Does cash conversion cycle affect cost of equity capital?

ABSTRACT

This study examines the impact of cash conversion cycle (CCC) on cost of equity (COE). A CCC measures the time it takes for a firm to convert its inventory into cash flows from sales. A CCC is one of several metrics that evaluates a firm’s operational risk, and this paper investigates whether CCC affects COE. Using 29,248 firm-year observations that span 1984–2018, we find that firms with longer CCC have higher equity financing costs. Furthermore, we observe significant moderating effects of product market conditions and information asymmetry. The positive relationship becomes weaker (stronger) with greater competition and demand uncertainty (information asymmetry). Our findings provide useful insights for managers as our results reveal that investors recognize CCC as a value-relevant signal in determining COE.

KEYWORDS:

• Cash conversion cycle
• cost of equity capital
• market competition
• information asymmetry

JEL CLASSIFICATION:

• G30
• G32
• M40
• M41

Disclosure statement

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

Notes

¹ We alternatively use four individual measures and the results do not alter our inferences.

² There is still on-going debate on whether accrual quality is a priced risk factor or not. First, Francis et al. (2005) find that accrual quality is a priced risk factor using a time-series model. However, using a two-stage asset price model, Core, Guay, and Verdi (2008) show that accrual quality is not a priced risk factor. Recently, some papers suggest that accrual quality is still a price risk factor when the economic shocks are appropriately controlled in the two-stage asset pricing model (Kim and Qi 2010; Ogneva 2012).

³ We multiply the standard deviation of CCC and the regression coefficient of CCC (62.0168 × 0.0000204 = 0.001265).

⁴ In our untabulated results, CCC squared (Baños-Caballero, García-Teruel, and Martínez-Solano 2012, 2014) is also significantly and positively associated with COE but at a significantly smaller magnitude compared to CCC.

⁵ We also employ PCA methodology as a robustness test and our results (untabulated) remain consistent. Also for robustness, we analyse four measures of COE individual and our results (untabulated) remain the same.

⁶ The literature of estimation risk supports that heterogeneous information among investors increases estimation risk, leading to an increase in the COE (e.g. Barry and Brown 1985; Coles, Loewenstein, and Suay 1995). With the assumption of imperfect market competitions, Lambert, Leuz, and Verrecchia (2012) analytically provide the evidence of the indirect link between information risk and the COE via information asymmetry among investors.