Abstract
Efficient management of working capital is a fundamental part of the overall corporate strategy in creating shareholders’ value. Today, the management of Working Capital is one of the most important and challenging aspects of overall financial management. Optimization of working capital balance means minimizing working capital requirements and realizing maximum possible revenues. Efficient WCM increases firms’ free cash flow, which, in turn, increases the firms’ growth opportunities and returns to shareholders. Even though firms are traditionally focused on long term capital budgeting and capital structure, the recent trend is that many companies across different industries focus on WCM efficiency.
The present study analyses the efficiency of working capital management and its components i.e. inventory amount, cash and bank balances and various current liabilities. The study attempts to determine the efficiency and effectiveness of management in each segment of working capital. Since the net concept of working capital has been widely considered in the present study, management of both current assets and current liabilities are also critically reviewed in due course. Thirty Bombay Stock Exchange (BSE) listed cement companies located in different regions of India have been selected as a sample for the study. This study is mainly confined to selected Indian cement companies using CMIE Prowess 4.0 database software. Information about the companies including nature of the company, size, age, state and region, company background, value of total assets and annual financial statements for the period 2006 to 2015 have been obtained from this database. The help of statistical software, SPSS version 21.0, has been taken for various statistical analyses required for this study. An attempt has been made to investigate the existence of the relationship between working capital management and profitability, average receivable period, inventory conversion period, average payment period and cash conversion cycle, which expresses the efficiency of working capital. It is found that there exists a negative relationship between profitability and number of days of accounts payables and number of days of inventory, but a positive relationship between profitability and number of days of accounts receivables. WCM and profitability show a positive relationship (as measured by cash conversion cycle) as against the theoretical foundation. The present analysis of the study reveals that shortening of the cash conversion cycle negatively affects the profitability of the firm.
Introduction
Working capital decisions normally provide a classic example of risk-return trade-off of financial decision making practice. Efforts to increase a firm’s net working capital, i.e., current assets less current liabilities, reduce the risk of a firm not being able to pay its outstanding bills on time. This, at the same time, reduces the overall profitability of the firm. Working capital management (WCM) involves a risk-return trade-off: by not taking additional risks unless and until it is well-compensated with additional assured returns. The existence of a firm largely depends on its ability to efficiently and effectively manage its working capital. WCM involves the process of converting investment into inventories and accounts receivables into liquid cash for the firm to use in paying its operational bills. WCM is at the heart of every firm’s day-to-day operating environment, and thereby improving corporate profitability.
Decisions relating to working capital involve managing the relationship between a firm’s short-term assets and liabilities to ensure that a firm is able to continue its operations with sufficient cash flows to satisfy both maturing short-term debts and upcoming operational expenses at a minimal cost, thereby increasing corporate profitability. Working capital decisions provide a classic example of the risk-return trade-off of financial decision-making. Increasing a firm’s net working capital -current assets less current liabilities – reduces the risk of a firm not being able to pay its bills on time. This, at the same time, reduces the overall profitability of the firm. Working capital management involves a risk-return trade-off: not taking additional risk unless compensated with additional returns. The existence of a firm depends on its ability to manage its working capital. Working capital management involves the process of converting investment into inventories and accounts receivables into cash for the firm to use in paying its operational bills. As such, working capital management is, thus, at the very heart of the firm’s day-to- day operating environment, and improving corporate profitability.
An important part of managing working capital is maintaining liquidity in day-to-day operations to ensure smooth running of the firm and meeting its obligations, as well as to ensure that the business is earning sufficient profits for its survival and growth. There are chances of mismatch in current assets and current liabilities during this process, which could affect the growth and profitability of the business. A popular measure of working capital management [WCM] is the cash conversion cycle, that is, the time lag between the expenditure for purchase of raw materials and the collection from sales of finished goods. The longer this time lag, the larger the investment in working capital. A longer cash conversion cycle however, might increase profitability because it leads to higher sales. On the other hand, corporate profitability might also decrease with a longer cash conversion cycle if the costs of higher investment in working capital rise faster than the benefits of holding inventory or granting more trade credit to customers. Many research studies like Shin and Soenen [1998] have highlighted the importance of shortening the cash conversion cycle (CCC), as managers can create value for their shareholders by reducing the cycle to a reasonable minimum.
A firm may adopt an aggressive working capital management policy with a low level of current assets or it may use a conservative working capital management policy where it may use working capital to finance a high level of current assets as a percentage of total assets. Wang (2002) points out that if a firm follows an aggressive credit cycle policy and the inventory levels are reduced significantly, the firm risks losing any appreciation in sales. Also, a significant reduction in trade credits granted may provoke a reduction in sales from customers requiring credit. In fact, opportunity costs may rise, depending on the discount percentage and discount period granted. On the other hand, investing heavily in working capital or using a conservative credit cycle policy may also result in higher profitability. Maintaining a high inventory level reduces the cost of possible interruptions and loss of business due to scarcity of products, reduces supply costs and can protect against price fluctuations. However, such benefits have to offset the reduction in profitability due to an increase in investment in current assets.