**3. The relationship between short-term debt usage in WCR financing and profitability**

Working capital financing strategies depends on the extent of utilization of short-term or long-term financing sources in funding working capital. Under an aggressive financing strategy, the firm funds its temporary working capital and a part of its permanent working capital with short-term debt, whereas under a conservative financing strategy, the firm funds its permanent working capital and a part of temporary working capital with long-term debt. The hedging approach, on the other hand, lies in the middle of these two approaches in which the firm funds its permanent working capital with long-term debt and temporary working capital with short-term debt. The effects of these approaches on profitability and risk are different. While aggressive approaches provide the highest profitability with the highest risk, the conservative approaches provide the lowest profit with the lowest risk. As for the profitability and risk, hedging approach lies in the middle [16].

When the working capital requirement is heavily financed through short-term debt, it provides various cost advantages to firms. The first advantage comes from the fact that the nominal interest rates on short-term debt are generally lower than the interest rates on long-term debt. The difference is called as the term premium. The term premium, which is the total of inflation and default premiums, increases as debt maturity lengthens. Since the inflation uncertainty rises with maturity, the inflation premium of short-term debt is lower than the inflation premium of long-term debt. The default premium of short-term debt is also lower than the default premium of long-term debt, because it is charged for one period. The shareholder-creditor conflict is limited in this short period of time. These types of agency conflicts can be immediately compensated by charging higher interest rates at the end of short maturities. For all of these reasons, the default premium on short-term debt is less than the default premium on long-term debt [17].<sup>3</sup>

Another cost advantage of short-term debt is that firms that use short-term funds only borrow the amount that they need. So, the interest that is paid on short-term funds is the interest cost of the money that is actually used. This is especially important for the firms that have seasonal fluctuations in their current assets. However, in terms of long-term debt, firms may borrow more than their needs.

The third cost advantage of short-term debt is related to agency costs. Short-term debt requires making periodical payments and declaring periodical information about the main operations of the firms. Myers stated that short-term debt usage decreases underinvestment and asset substitution problems [18]. Also, Stulz noted that short-term debt is a strong device in the monitoring of management [19]. In a theoretical model developed by Rajan and Winton, it is shown that management can be monitored with minimum effort using short-term funds [20]. As a result, it can be said that short-term debt usage decreases agency costs.

In addition to all of the cost advantages stated above, there are refinancing and interest rate risks of using short-term funds. At the end of short-term debt maturity, the firms that use short-term funds may need new funds and can obtain new funds from the current interest rates that exist on the market. Refinancing may be more difficult for the firms that currently have high short-term debt-to-WCR ratios. Since the default risk is higher for these firms, the lenders may charge higher interest rates for bearing that risk. Short-term borrowing can negatively affect profitability in such cases.

To sum up, the cost advantage of using short-term funds depends on the current proportion of WCR that is financed with short-term debt. If a firm currently has a low short-term debt-to-WCR ratio, additional short-term borrowing will decrease costs and increase profitability. However, if the stated ratio is high, additional borrowing will increase the costs of the firm—due to the increased financial risk—and therefore hamper profitability. Based on these reasons, we expect a concave-shaped relation (reversed U-shaped relation) between the proportion of short-term funds in WCR financing and profitability. The first aim of this study is to reveal whether the expected relationship exists in chemical, petroleum, rubber, and plastic sector of Istanbul Stock Exchange in the period analyzed. The results obtained from the analysis show the peak point up to which short-term debt-to-WCR ratios increase profitability.

Financial flexibility is defined as the ability to react to the unexpected changes of cash flows and investment opportunities by obtaining and using the minimum cost funds [21]. When compared to other firms, financially flexible firms can utilize the minimum cost funds whenever they need. Due to the difference of such firms in obtaining short-term funds, it is expected that the cost advantage of short-term debt prevails up to higher short-term debtto-WCR ratios. In another saying, it is expected that the breakpoint occurs at higher levels of short-term debt-to-WCR ratios for that type of firms [8].

<sup>3</sup> The default premium on long-term debt is higher especially for the financially weak firms. Since the shareholder-creditor conflict is higher in these types of firms, this increases the default premium [17].

#### **3.1. Data and methodology**

can be immediately compensated by charging higher interest rates at the end of short maturities. For all of these reasons, the default premium on short-term debt is less than the default

Another cost advantage of short-term debt is that firms that use short-term funds only borrow the amount that they need. So, the interest that is paid on short-term funds is the interest cost of the money that is actually used. This is especially important for the firms that have seasonal fluctuations in their current assets. However, in terms of long-term debt, firms may borrow

The third cost advantage of short-term debt is related to agency costs. Short-term debt requires making periodical payments and declaring periodical information about the main operations of the firms. Myers stated that short-term debt usage decreases underinvestment and asset substitution problems [18]. Also, Stulz noted that short-term debt is a strong device in the monitoring of management [19]. In a theoretical model developed by Rajan and Winton, it is shown that management can be monitored with minimum effort using short-term funds [20].

In addition to all of the cost advantages stated above, there are refinancing and interest rate risks of using short-term funds. At the end of short-term debt maturity, the firms that use short-term funds may need new funds and can obtain new funds from the current interest rates that exist on the market. Refinancing may be more difficult for the firms that currently have high short-term debt-to-WCR ratios. Since the default risk is higher for these firms, the lenders may charge higher interest rates for bearing that risk. Short-term borrowing can nega-

To sum up, the cost advantage of using short-term funds depends on the current proportion of WCR that is financed with short-term debt. If a firm currently has a low short-term debt-to-WCR ratio, additional short-term borrowing will decrease costs and increase profitability. However, if the stated ratio is high, additional borrowing will increase the costs of the firm—due to the increased financial risk—and therefore hamper profitability. Based on these reasons, we expect a concave-shaped relation (reversed U-shaped relation) between the proportion of short-term funds in WCR financing and profitability. The first aim of this study is to reveal whether the expected relationship exists in chemical, petroleum, rubber, and plastic sector of Istanbul Stock Exchange in the period analyzed. The results obtained from the analysis show the peak point up to which short-term debt-to-WCR ratios increase profitability.

Financial flexibility is defined as the ability to react to the unexpected changes of cash flows and investment opportunities by obtaining and using the minimum cost funds [21]. When compared to other firms, financially flexible firms can utilize the minimum cost funds whenever they need. Due to the difference of such firms in obtaining short-term funds, it is expected that the cost advantage of short-term debt prevails up to higher short-term debtto-WCR ratios. In another saying, it is expected that the breakpoint occurs at higher levels of

The default premium on long-term debt is higher especially for the financially weak firms. Since the shareholder-creditor

As a result, it can be said that short-term debt usage decreases agency costs.

premium on long-term debt [17].<sup>3</sup>

180 Financial Management from an Emerging Market Perspective

tively affect profitability in such cases.

short-term debt-to-WCR ratios for that type of firms [8].

conflict is higher in these types of firms, this increases the default premium [17].

3

more than their needs.

In this study, 25 manufacturing firms that were quoted to Borsa Istanbul over the 2005–2016 period are analyzed. The balance sheets and income statements are obtained from the "Data Stream" database. The observations with negative WCF are excluded from the analysis.

The study is conducted using panel data analysis. As explained by Kennedy, there are four main advantages of using this method. One advantage is that panel data analysis controls for heterogeneity among firms. Uncontrolled heterogeneity may lead to omitted variable problems. Secondly, the time series dimension of panel data reduces the problems associated with multicollinearity. Thirdly, panel data analysis permits the testing of hypotheses that cannot be solely tested by time series or cross-sectional analysis alone. Finally, since panel data analysis takes into account dynamic adaptation processes, it has advantages over both time series and cross-sectional analyses [22].

Due to the endogeneity problem, the two-step generalized method of moments (GMM) method based on the study of Arellano-Bond is utilized in this study [23]. The endogeneity problem arises when the correlation between the independent variables and the error term is different than zero. The best way to solve this problem is to use instrumental variables [24]. Since the least squares method leads to biased results when instrumental variables are used, two-step least squares or GMM methods are generally preferred. The models that are used in this study are estimated using the Arellano-Bond estimator.<sup>4</sup>

Following the study of Banos-Caberollo, Garcia-Teruel, and Martinez-Solano, the following model is constructed (Model 1) [8]:

$$\text{ROE}\_{\downarrow t} = \beta\_0 + \beta\_1 \text{WCF}\_{\downarrow t-1} + \beta\_2 \text{WCF}\_{\downarrow t-1}^2 + \beta\_3 \text{SIZE}\_{\downarrow t-1} + \text{B}\_4 \text{GROWTH}\_{\downarrow t-1} + \beta\_5 \text{LEV}\_{\downarrow t-1} + \varepsilon\_{\downarrow t} \tag{1}$$

The dependent variable ROEi,t is the return on equity and is calculated by dividing net profit by total equity. WCFi,t−1 is a variable that shows the proportion of WCR that is financed with short-term financial debt. Working capital requirement is calculated by subtracting accounts payable from current assets. Since the expected theoretical relationship between ROEi,t and WCFi,t−1 is nonlinear, the square of WCFi,t−1 is added to the model. The positive and negative effects of short-term financing can be determined by using WCFi,t−1 and the square of WCFi,t−1. The SIZEi,t−1 variable measures the natural logarithm of total assets, and it is added to the model in order to control the firm size. GROWTHi,t−1 shows the growth in sales and is calculated by dividing the difference between sales in year t and in year t−1 to the sales in year t−1. GROWTHi,t−1 is added to the model to control for the growth rates of the firms. The last control variable is LEVi,t−1, and it is calculated by dividing total debt by total assets. Ɛi,t is the error term. All of the independent variables are used in their 1-year lagged forms (**Table 1**).

The negative WCFi,t−1 values are excluded from the analysis. The breakpoint is mathematically calculated by −β\_\_\_1 2 β<sup>2</sup> equation. If there exist a concave relation between the proportion of WCR

<sup>4</sup> See Greene for details about the Arellano-Bond estimator [25].


**Table 1.** Variable definitions.

that is financed with short-term debt and profitability, β<sup>1</sup> is expected to be positive, whereas β2 is expected to be negative.

After the calculation of breakpoint using Model 1, dummy variables WCFLi,t−1 and WCFLi,t−1 are added to the Model 1 for the firms that have low and high WCFi,t−1 values. If the value of WCFi,t−1 is between zero and the breakpoint, the dummy variable WCFLi,t−1 takes the value of WCFi,t−1; otherwise, WCFLi,t−1 takes the value of the breakpoint. The other dummy variable WCFHi,t−1, takes the value of the difference between WCFi,t−1 and breakpoint if WCFi,t−1 is greater than the breakpoint; otherwise, WCFH i,t-1 takes the value of zero.

Following Ghosh and Moon, Banos-Caballero, Garcia-Teruel, and Martinez-Solano, the robustness of the findings in Model 1 is checked by utilizing the following model [8, 26]:

$$\text{ROE}\_{\natural t} = \beta\_0 + \beta\_1 \text{WCFL}\_{\natural t-1} + \beta\_2 \text{WCFH}\_{\natural t-1} + \beta\_3 \text{SIZE}\_{\natural t-1} + \text{B}\_4 \text{GROWTH}\_{\natural t-1} + \beta\_5 \text{LEV}\_{\natural t-1} + \varepsilon\_{\natural t} \tag{2}$$

Many studies pointed out the importance of low leverage ratios in providing financial flexibility (see [27–29]), while many others stated the importance of holding medium or high levels of cash [30–32]. Some studies showed that both leverage and cash ratios have a role in providing financial flexibility ([21, 33, 34]). In this study firstly firms are grouped according to their cash ratios. The firms that have cash ratio above the median value are accepted as "financially flexible." Secondly, the firms are grouped based on their leverage ratios. The firms that have leverage ratios below the median value are accepted as "financially flexible." In the third categorization, we combined the cash and leverage ratios. The firms that have leverage ratios in the bottom 75% of all firms and cash ratios in the top 75% of all firms are accepted as financially flexible. The dummy variables take the value of 1 if a firm is financially flexible; otherwise, they take the value of zero:

$$\begin{array}{c} \text{ROE}\_{\downarrow t} = \beta\_0 + (\beta\_1 + \delta\_1 \, \text{DUM}\_{\downarrow t-1}) \text{WCF}\_{\downarrow t} + (\beta\_2 + \delta\_2 \, \text{DUM}\_{\downarrow t-1}) \text{WCF}^2\_{\downarrow t-1} + \beta\_3 \, \text{SIZE}\_{\downarrow t} + \\ \text{B}\_4 \, \text{GROWTH}\_{\downarrow t+1} + \beta\_5 \, \text{LEV}\_{\downarrow t+1} + \varepsilon\_{\downarrow t} \end{array} \tag{3}$$

The breakpoint is determined by using the equation −(*β*<sup>1</sup> <sup>+</sup> *<sup>δ</sup>*<sup>2</sup> )/2(*β*<sup>2</sup> <sup>+</sup> *<sup>δ</sup>*<sup>2</sup> ).
