Development of a risk-adjusted working capital model: empirical evidence on its contribution to profitability and credit ratings

Compared to traditional areas of finance, academics and practitioners have devoted less attention to working capital management. Although working capital management is an integral part of corporate finance and contributes to the success of operational, financing and investment decisions, this area of corporate finance is relatively unexplored in the finance literature. To this effect, the Finance and Treasury Association of Australia has been promoting research in this area in order to raise awareness among academics and practitioners. This thesis aims to contribute to the literature and examine the latest working capital management practices of Australian firms.

This thesis proposes a new approach that reconciles traditional working capital management with risk management principles. By extending the traditional working capital approach, this research develops a risk-adjusted working capital model and examines the determinants of working capital for Australian firms over the period 2003-2008. Using dynamic panel data estimation and median regression techniques, this study finds mixed evidence supportive of the risk-adjusted working capital model. Sectoral analysis reveals heterogeneous working capital patterns. It also identifies the sectors with high reliance on cash and inventory. After controlling for fundamental factors (such as sales, size, leverage and profitability), significant differences in working capital practices are apparent. Firms with low-leverage appear to hold higher cash holdings than high-leverage ones. The evidence provided does not support the window dressing hypothesis.

The second section of this thesis examines the determinants of corporate profitability for publicly listed Australian firms by using three measures of corporate profitability namely, net profit, economic value added and return on assets. Through dynamic panel estimation technique, the determinants of corporate profitability are tested. Using panel least squares methods, median regression methodology and after controlling for sectoral variations, the findings shows that the determinants of corporate profitability vary across Australian sectors. The analysis is extended to control for firm’s fundamental characteristics such as working capital, corporate governance ratings and performance, and the results are still supportive of heterogeneous determinants. It is discernable that firms with the worst working capital deficit exhibit a significant negative relationship to debt ratio. The same significant negative relationship is observed between firms with poor corporate governance ratings and debt ratio. Profitable firms on the other hand have a tendency to hold positive cash holdings, whereas non- profitable firms tend to exhibit negative cash holdings.

Cash flow adequacy is one of the critical factors influencing corporate credit decisions. Since working capital deals with short-term cash flows, this thesis explores the interaction between working capital and corporate credit ratings. By employing working capital and firm’s characteristics as explanatory variables, this study examines the determinants of corporate credit ratings. Following a rigorous data selection process, corporate credit ratings of Australian firms are collected from Standard & Poor’s for the period 2003-2008. By employing ordered logit models, this thesis provides evidence on the determinants of corporate credit ratings. Empirical evidence suggests that working capital influences corporate credit ratings and this research shows that cash, inventory and size are determinants of corporate credit ratings.