Working capital management efficiency, managerial ability, and firm performance: new insights

ABSTRACT

This paper studies the association of managerial ability (MA) with efficiency in working-capital management (WCM) of firms. Using a large sample of 1,14,173 firm-year observations between 1988 and 2018 in the US, we show a negative contemporaneous relationship between MA and efficiency of WCM, indicating that more able managers manifest higher WCM efficiency and thereby affect firm performance positively through a mediating channel of WCM. Further, we show that this association is non-linear in nature with managers focusing more on long-term value-enhancing projects for the firm beyond a threshold MA level, having already attained the optimal efficiency in WCM. The results remain robust after a series of robustness tests.

KEYWORDS:

• Managerial ability
• cash conversion cycle
• components of working capital
• firm performance
• efficient working capital management

JEL CLASSIFICATION:

• M41
• G30
• G31

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

¹ For the sake of brevity, we refrain from including a more detailed discussion of how Demerjian, Lev, and McVay (2012) estimated managerial-ability score. We collect the MA data from the personal webpage of Prof. Peter Demerjian (http://faculty.washington.edu/pdemerj/data.html).

² The cash-conversion-cycle (CCC) is the composite days taken by a company to transform its investments in inventories into cash. It represents the number of days between the firm’s payment for inventory, and the receipt of cash from selling that inventory. The CCC is estimated as follows: CCC = DRO + DIO – DPO, where DIO is the number of days it takes to sell inventory, known as the Days Inventory Outstanding, DRO is Days-Receivables-Outstanding i.e. days to receive payment from customers, and DPO is Days-Payables-Outstanding, meaning days to pay suppliers for the same inventory. A shorter CCC indicates that a company is able to generate cash more quickly from its sales which implies enhanced efficiency in working-capital management. We explain, how CCC is estimated for this study in section III..

³ We discuss the same separately in sec 4.5.5.

⁴ First introduced by economist James Tobin in 1969, Tobin’s Q is the ratio of the market value of a firm to its reported book value. A Tobin’s Q higher than 1 suggests that the market value of the firm is greater than its book value, which can be interpreted as a sign of the company’s growth potential, future profitability, and overall performance. On the other hand, a Tobin’s Q lower than 1 signifies that the market value of the firm is lower than its reported book value, which can be seen as a sign of a declining firm. Any accounting-based measure of firm performance are suspect primarily for two reasons: first, accounting numbers can be manipulated and second, the general understanding in finance theory and literature is that markets are efficient and can see through the reported book numbers to capture the true value of a firm. Hence, Tobin’s Q is sometimes considered to be a better proxy to capture how effective a firm’s management has been in creating value for shareholders.

⁵ When independent variables of the sample firms do not experience considerable changes with time, the random-effect model works better than the fixed-effect regression (Levi, Li, and Zhang 2014). On the other hand, the benefit of firm fixed-effect model is that it simultaneously control for time-invarient firm characteristics and within firm variation of managerial skills (Adams and Ferreira 2009).

⁶ We thank reviewer for suggesting these tests.

⁷ We have done Breusch and Pagan Lagrangian multiplier tests and Hausman Text to understand which estimation model is most appropriate. The test statistic suggest that the firm-fixed effect model is the most appropriate.

⁸ 2% discount is allowed to customer for payment within 10 days, else full amount to be paid within 30 days.

⁹ Results are available on request.

¹⁰ The EPU data is gathered from https://www.policyuncertainty.com/.

¹¹ Industry mean adjusted CCC is untabulated.