Can Trade-Off Theory Explain Net Working Capital Management Decisions?

Abstract

This study applies a partial-adjustment model to test how well trade-off theory explains net working capital management decisions and examines working capital management dynamics. The results indicate that firms have long-run NWC targets and tend to gradually converge to the target from the firm's initial net working capital level within each period. We estimate that typical firms close approximately 50% of the gap between their actual and target net working capital each year. Such high adjustment speed implies that a typical firm closes half of a deviation from the target in about 13 months. Our results show that the trade-off theory can explain the management decisions regarding working capital holdings.