Bottom Line: Making investments in working capital—assets a firm uses for inventory, pending sales, and raw materials—is not as valuable to shareholders as converting profits into cash reserves, securities, or customer credits.
Corporate financial officers have traditionally emphasized the importance of operating or working capital. CFO magazine even deemed it so important that the magazine focused multiple conferences and articles strictly on trends in companies’ working capital performance—how they managed assets tied up in raw materials, unsold inventory, and outstanding payments from customers. Because this working capital can’t be used to service debts or fund other projects, management of the process is widely viewed as an important gauge of a company’s short-term financial vigor and operational efficiency.
For example, one vital metric of managing operating capital is the cash conversion cycle—the time elapsed between paying for raw materials and selling the finished product. In 1994, Walmart and Kmart were very similar companies. But Kmart had a longer cash conversion cycle: roughly 61 days compared to Walmart’s 40 days. Kmart eventually went bankrupt, in part because of the company’s failure to effectively manage its operational funds.
But a new study sheds light on another aspect of operational capital, suggesting it might not be as valuable for certain companies’ shareholders as previously thought. The authors of this study provide some of the first empirical insights on the relationship between working capital management and stock market performance. They analyzed all U.S. public corporations listed in the Compustat and Center for Research in Security Prices databases from 1990 through 2006. They excluded financial firms, which treat operating capital much differently, and ended up with an average of 3,786 companies per year.
Operational capital might not be as valuable for certain companies’ shareholders as previously thought.
Underscoring the importance that companies attach to having plenty of working capital on hand, the firms in the study put an average of more than 27 percent of their total assets into net operating capital—a rather substantial amount. But the stock market’s reaction to the building up of strategic reserves was somewhat less substantial, the authors found.
For the average firm, every additional dollar converted into net operating capital was valued by shareholders at only 52 cents. Not only is this number obviously much less than the actual value of the amount being invested, but it’s also far below the US$1.49 valuation that shareholders place on any additional dollar held in cash or liquid securities.
The general results varied somewhat, depending on firms’ financial state. The analysis implied that additional spending on operating capital is less valuable to shareholders when the company carries a high level of debt and therefore faces a greater risk of bankruptcy. In these cases, shareholders clearly value cash reserves or marketable securities as a guard against loan defaults or angry creditors. On the other hand, building up working capital is slightly more valuable for shareholders of firms that face financial constraints, such as limited access to credit, and that have a realistic prospect of increasing future sales.
More importantly, however, the study found that companies (no matter what financial state they’re in) should consider giving back to their customers, and carefully adjust their trade credit policies. Of all the different aspects of managing operational funds at the average firm, an incremental dollar invested in credit to customers had the greatest effect on increasing shareholders’ wealth. Credit agreements, which usually stipulate that a customer can buy materials on account and pay cash at a later date, are widespread in business-to-business contexts. They help keep resources and goods flowing through the supply chain, and are used as a way to stimulate future sales growth—something that shareholders hold dear.
But developing a successful capital management strategy isn’t as simple as just slashing working capital and reinvesting in cash and credits. A seminal 1974 study showed that a company’s failure to have products in stock for customers had a significant and negative impact on future sales. So firms must trade at least some of their current profits to cover the costs of having enough future inventory to satisfy demand. And it’s a serious concern. When customers face a “stock-out,” they walk out, according to a 2004 Harvard Business School study: If their desired product is not on the shelf, between 21 and 43 percent of customers (depending on the type of product they’re buying) will choose another store next time.
The current challenge for CFOs and other financial executives is to balance the need for a strategic reserve of inventory and raw materials—and the reality that there will always be lags in accounts receivable—against other ways to invest profits that appear to be more rewarding for shareholders. Namely, consider holding onto assets in cash, investing in securities that can quickly be liquidated, and giving credits to customers. “Altogether our evidence illuminates the importance of working capital management to shareholders and the subtle effects of financing on its wealth effects,” the authors conclude.
Source: Working Capital Management and Shareholders’ Wealth, Robert Kieschnick (University of Texas at Dallas), Mark Laplante (University of Georgia), and Rabih Moussawi (University of Pennsylvania), Review of Finance, September 2013, vol. 17, no. 5