The speed of adjustment in working capital requirement

Abstract

This paper analyzes the determinants of working capital requirement (WCR) and examines the speed with which firms adjust toward their target WCR. The findings indicate that firms adjust relatively quickly, which supports the hypothesis that current balance sheet items are easier to manipulate and could be changed quite easily, even in the short run. Moreover, we find that the speed of adjustment is not equal across all firms and varies according to their external finance constraints and their bargaining power. Firms with better access to external capital markets and greater bargaining power adjust faster due to their lower costs of adjustment.

Keywords:

• working capital management
• working capital requirement
• net trade cycle
• speed of adjustment
• heterogeneity

JEL Classification:

• G30
• G31
• G32

Notes

1. The tangible fixed assets are measured as a stock variable.

2. ZSCORE is defined as the following expression: where X₁ is the working capital/total assets; X₂ the retained earnings/total assets; X₃ the net operating profits/total assets; X₄ the market value of capital/book value of debt; and X₅ the sales/total assets.

3. We also find a partial adjustment process when employing other more general measures of working capital as the ratio (current assets – accounts payable)/total assets; and the ratio ((current assets – accounts payable)/sales)*365.

4. Following Flannery and Rangan (2006), we simulated 20 sets of panel data, each with 400 observations, and re-estimated our partial adjustment model for them. We obtained a mean speed of adjustment of 0.6326 and a standard deviation of 0.0118.

5. The results presented in Table 5 are maintained when the GDP is replaced by the interest rate and when both variables are included in the model.

6. The Whited and Wu (2006) index is given by CF is the ratio of cash flow to total assets; DIVPOS is a dummy variable that takes the value of one if the firm pays cash dividends; TLTD is the ratio of the long-term debt to total assets; LNTA is the natural logarithm of total assets; ISG is the firm's industry sales growth; and SG is firm sales growth.

7. We also find that firms with a greater access to external capital markets adjust faster when we employ other measures of access to external finance such as size, interest coverage, and the deviation of a firm's debt ratio from the industry median.