Working capital management as a routine: An action based access to the topic | BEH: www.beh.pradec.

eu

Peer-reviewed and Open access journal BEH - Business and Economic Horizons
ISSN: 1804-5006 | www.academicpublishingplatforms.com Volume 11 | Issue 3 | 2015 |pp.173-182
The primary version of the journal is the on-line version DOI: http://dx.doi.org/10.15208/beh.2015.13

Working capital management as a routine: An

action based access to the topic
Petra Kroflin1, Norbert Kratz2
1
Faculty of International Business, University of Cooperative Education, Ravensburg, Germany
2
Faculty of Taxation, University of Cooperative Education, Villingen-Schwenningen, Germany

corresponding e-mail: [email protected]

corresponding address: Marienplatz 2, room 2.17a, 88212 Ravensburg

In times of unstable capital markets on the one side and historically low interests on
the other, working capital management must be discussed from different perspectives.
Limited sources of liquidity, and the high refinancing risk of lending companies, make
the reduction of current assets and liabilities an even more important management
task than before. On the other hand, low interest rates raise the need for defining the
optimum level for working capital. Little research and empirical evidence exists when
it comes to lifting working capital targets to create value.
The objective of the present paper is to give evidence on whether German companies
adapt their behavior in terms of handling working capital in the actual economic
environment and to describe which practices have been established to perform this
adaptation. The given analysis is based on a qualitative study. The data used have
been gathered in 2014 and 2015 during semi structured interviews with CFOs or
financial executives of 15 German and Austrian industrial firms. Our study suggests

Business and Economic Horizons

that adaptation is realized rather by moderating management attention and focus to
the topic of capital cost but not by adjusting the financial targets themselves. This is
because working capital reduction as become a management routine.
JEL Classifications: G39, L21, M 6, M 19, M 21
Keywords: Working capital, working capital management, liquidity management, routine based
management action

Introduction

Managing working capital is an attitude not simply the application of models. Its a
management routine. The management of current assets and liabilities has traditionally
been paid much attention by German managers. Capital market instability and interest rate
fluctuation has made it an even more important management task than before. Incentive
schemes reflect the priority of minimizing capital employment. Today, the European
business environment is extraordinary in some respects.
On the one hand, due to limited sources of liquidity, and the high refinancing risk of
lending companies, the management of current assets and liabilities are significant in
generating cash and minimizing the financing risk of capital employment for profitable
investments. On the other hand, historically low costs of capital contest the working
capital reduction dictum. Limited profitable and riskless alternative investments raise the
question whether an extension of working capital could even help to generate additional
revenue and support economic value added (EVA) maximization, due to the often
forgotten impact of working capital on investor perception of company risk.
Even the term structure of interest rates, suggesting that short-term financing should
usually be cheaper than long-term financing, is not regularly the case today. The research
questions raised in the presented paper are:
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1. Is there a practical use for working capital concepts in a business context? Is working
capital precisely defined when used as a key performance indicator?
2. Does the actual situation on the capital markets have an impact on setting targets for
working capital? Is a deliberate increase of working capital conceivable within target
setting? Is working capital target setting subject to optimization?
3. Is the economic value added framework used to explain and influence the interaction
of working capital management with a companys overall goal of shareholder value
creation?
It starts with a literature review of more recent existing multi-layer research on the topic.
It selects papers, which relate to the specific situation of German industrial companies,
since these are the focus of the empirical study presented here. It then presents the
methodology of the empirical research, underlying this study, and develops four
summarizing propositions which are discussed in the last part of the article.
The current paper is structured as follows. In the beginning the literature review of more
recent existing multi-layer research on the topic is presented. We select papers, which
relate to the specific situation of German industrial companies, since these are the focus
of the empirical study presented here. Also a categorization of existing working capital
research is made. The actual business situation in Germany is described with a special
focus on interest rates and loan demand of German industrial firms. Further section
describes the employed methodology. Then the four propositions represent the findings
of the present research with the subsequent discussion and conclusion.

Literature review

Existing literature on the topic can be classified in different ways, e.g. methods used,
empirical archival or analyzed management practices. Our study categorizes the literature
according to the impact of working capital management on financial ratios which
dominates the respective research fields. Three main areas of research emerge.

Working capital in the context of a companys structural liquidity

The first large field of comprehensive working capital studies is cash-related research.
Working capital is analyzed in the context of cash, cash generation and consumption,
often measured by the number of days of the working capital cycle (DWCC) (Pfitzner and
Hilbert, 2014; Laux, 2012). The asset side of working capital is accentuated more and the
elements of trade receivables and inventories are focused. While a definition of working
capital (current assets less current liabilities), net working capital (excluding cash and short
term debt) and finally net operating working capital (trade receivables plus inventories less
trade payables) is easy, its management is not. Growing companies must invest constantly
in a certain level of inventory and accounts receivable, with long-term financing becoming
appropriate for short term assets, taking into consideration that the latter are not always
considered as current assets (Laux 2012). Hill, Kelly, and Highfield (2010) point out that
sales growth and costly external financing, amongst other factors, encourage firms to
pursue more aggressive working capital strategies. Firms with a greater internal financing
capacity and superior capital market access seem to follow a more conservative working
capital policy. Molina and Preve (2009) highlight managers tendency to increase working
capital components, in times of profitability problems, and demonstrate the opposite
behavior, in times of cash problems. They highlight this non-beneficial behavior, by
explaining that decreases in the trade receivables account for at least one-third of the
drop in performance of firms in financial distress (p.665). So, purely cash-oriented
working capital behavior seems to be questionable.

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Working capital as a component of cash flow

The context for such research is predominantly based on the capital side and concentrates
on the capital requirements of a company (partly determined by its working capital) and
the companys potential to generate internal financing. A more accurate intuition of
working capital emerges when we define working capital from the liabilities side (as long-
term capital minus fixed assets, which is mathematically equivalent). The net result, still on
the right side of the balance sheet, can be interpreted as financial component and
therefore, as a part of the capital structure decision of the firm (Etiennot, Preve, and
Allende, 2012, p. 163). In other words, working capital represents the amount of long-
term funds employed to the financing of current assets. Actively reducing working capital
seems to be an appropriate means to generate cash and reduce capital requirements, by
employing this cash accordingly. While a firm can be highly profitable, its ability to
generate sufficient positive net cash flows from operations will put pressure on
management to seek out additional sources of capital to support its working capital needs.
External financing is needed to meet the working capital requirements. The cost of
financing working capital has to be calculated, in relation to the benefit of holding specific
inventory levels or trade credit, to minimize the companys future dependence on debt
financing (Lifland, 2011/2012; Schning, Rutsch, and Schmid, 2012).
Another stream of literature in this category is country- or industry-specific working
capital studies.
For specific businesses and regional areas working capital requirements are analyzed and
evaluated. (Arunkumar and Radharamanan, 2012; Garcia, da Silva Martins, and Brandao,
2011; Goel, 2013; Koralun-Bereznicka, 2013; Makarani and Bineshian, 2013; Savita, 2011;
Valipur and Jashidi, 2012). The capital needed to finance working capital is also the
leading focus of those studies. A more static or structural view of balance sheet ratios,
based on hedging aspects, dominates this stream of research. Working capital is

Business and Economic Horizons

interpreted as a source of cash generation, on the one hand, and as the amount of long-
term capital devoted to financing current assets (limiting the amount of long-term capital
for fixed assets), on the other.
In this rather financing oriented stream of literature, variations of working capital, as an
element of cash flow, are part of the highly valued internally-generated financing. If cash
flow, as a pool of funds, is to be increased, there is a need for a definition of an adequate
or desirable level of remaining working capital. Whilst some authors would even accept a
negative working capital, others still believe in optimal level of working capital as a cash
reserve. The debate on the absolute or even optimal level of working capital, and its
periodic change as source of liquidity, as the outcome of successful working capital
management, needs to be further elaborated.

Working capital as a value driver

The group of studies in this context emphasize the possible link of working capital to
profitability, using a relatively simplistic perspective. Working capital management is
reduced to releasing capital employment and hence increasing liquidity. This liquidity is
used for strategic investments, with comparably higher returns, or for the reduction of
debt, which in turn reduces capital costs. An explicit return for investing capital in
inventory or trade receivables is mostly not considered (Paetzmann, 2008; Woehrmann,
Knauer, and Gefken, 2012).
A first step towards a more in-depth analysis of working capital management is to
compare returns with the cost of capital employed. Investments, in current as well as
long-term assets, should be undertaken if they will offer the most satisfactory returns to
shareholders - measured by net present values discounted at the cost of capital (Pass and
Pike, 1987, p.20). In these cases, defining an adequate level for the weighted average cost
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of capital (WACC) is a challenge, as expected returns depend on financial market trends

and assumptions.
Even more comprehensive shareholder value-oriented research undertakes an analysis of a
companys profitability, relative to its cost of capital, within the economic value added
framework, considering single elements of value creation (Michalski, 2007; 2008). A cause
and effect based explanation grid of the implications of the measures (often referred to as
working capital management) on EVA could further expand that stream of research.
To briefly summarize existing research, it can be stated that a large variety of multi-
facetted research exists. Most papers concentrate on single cause-effect analyses and on
the basic assumption that capital employment in working capital delivers a comparably
low return. Consequently, working capital management refers to working capital reduction
and rarely concentrates on its optimization.
Today, this approach has to be questioned and the topic of working capital management
as a management task should be reconsidered.

Business situation and capital availability

of German industrial companies in 2014

2014 was an economically unspectacular year in the Eurozone. In May, Germany reported
an expected growth rate of 2.5%. The actual rate was 1.5% in Germany and 0.8% for
Europe overall (Kater, 2014; Stephan 2014).
In industrialized countries, economic environments are mainly influenced by credit cycles,
while product life cycles assume a lesser importance. European companies benefited from
increased credit volumes, before the credit crisis, but now suffer from the need to
decrease leverage. Experts expect Europe to be confronted with the consequences of the
credit crisis for years to come. This will translate to moderate growth rates, low
investment activity and extremely low interest rates (Kater, 2014). Base rates in the United
States and Europe (with a one year delay) have been steadily lowered since the credit crises
or 2008 and 2009.
In a low interest environment, such as the situation companies experience today, the basic
rules of capital markets still persist: higher returns correlate with higher risk. Developing
easy and secure securities constitutes a challenge for the banking sector. Regulatory
interventions, such as the MiFID II or Basel III1, which aim to restrict credit access, have
proved counter-productive in this context. Empirical evidence demonstrates that Basel III
has not limited access to credit for large- and medium-sized German companies, but has
tightened credit standards for small enterprises (Schlumpberger, 2014; Bundesverband
ffentlicher Banken, 2015).
German corporate financing is traditionally dominated by long-term considerations.
Companies appreciate the stability of capital costs and the accuracy of planning activities.
Today, long-term financing is still available to companies, but due to existing regulations
and the existing interest environment it tends to be more costly. In many cases, companies
choose shorter term alternatives and carry the risk of prolongation and interest rate
increases. Alternatively, internal sources of financing are becoming more attractive. Access
to credit is easier in Germany than in other European countries, but German companies
still tend to behave rather conservatively, in this respect.

1 MiFID is the Markets in Financial Instruments Directive (Directive 2004/39/EC). It replaced the
Investment Services Directive (ISD) adopted in 1993. Basel III is a set of reform measures, developed by the
Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of
the banking sector. (For detailed explanations see reference list.)

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Even though 87 per cent of the credit requests from German companies could be satisfied
(Schlumpberger, 2014), the European Central Bank stated in their bank lending survey in
April 2014 that "in Germany, increasing net loan demand for both mergers and
acquisitions and debt restructuring was largely counterbalanced by declining net loan
demand for inventories and working capital" (European Central Bank, 2014).
The following figure demonstrates the developments in credit standards and loan demand
for enterprises in the euro area in total and in Germany in 2014. In Germany, the demand
for credit and credit standards for loans to enterprises remained unchanged.

FIGURE 1. CREDIT STANDARDS AND LOAN DEMAND IN THE EURO AREA IN 2014

Source: ECB (2014).

Note: CS stands for credit standards and DEM for demand. AVG stands for historical averages, which are
calculated over the period since the beginning of the survey, excluding the most recent round.

The credit standards of European banks are considerably below their historical average,
since the start of the survey in 2003 (15%).
Looking at developments by firm size, euro area banks reported unchanged credit
standards for loans to small and medium-sized enterprises (0% net tightening, from -3%
in the previous quarter), while they reported an easing of standards for loans to large firms

Business and Economic Horizons

(-3%, from 2% in the previous quarter). Regarding loan maturity, credit standards for
long-term loans were marginally tightened (with the net percentage of euro area banks at
1%, from 5%), whereas for short-term loans, credit standards were marginally eased (with
the net percentage of banks stable at -1%) (European Central Bank, 2014).
The above findings demonstrate that the lower cost of capital and the high disposability of
capital have not impacted German companies commitment to working capital reduction.
This raises the question whether the practice of working capital reduction independent
from capital cost is regarded as beneficial in the managers perception, e.g. as a value
creator, or whether it can be interpreted as routine behavior, without case specific
financial foundation.

Methodology

This study adopted a qualitative research method to examine the working capital
management practices of the respondents. This method is widely accepted in corporate
finance research for the purpose of analyzing actors (Silverman, 2009; Qu and Dumay,
2011). Patton (1990) notes that qualitative methods may be employed to discover "what
people do, know, think, and feel". Study participants were selected by purposive sampling.
The interviewer invited participants for a personal interview or a telephone interview,
both around 30 to 90 minutes long. The criteria for selecting interviewees were that the
respondent either had financial target setting competence himself/herself or had insight
into the target setting process. The required number of participants was reached when the
point of saturation was achieved, whereby additional interviews did not result in any new
findings (Creswell, 2006).
Data collection took place within semi-structured interviews. "A semi-structured interview
involves questioning guided by identified themes in a consistent and systematic manner
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interposed with probes to elicit more elaborate responses" (Qu and Dumay, 2011, p.9)1.
As Miles and Huberman (1994) state, this approach enables the generation of detailed
descriptions grounded in reality. The interview questions were developed on the basis of
an in-depth literature review. Interviews were audio recorded, transcribed and memos
were written to document important information gathered.
The interviews were analyzed using content analysis techniques (Miles and Huberman,
1994) following several steps. First interviews were analyzed and coded deductively, based
on the literature research. The second step was used to categorize text passages into
emerging themes. These emergent themes were used to group quotations from transcripts
and to eliminate irrelevant passages. This helped to manage data effectively and to have
access to quotations to represent participants' own views whenever necessary.
After the coding process, cross-case analysis helped to ensure that the developed themes
and categories really represented the participants' perspectives and were not consequences
of the researcher's own bias.
Fifteen business finance mangers from German large- and medium-sized companies were
interviewed before the point of saturation was achieved. One interviewee worked as the
CFO of an Austrian group, but has formerly worked in German groups for more than ten
years and was regarded as having good insight into German business practices.
Additionally, three expert interviews were carried out to deepen the authors'
understanding of the current market situation and banking environment in Germany.
The results of the research did not fully correspond to the findings in the literature, nor to
the authors' previous understanding of working capital, as a management activity, and
demonstrate a previously neglected routine-based dimension of working capital
management.

Findings

Proposition 1: Identification of the lack of a precise

working capital management definition

The first outcome of the current research is the lack of precision, when it comes to the
definition of the term working capital itself.
While some interview partners address working capital as the difference between current assets
and current liabilities, others differentiate between working capital and controlled working capital.
The latter articulated a very tight definition of working capital with inventory, accounts receivable
and payable as main working capital components. Another differentiation could be found between
working capital and net working capital, where net working capital excludes short-term loans
and overdraft arrangements, but includes all other parts of current assets and liabilities. In
the continuation of the interviews, the researchers concentrated on the narrow definition of
working capital being the difference between inventories and accounts receivable minus
accounts payable.
When it comes to a more precise description of what the interviewees referred to as working
capital management, the concentration on these narrowly defined elements can be affirmed
by the following statement of an interview partner: We concentrate on the elements being actively
influenced by operative management first.
The starting point of working capital management is typically a positive figure, whereas the
authors of this paper have the suspicion that this amount is too high in all the analyzed
companies. The following statement can be seen as a representative comment in this
respect: Typically firms, especially those in the manufacturing industry, will tend to keep a positive balance
1 The topics covered in these interviews were: WC definition, application of WC as KPI, areas of WC
responsibility, organizational localization of WC responsibility, responsibility for KPI target setting,
sanctioning of deviations, target adaptation to macro-economic parameters, management focus to WC
targets and target fulfillment over time.
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which creates cost. In no case was capital being used to finance inventories or accounts
receivable spontaneously assumed to be comparably well invested capital.
The aim of working capital management was described as the balancing out of working capital
needs and the extent of internal cash generation, availability of credit and the relative cost effectiveness of
different sources of financing.

Proposition 2a: The active manipulation of working capital

does not mean optimizing this ratio but setting reduction targets

As demonstrated, Germany is actually experiencing a historically low interest rate level.

According to the theory, this should reduce pressure on working capital and allow
companies to invest in higher working capital and hence attain higher profitability. The
findings of this research suggest that the impact of working capital reduction on liquidity
and profit is acknowledged, but not aligned consciously and not purposefully translated into
working capital targets.
Working capital performance improvements were in all cases sought by setting working
capital reduction targets. One representative statement demonstrates this trend: We treat
working capital management in the context of cash management. We only measure improvement - hence
reduction as percentage of revenue, we do not calculate absolute working capital targets on the basis of interest
rates. Another statement goes in the same direction: Working capital is a cash reserve. It serves as
cash generating balance sheet position but we do not define a minimum requirement of working capital.
Attention on working capital tends to serve as a general attitude rather than as an
analytically-developed integrated financial target system. Even in times of low interest rates,
reduction targets are not lowered. This is because on operative managers level only working
capital is tracked - but not the cost of its financing. This is because operative management is
measured on the basis of operative results like EBIT and working capital, and balance sheet

Business and Economic Horizons

performance savings in capital costs do not improve operative managers performance.

Proposition 2b: Managers varying attention to

working capital goes along with varying interest rates

Considering the above findings of unchanged targets it might be concluded that the actual
low interest rate environment does not impact working capital management practices at all.
Being confronted with this assumption, the interviewed partners reacted differently. For
some interviewees, reinvestment of available cash was completely out of their scope of
responsibilities and thus not an area of interest to them, so they did not really wonder about
unchanged working capital targets.
Others were fully aware of that discrepancy between theory and their business practice.
Instead of adapted targets they observed a "constant adaptation of management focus. While in
2008 and before, working capital performance targets were monitored strictly, today they
exist, but are not paid as much attention as previously. Another interviewee stated: Yes, of course we
have those targets also today. But not meeting them is not at all a problem. It is tacitly accepted that people
pay attention to other things actually. But we keep these targets in our systems because we do not want to fully
give up this idea.
Considering these statements the research outlined in this paper discovered that any
correlation of working capital levels and interest rates is not a consequence of target
adaptation. If working capital stayed unchanged in the analyzed companies between 2013
and 2014, thus if reduction was not achieved, this was not a consequence of adjusted targets
in the sense of deliberate working capital increase but it can be assumed that lower
management attention to the topic contributed to this development. In other words, targets
stayed unchanged but management did not really trace the achievement of these targets.

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Proposition 3: The balancing out of profitability and liquidity as proposed

in a value based context is not observed in German business practice

Even though value-oriented research on working capital management and the challenge of
defining an adequate level of WACC is addressed, as the basis for defining the working
capital optimum, no attention is given to this optimum level, as an ex ante target in the
literature. The optimum level is determined ex post, through correlation analyses between
working capital elements and economic variables.
Consequently, the question asked in the interviews was whether a focus on working capital
reduction would not automatically require the definition of an optimum level in parallel. The
present research confirms this gap in management thinking. In none of the cases was an
optimum working capital level calculated analytically.
One of the interviewees explained that phenomenon: The working capital is a typical financial
ratio without a mathematical optimum. Its optimum is defined via trial and error, so we only highlight
changes do not determine absolute levels.
With reference to the actual situation on capital markets, interviewees were asked about the
practical consequences of the current low interest environment on working capital reduction
targets. The findings diverged astonishingly from the established literature on this subject:
The actual interest rate level had no impact on working capital reduction targets in the
analyzed cases.
One finance manager stated of course, working capital reduction is not really satisfying today, because I
hardly find any meaningful investments for the cash, but we want to adhere to the idea of cash awareness and
responsibility at all levels of the organization. Another interviewee reflected: well, if I think about it
properly, it could make sense to even increase working capital nowadays, but we have not even thought about
that. We want to preserve the right attitude.
The above mentioned organizational separation of working capital needs responsibility and
the responsibility for its financing reduces working capital to its liquidity dimension whereas
payback of investments in working capital are rather not seen and traced back. This is also a
consequence key performance indicator tracking. Whereas operative managers are rather
measured at EBIT and working capital, treasurers tend to concentrate on EAT. Reduced
working capital financing costs in case of low interest rates will not be explicitly traced back
to its origins - neither will increased revenue and operating profit not be linked to extended
payment terms which does not create pressure to release the existing working capital
reduction emphasis.

Discussion and conclusion

Working capital management is a multi-facetted and profoundly re-searched topic. The

authors revealed a liquidity focus in much of the research as well as in German business
practice.
The current economic environment in German industry is characterized by low interest rates
and a high satisfaction rate of credit requirements. This questions the traditional focus on
working capital reduction and demands conscious optimization of this ratio.
The present study comes from an action-oriented perspective on working capital
management. Management requires action, therefore, a more in-depth investigation, of the
steps of action and the attention paid to commercial performance, may advance our
understanding of the working capital management process.
The presented findings provide evidence of a traditionally high attention to the liquidity
dimension of working capital and reveal a literal working capital reduction tradition in
German industry. They give empirical evidence to Delekers (2010) statement that working
capital management constitutes a communicative concern in the first instance.
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Interestingly, our study provides evidence that finance managers in German industrial
companies engage in working capital management in a rather intuitive manner, referring to
mechanical routinely used practices as:
- emphasizing the cash flow based dimension of working capital;
- concentrating on the changes of working capital not on absolute levels;
- continuing their working capital reduction strategy, independent from interest rates;
- adjusting their attention to working capital target achievement to the ease of access to
capital and to the level of interest rates.
Thus, the role of working capital adjustments in value frameworks does not have a direct
impact on working capital target setting practices in German industrial companies.
The importance of working capital awareness, as a central business activity also in a low
interest rate environment, is accommodated by unchanged targets, but reduced top
management attention. Working capital management practices are not profoundly altered,
but the reduction of management attention to the topic might attract operative managers
attention to other, possibly more profitable, areas.
It should be considered that this study only focuses on a small sample of twenty participants
and, therefore, generalization of the findings is restricted. Future studies should examine
branch based particularities and analyze in more detail how working capital targets are
elaborated and how finance man-agers deal with deviations from those targets.

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- 182 - 2015 Prague Development Center