# **1 Introduction**

Financial constraints are a prevailing problem facing firms in developing countries where capital is scarce and financial institutions are underdeveloped.<sup>1</sup> The World Bank Investment Climate Surveys, covering more than 26,000 firms across 53 developing countries, find that the cost and access to finance<sup>2</sup> is considered by firms to be among the top five problems they face (Hallward-Driemeier and Smith (2005)). The functioning of financial markets and the availability of credit affect the ability of firms to grow. They also influence the firms’ incentives to hire labor and invest, which in turn affect economic growth and poverty reduction.

An often ignored mechanism by which financial constraints can affect the firm is working capital. Working capital is needed to cover costs of operations before revenue is received. For example, the farmer needs to purchase seeds and fertilizer before his crop is harvested, the garment maker must buy fabric and pay workers before delivering the clothing and the stall owner must pay for produce before it can be sold. The need for working capital thus arises from the difference in the timing of when costs are incurred and when revenue is received. In some instances, financial arrangements can help overcome the timing problem, either through prepayment of accounts receivable (i.e. online shopping) or delayed payment of current liabilities (i.e. trade credit<sup>3</sup> ), however the majority of production requires cash to purchase inputs before goods or services are delivered.<sup>4</sup> Working capital accounts for a substantial proportion of firms’ financial needs, particularly in developing countries. Working capital is therefore likely to be an important avenue by which financial constraints can affect firm behavior. Table 1 presents the amount of working capital relative to sales revenue held on average by a sample of firms in the US and in Bangladesh within similar manufacturing industries in 2002. Working capital is measured as the firms’ net short term liquid assets: current assets (inventories, accounts receivable<sup>5</sup> , cash and short term credit) minus current liabilities (accounts payable and any short term debt). On average, US firms hold approximately 22 percent of sales revenue as working capital while Bangladeshi firms hold on average 35 percent. Firms in Bangladesh rely more on non-cash working capital (mainly inventories) compared to US firms, which is consistent with less available credit. In Bangladesh, working capital is considerably greater than investment. The average cost of investment spending relative to sales is less than 5%.

Recent business cycle models of emerging economies have relied on working capital as a propagation mechanism to transmit interest rate shocks to real outcomes (see Neumeyer and Perri (2005); Oviedo (2004)). The responses to interest rate shocks are magnified in these models because the need for working capital imposes additional borrowing requirements. In these models, the firm is assumed to always borrow the entire cost of production. Internally generated revenue is not considered as a source of finance. My model incorporates the option of internal finance. Accounting for the role of internal revenue is critical for understanding working capital, as the delay in revenue is the very mechanism that creates the need for working capital. Allowing for internally generated

> 1Constraints to external finance may arise due to a number of factors: credit market imperfections, scarcity of financial resources, volatile environments or the lack of contract enforcement mechanisms. (Stiglitz & Weiss(1981)).

> 2Cost to finance refers to the interest rate charged for loans. Access to finance refers to the need for collateral and the availability of loans.

> 3An interesting body of literature looks at the role of trade credit in financial development. See Fisman and Love (2004); Fisman (2001); Fisman and Love (2003); Burkart and Ellingsen (2004)

> 4In the 2003-2005 Bangladesh Panel Survey of Manufacturing Firms, the median percent of sales paid at delivery is 100 percent.

> 5Accounts receivable is money owed to the firm.

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