Working Capital Management: Theory and Financial Practice

Introduction

The objective of this study is to conduct a critical review of the relevant literature on working capital in terms of its theoretical construct and its contribution to advancing financial management practice. The term working capital is noted by 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."

Defining Working Capital

Seidman (2004) additionally states that from the perspective of financing, 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 notes 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. In this context, "working capital financing concerns how a firm finances its current assets" (Seidman, 2004). Seidman also identifies a "second, broader meaning of working capital," describing it specifically as the overall non-fixed-asset investments of the company.

Businesses frequently need to finance activities that do not involve the measurement of assets on the balance sheet. One example is when a firm requires funding for product redesign or for the formulation of a new marketing strategy — activities that demand expenditure on personnel rather than asset acquisition. Seidman (2004) characterizes these investments as "soft costs," in that there is no immediate return; instead, returns are realized over time. Working capital therefore represents a broader range of a firm's capital needs, inclusive of both current and non-fixed-asset investments relating to company operations (Seidman, 2004).

Trainor and Webzel (2010), in their work "Managing Working Capital Risk and Return," examine the impact of working capital risk and return on higher education liquidity. Their findings indicate that not all market-like funds were liquid, and marketable securities proved less marketable than expected. Some investments liquidated at deeply discounted prices, investment managers imposed new liquidity gates, and collateral postings were required. Additionally, capital calls were not offset by alternative fund distributions (Trainor and Webzel, 2010).

Managing Working Capital Risk and Return

With respect to debt, the impact of working capital risk and return management includes the failure of demand debt remarketing, rising variable interest expenses, and increased fees for letters of credit. Collateral postings and liquidation swaps also incurred penalties. Operating budget cuts further compounded these pressures due to weak investment performance (Trainor and Webzel, 2010). It is possible to balance risk and reward through a "tiered approach to working capital management" because this approach allows 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).

Dong and Su (2010) examine the relationship between working capital management and profitability, arguing that 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." A firm's assets comprise: (1) fixed assets and (2) current assets. Fixed assets include land, buildings, plant, furniture, and similar items. Investment in these assets means that a portion of the firm's capital is "permanently blocked on a permanent or fixed basis and is also called fixed capital that generates productive capacity" (Dong and Su, 2010). Current assets, by contrast, consist of raw materials, work-in-progress, finished goods, and bills receivable — resources that continuously cycle through the production process into cash or receivables.

Relationship Between Working Capital Management and Profitability

Dong and Su (2010) note that current assets — sometimes called working capital — "may be regarded as the lifeblood of a business enterprise," referring to that portion of capital required for short-term financing. Management of working capital involves "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."

Working capital management is considered "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 a 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 a percentage of total liabilities" (Dong and Su, 2010). Maintaining an optimal balance among each working capital component is the primary objective of working capital management (Dong and Su, 2010). The ability of financial managers to effectively manage receivables, inventory, and payments is therefore a key determinant of business success.

Dong and Su (2010) further note that a firm can reduce financing costs and increase funds available for expansion by minimizing the amount of investment tied up in current assets. Langberson (1995), as cited in Dong and Su (2010), reports that much of a financial manager's time is devoted to identifying non-optimal levels of current assets and liabilities and bringing them to optimal levels. One popular method of measuring working capital management efficiency is the cash conversion cycle, defined as "the sum of days of sales outstanding (average collection period) and days of sales in inventory less days of payables outstanding." The longer the time lag in this cycle, the larger the working capital investment required (Dong and Su, 2010).

Dong and Su's (2010) research supports a "strong negative relationship between the measures of working capital management — including the number of days accounts receivable and the cash conversion cycle — with corporate profitability." A positive relationship was also found between the number of days accounts payable and profitability. They state specifically:

"The negative relationship between corporate profitability — measured by gross operating profitability — and cash conversion cycle — used as a measure of working capital management efficiency — shows that when the 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)

Analysis of working capital management and profitability on the Vietnam stock market similarly indicates a negative relationship between the number of accounts receivable days and inventories on the one hand and profitability on the other. The findings suggest that managers can increase profitability by reducing the number of days accounts receivable and inventories are held. The study also finds that more profitable firms "wait longer to pay their bills" (Dong and Su, 2010). A stated limitation of the study is that it is confined to internal factors only and does not consider external factors such as "industry dummy, level of economic activity," and similar variables (Dong and Su, 2010).