Page 223 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes liquid assets have access to the commercial paper market. The former characteristics however
seem sufficient for firms to be able to issue commercial paper successfully given the fact that
they have less working capital on average.
The firm controls the various components of working capital to a different extent. In general it
will have more control over inventories of materials than over inventories of finished products
or accounts receivable. Moreover, the bank might set a limit to short term debt or demand a
minimum level of cash. As a consequence the interpretation of working capital as a measure of
liquidity depends crucially on its definition. For instance high working capital defined as cash
minus short-term debt, might actually be a sign of low liquidity when it reflects restrictions
imposed by the bank. The empirical literature on the interaction between investment and decisions
on working capital we are aware of is very limited.

Whited (1991) put the re-liquefaction theory of Eckstein and Sinai to a test. Allowing coefficients
to vary over time and controlling for demand by including output, she found that lags of
working capital contributed significantly to a Q regression of investment and that in accordance
with the theory investment was especially sensitive to the level of working capital just after the
trough of the business cycle (in 1983). Moreover when she split the sample using the criterion of
whether firms have a bond rating from Moody’s or not, this particular pattern in the coefficient
of working capital was only found for firms of low credit quality.
Fazzari and Petersen (1994) view working capital as a use of funds which is competing with fixed
investment but also as a means (source) to smooth investment such that fluctuations in cash flow
will not be transmitted fully to investment. Their empirical results indicate that when in addition
to cash flow, the (simultaneous) change in working capital enters a Q regression model of
ordinary investment, the coefficient of cash flow rises while the sign of the coefficient of the
investment in working capital is negative. This should not be interpreted as evidence that
investment and the change in working capital are negatively correlated. Their findings are
consistent with the following interpretation. The change in working capital takes out the
transitory component of cash flow such that the permanent component remains which determines
investment primarily (through the liquidity effect). In fact if a firm is liquidity constrained a
positive (negative) shock to cash flow will increase (decrease) both the stock of working capital
and investment. If the shock is transitory, the extent of investment smoothing determines the
actual size of the change in working capital. If the shock was negative (and transitory), the firm
will not reduce working capital when it has reached some minimum level necessary for operating
the firm but instead reduce investment more. Whited measures working capital as current assets
minus inventories, receivables and short term debt including the current portion of long term
debt.

Task Analyse and explain the situation in which a firm will not reduce working capital
when it has reached some minimum level necessary for operating the firm.

13.3.1 Working Capital and Marketable Securities

The securities most commonly held as part of the marketable securities portfolio are divided
into two groups:
1. Governmental issues and
2. Non-governmental issues.

The short-term obligations issued by the central government and available as marketable
security are treasury bills.

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