1 s2.0 S0927538X19302902 Main

Pacific-Basin Finance Journal 58 (2019) 101212
Contents lists available at ScienceDirect
Pacific-Basin Finance Journal

journal homepage: www.elsevier.com/locate/pacfin
Efficient working capital management, financial constraints and

T
firm value: A text-based analysis☆
Sandip Dholea, Sagarika Mishrab, , Ananda Mohan Palc
⁎
a
Monash Business School Monash University, Australia
b
Department of Finance Deakin University, Australia
c
Department of Business Management University of Calcutta, India
ARTICLE INFO ABSTRACT
Keywords: In this paper we examine the association between efficient working capital management and
Financial constraints financial constraints for a sample of Australian firms. Using a text-based measure of financial
Working capital management constraints, we show that efficient working capital management is associated with lower fi-
Future stock Price nancial constraints in firms in the next two to three years. Ours is the first study to use a text-
Analyst target Price
based measure of financial constraints for Australian firms. We also show that the negative as-
sociation between financial constraints and future share price is significantly weakened for firms
JEL classification:
with efficient working capital management, suggesting that such firms have higher market va-
G12
G32 luations despite being financially constrained. Finally, analysts seem take into account working
M41 capital management of firms when setting the one year ahead target price.
1. Introduction
There is increasing scrutiny of financial performance that's associated with managing working capital. And, even though it does
not appear on an income statement, working capital can amount to significant revenue for a company.1
In this paper, we study the importance of working capital management in reducing the likelihood of future financial constraints
and signalling higher firm value. Working capital management is important because it enables firms to free up cash and improve
liquidity. Deloof (2003) shows that efficient management of the cash conversion cycle can improve corporate profitability sig-
nificantly. Baños-Caballero et al. (2012) show that an optimal level of working capital is associated with higher profitability of
Spanish SMEs. Aktas et al. (2015) also find that an optimal level of working capital improves operating performance. These studies
highlight the importance of good working capital management.
The importance of working capital management is highlighted by the fact that firms often struggle to manage their working
capital effectively, and thereby lose significant opportunities to create value. Indeed, a recent survey by PriceWaterhouseCoopers
revealed that 203 companies in Australia and New Zealand saw deteriorations in their working capital performance by more than 5%
☆
We are grateful for helpful comments from the anonymous referees, seminar participants at Monash University and the Annual AFAANZ
Conference (Brisbane, 2019) for helpful comments and suggestions. We thank Vincent Bicudo De Castro and Zico Gonsalves for sharing the annual
reports of Australian firms. We gratefully acknowledge financial support from Deakin University.
⁎
Corresponding author.
E-mail addresses: sandip.dhole@monash.edu (S. Dhole), mishra@deakin.edu.au (S. Mishra), ampbm@caluniv.ac.in (A.M. Pal).
1
Cassio Calil, Managing Director of Corporate Client International Banking for J.P. Morgan Commercial Banking, `` Optimizing Working Capital”
webinar, September 24, 2014; https://www.chase.com/commercial-bank/executive-connect/working-capital-webinar.
https://doi.org/10.1016/j.pacfin.2019.101212
Received 14 May 2019; Received in revised form 19 August 2019; Accepted 24 September 2019
Available online 25 October 2019
0927-538X/ © 2019 Elsevier B.V. All rights reserved.
S. Dhole, et al. Pacific-Basin Finance Journal 58 (2019) 101212
in 2017.2 The survey further revealed that Australian and New Zealand firms could unlock
$90.60 billion by improving their working capital management practices. Given the importance of working capital, we ask
whether efficient working capital reduces the likelihood of firms being financially constrained in the future and, whether financially
constrained firms with more efficient working capital management have higher future prices.
There is anecdotal evidence of the benefits of efficient working management. In 1994, Dell, Inc. turned to the management of its
cash conversion cycle in order to reverse its recent losses. That strategy contributed to Dell growing its return on invested capital to
167%, 10 times the industry average, in the second quarter of 1997.3
Working capital management involves both choosing the amount to invest and managing the cash conversion cycle (the time it
takes to convert working capital into cash). It is not enough for companies to invest in working capital. Deciding the amount to invest
in working capital is important because over-investment in working capital may increase idle investment and therefore be value-
reducing. This is consistent with the results of some prior research (Kieschnick et al., 2013; and de Almeida and Eid Jr, 2014) that
incremental investment in working capital are could be value reducing. To manage working capital effectively, it is also important for
firms to manage the cash conversion cycle, because that creates liquidity. Given the importance of both level of working capital and
the cash conversion cycle, we focus on both these aspects of working capital management in this study. This is an important feature of
our study. Specifically, extant research on working capital management usually focuses on only one aspect of working capital
management (for example, Ding et al., 2013 define working capital management in terms of investment in working capital, whereas
Baños-Caballero et al. (2014) define it in terms of the cash conversion cycle). By focusing on both the level of investment and cash
conversion cycle, we provide a more comprehensive analysis of the importance of working capital.
We focus on whether efficient working capital management affects the likelihood of future financial constraints. Campello et al.
(2010) and Almeida and Campello (2007) argue that financial constraints negatively affect future performance. Financially con-
strained firms often pass up potentially profitable investment opportunities, and the ability of firms to avail external financing.
Given the adverse consequences of financial constraints, prior research has identified factors that reduce the likelihood of financial
constraints. For instance, Erel et al. (2015) show that financially constrained target firms experience financial relief after being
acquired. Ratti et al. (2008) show that bank concentration could reduce financial constraints, and Love (2003) shows that financial
liberalisation could reduce financial constraints. These studies thus show that some external factors could reduce financial con-
straints. Internal capital markets could also reduce the likelihood of financial constraints, as Shin and Park (1999) and Desai et al.
(2007) argue. Using a sample of Australian firms and a text-based measure of financial constraints developed by Bodnaruk et al.
(2015), we show that efficient working capital management reduces the likelihood of the firm facing financial constraints up to three
years into the future.
We next examine the valuation implications of working capital, by studying whether the negative effect of financial constraints on
future share prices is less for firms with more efficient working capital management. Our research is based on findings in prior
research (Denis and Sibilkov, 2009) that cash holdings enable financially constrained firms to make (value increasing) investments.
We find that, while there is a negative association between financial constraints and one-year ahead share price, this negative
association becomes weaker for firms with more efficient working capital management. In important additional analysis, we show
that analysts seem to recognise the importance of working capital management for financially constrained firms, as evidenced by
higher target prices for such firms.
We focus on Australian firms for the following reasons. First, Australia has a developed capital market with strong investor
protection laws (Leuz et al., 2003). Since firms operating in capital markets with strong investor protection laws tend to manage
earnings less (Leuz et al., 2003) and have more informative earnings announcements (DeFond et al., 2007), financial statements of
Australian firms are of high quality and useful for analysis. Second, despite the fact that Australia has a developed capital market, it
has a significant number of small firms, which are more likely to be affected by financial constraints (Belghitar and Khan, 2013).
Indeed, the mean total assets for our sample of firms is AUD 45.90 million. This contrasts with USD 7270 million for US firms
(Glendening et al., 2019). The fact that a significant number of small firms is listed on the Australian Stock Exchange (ASX) and the
fact that Australia has a developed capital market makes it an interesting institutional setting to study financial constraints.
Further, (poor) working capital management is an issue of relevance for Australian companies. Indeed, as discussed above, the
2018 working capital survey of Pricewaterhouse Coopers finds that about 50% of the surveyed Australian and New Zealand com-
panies saw their working capital performance deteriorate by more than 5% between 2017 and 2018, and that these companies could
unlock $90.6 billion in value by managing their working capital more effectively. These survey results make our research setting of
particular relevance.
Our study relates to Ding et al. (2013) and Baños-Caballero et al. (2014). However, in our opinion, our study differs significantly
from these studies. Ding et al. (2013) is more closely related to our study, because they analyse the association between financial
constraints and working capital investment. They argue that high investment in working capital allows firms to invest more during
periods of financial constraint. Ding et al. (2013) focus only on the investment in working capital; they do not study the importance of
the efficiency of working capital management. In contrast, we consider both the level of working capital (through measures like cash
to asset ratio, and current ratio) and also the efficiency of working capital management (cash conversion cycle). Investment in
working capital, by itself, does not measure the efficiency of working capital management. Indeed, high level of working capital could
suggest that the firm has idle investment or poor cash conversion issues, as it is not able to generate enough cash from its working
2
See https://www.pwc.com.au/publications/pdf/working-capital-survey-nov18.pdf
3
See https://www.strategy-business.com/article/9571?gko=be3fe.
2
capital. Second, Ding et al. (2013) study how investment in working capital allows financially constrained firms to make investments
in the current period. This research question is fundamentally different from ours, since we study whether current working capital
management is associated with future financial constraints, and whether more efficient working capital management allows finan-
cially constrained firms to enjoy relatively higher valuations. Ding et al. (2013) do not study the valuation implications of working
capital management. Finally, unlike Ding et al. (2013), who measure financial constraints by the ratio of current cash flow to capital
stock, we use a novel text-based measure of financial constraints that detects financial constraints more accurately than other
measures (Bodnaruk et al., 2015).
Our study also differs from Baños-Caballero et al. (2014). Baños-Caballero et al. (2014) primarily analyse the association between
net trading cycle (working capital efficiency) and firm performance. They find a U-shaped relation, which suggests that there is a
certain level of working capital efficiency that improves firm performance. They also find that financial constraints make the in-
flection point lower, i.e., a shorter trade cycle is associated with superior firm performance. In other words, financial constraints is a
moderating variable in Baños-Caballero et al. (2014). In contrast, it is one of the main variables of analysis in our paper – we focus
explicitly on the association between working capital management and financial constraints. Thus our research objective is different
from Baños-Caballero et al. (2014). Second, while net trade cycle is an important measure of working capital management, it does not
describe the level of investment in working capital. A more complete description of working capital management considers both the
efficiency and level of working capital. Our paper considers both aspects. Third, unlike Baños-Caballero et al. (2014), whose financial
constraint measure is based on financial statement variables, we use a more recent text-based measure, as described above.
We make the following contributions to extant literature. First, we provide a more complete analysis of the effect of working
capital management on future financial constraints. Most extant literature (for example, Ding et al., 2013; Baños-Caballero et al.,
2014) focus on either working capital investment or the trade cycle. By studying both the cash ratio and the cash conversion cycle, we
present comprehensive evidence on the importance of working capital management in reducing the likelihood of financial constraints
and improving firm value. This analysis is important as increasing working capital investment (or reducing trade cycle) by itself is
not always optimal (as the results of Kieschnick et al., 2013 show).
Ours is also the first study to use a text-based measure of financial constraints for Australian firms. As Bodnaruk et al. (2015) note,
this measure has several advantages over other commonly used measures, as it captures financial constraint more accurately by
focusing specifically on the language used by financially constrained firms in their annual reports.
We also contribute to the literature by demonstrating that financially constrained firms with efficient working capital manage-
ment have higher market valuations than those with less efficient working capital management. While prior studies (for example,
Denis and Sibilkov, 2009) allude to the importance of cash holdings to finance investment, ours is the first study, to our knowledge, to
demonstrate the valuation benefits of efficient working capital management for financially constrained firms.
The paper is organised as follows. We discuss prior literature, build our hypotheses and describe our research methodology in
Section 2; we describe the data in Section 3, and present the results of our empirical estimation in Section 4. We describe our
robustness tests in Section 5, and conclude the paper in Section 6.
2. Literature, hypotheses and research methodology
2.1. Working capital management
Working capital management significantly impacts firm performance and valuation. Indeed, net working capital accounts for a
significant proportion of a firm's capital employed. Firms maintain their investment in working capital for many reasons. Holding a
certain inventory balance at all times enables firms to reduce supply costs and protect against price fluctuations (Blinder and Maccini,
1991). Schiff and Lieber (1974) argue that holding inventory allows firms to service customers better and avoid high production costs
that arise from fluctuations in production. Similarly, allowing trade credit is an important policy to enhance sales and profits. In fact,
Emery (1984) argues that trade credit is a more profitable short-term investment than marketable securi- ties. Investment in working
capital can provide firms with liquidity, insuring it against the adverse effects of a shortfall of cash (Fazzari and Petersen, 1993).
However, too much of investment in working capital could also create problems for firms in terms of profitability (Deloof, 2003), as
idle investment reduces return and increases cost of financing. Therefore, an optimal investment in working capital is desirable.
While investment in working capital is an important part of working capital management, it is also important for firms to convert
working capital accounts to cash. This is because the inability to convert working capital to cash could create liquidity problems for
firms. Therefore, efficient working capital management also involves managing the cash conversion cycle. Prior research identifies
the importance of the management of the cash conversion cycle for small businesses, which could be cash constrained (Belghitar and
Khan, 2013) and firms with significant growth opportunities (Campello et al., 2011). Using a case study of a listed Brazilian company,
Zeidan and Shapir (2017) show that a shorter cash conversion cycle increases shareholder value. The evidence described above thus
suggests that efficient working capital management can affect shareholder value.
2.2. Financial constraints
Financial constraints adversely affect firms' prospects. In a survey of Chief Financial Officers (CFOs), Campello et al. (2010) report
that financial constraints cause firms to reduce their investment in tech spending, capital expenditure and employment. Further,
such firms pass up potentially profitable investment opportunities and draw more heavily upon lines of credit. Musso and Schiavo
(2008) show that the presence of financial constraints significantly increases the likelihood of firms exiting the market. The evidence
3
that financial constraints affect investment is also backed up by prior empirical research. For example, Almeida and Campello (2007)
show that there is a positive association between asset tangibility and access to external capital for financially constrained firms,
suggesting that when firms face financial constraints, higher (lower) tangibility of assets makes it easier (more difficult) to obtain
external financing. Fazzari et al. (1988) report that investment-cash flow sensitivity is high for financially constrained firms and
Fazzari and Petersen (1993) show that financial constraints adversely affect working capital. Campello and Chen (2010) show that
the operating earnings and capital expenditures of financially constrained firms are significantly affected during periods of negative
macro-economic shocks, suggesting that the effect of financial constraints is more prominent during bad economic periods. Using a
sample of Japanese firms, Gan (2007) shows that collateral losses restrict the ability of firms to obtain bank credit. This suggests that
the risk of financial constraint is real. Consistent with this idea, Whited and Wu (2006) show that financial constraint is a priced risk
factor.
2.3. Hypotheses
In light of the above discussion, it becomes important to ask whether there are factors that reduce the likelihood (or extent) of
financial constraints. Erel et al. (2015) argue that acquisitions could play a role in alleviating the financial constraints problem.
Specifically, they report that financially constrained target firms experienced significant reductions in the level of cash held, the
sensitivity of cash to cash flow, and the sensitivity of investment to cash flow, subsequent to being acquired. Ratti et al. (2008) argue
that greater market power increases banks' incentive to produce information on potential borrowers. Consistent with this argument,
they find that greater bank concentration reduces the extent of financial constraints. Laeven (2003) and Love (2003) present evidence
that financial liberalisation and financial development reduce financial constraints.
The evidence discussed above shows the role of external factors in reducing financial constraints. In this paper, we focus on an
important firm-specific factor – the role of working capital management. Much prior research (for example, Almeida et al., 2004; and
Faulkender and Wang, 2006) shows that firms facing financial constraints tend to accumulate cash, suggesting that the availability of
cash can help firms tide over periods of financial constraints. However, these studies do not examine how the management of cash
affects the likelihood of the firm facing financial constraints in future. This is an important question, since it could potentially inform
practice on how to reduce the likelihood of financial constraints.
Efficient working capital management is important because it enables companies to remain liquid and financially viable over the
short and long-term. Indeed, Aktas et al. (2015) and Deloof (2003) find that efficient working capital management is value en-
hancing. In a study of Chinese firms, Ding et al. (2013) show that good working capital management could alleviate the effect of
financial constraints. These studies highlight the importance of efficient working capital management. Based on this research, we
could argue that firms with more efficient working capital management would be less likely to face financial constraints.
Efficient management of working capital minimises the idle investment in working capital and, consequently, reduces the re-
quirement of funds to finance the working capital. In this way, it increases the return on working capital investment and enables the
firm to bear higher cost of borrowing. Financial constraints arise when the need for finance is high, and the ability to bear the cost of
finance is low. When the need for finance is less and the ability to bear cost of finance higher, the likelihood of financial constraints
becomes lower.
Despite the theoretical reasons for the value-enhancing effects of efficient working capital management, some studies find that
investment in working capital does not enhance firm value. For example, Kieschnick et al. (2013) show that a dollar investment in
working capital increases shareholder value by less than a dollar, and that, an incremental dollar invested in financially un-
constrained firms actually reduces firm value. This is because the valuation of an incremental investment in working capital is
influenced by several factors, such as future sales expectation, bankruptcy risk, debt load, financial constraints, etc. Indeed, Fazzari
and Petersen (1993) note that financial constraints could actually depress working capital investment. Similarly, using a sample of
Brazilian firms, de Almeida and Eid Jr (2014) find that investment in working capital is actually value reducing.
Based on the discussion above, we state our first (refutable) hypothesis in the null form as follows:
Hypothesis 1. Efficient working capital management is not associated with future financial constraints.
Prior research finds that financial constraints affect firm value. Lamont et al. (2001) show that financially constrained firms have
low average stock returns, suggesting that financial constraints adversely affect share price growth and, hence, firm value. As
Campello et al. (2010) note, firms tend to pass up potentially profitable investment opportunities when they are financially con-
strained, thereby adversely affecting their future prospects and valuations. Desai et al. (2007) show that affiliates of US multinational
firms increase their investment, assets and sales, relative to local firms when the local currency depreciates. One of the reasons for
this is the availability of cash from internal capital markets, which local firms do not have access to. Shin and Park (1999) examine
the benefits of internal capital markets in Korea and find that firms affiliated to Korean chaebols are less likely to be financially
constrained, owing to access to internal capital markets. Similarly, focusing on the 2007–2009 Global Financial Crisis, Kuppuswamy
and Villalonga (2015) show that there is a value-increasing effect of corporate diversification, owing to the financing and investment
advantages of diversification. Denis and Sibilkov (2009) show that accumulated cash holdings allow financially constrained firms to
have higher investments.
Building on the above literature, we next examine how efficient working capital management affects the valuations of financially
constrained firms. One of the important objectives of working capital management is to improve liquidity and ensure that assets are
4
put to their most productive use.4 As the above discussion suggests, firms that are able to management their working capital ef-
fectively, would be more likely to have higher levels of investment when they are financially constrained. Denis and Sibilkov (2009)
show that there is a positive association between investment and value for financially constrained firms that have higher cash
holdings. This leads to our second hypothesis (in the alternate form).
Hypothesis 2. Firms with more efficient working capital management have higher future share prices.
2.4. Research methodology
2.4.1. Measuring financial constraints

Most financial constraints studies use accounting variables to measure financial constraint in a firm. However, textual analysis
could also help identify financial constraints. Kaplan and Zingales (1997) (hereafter KZ) and Hadlock and Pierce (2010) (hereafter
HP) examine 10-K text to identify instances where managers discuss difficulties in obtaining external financing, liquidity problems, or
forced reduction in investment. KZ and HP classify these firms as financially constrained and use accounting characteristics to predict
whether firms will be classified as financially constrained within their framework. Because of the time-consuming nature of analysis,
they focused on small samples of firms.
Hoberg and Maksimovic (2014) also use textual analysis of 10-Ks focus on the liquidity and capital utilsation subsection of the
Management Discussion and Analysis (MD&A) section of the annual report to identify financial constraints. Buehlmaier and Whited
(2018) use manual searches of news articles that feature financially constrained firms to construct their text-based measure of
financial constraints. Their measures extend the measures of Hoberg and Maksimovic (2014).
Bodnaruk et al. (2015) measure of financial constraint expands on the KZ and HP's approach of using subjective information to
measure firms' financial constraint. They measure the level of constraints using the frequency of negative words within the entire 10-
Ks. This is because the tone of managers' words capture subtle signs that the company will face greater future financial challenges.
Following the idea we use Bodnaruk et al. (2015) measure of financial constraint to do our analysis.
To generate financial constraints, we start with the annual reports of all the Australian Stock Exchange Listed firms for the period
2000–2016, obtained from the Connect4 database. We con- verted the annual reports to the text format to facilitate our textual
analysis. Specifically, graphics and images in the pdf or word version of the annual report have little textual content. This approach is
consistent with Bodnaruk et al. (2015).
We use the financial constraint dictionary of Bodnaruk et al. (2015) to search the raw text files and construct our financial
constraint variable. This dictionary has a list of 184 words (we provide this word list in Appendix B) commonly used by firms facing
financial constraints. We counted the frequency of the financial constraint words in the annual reports, and also the total number of
words in the annual reports. Finally, we generated our financial constraint variable – the percentage of financial constraint in the
annual report. For example, if a firm has 5000 words in its 2016 annual report, of which 500 words are financial constraint words, the
financial constraint measure for 2016 for that firm would be 0.10.
2.4.2. Measuring working capital management

Since working capital management involves both the amount of working capital, and the conversion of working capital into
cash, our measures reflect both these aspects of working capital management. In this study, we use two main measures of working
capital management – one designed to measure the amount of working capital, and one to measure the conversion of working capital
to cash. Our measures are cash ratio (the ratio of cash to total assets), and the cash conversion cycle (days receivables plus days
inventory minus days payable). Our measures of working capital management are based on prior research (for example, Deloof, 2003;
Ding et al., 2013).
2.4.3. Model to test Hypothesis 1

We estimate the following model to test Hypothesis 1:
FCit = 0 + 1 WCMit n + 2 MTBit + 3 Sizeit + 4 Levit + 5 ROAit + 6 StdRetit + j Indj + t Yeart + it

j t (1)
In Eq. (1) above, FCit is our measure of financial constraints described above. The variable of interest in Eq. (1) above is WCMit−n.
This variable measures the efficiency of working capital. More efficient working capital is captured by higher values of current ratio,
quick ratio, and cash ratio, and lower values of cash conversion cycle. H1 predicts that the coefficient β1 is negative for cash ratio, and
positive for cash conversion cycle. We include size (measured by the natural logarithm of total assets) as a control variable, following
prior research (for example, Hadlock and Pierce, 2010) that finds that size is associated with financial constraints. We also control for
market-to-book ratio (measured as the ratio of market capitalisation to the book value of equity), since a high market-to-book ratio
represent growth opportunities, and leverage (ratio of long-term and short-term debt to equity), following Denis and Sibilkov (2009).
We also control for profitability (ROA, defined as the ratio of net income to total assets) and stock return volatility (StdRet, defined as
the 12-month standard deviation of monthly stock returns). Finally, we include industry and year fixed effects. We present the list of
constraining words in Table 1 and detailed variable definitions in Table 2.
4
See https://www.cfainstitute.org/membership/professional-development/refresher-readings/2019/working-capital-management
5
Table 1
List of constraining words.
Abide Earmark Irrevocable Prevents
Abiding Earmarked Irrevocably Prohibit
Bound Earmarking Limit Prohibited
Bounded Earmarks Limiting Prohibiting
Commit Encumber Limits Prohibition
Commitment Encumbered Mandate Prohibitions
Commitments Encumbering Mandated Prohibitive
Commits Encumbers Mandates Prohibitively
Committed Encumbrance Mandating Prohibitory
Committing Encumbrances Mandatory Prohibits
Compel Entail Mandatorily Refrain
Compelled Entailed Necessitate Refraining
Compelling Entailing Necessitated Refrains
Compels Entails Necessitates Require
Comply Entrench Necessitating Required
Compulsion Entrenched Noncancelable Requirement
Compulsory Escrow Noncancellable Requirements
Confine Escrowed Obligate Requires
Confined Escrows Obligated Requiring
Confinement Forbade Obligates Restrain
Confines Forbid Obligating Restrained
Confining Forbidden Obligation Restraining
Constrain Forbidding Obligations Restrains
Constrained Forbids Obligatory Restraint
Constraining Impair Oblige Restraints
Constrains Impaired Obliged Restrict
Constraint Impairing Obliges Restricted
Constraints Impairment Permissible Restricting
Covenant Impairments Permission Restriction
Covenanted Impairs Permissions Restrictions
Covenanting Impose Permitted Restrictive
Covenants Imposed Permitting Restrictively
Depend Imposes Pledge Restrictiveness
Dependence Imposing Pledged Restricts
Dependences Imposition Pledges Stipulate
Dependant Impositions Pledging Stipulated
Dependencies Indebted Preclude Stipulates
Dependent Inhibit Precluded Stipulating
Depending Inhibited Precludes Stipulation
Depends Inhibiting Precluding Stipulations
Dictate Inhibits Precondition Strict
Dictated Insist Preconditions Stricter
Dictates Insisted Preset Strictest
Dictating Insistence Prevent Strictly
Directive Insisting Prevented Unavailability
Directives Insists Preventing Unavailable
The Table above lists the constraining words identified by Bodnaruk et al. (2015). These are the words typically used by firms facing
financial constraints.
Table 2
Variable definitions.
Variable name Definition
FC Percentage of financially constraining words in the Australian annual reports. See Table 1 for the list of constraining words.
MTB The ratio of market capitalisation (closing share price for the year mul- tiplied by common shares outstanding) to the book value of equity
Size Natural logarithm of total asset
Lev Short term debt plus long term debt scaled by total shareholders' equity. ROA Net income (net profit after tax) scaled by total assets
StdRet Standard deviation of monthly stock returns
CCC Cash conversion cycle. It is the sum days receivables and days inventory, minus days payables. We scale CCC by 1000 in our regression
models in order to generate meaningful regression coefficients.
CashRatio Ratio of cash and short-term investments to total assets
CR Current ratio – defined as the ratio of current assets to current liabilities Age The difference between the IPO date and the current date
SA_Index Following Hadlock and Pierce (2010), the SA index is defined as [− 0.737*ln(Total Assets)] + [0.043*ln(Total Assets)2]−(0.040*Age).
GFC A dummy variable equal to 1 if the observation is from the period of the Global Financial Crisis (2008–2009); zero otherwise.
The Table above presents definitions of variables used in the empirical analyses.
6
2.4.4. Model to test Hypothesis 2

As mentioned above, Hypothesis 2, predicts that financially constrained firms with more efficient working capital management
have higher future prices than those with less efficient working capital management. In order to test this hypothesis, we first sort
firms into terciles of working capital management (measured as above). Then, for each tercile, we estimate the following model:
Pit + 1 = 0 + 1 FCit + 2 MTBit + 3 Sizeit + 4 Levit + 5 ROAit + 6 StdRetit + j Indj + t Yeart + it

j t (2)
In Eq. (2) above, Pit+1, measures the firm's share price in year t + 1. The variable of interest is FCit. This variable (defined above),
measures financial constraint in year t. Based on the association between financial constraints and profitability and investment
described above, we expect a negative coefficient β1. However, if efficient working capital management improves firm value, then the
negative association between P and FC would become weaker for firms with more efficient working capital management. Conse-
quently, we expect β1 to be more negative for firms in the lowest (highest) tercile of cash ratio (cash conversion cycle).
3. Description of data
Our empirical analysis is based on a sample of firms listed on the Australian Stock Exchange during the period 2000–2016. We
obtain the annual reports from Thomson Reuters' Connect4 database, financial statement data and annual stock price data from the
Morningstar DatAnalysis Premium database. We obtain stock returns data from the SIRCA Monthly Prices database. Finally, we
obtain analyst target price data from IBES.5 Our initial sample consists of 8010 firm-year observations in the intersection of the
DatAnalysis Premium, Connect4 and SIRCA Price databases. This initial sample has a significant number of missing values of the
dependent and independent variables used in the study. For example, the number of missing values of cash conversion cycle amounts
to more than 40% of the initial sample. We therefore lose 3448 observations with missing values of the variables of interest. We
exclude financial institutions and utility firms from our sample. This leads to a further loss of 160 observations. Following convention,
we winsorise our variables of interest in the 1st and 99th percentiles of their distribution. Our sample consists of 4422 firm-year
observations with non-missing values of our financial constraint variable. We present our sample selection criteria in Panel A of
Table 3.
Table 3, Panel B presents descriptive statistics for some important variables. We see that the mean (median) value of FC is 0.427
(0.426). This suggests that 0.43% of the words used by Australian firms are constraining words, as defined by Bodnaruk et al. (2015).
This contrasts with the results reported by Bodnaruk et al. (2015) for their sample of US firms – Bodnaruk et al. (2015) report a mean
value of 0.69 for their full sample. Since ours is the first paper to use this measure of financial constraints for Australian firms, we do
not have a benchmark to evaluate these numbers. The higher proportion of constraining words for US firms could be on account of
the fact that the US environment is highly litigious. This would naturally cause management to use more defensive language.
However, untabulated results show that the financial constraint measure is significantly correlated with financial leverage (0.329).
This is consistent with the fact that debt is positively correlated with financial constraint (Buehlmaier and Whited, 2018). We further
find that our measure of financial constraints is significantly negatively correlated with return on assets (−0.061), consistent with
financial constraints being negatively associated with profitability (Campello et al., 2010). This validates our financial constraint
measure.
The mean (median) cash conversion cycle is 87.442 (20.186) days. Since days payables had a large number of extreme values, we
winsorised days payable at the 1st and 90th percentiles of its distribution.6 The mean (median) cash ratio is 0.222 (0.126), suggesting
that the average cash balance of Australian firms is approximately 22%. The mean (median) current ratio is 5.482 (1.820), and the
mean (median) quick ratio is 5.128 (1.360). This is consistent with Xu et al. (2013).
The mean total assets of our sample firms is $45.90 million, suggesting that larger firms dominate our sample. The mean market-
to-book ratio is 3.146, and the mean leverage is 0.777. Our descriptive statistics are generally consistent with prior studies that use
Australian data–for instance, Fergusson et al. (2019), Xu et al. (2013), Kent et al. (2010).
We present the industry distribution of our sample in Panel C of Table 3. The Table shows that firms in the materials sector
account for most observations, followed by firms in the energy, industrials, healthcare and consumer discretionary sectors. This is
consistent with the general distribution of firms in the Morningstar DatAnalysis Premium database.
4. Empirical tests
4.1. Working capital management and financial constraints
We report the results for Hypothesis 1 (the association between working capital management and financial constraints) in Table 4.
Recall that we estimate Eq. (1) to test the hypothesis and that we predict a negative (positive) coefficient on WCM for cash ratio (cash
conversion cycle) – Table 4, Panel A (Panel B). Columns 1–3 of Panel A present results for WCMt−1 – WCMt−3 respectively. Consistent
with expectations, we find that the coefficient on WCM is negative in all three columns (coefficient = −0.031, −0.036, and −0.042
5
We use the IBES data only for additional analyses. Our final sample is much smaller if we use the IBES data.
6
Winsorising at the conventional 1st and 99th percentiles produces a large negative mean cash conversion cycle, although the median is still
positive. Our results do not change as a result of winsorising days payable at the 90th percentile.
7
Table 3
Description of the sample
Details N
Panel A: sample selection
Initial Sample in the intersection of the DatAnalysis Premium, Connect4 and SIRCA Price databases 8010
Less:
Missing values of key variables 3448
Financial Institutions and Utilities 160
Total 4402
P25 Mean Median P75 SD
Panel B: descriptive statistics
FC 0.352 0.427 0.426 0.502 0.117

CCC −62.474 87.442 20.186 74.472 1468.828
CashRatio 0.045 0.222 0.126 0.312 0.240
QuickRatio 0.800 5.128 1.360 3.450 28.993
CurrentRatio 1.120 5.482 1.820 3.930 28.980
Size 16.008 17.642 17.336 19.128 2.303
MTB 0.862 3.146 1.620 3.293 4.865
Lev 0.123 0.777 0.348 0.814 1.370
Std_Ret 0.088 0.174 0.134 0.208 0.153
ROA −0.24 −0.241 0.000 0.080 0.828
AFP 0.867 6.162 2.175 5.300 13.026
P 0.100 2.645 0.390 2.105 7.839
SA_Index −1.207 0.058 −0.317 1.002 1.790
Industry N Mean Median Std Dev
Panel C: industry distribution
Communications 144 0.434 0.432 0.117

Consumer discretionary 374 0.417 0.418 0.126
Consumer staples 137 0.429 0.445 0.102
Energy 602 0.433 0.434 0.116
Healthcare 470 0.417 0.416 0.111
Industrials 521 0.443 0.437 0.130
Information technology 261 0.408 0.416 0.116
Materials 1732 0.434 0.432 0.113
Real estate 181 0.366 0.364 0.116
Total 4422 0.427 0.427 0.117
The Table above presents the industry distribution for our sample of Australian firms for the period 2000–2016. The sample does not include
financial institutions and utility firms. The sample consists of 4422 firm-year observations with non-missing values of the financial constraint
variable. We present detailed variable definitions in Table 2
respectively; p-value = 0.000 in all columns). This suggests that firms with higher cash ratios are less likely to face financial con-
straints in the next three years. Consistent with Bodnaruk et al. (2015), we find that the coefficients on MTB and Size are negative
(coefficient = −0.001, and −0.008 respectively; p-value = 0.001 and 0.000 respectively).7 Consistent with Korajczyk and Levy
(2003), we find that the coefficient on Lev is positive (coefficient = 0.003; p-value = 0.038).
From Panel B, we note that the coefficient on WCM is positive for all columns 1 and 2 (coefficient = 0.026, and respectively; p-
value = 0.006, and 0.001 respectively). This suggests that high cash conversion cycle increases the extent of financial constraint in
the next two years. Stated differently, our results suggest that low cash conversion cycle reduces the extent of financial constraint
over the next two years. This result is consistent with Panel A, and further supports Hypothesis 1. The signs and significances on the
control variables are consistent with Panel A above.
4.2. Working capital management and future share price
We report the results for Hypothesis 2 (examining how efficient working capital management affects the future price of financially
constrained firms) in Table 5. Recall that we divide our sample into terciles of the cash ratio and cash conversion cycle and estimate
Eq. (2) for each tercile in order to test Hypothesis 2. Hypothesis 2 predicts that the negative association between financial constraints
7
For brevity, we only describe results for the first column.
8
Table 4
Cash ratio and financial constraints
CashRatio in year
t-1 t-2 t-3
Panel A: Cash ratio
WCM −0.031∗∗∗ −0.036∗∗∗ −0.042∗∗∗

(0.000) (0.000) (0.000)
MTB −0.001∗∗ −0.002∗∗ −0.002∗∗
(0.001) (0.002) (0.002)
Size −0.008∗∗∗ −0.008∗∗∗ −0.008∗∗∗
(0.000) (0.000) (0.000)
Lev 0.003∗∗ 0.006∗∗∗ 0.006∗∗∗
(0.038) (0.000) (0.001)
ROA 0.001 0.000 0.004
(0.828) (0.957) (0.431)
StdRet −0.013 −0.015 0.001
(0.316) (0.212) (0.927)
Constant 0.397∗∗∗ 0.413∗∗∗ 0.459∗∗∗
(0.000) (0.000) (0.000)
Observations 4334 4015 3634
Industry and year effect Included Included Included
Adjusted R2 0.299 0.261 0.191
CCC in year
t-1 t-2 t-3
Panel B: Cash conversion cycle
WCM 0.026∗∗ 0.029∗∗∗ 0.012

(0.006) (0.001) (0.274)
MTB −0.003∗∗∗ −0.003∗∗∗ −0.003∗∗∗
(0.000) (0.000) (0.000)
Size −0.007∗∗∗ −0.007∗∗∗ −0.007∗∗∗
(0.000) (0.000) (0.000)
Lev 0.005∗∗ 0.008∗∗∗ 0.008∗∗∗
(0.000) (0.000) (0.000)
ROA −0.005 −0.005 0.000
(0.259) (0.467) (0.987)
StdRet −0.002 −0.012 0.006
(0.913) (0.408) (0.736)
Constant 0.359∗∗∗ 0.375∗∗∗ 0.415∗∗∗
(0.000) (0.000) (0.000)
Adjusted R2 0.350 0.305 0.217
, and ∗∗ represent statistical significance at the 1% and 5% levels of significance respectively. The p-values (presented in parentheses) are
∗∗∗
based on heteroscedasticity-adjusted robust standard errors.

The Table above presents results of the equation below, testing the association between financial constraints and working capital manage-
ment. In this Table, we use the cash conversion cycle (CCC) to measure working capital management:
FCit = 0 + 1 WCMit n + 2 MTBit + 3 Sizeit + 4 Levit + 5 ROAit + 6 StdRetit + j j Indj + t t Yeart + it
All variables are defined in Table 2.
and future share price would be less negative for the highest (lowest) tercile of the cash ratio (cash conversion cycle). We present
results for the cash ratio in Panel A of Table 5. Columns 1–3 present the results of the estimation of Eq. (2) for tercile 1–3 of the cash
ratio respectively. From Panel A, we note that the coefficient on FC is negative in column 1 (coefficient = −2.961; p- value = 0.023),
suggesting that financially constrained firms have lower valuations. However, when we consider Columns 2 and 3, we see that the
coefficient on FC is not significant (p-value = 0.406 and 0.613). This suggests that for firms with high cash ratios, financial con-
straints do not negatively affect firm value, consistent with the idea that good working capital management reduces the negative
impact of financial constraints on firm value. We note that the coefficient on MTB, Size, and StdRet are positive (coefficient = 0.025,
0.228, and 0.003 respectively; p-value = 0.001, 0.000, and 0.014). These results are consistent with prior research (see for example,
Barth et al., 2017).
From Panel B, we see that the coefficient on FC is negative for column 2 (coefficient = −5.695; p- value = 0.003), suggesting that
financially constrained firms have lower valuations when their cash conversion cycles are moderately high. We note, however, that
the coefficient on FC in Column 1 is positive, suggesting that financial constraints do not negatively affect firm value for firms with
9
Table 5
Cash ratio, financial constraints and future share price.
Cash ratio terciles
Tercile 1 Tercile 2 Tercile 3
Panel A: cash ratio
FC −2.961∗∗ −2.815 −0.398

(0.023) (0.406) (0.613)
MTB 0.427∗∗∗ 0.948∗∗∗ 0.158∗∗∗
(0.000) (0.000) (0.000)
Size 1.180∗∗∗ 2.208∗∗∗ 0.854∗∗∗
(0.000) (0.000) (0.000)
Lev −0.421∗∗∗ −1.559∗∗∗ −0.244∗∗∗
(0.001) (0.000) (0.001)
ROA −0.158 −0.741 0.146
(0.596) (0.103) (0.259)
StdRet −2.949∗∗ 0.996 0.449
(0.006) (0.462) (0.407)
Constant −19.270∗∗∗ −42.310∗∗∗ −10.590∗∗
(0.000) (0.000) (0.002)
Adjusted R2 0.385 0.315 0.619
CCC Terciles
Panel B: cash conversion cycle
FC 1.127∗ −5.695∗∗ −0.423

(0.090) (0.003) (0.897)
MTB 0.142∗∗∗ 0.500∗∗∗ 0.603∗∗∗
(0.000) (0.000) (0.000)
Size 0.759∗∗∗ 1.642∗∗∗ 1.691∗∗∗
(0.000) (0.000) (0.000)
Lev −0.345∗∗∗ −0.652∗∗ −0.800∗∗∗
(0.000) (0.003) (0.001)
ROA 0.009 −0.078 0.555
(0.919) (0.860) (0.257)
StdRet −0.098 −2.549∗∗ −1.482
(0.854) (0.006) (0.261)
Constant −15.450∗∗∗ −28.590∗∗∗ −31.220∗∗∗
(0.000) (0.000) (0.000)
Adjusted R2 0.598 0.304 0.355
∗∗∗, ∗∗, and ∗ represent statistical significance at the 1%, 5% and 10% levels of significance respectively. The p-values (presented in
parentheses) are based on heteroscedasticity-adjusted robust standard errors.
The Table above presents results of the equation below, testing how working capital management moderates the association between
financial constraints and future share price (P). In this Table, we use the cash conversion cycle (CCC) to measure working capital man-
agement: Pit + 1 = 0 + 1 FCit + 2 MTBit + 3 Sizeit + 4 Levit + 5 ROAit + 6 StdRetit + j j Indj + t t Yeart + it
low cash conversion cycles (coefficient = 1.127; p-values = 0.090). Untabulated results suggest that the coefficient on column 1 is
significantly greater than that in Column 3 (p-value = 0.000), suggesting that the market views efficient working capital manage-
ment favourably. Seen in conjunction with the results in Table 4, these results highlight the importance of good working capital
management, and echo the sentiments of practitioners described above.
4.3. Additional analysis
We now examine whether financial analysts recognise the importance of good working capital management. Specifically, do
analysts consider the efficiency of a firm's working capital management in setting target prices, when the firm is financially con-
strained? This is an important analysis because analysts are superior users of financial information and serve an important inter-
mediary role in capital markets. A large volume of research (see for example, Beyer et al., 2010) shows that financial analysts shape
market expectations by generating quality equity recommendation and forecasts. To perform this additional test, we replace Pt+1 in
10
Table 6
Cash ratio, financial constraints and analyst target price.
CashRatio terciles
Panel A: cash ratio
FC −0.949∗∗ −0.343 −0.231

(0.036) (0.572) (0.422)
MTB 0.049∗∗∗ 0.148∗∗∗ 0.080∗∗∗
(0.001) (0.000) (0.000)
Size 0.223∗∗∗ 0.317∗∗∗ 0.231∗∗∗
(0.000) (0.000) (0.000)
Lev −0.106∗∗ −0.272∗∗∗ −0.129∗∗∗
(0.019) (0.000) (0.000)
ROA 0.744∗∗ 0.212 −0.087
(0.013) (0.482) (0.622)
StdRet −0.460∗ −0.029 −0.266
(0.051) (0.934) (0.265)
Constant −2.414∗∗∗ −5.386∗∗∗ −3.993∗∗∗
(0.000) (0.000) (0.000)
Adjusted R2 0.472 0.592 0.497
CCC Terciles
Panel B: cash conversion cycle
FC −0.077 −1.160∗∗ −0.092

MTB (0.870) (0.001) (0.843)
0.087∗∗∗ 0.105∗∗∗ 0.098∗∗∗
Size (0.000) (0.000) (0.000)
0.201∗∗∗ 0.327∗∗∗ 0.274∗∗∗
Lev (0.000) (0.000) (0.000)
−0.131∗∗∗ −0.303∗∗∗ −0.143∗
ROA (0.000) (0.000) (0.068)
0.208 0.298 0.395
StdRet (0.232) (0.414) (0.136)
0.007 −0.617∗∗∗ 0.244
Constant (0.990) (0.000) (0.430)
−2.946∗∗∗ −5.322∗∗∗ −4.154∗∗∗
Observations (0.000) (0.000) (0.000)
383 469 472
Adjusted R2 0.478 0.617 0.528
The Table above presents results of the equation below, testing how the association between financial constraints and analyst target
price (AFP) is moderated by working capital management. In this Table, we use the cash conversion cycle (CCC) to measure working
capital management:
AFPit + 1 = 0 + 1 FCit + 2 MTBit + 3 Sizeit + 4 Levit + 5 ROAit + 6 StdRetit + j j Indj + t t Yeart + it
Eq. (2) with analysts' one-year ahead target prices (AFPt+1) and then we follow the procedure described above for testing
Hypothesis 2. If analysts do recognise the importance of good working capital management, we predict that their target prices would
be lower for firms with lower (higher) cash ratios (cash conversion cycles). We present these results in Table 6.
We present results for the three terciles of cash ratio in the three columns of Panel A, Table 6. We see from Table 8 that the
coefficient on FC is negative for the lowest tercile of cash ratio (coefficient = −0.949; p-value = 0.036). It is not significant in
Columns 2 and 3 (p-value = 0.0.422 and 0.572 respectively). This is consistent with the results reported in Table 5, and suggests that
analysts set lower target prices for financially constrained firms with lower cash ratios, consistent with the idea that such firms are
more likely to face liquidity issues in the future. In contrast, the insignificant coefficient on FC for the high cash ratio firms suggests
that analysts believe that financial constraints are unlikely to have lasting impacts on these firms, since they have higher liquidity and
would likely be able to see through the period of financial constraints. The signs and significances of the control variables are
consistent with those reported in Table 5 above.
11
We present results for the cash conversion cycle in Panel B, Table 8. As in Panel A above, we present results for the three terciles of
the cash conversion cycle in the three columns of Panel B. We note from the Table, that the coefficient on FC is negative and
significant in column 2 (coefficient = −1.160 respectively; p-value = 0.001). It is not significant in Column 1 (p-value = .140).
Although the coefficient on FC is not significant in column 3 (p-value = 0.843), the fact that the coefficient is not significant in
column 1 suggests that analysts believe that financially constrained firms with low cash conversion cycles to be less likely to face
liquidity issues in the future. Therefore, they do not lower target prices for such firms. Our results also suggest that analysts do not
seem to consider very high cash conversion cycles to impact value when firms are financially constrained. By itself, this result is
difficult to explain. However, when we consider the results for cash ratio in Panel A above, we could argue that if financially
constrained firms with high cash conversion cycles have large cash balances, it likely alleviates analysts' concerns about liquidity for
such firms. Our results in Table 6 generally verify the main results in Table 5 above. They also contribute to the literature by
providing evidence that analysts do appear to factor in working capital, when issuing target price forecasts.
5. Robustness tests
We perform important robustness tests in this study. Specifically, we replicate our main results by using an alternate measure of
financial constraints. Next, we use alternate measures of working capital management. We also test the robustness of our results by
explicitly controlling for the period of the Global Financial Crisis. Finally, we acknowledge that financial constraints might influence
working capital management and test whether the direction of the association flows from financial constraints to working capital,
rather than the other way, as presented in our main tests.
5.1. Alternate measures of working capital management
We now replicate Table 4 with an alternate proxy of financial constraints – the current ratio (Laurent, 1979). Higher values of
current ratio suggests higher liquidity, and thus better working capital management. We present these results in Tables 7 and 8.
Table 7 shows the results of Hypothesis 1 – the association between working capital management and financial constraints. Recall
that Hypothesis 1 predicts that firms with better working capital management are less likely to have financial constraints in the
future. Accordingly, we expect a negative association between current ratio and financial constraints, i.e., we expect the coefficient β1
in Eq. (1) to be negative. We see from the Table that the coefficient on WC is negative in columns 1 and 2 (t − 1, and t − 2),
suggesting that firms with higher current ratios are less likely to be financially constrained over the next two years (coeffi-
cient = −0.047, and −0.044 respectively; p-value = 0.004, and 0.033 respectively). This is consistent with Table 4 above.
We present the results of Hypothesis 2 in Table 8. Hypothesis 2 predicts that the negative association between financial con-
straints and future share price is lower for firms with more efficient working capital management. As discussed above, we estimate
Eq. (2) to test the Hypothesis. Following the approach above, we divide our sample into terciles of current ratio, and estimate Eq. (2)
for each tercile. Hypothesis 2 predicts that the coefficient on FC (β1) is less negative for tercile 3 of current ratio, since firms in tercile
Table 7
Current ratio and financial constraints.
CR in year
t-1 t-2 t-3
WCM −0.047∗∗ −0.044∗∗ −0.007

(0.004) (0.033) (0.691)
MTB −0.002∗∗∗ −0.002∗∗∗ −0.002∗∗∗
(0.000) (0.000) (0.000)
Size −0.006∗∗∗ −0.006∗∗∗ −0.005∗∗∗
(0.000) (0.000) (0.000)
Lev 0.007∗∗∗ 0.010∗∗∗ 0.010∗∗∗
(0.000) (0.000) (0.000)
ROA 0.006 0.004 0.007
(0.147) (0.372) (0.174)
StdRet −0.017 −0.021∗ −0.004
(0.169) (0.072) (0.755)
Constant 0.354∗∗∗ 0.368∗∗∗ 0.405∗∗∗
(0.000) (0.000) (0.000)
Adjusted R2 0.278 0.243 0.171
The Table above presents results of the equation below, testing the association between financial constraints and working capital
management. In this Table, we use the current ratio (CR) to measure working capital management:
FCit = 0 + 1 WCMit n + 2 MTBit + 3 Sizeit + 4 Levit + 5 ROAit + 6 StdRetit + j j Indj + t t Yeart + it .
12
Table 8
Current ratio, financial constraints and future share price.
FC −3.605∗∗ −0.767 −1.931∗

(0.031) (0.759) (0.092)
MTB 0.369∗∗∗ 0.707∗∗∗ 0.277∗∗∗
(0.000) (0.000) (0.000)
Size 1.465∗∗∗ 1.732∗∗∗ 0.813∗∗∗
(0.000) (0.000) (0.000)
Lev −0.471∗∗∗ −1.417∗∗ −1.488∗
(0.000) (0.011) (0.058)
ROA −0.240 0.964 0.163
(0.203) (0.184) (0.335)
StdRet −0.913 −3.276∗∗ −0.143
(0.415) (0.025) (0.759)
Constant −25.450 −31.440∗∗∗ −12.940∗∗∗
(0.000) (0.000) (0.000)
Observations 1,008 1,086 1,077
Industry and Year Effect Included Included Included
Adjusted R2 0.419 0.198 0.695
, , and ∗ represent statistical significance at the 1%, 5% and 10% levels of significance respectively. The p-values (presented in
∗∗∗ ∗∗

The Table above presents results of the equation below, testing how the association between financial constraints and future share price
(P) is moderated by working capital management. In this Table, we use the current ratio (CR) to measure working capital management:
Pit + 1 = 0 + 1 FCit + 2 MTBit + 3 Sizeit + 4 Levit + 5 ROAit + 6 StdRetit + j j Indj + t t Yeart + it
3 have the highest levels of current ratio, and therefore have the most efficient working capital management. We find from Table 8
that the esti- mated coefficient 1is negative for terciles 1 and 3 of current ratio (coefficient = −3.605 and −1.931 respectively; p-
value = 0.031, and 0.092 respectively). We also find that 1 is significantly more negative for terciles 1 than 3 (p-value = 0.000).
This suggests that financial constraints affect firm value significantly more negatively for firms with poorer working capital man-
agement, consistent with the results reported in Table 5 above.
5.2. The Hadlock and Pierce (2010) SA index as an alternate proxy for financial constraints
Bodnaruk et al. (2015) argue that their measure of financial constraints (our main measure) is superior to other commonly used
financial constraint proxies. However, we check the robustness of our results using the SA Index of Hadlock and Pierce (2010) as an
alternate measure of financial constraints. Unlike the Bodnaruk et al. (2015) measure, the SA Index is not text-based. Rather, it is
based on the size and age of the firm. We replicate our results in Table 3 using this alternate measure of financial constraints. We
present results in Table 9. Table 9 presents the results for Hypothesis 1, using the SA Index. It shows that the coefficient on WC is
positive for all three columns (t – 1 to t − 3) when we use the cash ratio as the proxy of working capital management, suggesting that
firms with higher cash ratios are more likely to be financially constrained over the next three years (coefficient = 0.312, 0.390, and
0.461 respectively; p-value = 0.000 in all three columns). In contrast, the coefficient on WC is negative when we use the cash
conversion cycle (coefficient = −0.106, −0.143, and −0.224 respectively; p-value = 0.084, 0.067, and 0.013 respectively). This is
not consistent with Tables 3–4. However, this result is not surprising because the SA Index is a poor proxy of financial constraint.
Indeed, as Bodnaruk et al. (2015) show, the SA Index (and similar measures) predict liquidity events very poorly.
5.3. Controlling for the effect of the global financial crisis
Our sample period includes the period of the Global Financial Crisis (2008–2009). Although Australia was not significantly
affected by the crisis, it could be argued that Australian firms with exposure to affected markets would feel the effect of the crisis.
Thus, they might use the constraining words more frequently during this period. If this is so, it could affect our empirical result. To
rule out this effect, we now explicitly control for the crisis period. Specifically, we modify Eq. (1) as follows:
FCit = 0 + 1 FCit n + 2 MTBit + 3 Sizeit + 4 Levit + 5 ROAit + 6 StdRetit + 7 GFCt + j Indj + t Yeart + it
j t (3)
In Eq. (3) above, GFCt is a dummy variable equal to 1 for the years 2008 and 2009; it is zero otherwise. We present these results in
Table 10, Panel A. Column 1 of Table 10 reports results for the cash ratio and Column 2 for the cash conversion cycle. We note that
the coefficient on GFC is positive (coefficient = 0.245 and 0.246 respectively; p-value = 0.000 and 0.000 respectively), suggesting
that the period of GFC increased the likelihood of the firm being financially constrained one year later. The Table also shows that the
coefficient on cash ratio is negative (coefficient = −0.035; p-value = 0.000) and that on the cash conversion cycle is positive
(coefficient = 0.026; p- value = 0.006), consistent with Tables 4–5 above. This shows that our results are not driven by the crisis.
13
Table 9
Working capital management and financial constraints: using the Hadlock and Pierce (2010) SA index.
CashRatio in year CCC in year
t-1 t-2 t-3 t-1 t-2 t-3
WCM 0.312∗∗∗ 0.390∗∗∗ 0.461∗∗∗ −0.106∗ −0.143∗ −0.224∗∗

(0.000) (0.000) (0.000) (0.084) (0.067) (0.013)
MTB 0.025∗∗∗ 0.030∗∗∗ 0.030∗∗∗ 0.030∗∗∗ 0.038∗∗∗ 0.037∗∗∗
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Size 0.819∗∗∗ 0.815∗∗∗ 0.811∗∗∗ 0.813∗∗∗ 0.803∗∗∗ 0.794∗∗∗
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Lev −0.040∗∗∗ −0.047∗∗∗ −0.041∗∗ −0.053∗∗∗ −0.062∗∗∗ −0.059∗∗∗
(0.000) (0.000) (0.006) (0.000) (0.000) (0.000)
ROA −0.135∗∗∗ −0.141∗∗∗ −0.118∗∗ −0.142∗∗∗ −0.118∗∗∗ −0.086∗∗
(0.000) (0.000) (0.002) (0.000) (0.000) (0.014)
StdRet 0.361∗∗∗ 0.331∗∗∗ 0.236∗∗ 0.319∗∗∗ 0.262∗∗ 0.186⁎
(0.000) (0.001) (0.028) (0.000) (0.003) (0.060)
Constant −14.530∗∗∗ −14.490∗∗∗ −14.390∗∗∗ −14.380∗∗∗ −14.230∗∗∗ −14.050∗∗∗
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Observations 4017 3542 3105 4687 4224 3786
Industry and year effect Included Included Included Included Included Included
Adjusted R2 0.889 0.858 0.832 0.885 0.850 0.820
, , and ∗ represent statistical significance at the 1%, 5%, and 10% levels of significance respectively. The p-values (presented in parentheses) are
∗∗∗ ∗∗
based on heteroscedasticity-adjusted robust standard errors.

The Table above presents results of the equation below, testing the association between financial constraints and working capital management. In
this Table, we use the cash ratio (CashRatio) and cash conversion cycle (CCC) to measure working capital management:
FCit = 0 + 1 WCMit 1 + 2 MTBit + 3 Sizeit + 4 Levit + 5 ROAit + 6 StdRetit + j j Indj + t t Yeart + it
Table 10
Working capital management and financial constraints: controlling for the global
financial crisis
CashRatio CCC
Panel A: with year fixed effects

WCM −0.035∗∗∗ 0.026∗∗∗
(0.000) (0.006)
MTB −0.003∗∗∗ −0.00-
2∗∗∗
(0.000) (0.000)
Size −0.007∗∗∗ −0.00-
8∗∗∗
(0.000) (0.000)
Lev 0.005∗∗ 0.003∗∗
(0.005) (0.046)
ROA −0.005 −0.005
(0.259) (0.241)
StdRet −0.002 −0.002
(0.913) (0.888)
GFC 0.245∗∗ 0.246∗∗∗
(0.000) (0.000)
Constant 0.359∗∗∗ 0.393∗∗∗
(0.000) (0.000)
Observations 2990 2990
Industry and Included Included
year effect
Adjusted R2 0.350 0.352
Panel B: Without GFC years

WCM −0.035∗∗∗ 0.026∗∗∗
(0.000) (0.006)
MTB −0.007∗∗∗ −0.00-
8∗∗∗
(0.000) (0.000)
Size 0.004∗∗ 0.003
(0.027) (0.144)
Lev −0.002 −0.001
(0.686) (0.690)
(continued on next page)
14
Table 10 (continued)
CashRatio CCC
ROA −0.014 −0.014

(0.418) (0.407)
StdRet −0.007∗∗∗ −0.00-
8∗∗∗
(0.000) (0.000)
Constant 0.361∗∗∗ 0.396∗∗∗
(0.000) (0.000)
Industry and Included Included
year effect
Adjusted R2 0.370 0.368
∗∗∗, and ∗∗ represent statistical significance at the 1% and 5% levels of significance respectively. The p-values
(presented in parentheses) are based on heteroscedasticity-adjusted robust standard errors.
The Table above presents results of the equation below, testing the association between financial constraints and
working capital management. In this Table, we use the cash ratio (CashRatio) and cash conversion cycle (CCC) to
measure working capital management:
Table 11
The effect of financial constraints on future working capital management.
CashRatio CCC
FC −0.050 −0.020
(0.206) (0.455)
MTB 0.012∗∗∗ 0.000
(0.000) (0.775)
Size −0.037∗∗∗ −0.003∗∗∗
(0.000) (0.035)
Lev −0.034∗∗∗ −0.005∗∗∗
(0.000) (0.001)
ROA −0.028∗∗ 0.019∗∗
(0.020) (0.001)
StdRet −0.026 −0.009
(0.321) (0.646)
Constant 0.869∗∗∗ 0.092∗∗
(0.000) (0.017)
Industry and year effect Included Included
Adjusted R2 0.324 0.009
∗∗∗, and ∗∗ represent statistical significance at the 1% and 5% levels of significance respectively.
The p-values (presented in parentheses) are based on heteroscedasticity-adjusted robust standard
errors.
The Table above presents results of the equation below, testing the association between financial
constraints and working capital management. In this Table, we use the cash ratio (CashRatio) and
cash conversion cycle (CCC) to measure working capital management:
WCMit = 0 + 1 FCit n + 2 MTBit + 3 Sizeit + 4 Levit + 5 ROAit + 6 StdRetit + j j Indj + t t Yeart + it
15
Table 12
Using propensity score matching to control for endogeneity in working capital management
Variable Mean (High) Mean (Low) Median (High) Median (Low) p-value
Panel A: descriptive statistics of observable characteristics
Size 17.953 17.963 17.530 17.690 0.920

MTB 2.540 2.480 1.490 1.720 0.620
Lev 0.640 0.630 0.340 0.350 0.790
CashRatio CCC
Panel B: Working capital management and future financial constraints
WCM −0.036⁎⁎⁎ 0.025⁎⁎⁎

(0.001) (0.002)
MTB −0.004⁎⁎⁎ −0.003⁎⁎⁎
(0.000) (0.000)
Size −0.007⁎⁎⁎ −0.008⁎⁎⁎
(0.000) (0.000)
Lev 0.006⁎⁎⁎ 0.005⁎⁎
(0.009) (0.037)
ROA −0.008 −0.009
(0.158) (0.138)
StdRet 0.001 0.001
(0.956) (0.956)
Constant 0.354⁎⁎⁎ 0.388⁎⁎⁎
(0.000) (0.000)
Adjusted R2 0.350 0.352
⁎⁎⁎
, and ⁎⁎ represent statistical significance at the 1% and 5% levels of significance respectively. The p-values (presented
in parentheses) are based on heteroscedasticity-adjusted robust standard errors.
The Table above presents results of the equation below, testing the association between financial constraints and working
capital management. In this Table, we use the cash ratio (CashRatio) and cash conversion cycle (CCC) to measure working
capital management:
We also test for the effect of GFC by re-estimating Eq. (1) for the non-GFC years only. We present these results in Panel B of
Table 10. We present results for cash ratio (cash conversion cycle) in column 1 (column 2). Consistent with Table 4, we find that the
coefficient on cash ratio is negative (coefficient = −0.037; p-value = 0.000) and that on cash conversion cycle is positive (coeffi-
cient = 0.028; p-value = 0.006).
5.4. Testing whether financial constraints reduce the efficiency of working capital management
Hypothesis 1 above tests the notion that firms with more efficient working capital management practices would be less likely to
be financially constrained in the future. However, one could plausibly argue that the existence of financial constraints could have an
adverse effect on working capital policy. Indeed, Fazzari and Petersen (1993) show that financial constraints negatively affect the
investment in working capital. Fazzari and Petersen (1993), however, examine whether financially constrained firms reduce their
investment in working capital in the current period. As discussed above, we study whether current working capital management is
associated with the firm facing financial constraints in future. Therefore, it is unlikely that our empirical results would be affected by
the contemporaneous effect of financial constraints on working capital investment.
However, to rule out this possibility explicitly, we now examine how financial constraints affect future working capital invest-
ment. Specifically, we estimate the following model:
WCMit = 0 + 1 FCit n + 2 MTBit + 3 Sizeit + 4 Levit + 5 ROAit + 6 StdRetit + j Indj + t Yeart + it

j t (4)
In Eq. (4) above, the dependent variable is working capital management (cash ratio and cash conversion cycle) and the in-
dependent variable of interest is financial constraints. If the argument that current financial constraints affects future working capital
management adversely is true, we would observe a negative (positive) coefficient on financial constraints when the dependent
variable is cash ratio (cash conversion cycle). We present these results in Table 11. The dependent variable in Column 1 (2) is cash
ratio (cash conversion cycle). The Table shows that the coefficient on FCit is not significant (p-value = 0.455 and 0.206 respectively).
This suggests that current financial constraints do not affect future working capital management. This result alleviates concerns that
there might be reverse causality, i.e., future working capital management might be affected by current financial constraints.
16
Table 13
Working capital management and future financial constraints with firm fixed effects.
Working capital proxy
CashRatio CCC
WCM −0.023⁎ 0.017⁎⁎

(0.064) (0.035)
MTB −0.002⁎⁎⁎ −0.002⁎⁎⁎
(0.000) (0.000)
Size −0.004⁎ −0.005⁎
(0.100) (0.056)
Lev 0.004⁎ 0.003
(0.065) (0.113)
ROA 0.000 0.001
(0.962) (0.882)
StdRet −0.011 −0.011
(0.459) (0.458)
Constant 0.281⁎⁎⁎ 0.298⁎⁎⁎
(0.000) (0.000)
Firm and year effect Included Included
Adjusted R2 0.649 0.650
, and ⁎⁎ represent statistical significance at the 1% and 5% levels of significance respectively.

⁎⁎⁎
The p-values (presented in parentheses) are based on heteroscedasticity-adjusted robust stan-

dard errors.
The Table above presents results of the equation below, testing the association between fi-
nancial constraints and working capital management. In this Table, we use the cash ratio
(CashRatio) and cash conversion cycle (CCC) to measure working capital management:
FCit = 0 + 1 WCMit 1 + 2 MTBit + 3 Sizeit + 4 Levit + 5 ROAit + 6 StdRetit + i i Firmi + t t Yeart + it
5.5. Potential endogeneity in working capital management: propensity score matching
It is possible that firms with high working capital have certain other characteristics that reduce their likelihood of facing financial
constraints in the future. To address this issue we use a propensity score matching approach to identify a sample of control firms that
do not differ on other observable characteristics. Specifically, we estimate the following logit model:
Highit = 0 + 1 Sizeit + 2 MTBit + 3 Levit + j Indj + t Yeart + it

j t (5)
In Eq. (5) above, Highit is a dummy variable equal to 1 if the firm has a lower cash conversion cycle than the median of the
distribution for each year and industry; 0 otherwise. We use three explanatory variables in the model – size, market-to-book ratio, and
leverage to account for observable firm characteristics that might affect working capital management. We also include industry and
year fixed effects in the model. We form our matched sample based on the propensity score generated by the first-stage estimate
from Eq. (5). For each high working capital management firm, we identify one control firm with the closest propensity score within a
caliper of 0.001. We use this approach following prior research (Rosenbaum and Rubin, 1983). We then estimate Eq. (1) above on the
propensity score matched sample.
We present the results for the propensity score matched sample in Table 12. Panel A of Table 12 compares the descriptive statistics
of the observable firm characteristics for the high and low working capital samples. As the Table shows, the two samples are not
significantly different in terms of size (p-value = 0.920), market-to-book ratio (p-value = 0.620) and leverage (p-value = 0.790). We
present the results of Eq. (1) in Panel B of Table 12. The first (second) column describes the results for the cash ratio (cash conversion
cycle). For brevity, we only report results for financial constraints one year ahead. As the Table shows, the coefficient on cash ratio
(cash conversion cycle) is negative (positive) – coefficient = −0.036 (0.001); p-value = 0.038 (0.024). This is consistent with our
main results above.
5.6. Controlling for the effect of potential unobservable factors on financial constraints
Although we have included many control variables in our regressions, it is possible that there are some unobservable factors that
affect financial constraints. Not controlling for these factors could potentially cause us to over-estimate the effect of working capital
management on future financial constraints. Since it is difficult to identify the unobservable factors, we include firm effects in Eq. (1)
above in place of industry fixed effects and re-estimate the model. We present the results in Table 13. We show results for cash ratio in
column 1 and cash conversion cycle in column 2. Consistent with Table 4, we find that the coefficient on cash ratio is negative
(coefficient = −0.023; p-value = 0.064), and that on cash conversion cycle is positive (coefficient = 0.017; p-value = 0.035). These
17
results provide further support for our hypothesis.
6. Conclusion
We examine whether efficient working capital management reduces the likelihood of firms facing financial constraints in the
future. Prior research (for instance, Campello et al., 2010; Almeida and Campello, 2007) shows that financial constraints negatively
affect firms' investment and that they could lead to firms exiting the market (Musso and Schiavo, 2008). Given the serious impact of
financial constraints on firms' prospects, it is important to understand whether the likelihood of financial constraints could be reduced
by suitable corporate strategy. We examine the role of working capital management in this context.
Working capital is an important source of liquidity (Fazzari and Petersen, 1993). Therefore, managing working capital efficiently
helps firms tide over adverse economic periods and increase shareholder value (Zeidan and Shapir, 2017). Working capital man-
agement involves managing both the amount of working capital and the cash conversion cycle. However, extant literature has
typically examined only one aspect of working capital management. In our study, we focus on both the level of working capital (we
focus primarily on the cash ratio) and the cash conversion cycle and examine how efficient working capital management affects the
likelihood of firms facing financial constraints up to two years into the future. Using a new text-based measure of financial constraints
based on a recent study by Bodnaruk et al. (2015), and focusing on a sample of firms listed on the Australian Stock Exchange, we
show that a high (low) cash ratio (cash conversion cycle) significantly reduces the likelihood of financial constraints up to two years
into the future. This suggests that efficient management of working capital can reduce the likelihood of firms facing financial
constraints in the future.
We examine the benefits of working capital management further by next examining whether financially constrained firms with
more efficient working capital policies enjoy higher valuations. Our conjecture is based on the notion that more efficient working
capital management allows firms to absorb the liquidity shocks created by financial constraints. Prior research (Ding et al., 2013)
shows that financially constrained firms with more investment in working capital can invest to a significantly greater degree than
those with lower investment in working capital. We find that financially constrained firms with higher (lower) cash ratios (cash
conversion cycles) tend to have higher one year ahead prices and higher analyst target prices, suggesting that efficient working
capital policies can mitigate the adverse effects of financial constraints on firm value.
Our study is timely given recent reports by PricewaterhouseCoopers (PwC) and EY on the deteriorating trend of working capital
performance by firms in the US, Europe and Australia.8 Specifically, the 2018/19 Working Capital Report by PricewaterhouseCoopers
reveals that firms seem to be managing cash flows by cutting back on capital expenditure.9 This has potentially adverse consequences
for long-term growth. The PwC survey suggests that firms could pay for a 55 per- cent increase in capital expenditure by managing
working capital efficiently. This highlights the importance of our study. Our findings will therefore be of interest to practitioners, as it
provides large scale empirical evidence on the benefits of efficient working capital management.
Our study has an important caveat.10 Although our measure of financial constraints is based on prior research (Bodnaruk et al.,
2015), it may not always capture financial constraints. Indeed, it is possible that some of the words that appear in the list, for
example, “obligation” could be used to convey some other information. For instance, a company outlining that it does not have any
more financial obligation towards a lender does convey a positive message. We recognise this as a limitation of our study.
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Pacific-Basin Finance Journal 58 (2019) 101212

Contents lists available at ScienceDirect

Pacific-Basin Finance Journal

Efficient working capital management, financial constraints and

ARTICLE INFO ABSTRACT

2. Literature, hypotheses and research methodology

2.1. Working capital management

2.2. Financial constraints

2.4. Research methodology

2.4.1. Measuring financial constraints

2.4.2. Measuring working capital management

2.4.3. Model to test Hypothesis 1

FCit = 0 + 1 WCMit n + 2 MTBit + 3 Sizeit + 4 Levit + 5 ROAit + 6 StdRetit + j Indj + t Yeart + it

2.4.4. Model to test Hypothesis 2

Pit + 1 = 0 + 1 FCit + 2 MTBit + 3 Sizeit + 4 Levit + 5 ROAit + 6 StdRetit + j Indj + t Yeart + it

4.1. Working capital management and financial constraints

Panel A: sample selection

P25 Mean Median P75 SD

Panel B: descriptive statistics

FC 0.352 0.427 0.426 0.502 0.117

Industry N Mean Median Std Dev

Panel C: industry distribution

Communications 144 0.434 0.432 0.117

4.2. Working capital management and future share price

t-1 t-2 t-3

Panel A: Cash ratio

WCM −0.031∗∗∗ −0.036∗∗∗ −0.042∗∗∗

t-1 t-2 t-3

Panel B: Cash conversion cycle

WCM 0.026∗∗ 0.029∗∗∗ 0.012

based on heteroscedasticity-adjusted robust standard errors.

Tercile 1 Tercile 2 Tercile 3

Panel A: cash ratio

FC −2.961∗∗ −2.815 −0.398

Tercile 1 Tercile 2 Tercile 3

Panel B: cash conversion cycle

FC 1.127∗ −5.695∗∗ −0.423

4.3. Additional analysis

Tercile 1 Tercile 2 Tercile 3

Panel A: cash ratio

FC −0.949∗∗ −0.343 −0.231

Tercile 1 Tercile 2 Tercile 3

Panel B: cash conversion cycle

FC −0.077 −1.160∗∗ −0.092

5.1. Alternate measures of working capital management

t-1 t-2 t-3

WCM −0.047∗∗ −0.044∗∗ −0.007

FC −3.605∗∗ −0.767 −1.931∗

parentheses) are based on heteroscedasticity-adjusted robust standard errors.

5.3. Controlling for the effect of the global financial crisis

t-1 t-2 t-3 t-1 t-2 t-3

WCM 0.312∗∗∗ 0.390∗∗∗ 0.461∗∗∗ −0.106∗ −0.143∗ −0.224∗∗

based on heteroscedasticity-adjusted robust standard errors.

Panel A: with year fixed effects

Panel B: Without GFC years

ROA −0.014 −0.014

Panel A: descriptive statistics of observable characteristics

Size 17.953 17.963 17.530 17.690 0.920

Panel B: Working capital management and future financial constraints

WCM −0.036⁎⁎⁎ 0.025⁎⁎⁎

WCMit = 0 + 1 FCit n + 2 MTBit + 3 Sizeit + 4 Levit + 5 ROAit + 6 StdRetit + j Indj + t Yeart + it

WCM −0.023⁎ 0.017⁎⁎

, and ⁎⁎ represent statistical significance at the 1% and 5% levels of significance respectively.