study, finding that the effects of firm determinants on working capital management vary considerably across the five emerging markets in Latin America--specifically, Argentina, Brazil, Chile, Mexico and Peru, during the period 1996-2008.

   However, to our knowledge, none of the prior studies have comparatively examined the working capital management in as many East Asian emerging economies as we do in this paper, even though the East Asian emerging markets have been considered some of the largest and fastest-growing global manufacturing centers, and during this process they have jointly endured a severe financial crisis breaking out in 1997 and suffering widespread liquidity crunch within the region. Our study is also the first attempt to investigate the possible variations in working capital management effectiveness in this region throughout the global "Great Recession" of 2008, and the likely presence of optimal working capital level in which the firm value can be maximized.

3. Hypotheses

   Business Cycle Indicators

   The...