How Does Working Capital Management Affects Firm Profitability?

How Does Working Capital Management Affect Firm Profitability?
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How Does Working Capital Management Affect Firm Profitability?
Introduction
Recent financial crises and uncertainties to business operations have historically resulted in the downfall of gargantuan organizations such as the Lehman Brothers. Besides, the current COVID-19 pandemic has changed the business landscape and peoples' ways of life, which significantly affect profitability. These events have presented a challenge to researchers in the field of capital market research to realize the importance of managing organizational resources such as working capital. Working capital has been described as the available capital that is available to businesses in meeting their daily operations. Based on the type of industry, working capital can comprise a relatively bigger share of an organization's total amount of assets. Owing to the significant impact of working capital on the financial performance of firms, business executives around the world need to emphasize the efficient utilization of available resources. Working capital management (WCM) refers to efficient approaches that executives can employ when dealing with available cash in daily business operations to achieve an optimum impact (Anton and Nucu, 2021). Good WCM results in increased cash flows, a subsequent reduced need for external funding, and reduced chances of a firm defaulting. This review on the impact of working capital management on a firm's profitability explores the benefits of holding working capital and cash conversion cycle, which is one of the key factors in working capital management.
Benefits of holding working capital
Inventory management is one of the critical practices in WCM that have attracted increased empirical research over the past years (Singh and Kumar, 2017). Holding more inventories can significantly affect businesses from the perspective of fluctuations in prices. However, Anton and Nucu (2021) have argued that increasing the cost of working capital investments relative to the benefits gained from holding larger inventories or allowing trade credit to clients can lower the levels of a firm's profits. An increasing amount of studies has supported a non-linear association or a U-shaped relationship between increasing working capital and business profitability. These studies argue that investments in working capital can positively impact a firm's profitability only up to a certain level when this association stops. Above this point, which is also known as the optimum level or the break-even point, working capital becomes a negative determinant of corporate profitability (Herer and Yucesan, 2016). This is known as the inverted U-shaped relationship that accounts for a combination of negative and positive combinations with a break-even point. However, many firms are often exposed to significant risks associated with small inventory levels. In such firms, holding low inventory levels can negatively modify sales and lower profits (Anton and Nucu, 2021). Therefore, increasing the levels of working capital through holding inventories can significantly impact firms' profitability.
Several studies have appreciated the fact that by increasing the levels of working capital, businesses will generate higher costs of holding and managing the working capital and thus result in negative effects for companies in terms of firms' values. Nevertheless, the association between the firm's value and the components of working capital will largely depend on the levels of risk sensitivity of firms. However, as Michalski (2016) has noted, maintaining higher working capital levels before, during, and after financial crises or pandemics such as the current COVID-19 pandemic can act as a hedging instrument that cushions against the cost of disruptive production. From corporate finance literature, it is clear that there is a lack of a general agreement on how working capital plays a role in the performance of firms. These differences can be accounted for by using measures such as cash conversion cycle (CCC), the most popular indicator used as a net trade cycle or proxies.
The Working Capital Cycle
The working capital cycle is described as the period it takes for a business to convert the total of networking capital into cash. Different measures for working capital have been suggested to account for the divergent explanations of how working capital can facilitate firms' profitability. By using these measures, working capital is expressed as a composite measure, although some literature has described working capital at individual levels of net trade or cash conversion cycle. There are several reasons to account for different relationships between working capital and firms' profitability. Businesses may realize different results based on ownership structures, tax provisions, financial flexibility, or leverage. While the corporate finance literature has always stressed the importance of short-term financial decisions that affect the profitability of firms, long-term measures can serve to sustain a business in times of turmoil (Tan and Tulaca, 2019). One of the important aspects that businesses need to consider in managing long-term working capital is the cash conversion cycle (CCC) as they ensure a sustained operation of firms and growth in profits.
Richards and Laughlin introduced the concept of the cash conversion cycle in 1980 as a critical dynamic indicator in analyzing firms' liquidity (Tan and Tuluca, 2019). Since CCC is an important financial metric that financial analysts and financial managers use to make critical decisions, it is necessary to understand its purpose and association with a firm's profitability (Tan and Tuluca, 2019). According to Sugathadasa (2018), CCC is used to determine the efficiency of converting inventories in an organization into sales and orders into cash. It is also widely used to measure liquidity management and assess the levels of current assets and liabilities. The CCC is used to measure the length of time between cash payments for inventory purchase and the end of the firm's operating cycle. However, most inventory purchases and sales of goods are often made on credit, and this practice creates a scenario that ties up funds available for running a business (Sugathadasa, 2018). Therefore, maintaining profitability through checking liquidity levels is critical for business success and continued operation. CCC helps firms to check on the liquidity and the available capital that can be used to run a business regardless of the time it takes to convert orders into cash or inventories into sales.
Case study: Nike, Inc., and WCM
Analysis
Formerly known as the Blue ribbon Sports, Inc., the company changed its name to Nike, Inc., in 1971, 7 years after it was founded in 1964, and is presently headquartered in Beaverton, Oregon (Finbox.com). Nike, Inc. and its subsidiaries deal with the designing, developing, marketing, and selling of apparel, athletic footwear, equipment, and accessories globally. The company has six categories of brands including athletics, basketball, football, sportswear, training, and the Jordan brand. Nike also markets brands that are specially meant for children and recreation and athletic users such as American football, cricket, baseball, skateboarding, lacrosse, tennis,s walking, and other outdoor activities. The international sports firm also sells apparel licensed by professional teams and colleges and sports apparel and league logos among others. To understand the effectiveness of a company in terms of WCM, it is important to analyze its CCC as a metric that compares both the number of days the firm takes to sell its inventories as well as the duration it takes to collect receivables relative to the number of days afforded to offset its bills. CCC serves to measure the time between cash outflow and inflow within a sales cycle. For instance, several companies will buy their inventories often on credit and do so when they sell their products. This approach increases a company’s accounts payable liabilities and accounts receivable assets. Important to note is that cash has not been involved during these dealings until the actual payments are reflected on Accounts Payable or collections are indicated on the Accounts Receivables. A negative CCC of a company is an indicator that the firm is capable to receive payments for the sale of its products before paying the suppliers. In business, this is a good sign for Net-working capital as well as the free flow of cash.
CCC is generally defined as Inventory turnovers plus the Sales turnovers minus Payable turnovers, using the formulae below, where the COGS is the cost of goods sold.
Inventory turnover =COGSaverage inventory1
Receivables turnover =Salesaverage receivables2
Payable turnover =COGSaverage payables3
Data from Table 1 below is used to calculate the Inventory turnover, receivable turnover, and payable turnover as shown below
Fiscal Year

COGS

Avg. Inventory

Avg receivables

Avg. Payables

2018

$20.4441B

$5.158B

$3.498

$2.279B

2019

$21.643B

$5.441B

$4.272

$2.612B

2020

$21.162B

$6.495 B

$2.749

$2.248B

Inventory turnover =COGSaverage inventory
For:2018$20.441B$5.15...