The effects of working capital management on profitability
The effects of working capital management on profitability.
Every business requires a working capital for it to survive. Working capital is a vital part of business investment which is essential for a continuous business operation which helps firms to maintain their liquidity and profitability of a company. The relationship between working capital management and profitability is a critical aspect of financial management for businesses. Working capital, representing the operational liquidity of a company, measures the ability to meet short-term obligations and sustain day-to-day operations. Effective management of working capital plays a pivotal role in influencing a company’s profitability. Understanding this relationship is important for businesses seeking to optimize their liquidity and enhance profitability in a dynamic economic environment Ponsian, Chrispina, Tago and Mkiibi (2014).
Definition of effective working capital
In financial management the term working capital refers to the money needed for the firm to continue their day-to-day operation activities such as cash required for the purchase of raw materials, payment of salaries, payment of rent or any other day to day expenditure. The aim of working capital management is to promote a satisfactory level of liquidity, profitability and create shareholders value. This approach emphasizes maintaining proper levels of both current assets and current liabilities by providing enough cash to meet the short-term obligations of a firm. The formula for calculating working capital is:
Working Capital=Current Assets−Current Liabilities
Current Asset refer to assets that are expected to be converted into cash or used up within one year such as
- Cash and Cash Equivalents. That is Currency, bank accounts, and highly liquid investments.
- Accounts Receivable. Which is amounts owed to the company by customers for goods or services sold on credit.
- Inventory. That is raw materials, work-in-progress, or finished goods held for production or sale
While on the other hand Current liabilities encompass obligations that are due within one year, which include
- Accounts Payable. Amounts owed by the company to suppliers for goods or services purchased on credit.
- Short-Term Debt. Any debt or loan repayments due within the next year.
- Accrued Liabilities. Unpaid expenses or obligations that have been incurred but not yet paid.
The impact of working capital on profitability
The importance of working capital management WCM on profitability also highlights the kind of relationship between the method and cost of the financing assets, as current assets are usually financed from short-term sources of funds. The difference between current assets and current liabilities is the net working capital, which, if financed from long-term sources that will increase the burdens and the costs incurred by the company, thereby negatively affecting its profitability (Ramzi Ali Maudhah). Hence, working capital of the company is considered its lifeblood and one of the most critical factors that contribute to the continuity of the company’s work, where the effective management of the working capital is a necessary process to achieve the company’s goals.
Businesses in the past paid more attention to working capital by focusing instead on concerns that raising and using debt and equity capital, by choosing information and manufacturing technology to run operations, and attempting to develop domestic and global marketing strategies to sell product. However, recent economic problems, specifically the great Recession that began in 2008 (James Sagner 2014) have forced companies to consider ways of improving profitability, to cut costs, and to make business processes efficient which are required for survival.
As mentioned by Deloof (2003), current assets and current liabilities play important roles in stimulating the firm’s profitability performances. Where they both ensure the firm is able to maximize return on assets and minimize payments for liability. Efficient working capital management positively impacts cash flows, which in return enhances profitability of the firms. He further stated that managers can increase firm profitability by decreasing the number of days accounts receivable and inventories.
Moreso, efficient working capital management ensures that a company maintains an optimal level of liquidity in other to meet its short-term obligations since liquidity is very vital for addressing unexpected expenses, and taking advantages of investment opportunities, and serving as a buffering during economic downturns Gitman, L. J., & Zutter, C. J. (2019). Principles of Managerial Finance (15th ed.). In addition, balancing liquidity with operational efficiency involves optimizing the management of current assets and liabilities. Gitman and Zutter (2019) highlight that maintaining too much on inventory or extending account receivable against the period it was normally supposed to will excessively tie up the funds that could be utilized more efficiently. Conversely, delaying payment to suppliers may strain the relationship and affect the supply chain. Furthermore, working capital ratios and quick ratios indicate the company’s liquidity and efficiency in managing short-term resources.
Effective working capital management significantly impacts on a company’s profitability. The relationship between working capital and profitability is complex and multifaceted, involving careful consideration of current assets and liabilities. Research indicates that optimizing the cash conversion cycle, maintaining optimal levels of current assets, and managing liabilities judiciously contribute to enhanced profitability. Balancing liquidity with operational efficiency is essential, as excess working capital can lead to underutilization of funds, while insufficient working capital can jeopardize a company’s ability to meet short-term obligations. Overall, businesses that strategically manage their working capital tend to experience improved cash flows, greater financial stability, and ultimately, higher profitability.
Ponsian N, Chrispina K, Tago G, Mkiibi H. The effect of working capital management on profitability. International Journal of Economics, Finance and Management Sciences. (2014)
Impact of working capital management on profitability: evidence from listed companies in Qatar Maad A. Q. Aldubhani, Jitian Wang and Tingting Gong, Ramzi Ali Maudhah (2021)
Gitman, L. J., & Zutter, C. J. (2019). Principles of Managerial Finance (15th ed.). Pearson.
Working Capital Management and Firms’ Profitability: Dynamic Panel Data Analysis of Manufactured Firms Kafeel ,Javed Ali, Maaz Ud Din, Abdul Waris, Muhammad Tahir, Sher Khan,
James Sagner Working Capital Management (2014)