Working capital models

The business model is the economic foundation of a firm, and it consists of five sub-models: revenue model, gross margin model, operating model, working capital model, and investment model (Mullins and Komisar, 2009). In this thesis, the focus is on the working capital model. Farris and Hutchison (2003) stated that instead of individually attempting to reduce inventories and accounts receivables and increase accounts payables, companies should find their own unique combinations of all three components to optimize their working capital. This is the starting point for studying the working capital models in this thesis.

Previous research related to working capital models has mainly approached the topic by studying what kinds of working capital management practices and policies are applied in

2.3 Working capital models 37 the companies. These studies have mostly used surveys to discover the policies regarding working capital management. One of the earliest academic journal papers of this type was the one authored by Belt and Smith (1991), in which working capital management practices were compared in Australia and the United States. The questions of the survey concerned the overall working capital policy (e.g. the existence and review regularity of the working capital policy), the management of working capital (e.g. measures and most important actions of working capital), and the management of the components of working capital (e.g. policies regarding inventory replenishment and cash discounts offered by the suppliers). The results showed that the companies in the two countries differed in the practices related to inventory management and credit collection, but they faced similar problems regarding working capital in which they responded in a relatively similar manner. Later, Khoury et al. (1999) conducted a similar study in Canada. The studies by Ricci and Morrison (1996) and Ricci and Di Vito (2000), in turn, focused on the impact of international business on the practices related to the financial flows of working capital.

However, these studies mainly reviewed the practices that companies reported to use, and did not particularly identify or categorize any specific working capital models based on the results.

A step towards working capital models was taken by Howorth and Westhead (2003), who analyzed the working capital management routines of a large sample of small companies.

They collected data via a structured questionnaire and received 343 valid responses, in which companies reported the frequency of 11 working capital management related routines. Table 2 describes the routines and the proportion of companies that reported reviewing the routine in question. The most reviewed routine was the creditor payment periods, whereas inventory management related routines (stock levels, stock reorder levels and stock turnover) were among the less reviewed routines.

Table 2. Working capital management routines and their use in the companies. (Howorth and Westhead, 2003).

Working capital management

routine % of companies reviewing the routine

Payment period to creditors 75 %

Customer credit risk 71 %

Cash budgeting 70 %

Customer credit periods 70 %

Doubtful debts 68 %

Finance of working capital 68 %

Stock levels 64 %

Bad debts 61 %

Stock reorder levels 60 %

Stock turnover 59 %

Customer discount policy 30 %

The results of Howorth and Westhead (2003) showed that the majority of the small companies focused on one area of working capital management instead of the holistic view. The authors identified four distinctive types of companies via cluster analysis: 1) companies were either focused on cash management routines, 2) inventory management routines, 3) credit management routines, or 4) did not use any working capital management routines. Additionally, characteristics regarding e.g. the age and size of the firm, level of sophistication of financial skills, and the use of external finance, for each cluster were studied. The results revealed that larger and younger firms focused on cash management and had more external finance, whereas smaller and younger companies concentrated on stock management. They also used less external finance and had longer production cycles. Companies focused on credit management routines were less profitable, and purchased more on credit and had fewer customers paying on time than other clusters. The companies with no working capital management routines had less sophisticated financial skills, less external finance and higher profitability.

The study of Howorth and Westhead (ibid.) was the first to provide categorization for the working capital models. Padachi and Howorth (2014) followed a similar approach in their study of Mauritian small and medium sized firms. They also identified four clusters which were described as follows: 1) no working capital management routines, 2) debtor and stock review, 3) stock review, and 4) all working capital management routines. Both studies were limited to small and small and medium sized firms, and the results by Howorth and Westhead (2003) indicate that the lack of resources may make companies concentrate on only one aspect of working capital. Therefore, identifying working capital models in a different context may bring up deviating findings.

While other studies on working capital management practices were based on the data collected via surveys, Meszek and Polewski (2006) used quantitative financial data in

2.3 Working capital models 39 their study of working capital management strategies in the construction industry. The authors presented a framework for the working capital management strategies in a company (Figure 4) which introduced aggressive, moderate and conservative working capital strategies. According to the authors, an aggressive working capital management strategy is based on the large amount of current liabilities and small amount of current assets. In this strategy, income and risk are high. The conservative strategy is the opposite:

it is based on the small amount of current liabilities and large amount of current assets.

The conservative strategy leads to a low income and has a low risk. The moderate strategy is located between the aggressive and conservative strategies, and its income and risk are on an average level. The results showed that five out of the six analyzed companies applied the moderate strategy, whereas one company followed the conservative policy.

Figure 4. Working capital management strategies in a company. (Meszek and Polewski, 2006)

Farris and Hutchison (2003) have also introduced a matrix to map different working capital management approaches. In their paper, they introduced a taxonomy to classify industries by their working capital performance. The authors used this cash-to-cash map

Aggressive

(see Figure 5) to categorize different industries into groups on the basis of their accounts receivable (AR), accounts payable (AP), and inventory levels.

Figure 5. Cash-to-cash map (adapted from Farris and Hutchison, 2003).

The authors (ibid.) divided the industry sectors into different categories of their cash-to-cash map by using median values of each sample to characterize the level of working capital components in each industry. Then, the total sample was split into two halves according to high and low categories. The purpose of the matrix is to provide an opportunity to identify possible benchmark industries in terms of working capital management.