Working Capital Research Paper

  • Length: 11 pages
  • Subject: Business - Management
  • Type: Research Paper
  • Paper: #95624632

Excerpt from Research Paper :

Management System -- Working Capital Management

Working Capital: Theoretical Construct & Contribution to the Effectiveness to Advance Financial Management Practice

This work examines working capital and its theoretical constructs and contributes to the Effectiveness to Advancce Financial Management Practice. The term 'working capital' is reported in the work of Seidman (2004) to have several meanings "in business and economic development finance. In accounting and financial statement analysis, working capital is defined as the firm's short-term or current assets and current liabilities. Net working capital represents the excess of current assets over current liabilities and is an indicator of the firm's ability to meet its short-term financial obligations." (Seidman, 2004)

Introduction

The objective of this study is to conduct a critical review of the relevant literature in terms of its theoretical construct and its contribution and effectiveness in advancing financial management practice. The term 'working capital' is stated in the work of Seidman (2004) to have several meanings "in business and economic development finance. In accounting and financial statement analysis, working capital is defined as the firm's short-term or current assets and current liabilities. Net working capital represents the excess of current assets over current liabilities and is an indicator of the firm's ability to meet its short-term financial obligations."

I. Defining 'Working Capital'

Seidman (2004) additionally states that from the view of financing that working capital "refers to the firms' investment in two types of assets. In one instance, working capital means a business's investment in short-term assets needed to operate over a normal business cycle." Seidman states that this 'corresponds to the required investment in cash, accounts receivable, inventory, and other items listed as current assets on the firm's balance sheet." (2004) According to Seidman, in this context, "working capital financing concerns how a firm finances its current assets." (2004) Seidman reports a "second broader meaning of working capital" stating that it is specifically the "overall no fixed asset investments" of the company. (2004)

Businesses many times need to finance activities that do not involve measurement of assets on the balance sheet. The example stated is when the firm has a requirement for funding for the purpose of product redesign or for the purpose of formulation of a new strategy for marketing which makes a requirement of funds for personnel hiring rather than for asset acquisition accounting purposes. Seidman reports that these investments are 'soft costs' in that there is no immediate return but instead the returns are such that are realized over time. (Seidman, 2004, paraphrased) Working capital therefore is representative of a broader range of the capital needs of the firm and is inclusive of both current and nonfixed asset investments relating to the company operations. (Seidman, 2004, paraphrased)

III. Management of Working Capital Risk and Return

The work of Trainor and Webzel (2010) entitled "Managing Working Capital Risk and Return" relates that the impact of working capital risk and return on higher education in terms of liquidity include that not all market-like funds were liquid and marketable securities were not as marketable as expected. In addition, some investments liquidate at a price that is discounted deeply and investment managers imposed new liquidity gates and collateral postings were required. Finally, it is stated that capital calls were not offset of alternative funds distributions. (Trainor and Webzel, 2010)

In terms of debt the impact of management of working capital risk and return include that demand debt remarketing failed and the variable interest expense is rising and the fees for letters of credit. Finally collateral posting and liquidation swaps incurred penalties. Further impacting higher education in the area of working capital risk and return management is that operating budgeting cuts took place due to weak performance of investments. (Trainor and Webzel, 2010, paraphrased) It is possible to balance risk and reward through a "tiered approach to working capital management" because this approach is reported to make allowance for a "custom cash investment strategy to fit the investor's risk tolerance and liquidity requirements and preservation of capital needs and the ability to combine liquidity with the opportunity for yield enhancement by moving away from money market strategies to other short-term strategies." (Trainor and Webzel, 2010)

IV. Relationship Between Working Capital Management and Profitability

The work of Dong and Su (2010) examines the relationship existing between working capital management and profitability and states that the working capital management "plays an important role for success or failure of firm in business because of its effect on firm's profitability as well on liquidity." The assets of a firm are inclusive of: (1) fixed assets; and (2) current assets. (Dong and Su, 2010) Fixed assets are inclusive of land, building, plant, furniture and so forth. The firm's investment sin these assets means that some of the capital of the firm is "permanently blocked on a permanent or fixed basis and is also called fixed capital that generates productive capacity." (Dong and Su, 2010) It is reported that there is no change in the form of these assets however, "current assets consisting of raw materials, work-in -- progress, finished goods, bills receivables and material into semi=finished products, semi-finished products into finished products, finished products into debtors and debtors turned over cash or bills receivables." (Dong and Su, 2010)

Dong and Su relate in their study that the firm's fixed assets are increasingly used in production of organization and used in the fixed assets "for day-to-day working. Therefore, the current assets, called capital, may be regarded as the lifeblood of a business enterprise…" and is reported to refer to "that part of the capital and to be such that is a requirement in short-term financing." (Dong and Su, 2010) Management of working capital is inclusive of "planning and controlling current assets and current liabilities in a manner that eliminates the risk of inability to meet due short-term obligations on the one hand and avoid excessive investment in these assets on the other hand." (Dong and Su, 2010)

Working capital management is held as "one of the most important issues in organization, where many financial managers are finding it difficult to identify the important drivers of working capital and the optimum level of working capital. As a result, companies can minimize risk and improve their overall performance if they can understand the role and determinants of working capital. A firm may choose an aggressive working capital management policy with a low level of current assets as percentage of total assets, or it may also be used for the financing decisions of the firm in the form of high level of current liabilities as percentage of total liabilities." (Dong and Su, 2010) It is critical that an optimal balance be kept "among each of the working capital components" and this is the primary objective of management of working capital. (Dong and Su, 2010, paraphrased) The ability of the financial managers in effectively managing receivables, inventory, and payments is that determining the success of the business in large part. (Dong and Su, 2010, paraphrased)

Dong and Su go on to relates that it is possible for the firm to realize a decrease in financing costs as well as raise the available funds for protections involving expansion through minimization of the amount of investment tied up in current assets and it was reported in Lamgberson (1995) that the largest part of the time and efforts of financial managers are the identification of the "non-optimal levels of current assets and liabilities and bring them up to optimal levels." (Dong and Su, 2010) One popular method of measuring the firm's working capital management is stated to be that of the "cash conversion cycle, which is defined as the sum of days of sales outstanding (average collection period) and days of sales in inventory less days of payables outstanding." (2006)

The longer the time lag the larger working capital investment will be. Dong and Su, 2010) Dong and Su state that their research provides support for the findings that a "a strong negative relationship between the measures of working capital management and including the number of days account receivable number of days conversion cycle with corporate profitability." (2010) In addition findings show that a positive relationship exists between "number of day's accounts payable and profitability." (Dong and Su, 2010 )

Dong and Su specifically stated as follows:

"The negative between corporate profitability that measured by gross operating profitability and cash conversion cycle that used as measuring efficiency of working capital management shows that cash conversion cycle is longer, profitability is smaller. This study suggests that managers can create value for their shareholders by reducing the cash conversion cycle to a reasonable range." ( Dong and Su, 2010)

The study discovers that when analyzing working capital management and profitability on Vietnam stock market also indicates that there is a negative number of accounts receivable days and inventories and findings additionally state that analysis of the link between working capital management and profitability demonstrated that managers increased profitability by "reducing the number of days accounts…

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