The Cycle Times of Working Capital: Financial Value Chain Analysis Method

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Miia Pirttilä

THE CYCLE TIMES OF WORKING CAPITAL:

FINANCIAL VALUE CHAIN ANALYSIS METHOD

Acta Universitatis Lappeenrantaensis 609

Thesis for the degree of Doctor of Science (Technology) to be presented with due permission for public examination and criticism in the Auditorium of the Student Union House at Lappeenranta University of Technology, Lappeenranta, Finland on the 5th of December, 2014, at noon.

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Supervisor Professor Timo Kärri

School of Industrial Engineering and Management Department of Innovation Management

Lappeenranta University of Technology Finland

Reviewers Professor Marko Järvenpää

Faculty of Jyväskylä University School of Business and Economics University of Jyväskylä

Finland

Assistant Professor Paulo Afonso

Research Centre for Industrial and Technology Management University of Minho

Portugal

Opponent Professor Marko Järvenpää

Faculty of Jyväskylä University School of Business and Economics University of Jyväskylä

Finland

ISBN 978-952-265-696-4 ISBN 978-952-265-697-1 (PDF)

ISSN-L 1456-4491 ISSN 1456-4491

Lappeenranta University of Technology Yliopistopaino 2014

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Abstract

Miia Pirttilä

The Cycle Times of Working Capital: Financial Value Chain Analysis Method Lappeenranta 2014

93 p.

Acta Universitatis Lappeenrantaensis 609 Diss. Lappeenranta University of Technology ISBN 978-952-265-696-4

ISBN 978-952-265-697-1 (PDF) ISSN-L 1456-4491

ISSN 1456-4491

Interest towards working capital management increased among practitioners and researchers because the financial crisis of 2008 caused the deterioration of the general financial situation.

The importance of managing working capital effectively increased dramatically during the financial crisis.

On one hand, companies highlighted the importance of working capital management as part of short-term financial management to overcome funding difficulties. On the other hand, in academia, it has been highlighted the need to analyze working capital management from a wider perspective namely from the value chain perspective. Previously, academic articles mostly discussed working capital management from a company-centered perspective.

The objective of this thesis was to put working capital management in a wider and more academic perspective and present case studies of the value chains of industries as instrumental in theoretical contributions and practical contributions as complementary to theoretical contributions and conclusions. The principal assumption of this thesis is that self- financing of value chains can be established through effective working capital management.

Thus, the thesis introduces the financial value chain analysis method which is employed in the empirical studies. The effectiveness of working capital management of the value chains is studied through the cycle time of working capital.

The financial value chain analysis method employed in this study is designed for considering value chain level phenomena. This method provides a holistic picture of the value chain through financial figures. It extends the value chain analysis to the industry level. Working capital management is studied by the cash conversion cycle that measures the length (days) of time a company has funds tied up in working capital, starting from the payment of purchases to the supplier and ending when remittance of sales is received from the customers.

The working capital management practices employed in the automotive, pulp and paper and information and communication technology industries have been studied in this research project. Additionally, the Finnish pharmaceutical industry is studied to obtain a deeper understanding of the working capital management of the value chain. The results indicate that the cycle time of working capital is constant in the value chain context over time. The cash

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conversion cycle of automotive, pulp and paper, and ICT industries are on average 70, 60 and 40 days, respectively. The difference is mainly a consequence of the different cycle time of inventories. The financial crisis of 2008 affected the working capital management of the industries similarly. Both the cycle time of accounts receivable and accounts payable increased between 2008 and 2009. The results suggest that the companies of the automotive, pulp and paper and ICT value chains were not able to self-finance. Results do not indicate the improvement of value chains position in regard to working capital management either. The findings suggest that companies operating in the Finnish pharmaceutical industry are interested in developing their own working capital management, but collaboration with the value chain partners is not considered interesting.

Competition no longer occurs between individual companies, but between value chains.

Therefore the financial value chain analysis method introduced in this thesis has the potential to support value chains in improving their competitiveness.

Keywords: financial value chain analysis, working capital management, cash conversion cycle, financial supply chain management

UDC 658.14/.17:658.7:65.012.4:330.14

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Acknowledgements

I am using this opportunity to express my gratitude to everyone who supported me throughout the doctoral studies. I am thankful for their aspiring guidance, invaluably constructive criticism and friendly advice during the doctoral studies. I am sincerely grateful to them for sharing their fruitful comments on a number of issues related to the articles as well as the doctoral dissertation.

I would like to express my deepest gratitude to Professor Timo Kärri. Without his supervision this dissertation would not have been possible. Furthermore, I would like to thank the reviewers of the dissertation, Professor Marko Järvenpää and Assistant Professor Paulo Afonso, who provided their constructive comments to improve and finalize this thesis.

I give my warm thanks to the members of the C³M research team. Special thanks to Sari and Lotta; you helped me a lot during this project. I wouldn’t say no to co-authoring or excursions in the future; it has been fun to write and travel with you.

I am grateful for the financial support received from the Finnish Doctoral Program in Industrial Engineering and Management and the Research Foundation of Lappeenranta University of Technology. I would also like to thank Jutta Jäntti for revising the language of this thesis.

Finally, I would like to express my warmest thanks to friends-and-relations.

“Some people care too much. I think it's called love.” A.A. Milne, Winnie-the-Pooh

Lund, November 2014

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List of figures

Figure 1. The research pyramid ... 19

Figure 2. The contribution of original publications to the dissertation ... 22

Figure 3. Structure of the first part of the dissertation ... 23

Figure 4. The number of articles about working capital management per year ... 25

Figure 5. Net working capital and working capital on the balance sheet ... 27

Figure 6. Cash conversion cycle ... 31

Figure 7. CCC and its components for all US manufacturing firms, 1950-1983 ... 42

Figure 8. The percentage change of US real gross domestic product ... 43

Figure 9. The median of CCC and its components from 1986 to 2001 of US firms ... 44

Figure 10. The median of CCC and its components of European firms from 1995 to 2004 . 45 Figure 11. The median of CCC and its components of European companies from 2002 to 2012 ... 46

Figure 12. The median of CCC and its components of US companies from 2002 to 2012 .. 46

Figure 13. The median of CCC and its components of European companies from 2003 to 2009 when the denominator of DIO and DPO is COGS ... 48

Figure 14. The median of CCC and its components of US companies from 2003 to 2009 when the denominator of DIO and DPO is COGS ... 48

Figure 15. Financial value chain analysis method... 55

Figure 16. The histogram of CCCs ... 58

Figure 17. The structure of the value chain of automotive industry and research sample .... 62

Figure 18. The structure of the value chain of pulp and paper industry and research sample63 Figure 19. The structure of the value chain of ICT industry and research sample ... 65

Figure 20. Cash conversion cycles of the automotive value chain in 2006–2008. ... 69

Figure 21. Cash conversion cycles of the pulp and paper value chain in 2004–2008. ... 71

Figure 22. Cash conversion cycles of the ICT value chain in 2006–2010... 73

Figure 23. CCC and its components in the automotive, pulp and paper and ICT industries . 74 Figure 24. The cash conversion cycles of the stages of the automotive, pulp and paper and ICT industries in a descending order ... 76

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List of tables

Table 1. Basic beliefs associated with the postpositivism and pragmatic ... 20

Table 2. Main trade credit theories ... 28

Table 3. Selected financial data of BMW and CCC and its components ... 32

Table 4. Scopus search for ‘cash conversion cycle’ and ‘cash-to-cash’ ... 33

Table 5. Computation of the cash conversion cycle ... 35

Table 6. Selected financial data of Nokia and computation of the cash conversion cycle . 36 Table 7. Selected studies on the effect of working capital management on profitability ... 40

Table 8. The percentage change of EU's real GDP growth rate - volume ... 46

Table 9. Trade credits proportion of total assets for firms in the G7 countries ... 49

Table 10. Cash conversion cycle medians of industry sectors in 2009 ... 49

Table 11. The median of CCC of food stores and food and kindred products and yearly change of CCC ... 53

Table 12. Examples of the inventory valuation methods of companies ... 57

Table 13. Average and median of CCC of automotive, pulp and paper and ICT industries 57 Table 14. Test of normality ... 59

Table 15. Data used in the articles of the dissertation ... 60

Table 16. Descriptive statistics on the value chains, year 2008 ... 61

Table 17. A summary of the articles one to four... 68

Table 18. Results of regression analysis ... 83

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List of abbreviations and definitions

CCC cash conversion cycle COGS cost of goods sold

DIO days inventory outstanding

DSO days accounts receivable outstanding DPO days accounts payable outstanding

EU European Union

ICT information and communication technology ROI return on investment

UK United Kingdom

US the United States

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List of original publications

The articles included in this dissertation are listed below with a summary of the author’s contribution.

Article 1

Lind, L., Pirttilä, M., Viskari, S., Schupp, F. and Kärri, T. (2012) ‘Working capital management in the value chain of automotive industry: financial value chain analysis’, Journal of Purchasing and Supply Management, Vol. 18, No. 2, pp.92-100.

The author planned the study and analyzed the data with co-authors. The author designed the tool for financial value chain analysis. The author was responsible for writing the revised article.

Article 2

Pirttilä, M., Viskari, S. and Kärri, T. (2010) ‘Working capital in the value chain: cycle times of pulp and paper industry’, Proceedings of 19^th International IPSERA conference, May 16-19, 2010, Lappeenranta, Finland.

The author planned the study and analyzed the data with co-authors. The author was responsible for gathering the data, conducting the analysis and writing the article.

Article 3

Lind, L., Pirttilä, M., Viskari, S. Schupp, F and Kärri, T. (2012) ‘Competing with the negative cycle time of working capital in ICT value network’, 21^st Annual IPSERA conference, April 1-4, 2012, Naples, Italy.

The author analyzed the data with co-authors. The author’s tool for financial value chain analysis was used. The author was responsible for writing the results.

Article 4

Pirttilä, M., Viskari, S., Lind, L. and Kärri, T. (2014) ‘Benchmarking working capital management in the inter-organisational context’, Int. J. Business Innovation and Research, Vol. 8, No. 2, pp.119–136.

The author was responsible for planning the article, conducting the analysis and writing the article. Author updated the data used in the article.

Article 5

Pirttilä, M., Kivinen, K., Monto, S. and Kärri T. (2013) ‘Working capital management in a Finnish pharmaceutical supply chain’, 22^nd Annual IPSERA conference, March 24-27, 2013, Nantes, France.

The author planned the study and analyzed the data with co-authors. The author was responsible for collecting quantitative data and writing the article.

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Part I

Overview of the dissertation

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1 Introduction

1.1 Background and research environment

Interest towards working capital management among managers and academics increased because the financial crisis of 2008 caused deterioration of the general financial situation.

The reasons for financial crisis were a combination of banks’ restraints in lending, worldwide insecure consumers and self-made problems in some industries, such as existing excess capacities in the automotive industry, especially the capacities of car manufactures.

In addition to the financial crisis started in 2008, financing for companies has become increasingly difficult due to the previously enacted Basel II. During a period of restrained granting of credit by banks, demand for capital from the supply chain increased. (Hofmann et al., 2011) Therefore the importance of managing working capital effectively increased dramatically during financial crisis. Companies highlighted the importance of working capital management as part of short-term financial management to overcome funding difficulties.

In this thesis the working capital management is considered from an operational view (Hill et al. 2010) consisting inventories, accounts receivable and accounts payable. Furthermore, the supply chain is understood as a sub-set of the value chain similar to the one in the study of Al-Mudimigh et al. (2004). While the concept of supply chain focuses on operations and logistics, in other words material flows (Tan, 2001), the value chain extends the focus to the information and cash flows. In previous literature, information and cash flows have been considered as part of the supply chain as well (Hofmann and Kotzab, 2010). The term value chain is selected to emphasize the importance of working capital management in the supply chain. The aspects of value chain other than those related to working capital management are out of the scope of this study, so the use of the term financial value chain is in well-justified.

1.2 Objectives and scope

Previous management accounting literature has focused mostly on supplier - customer relationships, and little attention has been paid to managerial issues in value chains (Lind and Thrane, 2010). This thesis looks at the working capital management of inter-organizational value chains as a whole.

A number of previous working capital management studies have focused on company level working capital management (e.g. Baños-Caballero et al. (2014); Marttonen et al. (2013);

Tauringana and Afrifa (2013)). Few studies have examined working capital management in inter-organizational value chains (Losbicler et al., 2008; Hofmann and Kotzab, 2010;

Hofmann and Belin, 2011; Monto, 2013). Recent studies have highlighted the need to study working capital management at the value chain level (Hoffman and Kotzab, 2010; Grosse- Ruyken et al., 2011; Viskari et al., 2012a).

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The objective of this dissertation is to study working capital management in value chains.

Three different industries were studied. The main assumption is that effective working capital management can mitigate the need to borrow from financial institutions. Furthermore, the dissertation introduces a new method for the study of financial value chains, namely the financial value chain analysis. Here, ‘method’ means a structured process that should be followed to reach reliable results. The goal of the dissertation is to describe the working capital management of the value chain by the cycle time of working capital. The research period is from 2006 to 2010 in general.

It is assumed that working capital management should be studied in different types of business environments to get a better understanding of it. The studied value chains represent the automotive industry, pulp and paper industry and information and communication technology (ICT) industry. Automotive and pulp and paper industries are capital-intensive and represent batch production and traditional process industries, respectively. Furthermore, business models in the ICT industry are different from the ones applied in automotive and pulp and paper industries. The ICT industry is characterized by an integrated business environment, fast technology development and service-orientation. The end products of these three value chains differ significantly from each other from daily consumer goods to consumer durables or even luxury items, as well as in terms of the variety of customers.

Additionally, the Finnish pharmaceutical industry was studied to increase understanding of the results of quantitative research followed through financial value chain analysis method by interviewing the practitioners working in the industry. Furthermore, the Finnish pharmaceutical industry seemed to be holding up well in the financial crisis of 2008, which increased the interest to study it in addition to the open-mindedness to discuss working capital management.

The study addresses four research questions:

1) How to analyze the financial value chain phenomenon?

2) How many days have the value chains tied up working capital?

a. What are the cycle times of working capital?

b. How have the cycle times of working capital and its components changed during the period of study?

3) How have the value chains performed in regards to working capital management?

4) How has the financial crisis of 2008 affected the cycle time of working capital in the value chains?

The second question arose from the request to study working capital management in the value chain context. This leads to a need to consider what kind of method should be used in order to succeed in the study of working capital management of value chains (RQ 1). Previous studies have either demonstrated working capital management concepts as supplier – focal company or supplier – focal company – customer value chains, but the cycle time of working capital as days has not been studied (e.g. Hofmann and Kotzab, 2010), or they have studied the cycle time of working capital of single industries that are formed by competitors (e.g.

Losbicler et al., 2008; Farris and Hutchison, 2003). The third question benchmarks working

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capital management in the value chains of automotive, pulp and paper and ICT industries in order to study the effect of the industry on the cycle time of working capital as well as the importance of management of working capital. Hill et al. (2010) and Chiou et al. (2006) argue that working capital management is determined by internal factors, and external factors, such as industry, do not have a significant impact. Farris and Hutchison (2003) suggest that it is important to look at the cycle time of working capital by industry to create realistic expectations and objectives for working capital management. Research question four considers the financial crisis 2008 influence to cycle times of working capital in automotive, pulp and paper and ICT industries. The crisis boosted the importance of working capital management in general, and it has inspired researchers to study its effects on companies.

Kestens et al. (2012) have indicated that the crisis had a negative impact on the overall availability of accounts payable. Molina and Preve (2009) found out that companies having cash flow problems are reducing the level of accounts receivable. Previous studies have focused on accounts receivable and payable instead of operating working capital, and they are focused on single companies.

1.3 Research methodology

This section concerns the methodology and research design of the dissertation. The section is based on the idea of the existence of a research pyramid (Figure 1) that consists of four levels: research paradigm, research methodology, research method and research techniques (Jonker and Pennink, 2010).

Figure 1. The research pyramid (Jonker and Pennink, 2010) Research

paradigm

Research methodology

Research methods

Research techniques

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Paradigm is understood as a basic set of beliefs and assumptions which guide inquiries. In this research project, two schools of thought about paradigms were considered important:

postpositivism and pragmatism. The author has viewed the reality through these paradigms during the study. The aim of postpositivism is to provide solutions for problems which occur in practice. It reflects the need to examine causes which influence outcomes. The knowledge developed through a postpositivist lens is based on careful and critical observation and measurement of objective reality. Developing numeric measures of observations and studying the behavior of individuals have become paramount for postpositivist researchers. In this context, studies are conducted as follows: a researcher begins with a theory, collects the data which either supports or refutes the theory, and then makes necessary revisions before additional tests are conducted. (Creswell 2003; Jonker and Pennink, 2010) Furthermore, pragmatism arises out of actions, situations and consequences rather than antecedent knowledge, as in postpositivism. Thus, the researcher has freedom to choose the methods, techniques and procedures of research. Pragmatism enables the use of multiple methods, different worldviews, different assumptions and different forms of data collection and analysis (Creswell 2003). Table 1 summarizes the basic beliefs of paradigms considered important in this thesis.

Table 1. Basic beliefs associated with the postpositivism and pragmatic (Mertens, 2014) Basic beliefs Postpositivism Pragmatic

Ontology One reality; knowable within a specified level of probability

Asserts that there is single reality and that all individuals have their own unique interpretation of reality Epistemology Objectivity is important; the

researcher manipulates and observes in a dispassionate, objective manner

Relationships in research are determined by what the researcher deems as appropriate to that particular study

Axiology Respect privacy; informed consent;

minimize harm (beneficence);

justice/equal opportunity

Gain knowledge in pursuit of desired ends as influenced by the researcher’s values and politics Methodology Quantitative (primarily);

interventionist; decontextualized

Match methods to specific

questions and purposes of research;

mixed methods can be used as researcher works back and forth between various approaches.

Kasanen et al. (1993) claimed that management accounting research has merely utilized the innovations constructed elsewhere. The financial value chain analysis method that is developed in this study can be considered as theoretical construction in management accounting research. It produces a solution to the explicit problem: how to analyze the financial value chain phenomenon. However, this study itself cannot be considered as a constructive study.

The next paragraphs discuss the philosophical foundation which has guided this study in more detail. The phenomenon, financial value chain, already exits out there, and the goal of

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this research is to increase an understanding of it and study causes which have influenced the current situation of working capital management. This is a typical ontological starting point of explanatory research (Holmström et al., 2009). Epistemology covers the question of how we know what we know or what we assume to know (Jonker and Pennink, 2010). The correspondence, coherence, and pragmatic theory of truth are the traditional theories of truth (Haaparanta and Niiniluoto, 1998). This study develops relevant true statements which can explain the working capital management in value chains. The truth is in relation to present business environment. The dynamic nature of business environment will change the true statements over the years, however. In this study, axiology is understood mainly as ethics values (Resnik 2001). The author believes that research must be free of values in order to be valid. Co-operation with companies involved in the studied industries did not generate ethical conflicts between scientific values and business values.

Methodology – in other words, strategies of inquiry – is associated with conducting research.

The characteristics of pragmatism are probably best seen in the research methods of this thesis because it adapts strategies associated with quantitative and qualitative approaches.

Quantitative strategies invoke the postpositivist perspective in particular. As previous theory of working capital management in value chains is scarce, the results of this thesis will mainly increase understanding of the subject. Quantitative strategies include experiments, non- experimental designs, such as equation models, and surveys (Creswell 2003). This thesis applies non-experimental designs. On the other hand, qualitative strategies have been conducted with a large number of various paradigms, such as the pragmatic. It employs several different strategies of inquiry (e.g. Wolcott (2001) has identified 19 different strategies). This thesis has employed multiple case studies. The advantage of multiple case study research is its deeper understanding of a research phenomenon. The automotive industry, pulp and paper industry and ICT industry can be considered as the cases of this dissertation. It was considered that industrial factors, globalization, and the features of end products may have affected the development of working capital management in these value chains. For this study, the researcher has created her own method called “financial value chain analysis” to analyze working capital management in value chains. The financial value chain analysis and research techniques are discussed in chapter 3.2.

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1.4 Outline of the dissertation

Figure 2 shows how the articles attached to this thesis are related with the purposed research questions.

Figure 2. The contribution of original publications to the dissertation

All five articles discuss the development of the financial value chain analysis method answering the first research question ‘How to analyze financial value chain phenomenon?’.

Articles one to three describe the research process carried out through the financial value chain analysis method in automotive, pulp and paper, and ICT industries. Together with article four, they validate the financial value chain analysis method. Article five aims to mitigate the limitations of the method. The second research question ‘How many days have the value chains tied up working capital?’ is addressed in publications one to three. The first article studies the working capital management of automotive industry. The second article examines the pulp and paper industry and the third the ICT industry. Article four combines the three antecedent articles benchmarking the industries answering the third research question ‘How have the value chains performed in regards to working capital management?’.

It also examines working capital management in a longer period than the antecedent articles.

Article four studies the working capital management of the selected industries as the result of the financial crisis begun in 2008 answering the fourth research question ‘How has the financial crisis of 2008 affected the cycle times of working capital in the value chains?’.

Some evidence of the effects of the financial crisis can also be detected in article three.

Article five supports some conclusions the authors have done in articles one to four.

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The dissertation consists of two parts. The first part provides an introduction and an overview of the research, theoretical foundations, research contribution and conclusions. The original publications are included in the second part of the thesis following the order presented in the list of original publications. Figure 2 summarizes the structure of the first part and illustrates how the sections lead to the contributions. The contribution of the articles presented in the second part of this thesis is discussed in chapters 3 and 5. To compare the structure to the research questions, the first question is answered in the third chapter, where the financial value chain analysis method developed during the research project is introduced. Research questions 2, 3 and 4 are answered in the fifth chapter.

Figure 3. Structure of the first part of the dissertation

Part I of this thesis proceeds from the literature review (Chapter 2) to the empirical part of the study. Chapter 3 discusses previous literature on financial value chain analysis introducing the method developed to study working capital management in the value chain context.

Additionally, the reliability of the working capital management measure is evaluated in the chapter. Chapter 4 introduces the value chains of automotive, pulp and paper and ICT industries, including the names of companies whose value chains were studied in the thesis. It presents the general impression of industries that may have affected the working capital management of industries as well as the reliability of samples. Furthermore, Finnish pharmaceutical industry is described briefly. Chapter 5 summarizes the key findings of

Results and main findings of the original publications

Research results

1 Introduction

2 Theoretical foundation

3 Financial value chain analysis

5 Research contribution

6 Conclusions Background

of the research

Previous literature

Research cap

The scope of the thesis Research questions Research process

Measures of working capital management Trends of working capital management Research gap

Introduction of the financial value chain analysis method Justification of the research technique

Answer to the research question 1

The results of articles

Answers to the research questions two to four

Theoretical implications Practical implications Validity and reliability

Recommendations for further research Background

of the research

Previous literature

Research gap

The scope of the dissertation Research questions Research methodology Research process

Management of working capital Measures of working capital management Trends of CCC and working capital management

4 Industries studied Research

cap

Introduction of the studied value chains - automotive industry

- pulp and paper industry

- information and communication technology industry - Finnish pharmaceutical industry

Data

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articles included in the second part of the dissertation and answers the research questions.

Chapter 6 offers theoretical and practical conclusions and discusses the results of the thesis.

The validity and reliability of the conducted research and the results are analyzed. Part I ends with recommendations for further study which arise from the results of this dissertation.

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2 Theoretical foundations

2.1 Background and previous research

The bibliometric study of Viskari et al. (2011) showed that the number of articles on working capital has been growing between 1990 and 2010. Data for the study was retrieved from the databases ISI Web of Science and Scopus. The total number of articles on working capital management was 23. International Research Journal of Finance and Economics has published the most working capital management articles, a total of four papers, related to the issue in 1990-2010. This journal is a so called open access journal similar to two other open access journals, the European Journal of Scientific Research and Research Journal of Business Management, which have both published two papers on working capital management. The remaining 15 articles were spread across different journals. Viskari et al. (2011) found that the number of articles increased during the period. They assumed it to be a consequence of increased interest towards working capital management because of the financial crisis of 2008. However, they stress the fact that growth is a common trend in scientific publications in general. To sum up the recent development, a similar search was made for the years 2011 – 2013. The assumption of Viskari et al. (2011) was confirmed as the number of articles related to working capital management was 39 between 2011 and 2013. The International Research Journal of Finance and Economics has continued publishing articles concerning working capital management, seven articles in total during 2011-2013. Otherwise articles have been published by many journals. The number of articles is shown in Figure 4.

Figure 4. The number of articles about working capital management per year (Viskari et al., 2011)

Viskari et al. (2011) did not accept articles related to the management of working capital components, i.e. inventories, accounts receivable, and accounts payable, which explains the results of the study. Nearly half of the articles published between the years 1991 and 2013 study the relation between operational working capital management and profitability. The

0 2 4 6 8 10 12 14

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Number of articles

Year

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most common research frame is to study the effects of working capital management on the profitability of companies listed in one stock exchange. The most cited is the article of Deloof (2003) titled ‘Does working capital management affect profitability of Belgium firms? in the Journal of Business Finance & Accounting. Deloof may have been inspired by the article of Shin and Soenen (1998) titled “Efficiency of Working Capital and Corporate Profitability” in the journal of Financial Practice and Education. The article of Shin and Soenen (1998) does not include the articles Viskari et al. (2011) added to their sample, however. The other two topics are: what kind of practices companies use to manage their working capital (e.g. Belt, 1991; Khoury et al., 1999; Howorth and Westhead, 2003; Viskari et al., 2012b; Viskari and Kärri, 2012) and which characteristics and factors affect working capital management in companies (e.g. Baños-Caballero et al., 2010; Hill et al., 2010;). SMEs have been in focus as well (e.g. Howorth and Westhead, 2003; García-Teruel and Martínez-Solano, 2007; Baños- Caballero et al., 2010; Tauringana and Afrifa, 2013).The research has been concentrating mainly on the working capital management of individual companies.

During the financial crisis, working capital management was a hot topic in articles directed for managers (e.g. Seifert and Seifert, 2008; Greenberg, 2009; Hofler, 2009). Firms like StoraEnso, Kimberly Clark, and the Volkswagen group announced programs which aim to reduce tied up working capital to ensure the cash flow which was assumed to be the key to survival. Academic articles were few during and after the financial crisis, however. Mullins (2009) and Kesten et al. (2012) are some of the exceptions. Mullins (2009) stresses the importance of paying attention to working capital as an important part of cash flow rather than profits. He encourages a company to consider its revenue model; how early customers could pay compared to the delivery of goods or services. Secondly, he guides to analyze the payment terms given by key suppliers and compare those to the industry norms. Thirdly, a company should analyze how much cash is tied up in inventories. The fourth and most revealing recommendation Mullins (2009) presents is that a company should consider the possibilities to operate differ dramatically than competitors in working capital terms.

Therefore it can be assumed that he demands new working capital management models for companies. The main message of Mullins is that failure to earn profit would not cause immediate failure, but cash running out is different. To avoid this during the downturn, it is essential to manage working capital. Furthermore, Kesten et al. (2012) investigated whether the 2008 financial crisis had an impact on the trade credit of companies. The results of the study show that both the ratio of accounts receivable and the ratio of accounts payable decreased during the 2008 financial crisis. They conclude that the financial crisis had a negative impact on the overall availability of trade credit.

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2.2 Management of working capital

The common definition of working capital is the capital of a business which is used in its day-to-day trading operations, calculated as current assets less current liabilities. It indicates a company’s efficiency and short-term financial health. The focus of the thesis is on operational issues. Therefore, working capital in this thesis is calculated as:

Working capital = Inventories + Accounts receivable - Accounts payable (1) This definition can be drawn from the viewpoint that through the normal course of the business, companies acquire inventory on credit, which in turn they use to create products.

These products are then sold, oftentimes on credit. These actions generate accounts payable and accounts receivable, with no cash exchanged until the company collects accounts receivable and settles the accounts payable. The other items of current assets and liabilities do not concern the daily operations of a company as directly as inventories and accounts receivable and payable, referred together as trade credit.

Working capital management entails short-term decisions for which maturity is one year maximum. These decisions are therefore not made on the same basis as capital-investment decisions. Capital investments often launch the need to tied-up working capital, for example the expansion of manufacturing capacity. Figure 5 shows the structure of a balance sheet and the position of net working capital and working capital on it.

BALANCE SHEET

ASSETS LIABILITIES AND

Fixed assets SHAREHOLDER'S EQUITY

Intangible assets Equity

Tangible assets Long-term debts Investments Current liabilities Other non-current assets Current debts

Current assets Trade accounts payable Inventories Other current liabilities Current financial assets

Receivables

Trade accounts receivable

Other receivables Net working capital Other current assets

Cash and cash equivalents Working capital

Figure 5. Net working capital and working capital on the balance sheet

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Working capital management uses a combination of policies and techniques that aim to affect the current assets and liabilities of a firm. In this thesis, the focus is on the inventories and trade credits of companies. Earlier literature presents a considerable number of methods to manage inventories, and the management of accounts receivable has been significantly studied as well. The following subsections present and briefly discuss ‘trade credit management’ and ‘inventory management’.

Trade credit management

The term trade credit is used in this section to introduce theories developed for the management of accounts receivable and payable. Trade credit is the payment time a supplier gives to its customer for the purchase of goods and services. The amount of trade credit of a single transaction is the same for the supplier and the customer. Researchers have developed theories to explain why companies offer payment time for their customers. Customers may have their own needs for having payment time as well. Burkart and Ellingsen (2004) note that companies simultaneously give and take trade credit. Summers and Wilson (2002) studied 655 randomly selected UK manufacturing companies, and their findings suggest that the availability of trade credit is not a major influence on supplier choice. Table 2 lists trade credit theories in short. It is not meant to be a comprehensive list of theories.

Table 2. Main trade credit theories

(Petersen and Rajan, 1997; Niskanen and Niskanen, 2006; Seifert and Seifert, 2008) Supply-side theories Description

Competitive pressure Companies have to offer trade credit because their competitors do so

Financing advantage The supplier may have better information on the credit worthiness of its customers than traditional lenders.

Price discrimination Companies use trade credit when direct price discrimination is not desirable / is prohibited on the basis of antitrust laws Transaction costs By offering trade credit, a firm may be able to reduce the

costs of warehousing the inventory if its customers have a better ability to stock.

Demand-side theories

Control protection Customers prefer trade credit rather than bank credit because suppliers are less likely to liquidate.

Credit rationing Trade credit is a funding source for firms which have difficulties in obtaining bank financing at lower prices, i.e.

small and young firms as well as illiquid firms of low credit worthiness.

Financing advantages Trade credit enables the growth of customer

Transaction costs Trade credit may reduce the transaction cost of paying bills.

A customer might want to cumulate obligations and pay them only monthly for example.

Trade credit allows customers to hold smaller cash balances and save money accordingly.

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Molina and Preve (2009) found out that companies tend to increase the use of accounts receivable when they start facing profitability problems, but provide less accounts receivable when they have cash flow problems and enter full financial distress. They also found that if a firm significantly reduces its accounts receivable in financial distress, sales will drop at least 13%. The study of Kesten et al (2011) confirms these findings, because the results indicate that the financial crisis had a negative impact on the overall availability of accounts payable.

Companies’ suppliers were not able to offer accounts receivable to the same extent as before the financial crisis. Petersen and Rajan (1997) find that firms use trade credit more when credit from financial institutions is not available.

Inventory management

Inventory management deals with a range of different approaches and models that can be used when developing inventory management systems and practices. The scope of inventory control concerns, for example, replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space for inventory, quality management, reorder points, order quantities, decisions of safety stocks, returns and defective goods, and demand forecasting. (Axsäter, 2006)

Reduction in the cycle time of inventories has a positive effect on the tied-up working capital of a company. If it is put into practice, for example in the form of reasonable batch sizes, it is not harmful from an inter-organizational collaboration point of view either.

2.3 Measures of working capital management

This section presents the two main types of measures of working capital management, which are ratios and cycle times. The ratios are developed mainly to support the analysis of financial statements, while the cycle times are developed to also support the management of operations. The cycle time measures were developed to criticize the working capital ratios, as well.

2.3.1 Working capital ratios

This section presents current ratio, quick ratio, net working capital per net sales, net working capital to total assets, and sales to net working capital. Working capital ratios received criticism, however. This leaded to the appearance of circulating capital ratio which was more dynamic than current and quick ratios.

The current ratio and the quick ratio mainly indicate a company's ability to pay back its short- term liabilities. The higher the ratio, the more capable the company is of paying its obligations. Current ratio is defined as current assets / current liabilities. The reference value of current ratio states that a current ratio of more than 2 is good. In this case, the company can carry on its operations without financial strain. A ratio of less than 1 suggests that the

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company would be unable to pay off its obligations if they came due at that point. The quick ratio is similar, except that it does not include inventory and prepayments in current assets that can be liquidated. Quick ratio measures the euro amount of liquid assets available for each euro of current liabilities. The target value of quick ratio is 1 to ensure that a company would be able to pay off its short-term obligations in one go. Therefore current ratio and quick ratio should be considered primarily as indices of financial strength and stability, not as measures of efficient utilization of funds.

Furthermore, the net working capital per net sales ratio measures the amount of net working capital (current assets – current liabilities) that is tied up to the extent of business (net sales).

The ratio is indicating the activity of business. The net working capital per net sales ratio of supermarkets is typically lower than that of manufacturing companies. The sales to net working capital ratio (also known as working capital turnover) reveals under- or over-trading by the company in relation to its resources. The net working capital to total assets ratio describes the capital structure of a company and reflects its financial stability. An increasing ratio is usually a positive sign, showing that the liquidity of the company is improving over time. There are no obvious rules of thumb for these ratios.

Analysts have used working capital ratios as tools for financial statement analysis of companies and models that aim to predict bankruptcies (e.g. Lee et al. 1996). However, working capital ratios have received criticism. For example Guthmann (1954) criticized the sales to net working capital ratio and Wright (1956) criticized current ratio stating that it is a measure which is not as useful as often claimed. In those days, it was considered that working capital is only appropriate if it is not too low (liquidity risk). Too high a working capital (inefficiency risk) was not considered often. Kirkman (1986) found that current ratio and quick ratio based on net working capital have not been found to be very good predictors of bankruptcy, possibly because they are static indicators. Current and quick ratios are based on the ‘gone-concern approach’ and therefore do not serve managers who manage a firm on a

‘going-concern approach’, trying to improve or maintain this dynamic stability. When a business is operating on going-concern basis, the normal course is that a partition of sales and supplies are never paid and a minimum level of inventories never leaves the company.

(Bhattacharya, 2009) Wright (1956) defined the circulating capital ratio as a means to solve the problems of current ratio that may rise through the strengthening of financial position and decrease through shortage of funds or through improved efficiency. He indicates that an upward or downward trend in current ratio can be due to causes which are not related to working capital management. The falling trend of current ratio might indicate, for example, that funds accrued from more effective selling have been invested in fixed assets. Wright differentiated inventories, accounts receivable and accounts payable from the remaining current assets and liabilities because each of these is related to sales. The circulating capital ratio is defined as the ratio of the value of inventories, plus accounts receivable, to the value of accounts payable.

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2.3.2 Cycle time measure of working capital

The cash conversion cycle (CCC) concept presents one possibility for measuring and controlling the effectiveness of working capital management on the basis of relative ratios.

Richards and Laughlin (1980) developed the CCC to criticize the use of current ratio and quick ratio as key indicators of a firm’s liquidity position. They state that the usefulness of these static liquidity indicators is limited by their failure to provide adequate information on cash flow attributes of the transformation process within a firm's working capital position.

Current ratio and quick ratio emphasize essentially liquidation, rather than a going-concern.

Richards and Laughlin stress that the focus of management should be on avoiding default situations, and that cannot be supported by using ratios that indicate a firm’s ability to meet its obligations through asset liquidation in the event of default. Shin and Soenen (1998), Deloof (2003), Hutchison et al. (2007), and Ulbrich et al. (2008) have agreed that CCC is a good proxy for working capital management.

The cash conversion cycle presents the length (in days) of time a firm has funds tied up in working capital, starting from the payment of purchases to the supplier and ending when remittance of sales is received from the customers. In other words, the CCC is a collection of three activity ratios: the cycle time of inventories (DIO) plus the cycle time of accounts receivable (DSO) less the cycle time of accounts payable (DPO). The DIO is calculated as inventory×365/sales, the DSO as accounts receivable×365/sales, and the DPO as accounts payable×365/sales. The importance of the CCC from the perspective of value chain management is that it bridges purchasing activities with suppliers, internal supply chain activities and sales activities with the customer (Farris and Hutchison, 2002). The CCC is illustrated in Figure 6 where a positive CCC is visualized.

Figure 6. Cash conversion cycle (adapted from Richards and Laughlin, 1980)

In this case, the company has to finance accounts receivable and, in part, inventories. There is evidence that a company can operate with a negative CCC (for example Apple Inc.), or the

Time (days) DPO

DIO

t0 t1 t2 t3

Purchase Cash outlay Product sales Cash received

DSO CCC

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CCC can be zero. A numerical example is provided in Table 3 to illustrate the primary point of CCC with an example.

Table 3. Selected financial data of BMW and CCC and its components (BMW Group, 2009; BMW Group, 2008; BMW Group, 2007)

The results of the study show that the shortening of the cycle time of inventories (DIO) from 2006 to 2007 did not improve the CCC, because during the same period the cycle time of accounts payable (DPO) shortened and offset the impact of the improved DIO. From the value chain point of view, a shortened DPO poses a lower risk for suppliers. The DIO mainly reflects the efficiency of the internal supply chain, and therefore its shortening by three days does not affect the other players of the value chain directly. The increase of the CCC from 2007 to 2008 indicates that the management of working capital was not as efficient in 2008 as it was in the previous years from the BMW Group’s point of view; the CCC lengthened by 24 days. The global economy grew strongly in 2006 and 2007 before the financial crisis of 2008 which caused a serious setback to the real economy. Sales of the BMW Group fell in Europe and North America. The BMW Group follows a sustainable leadership business model (Avery and Bergsteiner, 2011) which can be seen especially in the cycle time of accounts receivable and payable. The current share of receivables of financial services is added to DSO as the financial services are an important part of their business. In 2008, the share of new cars leased or financed increased. The repurchase of a previously off-balance-sheet portfolio of vehicles increased the DSO as well. This might indicate that the customers of BMW Group have difficulties in financing their purchases. The shortening of DPO may indicate that the BMW Group has supported its suppliers during the financial crisis of 2008.

Its good credit rating (A) might have helped the group lending at favorable rates. Those companies who could not borrow capital from financial markets financed their operations at the expense of customers and suppliers.

Million EUR

Year ended 31 December 2006 2007 2008

Sales 48 999 56 018 53 197

Inventories 6 794 7 349 7 290

Accounts receivable 14 761 16 668 18 176

Accounts Payable 3 737 3 551 2 562

DIO 51 48 50

DSO 110 109 125

DPO 28 23 18

CCC 133 133 157

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2.3.3 Cash conversion cycle in the literature

The cash conversion cycle is also known as cash-to-cash (C2C). Where the parallel term originated from, is not clear. C2C is widely used in managerial articles (e.g. Sherida, 2000;

Bowman, 2001; Ward, 2004) and supply chain management journal articles (e.g. Farris and Hutchison, 2002), whereas CCC is commonly used in financial journal articles (e.g. Deloof, 2003; Lazaridis and Tryfonidis, 2006). Lately, the streams have come together, possibly because more interest is shown towards the management of financial supply chains (Hofmann and Kotzab, 2010; Blackman and Holland, 2006). Table 4 shows results of the three search for ‘cash conversion cycle’ and ‘cash-to-cash’ (or ‘cash to cash’) from Scopus database in article title, abstract and keywords.

Table 4. Scopus search for ‘cash conversion cycle’ and ‘cash-to-cash’

Time ‘cash conversion cycle’ ‘cash-to-cash’

June 2014 55 22

February 2014 48 21

September 2013 41 21

The results shown in Table 4 do not include duplicates; therefore the number of articles discussing working capital management has increased by 15 articles between September 2013 and June 2014. The number of articles where cash conversation cycle is used has increased much more than the number of articles where cash-to-cash is used. The research group in which the author belongs, for example, solely uses the term cash conversion cycle, and three of the last seven new journal papers were written by members of this group, which could possibly affect search results.

Basically, the ideas of the definitions of CCC are similar even though they range from a general statement to detailed descriptions. The definitions include for example the following aspects.

“The cash conversion cycle, by reflecting the net time interval between actual cash expenditures on a firm's purchase of productive resources and the ultimate recovery of

cash receipts from product sales, establishes the period of time required to convert a dollar of cash disbursements back into a dollar of cash inflow from a firm's regular

course of operations.” (Richards and Laughlin, 1980, p. 34)

“Cash-to-cash is a composite metric describing the average days required to turn a dollar invested in raw material into a dollar collected from a customer” (Stewart, 1995, p.43)

“The cash conversion cycle, which mirrors the operating cycle, measures the interval between the time cash expenditures are made to purchase inventory for use in the

production process and the time funds are received from the sales of the finished products. This time internal is measured in days and is equal to the net of the average age

of the inventory plus the average collection period minus the average of accounts payable” (Schilling, 1996, p. 4-5)

“The Cash Conversion Cycle (CCC) is an additive measure of the number of days funds are committed to inventories and receivables less the number of days payments are

deferred to suppliers.” (Shin and Soenen, 1998, p. 38)

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“[D]efined as the time elapsed from the payment of cash for materials or components through to the receipt of cash for sale of the finished product” (Hofmann and Kotzab

2010, p. 308)

The development of CCC was directed to two branches after it was published in 1980. The first branch of development improved the accuracy of measure. Gentry et al. (1990) developed the weighted cash conversion cycle (WCCC), which takes into account the amount of funds committed at each step of the cycle. The weights are calculated by dividing the amount of cash tied up in each component by the final value of the product. The WCCC includes both the number of days and the amount of funds that is tied up at each stage of the cash cycle. Furthermore, Viskari et al (2012b) introduced the advanced cash conversion cycle (ACCC) for controlling the amount and cost of working capital. It refines and extends the concept of WCCC. The ACCC is designed for the operational level, and it observes the capital tied up in the operating cycle of an order from raw material purchases to the remittance of the customer for the delivered product. Both WCCC and ACCC are based on the internal data of a company or the value chain of a product, for example. Evaluation and validation of these models is difficult because data used in these models is not available in a database or in public.

The other branch of development criticizes the denominators for the three components of CCC. Shin and Soenen (1998) introduced the net trade cycle (NTC) where all three components of CCC are expressed as a percentage of sales. They stated that the denominators are all different, making the addition not particularly useful. Farris and Hutchison (2003) suggest that inventories and accounts payable should be divided by the cost of goods sold and accounts receivable by net sales. When the interest in the management of financial supply chains increased, a new problem emerged: the company’s cost of goods sold is not shown in the profit and loss account. At the moment, the cost of sales method is only absolutely mandatory according to US GAAP (Generally Accepted Accounting Principles in US). The International Financial Reporting Standards (IFRS) allow the use of the cost of sales method and the nature of expense method which does not reallocate expenses among functions within the company. Hofmann and Kotzab (2010) introduced the calculation of CCC based on the definition of Farris and Hutchison (2003), but actually they use the definition of Shin and Soenen (1998). In the footnotes, Hofmann and Kotzab (2010, p. 308) state: “Many companies use the cost of goods sold instead of net sales when calculating DPO and DIO. The article uses net sales across each working capital component to allow a balanced comparison across each C2C cycle element and provides true comparisons between industries”. Soenen (1993) notes that the net trade cycle increases the uniformity and simplicity of calculation.

Losbichler et al. (2008) point out that revenue data is usually more readily available than the cost of goods sold. It is not unambiguous to define the value of COGS for a company that follows the nature of expense method in its financial reporting. When the value of sales is used as the denominator instead of the COGS, the cycle time of inventories and accounts payable is shorter for most companies, because normally the value of sales is higher than the value of the COGS.

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2.3.4 Computation of cash conversion cycle

The exact calculation of CCC is not shown widely in papers. For example Stewart (1995) presents the cash-to-cash as the total inventory days-of-supply + days-sales outstanding (A/R) – Average-payment-period to suppliers (A/P). He merely says that inventories are divided by cost of goods sold, but the calculation of other components is not defined. Richards and Laughlin (1980) do not present the formula in the article but it can be defined on the basis of the numerical example given in the article. Table 5 presents how some authors have calculated the CCC in their studies.

Table 5.Computation of the cash conversion cycle

Source Formula

Richards and

Laughlin (1980) Inventories

COGS × 360 +Notes and accounts receivable

Net sales × 360

Accounts payable + Salaries, benefits and payroll tax COGS+Selling, general and administrative expense× 360

(2)

Shin and Soenen (1998), Monto (2013)

(inventories + accounts receivable - accounts payable)× 365

sales (3) Farris and

Hutchison (2003); Ding et al. (2013)

Inventories

COGS × 365 +Accounts receivable Net sales × 365 Accounts payable

COGS × 365

(4)

Deloof (2003);

Kroes and Manikas ⁽¹ (2014)

Inventory

COGS × 365 +Accounts receivable

Sales × 365

Accounts payable

COGS+change in inventory× 365 (5)

American Association of Individual Investors (2011)

average inventory

COGS × 365 +average accounts receivable

revenue × 365

average accounts payable

COGS × 365

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COGS = cost of goods sold

Average = (beginning value of balance sheet item + ending value of balance sheet item)/2

(1 reflects the calculation when the period is one year

There are slight differences in the calculation of CCC, as demonstrated in Table 5. Indeed, what is the orthodox way of calculating the CCC is difficult to say. Richards and Laughlin (1980) demonstrated the CCC of a single corporation and they did not have to consider the availability of data; this is possibly why the formula is the most complex. Shin and Soenen (1998) studied 58,985 firm-year records which forced them to consider the uniformity of

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data. They criticize the formula of Richards and Laughlin (1980), stating that the denominators are all different, not making the addition particularly useful, either. Farris and Hutchison (2003) studied the working capital management of different industries. Their data includes only US companies, and therefore they can partially follow the formula presented by Richards and Laughlin (1980). Deloof (2003) modified the denominator of accounts payable compared to the formula of Farris and Hutchinson (2003). Remarkably, Deloof chose this formula because the sample of study is formed of 1,009 large Belgian non-financial firms for the 1992-1996 period. In those days Belgian firms were possibly obligated to use the cost of sales method. The final example of the formula of CCC is from the American Association of Individual Investors, which is a nonprofit organization for individual investors. It is possible that the formula emphasizes the true view of working capital management. A company can fail or succeed compared to a normal year in terms of CCC. If an investor only follows a limited number of companies, it is not too hard to calculate CCC in this way. Table 6 depicts the data required for cash conversion cycle analysis as reported in the SEC 20-F reports for Nokia Corporation and computation of CCC using the five formulas presented in Table 5.

Table 6.Selected financial data of Nokia and computation of the cash conversion cycle

Million EUR

Year ended 31 December 2006 2007 2008 2009 2010

Net Sales 41 121 51 058 50 710 40 984 42 446

Cost of sales 27 742 33 754 33 337 27 720 29 629

Selling and marketing expenses 3 314 4 380 4 380 3 933 3 877 Administrative and general expenses 666 1 180 1 284 1 145 1 115

Inventories 1 554 2 876 2 533 1 865 2 523

Accounts receivable 5 888 11 200 9 444 7 981 7 570

Accounts payable 3 732 7 074 5 225 4 950 6 101

Social security, VAT and other taxes 966 2 024 1 700 1 808 1 585

Wages and salaries 250 865 665 474 619

Computation of CCC by formula 2006 2007 2008 2009 2010

2 16 18 24 15 9

3 33 50 49 44 34

4 24 35 39 30 21

5 26 38 38 29 23

6 n/a 27 37 40 26

Year 2010

components of CCC / formula 2 3 4 5 6

DIO 31 22 31 31 27

DSO 64 65 65 65 67

DPO 86 52 75 74 68

CCC 9 34 21 23 26

The results of the formulas presented in Table 6 illustrate that the original formula of Richards and Laughlin (1980) provides the most optimistic view of the cycle time of the working capital of Nokia Corporation. The rest of the formulas lead to more consistent results concerning the cycle time of working capital. Formulas three to six may illustrate the virtual

The Cycle Times of Working Capital: Financial Value Chain Analysis Method