The Importance of Working Capital Management to a Firm’s Value Maximization, under Crisis Conditions

The Importance of Working Capital Management to a Firm’s Value Maximization, under Crisis Conditions

Literature Review

Appuhami, (2008) points out that the financial crisis that engulfed the business world in the wake of 2008, triggered several researches on the topic of Working Capital Management. The global financial crisis had adverse impacts on organizations that were not properly leveraged thus firms have in the recent past decided to balance their working capital and profitability as one way of maintaining stability in their day to day operations even during crisis conditions. Generally, it is appreciated that the basic goal for which organizations are created is profit or value maximization. The prerequisite for starting a business venture is coming up with a business idea on a suitable venture after which the entrepreneur looks out for funding. Such funds are not only necessary for setting up a business but also vital to facilitate the day-to-day financing of short-term or everyday trading activities. Baltagi, (2008) adds that this type of capital is referred to as Working Capital. In order to reiterate on the impact of initial business funding and its impacts on the Working Capital, this paper seeks to present a literature review on business financing in relation to the importance of Working Capital Management to a firm’s value maximization, under crisis conditions.

A financial journal by Baltagi, (2008) states that business financing is a vital necessity for every business whether a startup or a full-fledged venture. Economists and entrepreneurs support that there are two major ways in which organizations can be financed. That is debt financing and equity financing. Debt financing can be defined as the process of soliciting for long term loans from financial institutions such as banks while equity financing is the process of seeking for financial assistance from venture capitalists or investors who issue money in exchange for partial ownership or shares from the business. All these forms of financing have both advantages and disadvantages. For instance, debt financing has been discredited by some people as being exorbitant especially when a business has to incur high interest rates which might not match up to the profits accrued from a startup business or the share ratios promised to other stakeholders. On the other hand, debt financing is advantageous as it gives a prospecting entrepreneur the necessary capital to start a business, acquire equipment, assets and buildings (Beranek, 2003). For a continuing business, the debts can be helpful when used as working capital especially when the firm is in distress.

The other advantage of debt financing is that the banks do not inflict the entrepreneur with their conditions on how the cash will be used thus the management of the business can is make pertinent choices regarding growth strategies and how the cash can be used to business growth or during crisis conditions. The other form of financing known as equity financing has the advantages of sharing profits and losses with the venture capitalist. Ben-Horim and Levy, (2008) makes it clear that the sharing of risks, profits, losses and liabilities make equity financing admirable while the second advantage is that the cash is not repaid thus the business can effectively use the money as working capital to foster growth. The major disadvantage though emanates from the reality that the entrepreneur will have to share profits based on an agreed ratio, which might suppress growth. Likewise, decision-making is barred in terms of decision making because the entrepreneur has to consult with the venture capitalist. In the end the business chances of growth based on the ease of influencing management policies is considerably reduced (Deloof, 2003).

In support of financing is the business structure, which is important in determining the working capital management of any given company. In fact, William and Marlene, (2009) recommends that firms must be willing to take on risks by investing in corporate bonds or common stock. In the eyes of a risk taking entrepreneur, who is often referred to as risk averse in financial terms, one fact remains subtle that the higher the risks incurred from a venture the higher the profitability, value maximization or return on investment. Apparently, Ben-Horim and Levy, (2008) argue that it is assumed that safe investments or rather those investments that do not count as being risky do not promise high returns on investment. From this line of argument and viewpoint, it is inevitable that Deloof, (2003) suggests that shareholders among other stakeholders could influence the working capital management policies enacted and implemented by any given organization. This is possible through their influence on the risk levels of a firm for instance corporate bonds in addition to preferred and common stocks. Generally, bonds can be described as being exclusively issued by the municipals, companies, treasury or even security. The last two of which are known as treasury and security bonds respectively.

A company’s bond represents the highest proportion of corporate bonds. This statement is supported by observations made by William and Marlene, (2009) who further added that corporate bonds are majorly dependent on the stability as well as the performance if the issuing company. Apparently, the performance of firms is pegged on financial ratios as depicted in their books of accounts, which adds up to supporting that working capital is important in the determination of corporate bonds and either preferred, or the common stock. Even though accountants support that corporate bonds have a lower risk level, which attributes to their inability to attract high returns in spite of their regular dividend payments, common stocks are much riskier hence promise a higher return on investment. Alternatively, Demirgu-Kunt and Maksimovic (2009), advise that firms could opt to venture into portfolios or diversified ventures as a way of leveraging the business against potential loss that could adversely affect the working capital.

This argument is made on the ground that investors or businesses that invest in different portfolio or sectors of the economy protect their companies from uncertainties related to recession, inflation and general loss of working capital to corrupt administrators managing one firm. This process is defined as vertical integration where a firm can also diversify in the same industry as a way of protecting its supply chain from adverse competition that might trigger fluctuations on the working capital held by the firm. In the long run, an investor or a firm that invests in two or more lines of business might decide to venture into different product lines ad this is healthy for any business because of the need to protect the working capital. These companies especially those financed by debt equity might make decisions to back up the portfolio by use of stocks and bonds. This is done when the management assesses the possibility of the investment being risky, the magnitude and the rating of agencies according to given propensities such as poor, moodiness or standard (Ruben, 2012).

In relation to portfolio management, there is the aspect of the size of a firm and its assets where Garcı´a-Teruel and Martı´nez-Solano, (2007) states, it is implicit that both small and large companies have to focus on policies targeting current or short term assets as an alternative way towards strengthening Working Capital Management especially  recessions. A good example is the 2008 Global Recession. The main areas of target for such organizations in distress or crisis conditions are short-term capital expenditures, short term assets and resources whose maturity is less than one year. The intrinsic values of these components are more often than not estimated using figures presented on the previous balance sheets and income statements. By so doing, organizations attempt to maximize their value as well as their working capital after post-economic crisis period. The efficiency of salvaging an organization from a crisis condition contributes towards profit or value maximization as well as gaining of competitive advantage. Business researchers and analysis support that strategic decisions undertaken by a firm to manage its working capital is directly to value maximization. Additionally the efforts made by the management of an organizations towards influencing organizational policies regarding the various forms of financing and working capital apportionment is important in determining the direction and impact on the books of accounts during turbulent financial times and crisis.

At this point, the managers have to make critical decisions regarding liquidity and profitability. This is because liquidity and profitability are two challenging decisions to make. Concisely, liquidity is the ability of the firm to convert its assets into cash so as to enable it meet its short term obligations (Ghosh and Maji, 2004). Actually, cash in hand and cash at bank are key indicators of the continuity of the financial health of organizations thus, the management has to be extra careful, to ensure that finances are managed not only efficiently but also profitably. The internal financial pressures subjected on a firm that fails to manage its working capital might lead to high credit risks and a pile up of stock, which then holds much of the working capital that could have otherwise been used to finance the day-to-day operations of the business.

As a medium measure to avert undesirable financial conditions that could be impending to any firm, the management has to make and adhere to tough decisions concerning cash management and enhancement of internal efficiencies as the most suitable way for value maximization during crisis. The priority for working capital management is often tailored towards reducing the asset-liability mismatch, and as a result increases profitability and value maximization in the short run (Hutchison, Farris & Anders, 2007). The complexity of focusing on liquidity is that the management might fail to strike a desirable trade-off between profitability and liquidity while attempting to maximize the value of the organization.

Beranek, (2003) supported this observation, when he stated that most firms often use trade credit in spite of its being costly to the business since the trade credits demand high interest rates of up to 18%. Because of the factors and complexities caused by the need to incur high interest rates, it becomes important for Companies to manage their working capital. Apparently, the need to manage working capital is bestowed upon all firms in spite of their sizes, and whether they are located in the emerging or developed countries alike. More so, working capital management is of great essence to firms operating in emerging markets and developing economies because of the limitations and restraints associated with the underdeveloped capital markets. Furthermore, the firms depend solely on owner financing, short-term financing from banks and other financial institutions and trade credits (Piet, 2009). This capital is usable on accounts receivables, inventories and investment in cash.

The impact of liquid capital, however, is more pronounced among small firms unlike for the large businesses because of the weak financial management policies coupled with inadequacies in long-term financing. Hence, given factors such as initial business financing, and the availability of working capital, it becomes subtle that a firm’s policies regarding working capital and its management policies, practices, and choices are directly correlated with the books of accounts and market performance alike. This is because, successful management of a firm’s resources is essential in increasing corporate profitability. This argument was supported by Alfayoumi and Abuzayed (2009), who reiterated that management success can be measured by the market value of the firm as well as using the market value of the shareholders of the firm.

Piet (2009), states that working capital management can be described as a cash conversion cycle; thus, the linkage between this subject, market performance, and management policies is important to the value addition process of a firm in distress. Essentially the interplay of these factors contributes towards the determination of inventory levels as supported by cost accounting inventory management models and mathematical equations. These factors further determine the financing and credit policies selected by the firms. William and Marlene (2009), suggests that for both small and big firms, the credit period within which the customers are allowed to pay for goods and services might impact not only on profitability but also on the working capital. Thus, the organization has to be lurid when drafting and implementing credit period policies. This is attributed to the fact that managers who understand the basic principles of managing working capital have to follow specified conceptual framework in order to increase the value of their firms during distress. For instance during recession or crisis conditions, it is highly advisable that the firm reduces of credits sales so as to increase their working capital which can be used during eventualities or when the organization is in dire need of financing.

According to Abdul and Mohamed (2006), capital structures are as important as capital budgeting decisions. The two are important components of corporate financing since effective working capital management is important in helping an organization react quickly to unanticipated changes in capital markets. Among these dynamics that might lead to crisis conditions include interest rates, economic recessions, and increase in raw material prices, competition or losing a lot of capital to bad debts as well as making of provisions for such debts. The importance of working capital management is evident by the way managers spend considerable amounts of time making decisions on current assets and short term investments which require the continued conversion of current assets into cash. There is also the other factor of obligation where firms are expected to pay current liabilities within given time periods either monthly or annually (Zariyawati, Annuar, Abdul Rahim, 2009).

The liquidity for most firms relies on the operating cash-flows which further implies that managing working capital is as important as managing the financing of the business. This importance attributed to working capital management is correlated to the state of current assets, current liabilities and their interrelationship. This insinuates that in the event that a company failed to maintain an adequate level of working capital then it is likely to be declared insolvent since it will become incapacitated with debts. The Altman’s multivariate predictor model uses working capital as one of its major model component thus it can be used to predict that state of working capital in organizations (Altman, 2008). The model is highly effective in predicting chances of failure since it proposes that a company has to maintain current assets that can cover its current liabilities during crisis conditions. The margin of current assets to current liabilities have to be maintained within a reasonable margin. This is because the margin is important in determining the liquidity ratios of the firm.

Furthermore, the Altman’s model suggests that the short-term financing has to be managed as a continuous process because they form the ingredients to the working capital management theory (Altman, 2008). The theory elaborates why organizations need to find a trade-off between risks and profitability to leverage itself during crisis conditions. In order for the managers to gain the utmost importance from working capital management, they have to consider working capital as a short-term decision, which requires considerations to be made regarding liquidity, profitability, cash flows and returns on capital. Generally, researches established that working capital management in companies could be affected by both internal and external factors.

Whereas external factors affect all companies in an industry, internal factors can be influenced by the firm thus internal factors such as the management of working capital have a direct impact on the attainment of competitive advantage for a firm. This counts as another advantage that can be directly associated with the management of working capital. To elaborate on this point, it is notable that external factors such as politics, economic environment, government policies and legislation directly affect the performance of an industry as a whole. In this respect, it is potent to create either a crisis condition or condition that will facilitate the thriving of the organization (William & Marlene, 2009). Contrastingly, internal factors such as the management policies, system, policies, practices, investment behavior, employee motivation, and financial capabilities among others, have either a direct, or indirect impact on the working capital. Therefore, the working capital management policies are important in reflecting the state and efficiency of the management efficiency as instigated by the management.

Estimating the Value of a Selected Company: Telefonica

From the information provided in the literature review regarding financing, the case scenario of Telefonica S.A becomes pertinent in cementing the realities associated with the dynamics of working capital management during crisis conditions. Telefonica is a multinational corporation that is specialized in the telecommunication and broadband industry. Its operations are diversified in 24 countries across Asia, Europe and both South and North America (Demirgu¨c¸-Kunt & Maksimovic, 2009). According to sales and marketing statistics reported in the Forbes Magazine in September, 2012, Telefonica has more than 320million subscribers who are constantly using its information, communication and entertainment services. The company’s headquarters are in Distrito Telefónica in Madrid, Spain but approximately 77% of its operations are diversified over global markets across America, Asia and Europe thus it stands at the 7th position in the Telco worldwide ranking with regard to market capitalization. Telefonica is listed in the Spanish Stock Exchange as well as in the New York Stock Exchange and has more than 1.5million shareholders. From the Income Statements dating back to 2011, the revenues collected in 2012 was 62,933 million euros which is a 0.65% decline as compared the 63,344 million euros accrued in 2011. These figures imply that 2012 had a lower EBIT with 5864 million dollars.

The analysis of Telefonica S.A is purely focused on their Working Capital Management whereby their short term or operating activity analysis is comprehensively made. In this case, activity ratios are defined as a measure of a company’s efficiency with regard to its day-to-day activities among them being the collection of management inventories and accounts receivables. In this respect the pertinent figures are summarized into the excel spreadsheet in Appendix I. Coupled with the reform measures that were instigated after the 2008 Global Economic Recession, the management at Telefonica found it prudent to define their inventory turnover as activity ratios that are calculated as a measure of revenue divided by their inventory. From the ratio summary shown in the table, Telefonica S.A depicted an improvement in 2009 but a deterioration from 2010 to 2012 consecutively.

The Receivables turnover on the other hand consisted of a ratio between revenue and receivables where Telefonica’s receivables showed an improvement from 2010, 2011 and 2012 respectively. Using 2008 as the base year, payable turnover which are calculated as the ratio of revenue divide with payables, it is noticeable that the payables increased from 2010, 2011 and 2012 alike. The Telefonica’s average receivables collection period improved from 2011, 2012 and 2012 while their operating cycle also improved across the same span of time. Despite these improvements the average payables payment period declined along the three year period marked from 2010 to 2012.

With these figures, Garcı´a-Teruel and Martı´nez-Solano, (2007) states  that it is implicit that Telefonica had to focus on policies targeting its short term assets as the only way towards strengthening its Working Capital Management especially after the 2008 Global Recession. The main areas of target was short term capital expenditures, short term assets and resources whose maturity is less than one year. These values were estimated using the figures presented on the previous balance sheets and income statements (Gitman, 2005). By so doing, Telefonica was targeting value maximization especially in the post-economic crisis period which had affected its profitability owing to the reduced expenditures and increased competition on telecommunication and broadband use during the recess. The efficiency with which working capital was managed was important in improving the competitive position as well as profitability at Telefonica.

Researchers and business analysts seconded the strategic decisions undertaken by Telefonica by supporting that management of working capital at Telefonica was directly proportional to value maximization (Gitman, 2005). Additionally the efforts made by the management in influencing organizational policies regarding the various forms of financing and working capital apportionment is important in determining the direction and impact on the books of accounts during the turbulent times and crisis. For instance is the effectiveness implied by the inventory management policies which is a direct reflection of the inventory turnover as shown in Appendix II

Calculations for 2012

Inventory turnover = Revenues ÷ Inventories
82,220 ÷ 1,566 = 52.49

These calculations imply that the inventory turnover, which is a ratio, accrued from the division of revenue and inventory deteriorated from the period between 2010 and 2011 as well as that period between 2011 and 2012. This is reflected in Appendix III

Calculations for 2012

Receivables turnover = Revenues ÷ Trade receivables
82,220 ÷ 11,607 = 7.08

The receivables turnover ratio for Telefonica supports the calculations aimed at establishing the working capital for the company (Gill, Biger & Mathur, 2010). This is basically attributed to the fact that receivables turnover which is a ratio between revenue and receivables improved from 2010 to 2011 after which it improved again in 2012. This is shown in Appendix IV.

Calculations for 2012

Operating cycle = Average inventory processing period + Average receivable collection period
= 7 + 52 = 59. These figures augment towards the determination of the cash conversion ratio. The operating cycle equates to the average period taken to process inventory in addition to the period taken to collect the receivables (Hill, Wayne Kelly & Highfield, 2010). Telefonica has had its operating cycle in the years ranging between 2010 and 2012, which totals up towards the determination of the cash conversion cycle.

Calculations for 2012

Cash conversion cycle = Average inventory processing period + Average receivable collection period – Average payables payment period
= 7 + 52 – 51 = 8

In general, the cash conversion ratio applied at Telefonica represents an important financial metric used to measure the period required to convert cash investments or current assets to working capital. These calculations are supported by the formulae applied in the calculation of the cash conversion ratio, which equals to 8. Apparently, Lazaridis and Tryfonidis, (2006) researched on the relationship exhibited by working capital management and corporate profitability. In the research, it was established that the two components have a statistical relationship especially among multinational companies such as Telefonica S.A. From the research, it was concluded that companies such as Telefonica could create profits by properly managing their cash conversion cycle at an optimum level. This relationship was further supported by Leach and Melicher, (2009) who voiced that if multinational companies abbreviated as MNC’s managed their working capital then profitability and value maximization will be possible during both crisis and non-crisis conditions.



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Appendix 1

Telefonica S.A., short-term (operating) activity ratios

Source: Data extracted from Telefonica S.A. Annual Reports

Appendix II

Inventory Turnover

Source: Data extracted from Telefonica S.A. Annual Reports

Appendix III

Receivables Turnover

Source: Based on data from Telefonica S.A. Annual Reports

Appendix IV

Operating Cycle

No. of days

Source: Data extracted from Telefonica S.A. Annual Reports

Appendix V

Cash Conversion Cycle

Source: Data extract from Telefonica S.A. Annual Reports