Working Capital Management: Importance, Objectives, Factors, And Relationship With Growth And Profitability

Objectives of Managing Working Capital

Discuss about the Working Capital Management.

The business requires funds to operate and the money that is available to the business for its day-to-day operation is termed as working capital. It is also expressed as surplus of current assets in excess of the current liability. The process of managing the immediate assets and liabilities so that the business could maintain adequate working capital is called working capital management (Hill 2013). In this report, a discussion is made about the working capital and its relation with the company’s growth and profitability.

The management of working capital serves various objectives that are given below:

• The working capital management guarantees that the businesses have adequate resources so that it can smoothly perform its day-to-day operations.
• The primary aim of managing the working capital is the reduction in the cost of capital.
• The working capital is managed with the objective of maximizing the return on investment in the current assets (Corelli 2016).

The Working Capital Management is extremely significant for any business because it provides numerous advantages to the business. These are given below:

• It helps the business to achieve higher return on capital employed by reducing the capital required;
• The working capital management will help the business to discharge its short term liability on time therefore improving its solvency and credit profile (Ding et al. 2013).
• The management of working capital helps the business to allocate its resources effectively thereby improving the cash management.
• The efficient management of working capital helps to increase the free cash flow and this causes higher business valuation.
• The work capital managed effectively places the business in a better position to handle any crisis.
• The working capital management gives the business competitive edge over its competitors.

The working capital includes the management of liabilities and assets that are of short term in nature. The main purpose of managing the working capital is to ensure that the businesses have sufficient working capital so that it can remain liquid but ensure that the business does not have excess liquidity so that the profit is not adversely affected (Sarkar 2015).

The working capital has two broad elements the current assets and the current liability. The current assets are referred to those assets that will be changed in to cash within a single year in the normal course of business activity. Examples are inventory, debtors, cash etc. The other element is the current liability and it includes those liabilities that the company will have to discharge within one year. Examples are creditors, short term loan etc. The process of managing these elements of the working capital is termed as working capital management (Akoto et al. 2013).

The issues pertaining to the working capital management has been widely discussed in the literature and the academics over a long period. In this, section of the report the existing literatures are discussed so that the association between the profitability and growth of the company with the efficiency of the working capital.

In the studies conducted by the Shin and Soenen in 1998 it was found that proficient working capital management is essential for generating value for the shareholders wealth. In the study, the connection between the profitability and the net trade cycle was investigated by using the procedure of correlation and regression analysis. The study was conducted during 1975 to 1994 on 58985 businesses and it was established that the relationship between the profitability and the net trade cycle is negative. That means if the net trade cycle of the business increases than profit decreases and vice versa (Napompech 2012).

Importance of Managing Working Capital

The cash conversion cycle was utilized as the indicator of liquidity for the Greek food industry in the study conducted by the Lyroudi and Lazardis in 2000. The study was conducted to understand the correlation between the cash conversion cycle with the current and quick ratios. The impact that the cash conversion cycle had on the profitability based on scale of operation of the company was also analyzed in the study. It was concluded that relationship between the cash conversion cycle and the current ratios and quick ratios is positive. On the other hand the debt to equity ratio has negative relationship with the liquidity ratio and it was found that there no major difference in the liquidity ratio of the large and small business (Aktas et al. 2015).

In 2003, Deloof studies the relationship among the working capital management and the corporate profitability. In this study, the sample was 1009 non-financial Belgian companies between 1992 and 1996. The result of the study showed that companies could enhance their profitability by curtailing the number of days of inventories and account receivables (Jagongo, A.O. and Makori 2013).

Eljelly conducted an experimental study in 2004 to examine the connection between the liquidity and the profitability by using the current ratios and cash gaps. The study was conducted on a sample of corporation from Saudi Arabia by using the technique of correlation and regression analysis. The study found that the relationship between the profitability and the liquidity level of the company is negative (Russo 2013).

Ganesan analyzed the connection linking the efficiency of the management of working capital and the profitability by means of the correlation and regression analysis in 2007. The study used ANOVA analysis to understand the relationship between the “working capital management and profitability” (Ogundipe et al. 2012). On the 443 financial statement of the telecommunication company during the year 2001 to 2007, the study was conducted. It was concluded that the working capital is inversely related to the profitability and it was also found that the telecommunication companies does not have much impact on the profitability of the equipment companies.

In 2007, Rehman and Nasar conducted a study on 94 companies scheduled in Karachi stock exchange. The study was conducted to find the affect that the working capital has on the ability of the company to make profit. In the study, the variables that were used are company size, debt ratio, current ratio, net operating profit and cash conversion cycle (Gill and Biger 2013). The control variable that was used in the study was “Financial Asset to Total Asset Ratio” and the procedures that were applied are Pearson correlation and regression analysis. The study established that there is an opposite link between the profit making ability of the company and the elements of the cash conversion cycle. Therefore, it can be concluded that the study shows that by reducing the cash conversion cycle the wealth of the shareholders could be increased.

Nature and Purpose

In 2010, a study was conducted by koperthuvi to establish the connection among the management of working capital and the company’s management. The studies were conducted on the manufacturing companies of the Sri Lanka. It was concluded that the appropriate administration of working capital has influence on the ability of the company to make profit and it was found that profitability decreases if the cash conversion cycle increases (Martin 2016). There was another study conducted in Sri Lanka by Lingenesiya and Nalini in 2011. On conclusion it can be said that there is an inverse relationship between the Cash conversion cycle and profitability.

The elements of working capital are the current assets and current liabilities that have been discussed earlier in the report. The elements of working capital are affected by various factors and while managing the working capital these factors should be considered (Ahmad and Bano 2015). The discussion relating to these factors are given below:

• The working capital is depended on the nature of the business. If the business is engaged in manufacturing then the requirement of working capital is more than those businesses engaged in trading and service providing.
• The scale of operation of the business also affects the component of the working capital. This means that the elements of the working capital are affected by the size of the business (Riaz et al. 2014).
• The elements of the working capital are affected by the cycle of the business.
• The seasonal factor also affects the different elements of the working capital. The more working capital is required by the business during the season than in the off-season.
• The elements of the working capital are affected by the factor of production cycle.
• The policy of allowing credit to the customer affects the elements of the working capital. The business that provides credit facility to the customer will require more working capital than the business that does not provide credit facility.
• The different elements of the working capital are affected by the operating efficiency of the business. The business with high efficiency requires less working capital than the business with low efficiency (Mungai 2013).
• The growth prospective also influences the elements of the working capital. The company that has high growth prospective will require more working capital.
• The level of competition also acts as a factor and affects the elements of the working capital.
• The inflation is another important factor that influences the element of working capital.

In this section of the report three companies of different sectors that are listed in Muscat Stock Market is chosen for identifying and calculating the working capital. The three broad sectors of MSM are financial sector, industry sector and service sector. The company that is chosen from the financial sector is Bank Muscat. The Al Jajera Steel Products Company is chosen from the Industry sector and Oman Hotels and tourism is selected from the service sector (Arshad, Z. and Gondal 2013). The calculations of the working capital of the companies are given below: 

Fig 1: Chart showing comparative Working Capital 

The calculation and the figure show that the working capital of the Al Jajera Steel Company is the highest at RO 1852113.00. The company that belongs to the industry sector has higher working capital than the other two sectors. This analysis of the companies of the three sectors has proved that the working capital is dependent on the nature of the business as discussed earlier in the report.  

Conclusion

The report has examined the association between the working capital with the business profitability. Based on this analysis the conclusion that can be drawn is that the working capital has negative relationship with the profitability of the business. An analysis was also conducted on the companies that are listed on the MSM of different sectors to identify the working capital. On the analysis, it has been found that cash and bank balance, as percentage of working capital for the Bank Muscat is 371%, for Al Jajera steel Products Company is 156% and the Oman Hotels and tourism company 43%. In an average cash and bank balance forms 190% of the working capital it shows that the companies in Oman invest cash in working capital. Therefore it can be said that the working capital is managed in a manner that it might have a negative impact on the profit making ability of the organization.

References

Ahmad, A. and Bano, S., 2015. Working Capital Management Matters Profitability of Textile Sector: With GLS Model. International Journal of Economics and Empirical Research, 3(11), pp.543-549.

Akoto, R.K., Awunyo-Vitor, D. and Angmor, P.L., 2013. Working capital management and profitability: Evidence from Ghanaian listed manufacturing firms. Journal of economics and International Finance, 5(9), p.373.

Aktas, N., Croci, E. and Petmezas, D., 2015. Is working capital management value-enhancing? Evidence from firm performance and investments. Journal of Corporate Finance, 30, pp.98-113.

Arshad, Z. and Gondal, M.Y., 2013. Impact of working capital management on profitability a case of the Pakistan cement industry. Interdisciplinary Journal of Contemporary Research in Business, 5(2), pp.384-390.

Corelli, A., 2016. Working Capital Management. In Analytical Corporate Finance (pp. 351-378). Springer International Publishing.

Ding, S., Guariglia, A. and Knight, J., 2013. Investment and financing constraints in China: does working capital management make a difference?. Journal of Banking & Finance, 37(5), pp.1490-1507.

Gill, A.S. and Biger, N., 2013. The impact of corporate governance on working capital management efficiency of American manufacturing firms. Managerial Finance, 39(2), pp.116-132.

Hill, R.A., 2013. Working Capital Management.

Jagongo, A.O. and Makori, D.M., 2013. Working Capital Management and Firm Profitability: Empirical Evidence from Manufacturing and Construction Firms Listed on Nairobi S ecurities Exchange, Kenya.

Martin, N., 2016. Working capital management: implementation of integrated inventory management solutions for raw materials.

Mungai, J.M., 2013. The relationship between working capital management and financial perfomance of private Hospitals in kenya (Doctoral dissertation, University of Nairobi).

Napompech, K., 2012. Effects of Working Capital Management on theProfitability of Thai Listed Firms. International Journal of Trade, Economics and Finance, 3(3), p.227.

Ogundipe, S.E., Idowu, A. and Ogundipe, L.O., 2012. Working capital management, firms’ performance and market valuation in Nigeria. World Academy of Science, Engineering and Technology, 61(1), pp.1196-1200.

Riaz, Z., Ahmad, N. and Iqbal, N., 2014. The relationship between working capital management and profitability: Evidence from Pakistan. International Letters of Social and Humanistic Sciences, (20), pp.14-25.

Russo, J.F.T.B., 2013. The working capital management: the determinants and the effect on profitability: evidence from portuguese smes.

Sarkar, S.N., 2015. Analysis of profitability crisis and working capital management in some selected public sector undertakings under the ownership and control of the state government of West Bengal.