An Analysis of the Working Capital Management

As the trends in development of financial management increases, none bears more weight than working capital. The possibility of every business activity rests on daily changes in receivables, inventory, and payables. It’s the lifeblood of the business, and every financial manager’s primary task is to keep it moving and put capital to work efficiently and effectively. (The faster a business expands, the more cash it will need to fund working capital and investment. Good management of working capital will generate cash, help to improve profits, solidify relationships with suppliers and customers, and reduce risks.

When it comes to managing working capital, time is money. If you can get money to move faster-speed the cash conversion cycle- by, say, reducing the amount of money tied up in inventory or accounts receivable, the liquidity of the business increases and incremental cash flow can be generated. Likewise, the business may be able to reduce its debt and interest expenses. If you can negotiate improved terms with suppliers, e.g., obtain longer terms; you can leverage financial resources in new ways. Money trapped in working capital is money not being used to grow.) (Harvest CFO) The working capital implies the short-term financial requirements of a business enterprise. It is a trading (current) capital, and not retained in the business for future more than a year. The form and substance of the money invested in it changes during the normal business operations period. The need for maintaining an adequate working capital can hardly be questioned.

Just as circulation of blood is very necessary in the human body to maintain life, the flow of funds is very necessary to maintain business. If it becomes weak, the business can hardly prosper and survive. Working capital starvation is generally credited as a major cause if not the major cause of small business failure in many developed and developing countries (Rafuse, 1996). The success of a firm depends ultimately, on its ability to generate cash receipts in excess of disbursements.

The cash flow problems of many small businesses are exacerbated by poor financial management and in particular the lack of planning cash requirements (Jarvis et al, 1996). The management of working capital is crucial to the financial health of businesses of all sizes. Since the amounts invested in working capital are usually high with respect to the total assets employed therefore; it is important that these amounts are used in an efficient and effective way. The importance of putting tight control over working capital investment is difficult to overstate. While the performance levels of small businesses have traditionally been attributed to general managerial factors such as manufacturing, marketing and operations, working capital management may have a consequent impact on small business survival and growth (Kargar and Blumenthal, 1994). A firm can be very profitable, however if this is not translated into cash from operations within the same operating cycle, the firm would need to borrow to support its continued working capital needs.

Thus, the twin objectives of profitability and liquidity must be coordinated and one should not impose on the other for long. Investments in current assets are unavoidable to ensure delivery of goods or services to the ultimate customers and a proper management of same should give the desired impact on either profitability or liquidity. If resources are fruitless at the different stage of the supply chain, this will delay the cash operating cycle. Although this might increase profitability owing to increase sales, it may also negatively affect the profitability if the costs tied up in working capital exceed the benefits of holding more inventory and/or compromise more trade credit to customers. One more component of working capital is accounts payable, however it is different in the sense that it does not use resources; instead it is often used as a short term source of finance. It actually helps firms to reduce its cash conversion cycle, but it has an hidden cost where discount is offered for early settlement of invoices. Keys to effective working capital management include: ! Manage accounts payable to match receivables ! Leverage suppliers’ and customers’ operations to improve your cash management ! Tie compensation to working capital improvement ! Look for alternative financing to get receivables off the books (factoring) ! Develop a culture that strives for continuous improvement

Measures of Working Capital Management Efficiency

The WCM processes involve important decisions on various aspects, including the investment of available cash, to maintain a certain level of inventory, managing accounts receivables, and account payables. however, we must understand WCM is not limited to these tasks, but is involved in various levels of interactions both internally and between external parties (suppliers, customers, distributors, bankers and retailers). For instance, the credit officers may be required to investigate credit history of their clients to understand their financial worth. Moreover, WCM can be divided into four crucial components, i.e. Accounts receivables, Inventory turnover, and payables management. Today, we see in any financial report the WCM is defined as ( current assets minus current liabilities), it shows the firm’s investment in cash, marketable securities, accounts receivable, and inventories less the current liabilities used to finance the current assets. For Instance, The net off of the Current Assets and current liabilities is called the Working Capital Management. I will use net-trade cycle (NTC) as a measure of working capital management in this study, in order to measure cash conversion cycle (CCC). The components of this calculation are as follows: Days Sales Outstanding: Measures average collection period for sales.

Computed as trade receivables, the Net of allowance for doubtful accounts, plus financial receivables, divided by net sales per day. A decrease in DSO represents an improvement, an increase indicate deterioration. DSO = Accounts Receivable / Total Credit Sales * 365 Days Sales of Inventory: Measures average time required to convert materials into finished goods and then to sell those goods. Computed as inventories divided by sales* per day. A decrease in DSI represents an improvement, an increase indicates deterioration. DSI = Inventory / Costs of goods sold * 365 Days Payable Outstanding: Measures average payment period for purchases and costs. Computed as trade payables divided by sales per day. An increase in DPO represent an improvement, a decrease indicates deterioration. DPO = Accounts Payable / Costs of goods sold * 365 Cash Conversion Cycle: The cash conversion cycle is the time between the acquisition of a raw material and the receipt of payment for the finished product. Thus, a firm’s average cash conversion cycle is calculated by adding DSO to DSI and subtracting DPO. The cash conversion cycle is a measure for the efficiency of working capital management as it indicates how quickly current assets are converted into cash. CCC = (DSO + DSI) – DPO The cash conversion cycle (CCC) provides management with a good measure as to how long the company must fund its operating cycle. For example, if your salespeople are using payment terms as sales incentives, resulting in DSO of 55 days, your inventory turns every 40 days and you pay suppliers in 30 days, then your cash conversion cycle is 65 days (55 DSO + 40 DII – 30 DPO). In other words, you will need to fund this period with either debt or equity capital (including retained earnings), which carries a cost.

The goal of the business is to minimize its cash conversion cycle, and thereby reduce the amount of outstanding working capital. This requires examining each component of CCC discussed above and taking actions to improve each element. To the extent this can be achieved without increasing costs or depressing sales, they should be carried out.

Many companies have experienced noticeable working capital improvements by wrapping the goals of improving cash flow and working capital into their compensation programs. Motivated employees that see their year-end paycheck affected by what they are able to do in this area gives the biggest bang for the buck. (Harvest CFO)

Review of the past studies

(Ganesan Vedavinayagam 2007) used net-trade cycle (NTC) as a measure of working capital management. NTC is basically equal to the CCC whereby all three components are expressed as a percentage of sales. The reason by using NTC because it can be an easy device to estimate for additional financing needs with regard to working capital expressed as a function of the projected sales growth. He examined the relationship between working capital management efficiency and profitability using correlation and regression analyses. ANOVA analysis is done to study the impact of working capital management on profitability by using a sample of 443 annual financial statements of 349 telecommunication equipment companies covering the period of 2001-2007. The study of Ganesan Vedavinayagam has found evidence that even though “days working capital” is negatively related to the profitability, it is not significantly impacting the profitability of firms in telecommunication equipment industry. He found that the Overall working capital management efficiency in telecommunication industry is poor. And he recommended that the telecommunication industry should improve working capital management efficiency by concentrating on reducing inventory and improving DPO by getting more credits from suppliers. (Abel Maxime 2008) highlighted the impact of working capital management on cash holdings of small and medium-sized manufacturing enterprises in Sweden.

The aim of this work was to theoretically identify significant factors related to working capital management which influence on the cash level of SMEs and (Abel Maxime) tested these in a large sample of Swedish manufacturing SMEs. The empirical investigation consisted of the statistical analysis; He compared the means and analyzed it with correlation analysis. He took the data from financial statements of the sample. The sample contained 13,287 Swedish manufacturing SMEs of the legal form ‘Aktiebolag’. He empirically found that working capital management efficiency, measured by the cash conversion cycle (CCC) is positively related to cash level. The findings were highlighted with respect to their potential utility for the achievement and maintenance of a firm’s target cash level. (Padachi Kesseven 2006) examined the trends in working capital management and its impact on firms’ performance, He took the dependant variable was return on total assets, as a measure of profitability and the relation between working capital management and corporate profitability is investigated for a sample of 58 small manufacturing firms, using panel data analysis for the period 1998 – 2003. He used the Statistical test Regression Analysis. The regression results showed that high investment in inventories and receivables is associated with lower profitability. The key variables used in the analysis were inventories days, accounts receivables days, accounts payable days and cash conversion cycle (CCC). He found that there is a strong significant relationship between working capital management and profitability in empirical analysis. An analysis of the liquidity, profitability and operational efficiency of the five industries showed significant changes and how best practices in the paper industry had contributed to performance.

The findings also revealed an increasing trend in the short-term component of working capital financing. (VIJAYAKUMAR A. and VENKATACHALAM A. 1996) studied, one major public sector sugar industry namely Tamilnadu Sugar Corporation (TASCO) . The period of study was from 1985-86 to 1993-94. The study covered the aspects of working capital analysis. (i) Component wise analysis (ii) Financing of working capital (iii) Trends of working capital and (iv) Working capital’s impact on profitability. The data for the study was collected from the annual reports of the selected units.

Statistical techniques namely co-efficient of correlation and multiple regression were used in the study. They tried to establish definite relationships between working capital ratios and profitability ratio; he applied correlation and multiple regression analysis between the variables. In the analysis, working capital ratios were taken as independent variables and Profit before tax as the dependant variable. The study of (VIJAYAKUMAR A. VENKATACHALAM A. 1996) indicated a moderate trend in the financial position and the utilization of working capital, He suggested that variations in working capital size should be avoided and attempts should also be made to use funds more effectively, by keeping an optimum level of working capital. Because, keeping more current assets causes a reduction in profitability.

Hence efforts should be made to ensure a positive trend in the estimation and maintenance of the working capital. (Zariyawati M. A., Annuar M. N., and Abdul Rahim A.S. 2006) empirically investigated the relationship between working capital management and firm profitability; they used the Cash conversion cycle as measure of working capital management. This study was used panel data of 1628 firm-year for the period of 1996-2006 that consisted of six different economic sectors which were listed in Bursa Malaysia. The data was collected from the database which consisted of financial statements of the listed firms in Bursa Malaysia. ((Operating income + depreciation)/total) asset as measure of profitability was used as the dependent variable. With regards to the independent variables, working capital management was measured by cash conversion cycle (CCC). The results were, the coefficient results of Pooled regression analysis provide a strong negative significant relationship between cash conversion cycle and firm profitability. This reveals that reducing cash conversion period results to profitability increase.

And they suggested that, in intention to create shareholder value, firm manager should concern on shorten of cash conversion cycle till accomplish optimal level. (Ramachandran Ramachandran, and Janakiraman Muralidharan 2006) analyzed the relationship between Working Capital Management Efficiency and Earnings before Interest& Taxes, of the Paper Industry in India during 1997-1998 to 2005-2006. To measure the Working Capital Management Efficiency, the Performance Index, Utilization Index, and Efficiency Index were computed, and were associated with explanatory variables, Cash Conversion Cycle, Accounts Payable Days, Accounts Receivables Days, Inventory Days, additional, Fixed Financial Assets Ratio, Financial Debt Ratio, and Size (Natural log of Sales) were considered as control variables in the analysis and were associated with the EBIT. The result implied that the Paper Industry has managed the working capital satisfactorily. The Accounts Payable Days has a significant (-)ve relationship with EBIT, which indicates that by deploying payment to suppliers they improve the EBIT. The Paper Industry in India performs remarkably well during the period, however, less profitable firms wait longer to pay their bills, and pursue a decrease in Cash Conversion Cycle. (Nobanee Haitham, and AlHajjar Maryam 2004) selected the 2123 Japanese non-financial firms listed in the Tokyo Stock Exchange for the period 1990-2004, to investigate the the relationship between working capital management and firm profitability. They regressed the cash conversion cycle, the receivable collection period, the inventory conversion period and the payable deferral period against return on investment (separately) for the full period and for each year of the study. A nonparametric correlation (Spearman) was also used to examine the relation between the variables of this study. The results suggested that managers can increase profitability of their firms by shortening the cash conversion cycle, the receivable collection period and the inventory conversion period, and managers can also increase the profitability of their firms by lengthening the payable deferral period.

And they also suggested that managers should be careful when lengthening the payable deferral period because this could damage the firm’s credit reputation and harm its profitability in the long run. (Mathuva, David M 2009) examined the influence of the working capital management components on corporate profitability, he chosen the sample of 30 listed firms of Nairobi Stock exchange (NSE) for the period of 1993 and 2008. In analysis both the pooled OLS and regression model were used, and He found that, there is a significant negative relationship between the time it takes for firms to collect cash from the customers. There existed a highly positive relation between the period taken to convert inventories to convert into sales. The means the firms that maintain sufficiently high inventory levels reduce cost of possible interruption in the production process and loss of the business due to scarcity of the products. This reduces the firm’s supply costs and protects them against price fluctuations. There existed the positive relationship between the time it takes to firm to pay its creditors the (average payment period) and profitability.

This implies that the longer the firm takes to pay its creditors the higher the profitable it is. (Smith and Begemann 1997) emphasized that those who promoted working capital theory shared that profitability and liquidity comprised the salient goals of working capital management. The problem arose because the maximization of the firm’s returns could seriously threaten its liquidity, and the pursuit of liquidity had a tendency to dilute returns.

This article evaluated the association between traditional and alternative working capital measures and return on investment (ROI), specifically in industrial firms listed on the Johannesburg Stock Exchange (JSE). The problem under investigation was to establish whether the more recently developed alternative working capital concepts showed improved association with return on investment to that of traditional working capital ratios or not. Results indicated that there were no significant differences amongst the years with respect to the independent variables. The results of their stepwise regression corroborated that total current liabilities divided by funds flow accounted for most of the variability in Return on Investment (ROI). The statistical test results showed that a traditional working capital leverage ratio, current liabilities divided by funds flow, displayed the greatest associations with return on investment. Well known liquidity concepts such as the current and quick ratios registered insignificant associations whilst only one of the newer working capital concepts, the comprehensive liquidity index, indicated significant associations with return on investment. I have reviewed the literature to set the base for the further study of the issue.

Several past studies show that working capital is the backbone for the firms, and must be efficiently utilized in order for the profitability, Most of the researchers have taken their stock exchanges to get the data for the firms in the shape of financial statements and then calculated CCC to analyze further with the statistical analysis, Mostly, Correlation, Multiple regression analysis are used in the researches however some have used ANOVA (The analyses of Variance) in their studies to investigate the impact of Working Capital Management on Profitability.

Cite this page