The Impact of Working Capital Management on the Profitability of the Listed Companies in

the London Stock Exchange

Saswata Chatterjee
affiliation not provided to SSRN

April 10, 2010

     :Abstract

For the successful working of any business organization, fixed and current assets play a vital
role. Management of working capital is essential as it has a direct impact on profitability and
liquidity. Conventionally, it has been seen that, if a company desires to take a greater risk for
bigger profits and losses, it reduces the size of its working capital in relation to its sales. If it is
interested in improving its liquidity, it increases the level of its working capital. However, this
policy is likely to result in a reduction of the sales volume, therefore of profitability. Hence, a
company should strike a balance between liquidity and profitability. This study analyzes the
impact of working capital on the profitability for a sample of 30 UK companies listed in London
Stock Exchange for a period of 3 years from 2006-2008. The effect of different variables of
working capital management include the Average collection period or the receivable days,
Inventory turnover in days, Average payment period or the payable days, Cash conversion
cycle, Current ratio and Quick ratio on the Net operating profitability of the UK companies.
Debt ratio and the size of the firm (measured in terms of natural logarithm of sales) have also
been used as a comprehensive measure of the working capital management. Pearson’s
.correlation is used for this analysis

The results show that, there is a strong negative relationship between variables of the working
capital management and the profitability of the firm. It means that, as the cash conversion
cycle increases it will lead to decreasing profitability of the firm, and managers can create a
positive value for the shareholders by reducing the cash conversion cycle to a possible
minimum level. It is also found that, there is a significant negative relationship between the
liquidity and the profitability of the UK firms. However, there exists a positive relationship
between size of the firm and its profitability. Furthermore, there is also a significant negative
relationship between debt used by the firm and its profitability. The results suggest that, the
managers can increase corporate profitability by reducing the number of day’s accounts

.receivable and inventories. Less profitable firms wait longer to pay their bills
Net Working Capital (which is also known as “Working Capital” or the initials
“NWC”) is a measurement of the operating liquidity available for a company to use in
developing and growing its business. The working capital can be calculated very
simply by subtracting a company’s total current liabilities from its total current assets.

Through this formula, a working capital amount can be determined to be either

positive or negative. Naturally, this will rely largely on the amount of debt owed by
the company. It should not come as a surprise that having plenty of working capital
tends to help companies achieve more success. This follows because working capital
allows companies to grow smoothly and make necessary improvements to their
corporate operations.

On the other hand, companies that are operating with negative working capital may
not have the financial support or flexibility to grow and/or improve, even when such
developments would be indicated. Hence, working capital can be an indicator of the
overall strength of a company.

There are three main indicators used in calculating working capital. Elements of the
“current assets” side of the equation will include accounts receivable, as well as any
inventory of goods on-hand. “Current liabilities” will include accounts payable.

A positive change in a company’s working capital will generally indicate one of two
developments. Either the company has increased its current assets by receiving cash
(or some other form of assets), or it has minimized its liabilities – often by paying off
a short-term creditor.

More on this topic (What's this?)

Cash Conversion Cycle Case Studies (The Curious Investor, 8/26/09)

Liquidity Analysis Part 1: Net Working Capital (The Value at Risk, 11/6/09)

Changes in Working Capital in Free Cash Flow FCF (Old School Value, 11/27/09)

Read more on Working Capital at Wikinvest

Tagged as: Definition

Accounts receivable, or A/R, is an accounting term that means the detailing of

transactions with the billing of customers who owe money to an organization after the
purchase of goods and services. With most businesses, customers will typically get an
invoice that details the transaction and the time frame in which the invoice must be
paid. The invoice is usually mailed through the post office or sent via electronic mail.

One of the typical time frames for payment is called Net 30. Net 30 means that the
payment for the invoice is due 30 days from the date printed on the document. There
are other common payment terms which are Net 45 or Net 60. These are just
examples but any time period could be used if both the business and customer agree
on the time frame.
 Marking the transaction of a particular customer or client can be a simple task but the
process of maintaining the records of all transactions and payments received can
actually be a full time position. A typical practice among many industries is the
receipt of payments up to 10-15 days after the due date has been reached. These
standards are established due to particular industry standards or a policy within a type
of corporation or it could be because of the financial position of the client.

When detailing a company’s balance sheet, the account receivable number is the
amount that customers owe the company. This is a good way to know what your
projected revenue will be.

More on this topic (What's this?)

How to Analyze Receivables & Inventory (Old School Value, 2/11/10)

Protection From High Debt (The DIV-Net, 12/30/09)

One In Eight Dollars In Receivables During November Collection Period Has Been Written Off
As Unc... (Phil’s Stock World - Members S..., 1/14/10)

What Does Inventory Mean?

The raw materials, work-in-process goods and completely finished goods that are considered to be the portion of a business's assets that are
ready or will be ready for sale. Inventory represents one of the most important assets that most businesses possess, because the turnover of
inventory represents one of the primary sources of revenue generation and subsequent earnings for the company's shareholders/owners.

Investopedia explains Inventory

Possessing a high amount of inventory for long periods of time is not usually good for a business because of inventory storage, obsolescence
and spoilage costs. However, possessing too little inventory isn't good either, because the business runs the risk of losing out on potential sales
and potential market share as well.

Inventory management forecasts and strategies, such as a just-in-time inventory system, can help minimize inventory costs because goods are
created or received as inventory only when needed.

Related Terms

 Carrying Cost Of Inventory

 Economic Order Quantity - EOQ
 First In, First Out - FIFO
 First In, Still Here - FISH
 Highest In, First Out - HIFO
 Inventory Turnover
 Just In Time - JIT
 Last In, First Out - LIFO
 Periodic Inventory
 Physical Asset
 More Related Terms

Related Links

 Inventory Valuation For Investors: FIFO And LIFO - We go over these methods of calculating this component of the balance
sheet, and how the choice affects the bottom line.
 Understanding The Cash Conversion Cycle - Find out how a simple calculation can help you uncover the most efficient
companies.
 Measuring Company Efficiency - We look at a retailer's inventory turnaround times, its receivables as well as its collection period.
 Analyzing Retail Stocks - Hit the mall and shop for future investments.
 Read This Before You Sell - There are five tell-tale signs that show when to walk away from an investment.
 Operating Performance Ratios: Operating Cycle - An indepth look at the Operating Cycle Ratio, its calculations and comments.
 What are the generally accepted accounting principles for inventory reserves?
 Is an earnings surprise priced into the opening value by market makers?
Rate this Term:  Your Rating:

INTRODUCTION

For increasing shareholder's wealth a firm has to analyze the effect of fixed assets and
current assets on its return and risk. Working Capital Management is related with the
Management of current assets. The Management of current assets is different from
fixed assets on the basis of the following points:

1. Current assets are for short period while fixed assets are for more than one Year.

>2. The large holdings of current assets, especially cash, strengthens Liquidity
position but also reduces overall profitability, and to maintain an optimum level of
liquidity and profitability, risk return trade off is involved holding Current assets.

3. Only Current Assets can be adjusted with sales fluctuating in the short run. Thus,
the firm has greater degree of flexibility in managing current Assets. The management
of Current Assets helps affirm in building a good market reputation regarding its
business and economic condition.

Now first let us discuss the paradigms of Working Capital Management.

CONCEPT OF WORKING CAPITAL:

The concept of Working Capital includes Current Assets and Current Liabilities both.
There are two concepts of Working Capital they are Gross and Net Working Capital.

1. Gross Working Capital: Gross Working Capital refers to the firm's investment in
Current Assets. Current Assets are the assets, which can be converted into cash within
an accounting year or operating cycle. It includes cash, short-term securities, debtors
(account receivables or book debts), bills receivables and stock (inventory).

2. Net Working Capital: Net Working Capital refers to the difference between
Current Assets and Current Liabilities are those claims of outsiders, which are
expected to mature for payment within an accounting year. It includes creditors or
accounts payables, bills payables and outstanding expenses. Net Working Copulate
can be positive or negative. A positive Net Working Capital will arise when Courtney
Assets exceed Current Liabilities and vice versa.

Concept of Gross Working Capital

The concept of Gross Working Capital focuses attention on two aspects of Current
Assets' management. They are:

a) Way of optimizing investment in Current Assets.

b) Way of financing current assets.

a. Optimizing investment in Current Assets: Investment in Current Assets should
be just adequate i.e., neither in excess nor deficit because excess investment increases
liquidity but reduces profitability as idle investment earns nothing and inadequate
amount of working capital can threaten the solvency of the firm because of its
inability to meet its obligation. It is taken into consideration that the Working Capital
needs of the firm may be fluctuating with changing business activities which may
cause excess or shortage of Working Capital frequently and prompt management can
control the imbalances.

b. Way of financing Current Assets: This aspect points to the need of arranging
funds to finance Country Assets. It says whenever a need for working Capital arises;
financing arrangement should be made quickly. The financial manager should have
the knowledge of sources of the working Capital funds as wheel as investment
avenues where idle funds can be temporarily invested.

Concept of Net Working Capital

This is a qualitative concept. It indicates the liquidity position of and suggests the
extent to which working Capital needs may be financed by permanent sources of
funds. Current Assets should be optimally more than Courtney Liabilities. It also
covers the point of right combination of long term and short-term funds for financing
court Assents. For every firm a particular amount of net Working Capital in
permanent. Therefore it can be financed with long-term funds.

Thus both concepts, Gross and Net Working Capital, are equally important for the
efficient management of Working Capital. There are no specific rules to determine a
firm's Gross and Net Working Capital but it depends on the business activity of the
firm.

Working capital management is concerned with the problems that arise while
managing the current assets the current liabilities and the interrelationship that exits
between them. Thus, the WC management refers to all aspects of a administration of
both current assets the current liabilities.

Every business concern should not have neither redundant nor cause excess WC nor
into should be short of W.C. both condition are harmful and unprofitable for any
business. But out of these two the shortage of WC is more dangerous for the well
being of the firms.

Impact/Harm of Redundant Or Excessive Working Capital

* Excessive WC means idle funds, which earn no profits for the business, cannot earn
proper rate of return on its investment.

* When there is a redundant WC, it may lead to unnecessary purchasing and

accumulation of inventories causing more chances if theft, waste and losses.

* Excessive WC implies excessive debtors and defective credit policy, which may
cause higher incidences of bad debts.
* It may result into overall inefficiency in the organizations.

* When there is excessive WC relation with banks and other financial institutions may
not be maintained.

* The redundant WC gives rise to speculative transaction.

* Due to low rate of return on investments the value of shares may also fall.

* In case of redundant WC there is always a chance of financing long terms assets

from short terms funds, which is very harmful in long run for any organization.

Dangers of Short or Inadequate Working CapitalØ A concern, which had adequate

WC, cannot pay its short-term liabilities in time. Thus it will lose its reputation and
should be not be able to get good credit facilities.

* It cannot by its requirements in bulk and cannot avail of discounts. It stagnates

growth.

* It becomes difficult for the firms to exploit favorable market conditions and
undertake profitable projects due to non-availability of WC funds.

* The firm cannot pay day-to-day expenses of its operations and its credit
inefficiencies, increases cost and reduces the profits of the business.

* It becomes impossible to utilize efficiently the fixed assets due to non-availability of

liquid funds thus the firms profitability would deteriorate.

* The rate of return on investments also falls with the shortage of WC.

* Operating inefficiency creeps in and it becomes difficult to implement operating

plans and achieve the firms profit targets.

Need for Working CapitalFor earning profit and continue production activity, the
firm has to invest enough funds in Current Assets in generating sales. Current Assets
are needed because sometimes sales do not convert into cash instantaneously and it
includes an operating cycle.

Operating Cycle: Operating cycle is the time duration required to convert sales, after
the conversion of resources into inventories, into cash. Investment in current assets
such as inventories and debtors is realized during the firm's operating cycle, which is
usually less than a year.

The operating cycle of a manufacturing company involves three phases: -

1. Acquisition of resources such as raw material, labor, power and fuel etc.

2. Manufacture of the product which includes conversion into work-in-progress into

finished goods.
3. Sale of the product either for cash or on credit.

These phases affect cash flows because sometimes sale is done on credit and it takes
sometimes to realize.

Length or Duration of the Operating Cycle: The length of the operating cycle of a
manufacturing firm in the sum of the following:

1.Inventory Conversion period

2. Debtors Conversion periods.

The total of Debtors Conversion Period and Inventory Conversion Period is referred
to as Gross Operating Cycle.

1. Inventory Conversions Period: The Inventory Conversion Period is the total time
needed for Producing and selling the product. It includes:

a. Raw Material Conversion Period.

b. Work-in-progress Conversion Period.

c. Finished Goods Conversion Period.

2. Debtors Conversion Period: It is the time required to collect the outstanding

amount from the customers.

Net Operating Cycle: Generally, a firm may resources (raw materials) on credit and
temporarily postpones payment of certain expenses. Payables, which the firm can
defer, are spontaneous sources of capital to finance investment in Courtney Assets.

The length of the time in which the firm is able to defer payments on various resource
purchases is Payables Deferral period. The deference between Gross Operating Cycle
and payables Deferral Period is called Net Operating Cycle. If depreciation is
excluded from Net Operating Cycle, the computation repercussion represents Cash
Conversion Cycle. It is net time interval between cash outflow.

Operating Cycle also represent the time interval over which additional funds, called
Working Capital, should be obtained in order to carry out the firm's operations. The
firm has to negotiate Working Capital from sources such as banks. The negotiated
sources of Working Capital financing are called non-spontaneous sources. If net
Operating Cycle of a firm increases it means further need for negotiated Working
Capital.

Calculation of Operating Cycle: The calculation of operating cycle helps to know

the exact period of WC turnover i.e. how long it takes to convert cash again into cash?
Through this calculation one can ascertain the WC period.

FORMULA: -Raw Material Holding Period = Avg. Stocks of Raw Material

Avg. cost of consumption per day

Work in progress Conversion Period = Avg. work in progress

Avg. cost of Production per day

Finished goods holding period = Avg. stock of finished goods

Avg. cost of goods sold per day

Receivables & Debtors collections Period = Avg. book debts.

Avg. credit sales per day

Credit period allowed by creditors = Avg. creditors

Avg. credit purchase

DURATION OF OPERATING CYCLE

GOC = RM + WIP + FG + D + R

NOC = GOC-C

Where GOV = Gross operating cycle.

NOC = Net operating cycle

RM = Raw material conversion period.

C = Credit period available

WIP = WIP conversion period

FG = FG holding period

D & R = Detors and receivables collection period.

Note:

 360 working days in a year are taken to calculate per day average.
 Avg. means opening + closing /2
 Depreciation is excluded while calculating cost of production & sales as it is a
non-fund expense and does not require working capital.

Permanent and Variable Working Capital

There is always a minimum level of current Assets, which is continuously required by

the firm to carry on its business operations. The minimum level of Current Assets is
referred to as permanent of fixed Working Capital. It is permanent in the same way as
the firm's fixed assets are. The extra Working Capital, needed to support the changing
production and sales activities is called fluctuating or variable or temporary Working
Capital.

Both Kinds of Working Capital, permanent and temporary, are necessary to facilitate
production and sale through the operating Cycle.

Estimating Working Capital Needs: Working Capital needs can be estimated by

three different methods, which have been successfully applied in practice. They are
follows:

1. Current Assets Holding Period: To estimate Working Capital requirements on the

basis of average holding period of Current Assets and relating them to costs based on
the company's experience in the previous years. This method is based on the operating
cycle concept.

2. Ratio of Sales: To estimate Working Capital requirements as a ratio of sales on

assumption that Current Assets change with sales.

3. Ratio of fixed Investment: To estimate Working Capital requirements as a

percentage of fixed investment.

The most appropriate method of calculating the Working Capital needs of firm is the
concept of operating cycle. There are some limitations with all the three approaches
therefore some factors govern the choice of method of Working Capital.

Factors considered are seasonal variations in operations, accuracy sales forecasts,

investment cost and variability in sales price would generally be considered. The
production cycle and credit and collection policy of the firm would have an impact on
Working Capital requirements.

Current Assets Financing

A firm can adopt different financing policies for Current Assets Three types of
financing used can be:

1. Long-term financing such as shares, debentures etc.

2. Short-term financing such as public deposits, commercial papers etc.

3. Spontaneous financing refers to the automatic sources of short-term funds arising in

the normal course of a business such as trade credit (suppliers) and outstanding
expenses etc.

The real choice of financing Current Assets is between the long term and short-term
sources of finances. The three approaches based on the mix of long and short-term
mix are:
1. Matching Approach: When the firm follows matching approach (also known as
hedging approach), long term financing will be used to finance Fixed Assets and
permanent Current Assets and short-term financing to finance temporary or variable
Current Assets. The justification for the exact matching is that, since the purpose of
financing is to pay for assets, the source of financing and the assets should be
relinquished simultaneously so that financing becomes less expensive and
inconvenient. However, exact matching is not possible because of the uncertainty
about the expected lives of assets.

2. Conservative Approach: The financing policy of the firm is said to be a

conservative when it depends more on long-term funds for financing needs. Under a
conservative plan, the firm finances its permanent assets and also a part of temporary
Current Assets with long term financing. In the periods when the firm has no need for
temporary Current Assets, the idle long-term funds can be invested in the tradable
securities to conserve liquidity. Thus, the firm has less risk of shortage of funds.

3. Aggressive Approach: An aggressive approach is said to be followed by the firm

when it uses more short term financing than warranted by the matching approach.
Under an aggressive approach, the firm finances a part of its permanent current assets
with short term financing. Some firms even finance a part of their fixed assets with
short term financing which makes the firm more risky.

Managing Current Assets: Management of Current Assets is done in three parts.

They are:

1) Management of cash and cash equivalents.

2) Management of inventory.

3) Management of accounts receivable and factoring.

Thus, the basic goal of WC management is to manage the current assets the current
liabilities of the firm in such a way that a satisfactory level of WC is maintained, i.e. it
is neither inadequate nor excessive WC management policies of a firms have a great
effect on its Profitability, Liquidity and Structural health of the organization.

WC management is an integral part of overall corporate management. For proper WC

management the financial manager has to perform the following basic functions:-

· Estimating the WC requirement.

· Determining the optimum level of current assets.

· Financing of WC needs.

· Analysis and control of WC.

WC management decision are three dimensional in nature i.e. these decisions are
usually related to these there sphere or fields.
· Profitability, risk and liquidity.

· Composition and level of current assets.

· Composition and level of current liabilities.

PRINCIPLES OF WORKING CAPITAL

There are four principle of working capital management. They are being depicted as
below :

(i) Principle of Risk Variation: - The goal of WC management is to establish a

suitable trade between profitability and risk. Risk here refers to a firm's ability to
honor its obligation as and when they become due for payments. Larger investment in
current assets will lead to dependence. Short term borrowings increases liquidity,
reduces risk and thereby decreases the opportunity for gain or loss On the other hand
the reserve situation will increase risk and profitability And reduce liquidity thus there
is direct relationship between risk and profitability and inverse relationship between
liquidity and risk.

(ii) Principle of Cost Capital: - The various sources of raising WC finance have
different cost of capital and the degree of risk involved. Generally higher the cost
lower the risk, Lower the risk higher the cost. A sound WC management should
always try to achieve the balance between these two.

(iii) Principle of Equity Position: - This principle is considered with planning the
total investment in current assets. As per this principle the amount of WC investment
in each component should be adequately justified by a firms equity position Every
rupee contributed current assets should contribute to the net worth of the firm The
level of current assets may be measured with the help of two ratios. They are:

· Current assets as a percentage of total assets.

· Current assets as a percentage of total sales.

(iv) Principle of Maturity Payment: - This principle is concerned with planning the
source of finance for WC. As per this principle a firm should make every effort to
relate maturities of its flow of internally generated funds in other words it should plan
its cash inflow in such a way that it could easily cover its cash out flows or else it will
fail to meet its obligation in time.

REFERENCE

1. Anand, M. 2001. "Working Capital performance of corporate India: An

empirical survey", Management & Accounting Research, Vol. 4(4), pp. 35-65.
2. Bhalla, V. K., 'Working Capital Management', Anmol, New Delhi, 2005.
3. Bhattacharya, Hrishikes, 'Working Capital Management: Strategies and
Techniques', Prentice-Hall of India Products, 2004.
4. Burns, R and Walker, J. 1991. "A Survey of Working Capital Policy Among
Small Manufacturing
 5. Firms", The Journal of Small Business Finance, 1 (1), pp. 61-74
6. Padachi, Kesseven, 'Trends in working capital managmenet and its impacts on
firms performance: An analysis of Mauritius small manufacturing firm',
International Review of Business Research Papers, Vol. 2., October 2006, p-
45-58.
7. Sadri, Sorab & Tara, Sharukh, N., 'Understanding Working Capital
Management', Rai Business School, Mumbai, March 25, 2006.

Rural Labor Enquiry, A Report on wages & earnings of Rural Labor Household, 38th
round National sample survey, Labor bureau, Ministry of Labor, Government of India,
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H. L Kumar, Labor Laws, Universal Law Publishing Co. Pvt. Ltd., G.T. Karnal Road,
Delhi-110033

K. Aswathappa, Business Environment, Himalaya Publishing House "Ramdoot" Dr.

Bhalerao Marg, Girgaon, Bombay-400004

C.R. Kothari, Research Methodology, New Age International (P) Ltd. Publishers,
Ansari Road, Daryaganj, New Delhi-110002

Dr. M.M.Varma & R.K. Agrawal, Mercantile and Industrial Law, King Book
Publishers, 1684, Nai Sarak Delhi-110006

S. C. Shrivastava, Industrial Relations and Labor Laws, Vikas Publishing House, 576,
Masjid Road Jangpura, New Delhi-110014

Mamoria, C.B. (1999): 'Personnel Management' Himalaya Publication, New Delhi.

Kothari, C.R. (2000): 'Research Methodology' Vishwa Prakashan, New Delhi.
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New Delhi Bhatia: Compensation management
Title: Effects of working capital management on SME profitability

Author(s): Pedro Juan García-Teruel, (Deptartment of Management and

Finance, Faculty of Economy and Business, University of Murcia,
Murcia, Spain), Pedro Martínez-Solano, (Deptartment of
Management and Finance, Faculty of Economy and Business,
University of Murcia, Murcia, Spain)

Citation: Pedro Juan García-Teruel, Pedro Martínez-Solano, (2007) "Effects

of working capital management on SME profitability", International
Journal of Managerial Finance, Vol. 3 Iss: 2, pp.164 - 177

Keywords: Profit, Small to medium-sized enterprises, Working capital

Article type: Research paper

DOI: 10.1108/17439130710738718 (Permanent URL)

Publisher: Emerald Group Publishing Limited

Abstract: Purpose – The object of the research presented in this paper is to

provide empirical evidence on the effects of working capital
management on the profitability of a sample of small and medium-
 sized Spanish firms.

Design/methodology/approach – The authors have collected a panel

of 8,872 small to medium-sized enterprises (SMEs) covering the
period 1996-2002. The authors tested the effects of working capital
management on SME profitability using the panel data methodology.

Findings – The results, which are robust to the presence of

endogeneity, demonstrate that managers can create value by
reducing their inventories and the number of days for which their
accounts are outstanding. Moreover, shortening the cash conversion
cycle also improves the firm's profitability.

Originality/value – This work contributes to the literature in two ways.

First, no previous such evidence exists for the case of SMEs.
Second, unlike previous studies, in the current work robust test have
been conducted for the possible presence of endogeneity problems.
The aim is to ensure that the relationships found in the analysis
carried out are due to the effects of the cash conversion cycle on
corporate profitability and not vice versa.