How Does Working Capital Management Affect Firm Profitability?

How Does Working Capital Management Affect Firm Profitability?
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How Does Working Capital Management Affect Firm Profitability?
Introduction
Traditional studies in corporate finance have focused increased attention on the long-term management of businesses, with researchers investigating how decisions in capital structures, investments, dividends, and company evaluations, affect business operations and long-term sustainability (Singh and Kumar, 2017). Nevertheless, research on short-term financial decisions such as working capital has remained scanty over the past years, even though working capital remains to be a critical part of maintaining the financial health of businesses of all scales. Working capital management (WCM) is an invaluable component of corporate finance theories that deal with the short-term management of financing and investment decisions of a business. Regardless of size, many firms worldwide often have some portions of cash that are tied up in the form of working capital, while short-term payables serve to finance short-term financial needs for the businesses. Therefore, working capital funds are forms of hidden financial sources that can be used to improve the profitability of businesses. This implies that WMC can have an immediate and direct impact on both the liquidity and profitability of firms and their net worth (Singh and Kumar, 2016). Over the last years, inventory management, payable management, and receivable management have increased interest among researchers in corporate finance. According to Kaur (2017), WMC involves the management of cash, accounts receivable and payables, and inventories to determine the appropriate level of current assets and the efficient use and the choice of funding the business. This paper examines the effect of inventory and cash management as important components of working capital management on firms' profitability using a review of the literature and a case study of Coca-Cola company within the food and beverage industry.
Literature review
In today's business environment, the management and control of working capital have gained increased attention among experts in the field of corporate finance (Wassie, 2020). Managing working capital is complicated because there is a high portion of working capital in any ordinary business. Working capital management (WCM) is the administration and control of the current assets with an accounting year to convert into cash, the current liabilities that are payable within a year, and the relationship between the current assets and current liabilities. As Wassie (2020) describes, working capital is the circulating capital that ensures the survival of a business as it plays a critical role in the ongoing operations within a firm. Levels of current assets and current liabilities can have varying impacts on business performance or profitability. While studies have stressed the importance of maintaining high levels of working capital, Wassie (2020) argues that too much working capital in the form of current assets may hurt business operations. Similarly, lower levels of current assets may result in a decline in liquidity and understocking, which may pose challenges in maintaining an optimum level of working capital. The purpose of managing the working capital is traditionally known to offset the balance between current assets and liabilities, and for that reason, WCM serves to administer, control, and manage current assets and current liabilities in a given business to maximize profits or performance and maintain an appropriate liquidity level. This review examines how proper management of inventory and cash components of WCP can be critical in increasing profitability in businesses.
Inventory
Over the recent years, there have been models that have aimed to incorporate factors relevant to corporate finance, such as finite supplier capacity, demand uncertainty, and yield losses. However, an area that has not received attention is working capital management and its components that result in serious financial constraints in businesses (Bendavid, Herer, and Yucesan, 2016). In many businesses, operations are must be self-financing, implying that such business processes must replenish their inventories. In such scenarios, businesses are largely impacted by their current levels of inventory, including their payables and receivables (Atnafu and Balda, 2018). Receivables include trade credits that many businesses extend to their customers, while payables are trade credits that businesses receive from their suppliers. Any imbalance in inventory results in serious financial constraints and might lead to the collapse of businesses. In times of an economic crisis, financial constraints in businesses are a common scenario that makes it difficult for companies to secure external financing (Bendavid, Herer, and Yucesan, 2016). Since many small and medium enterprises are self-financing, business owners face challenges in replenishment decisions due to a constraint on cash flows, periodically updated after sales and purchases have been affected. In this case, operational and financial parameters interact due to working capital constraints on such businesses. Bendavid, Herer, and Yucesan (2016) have shown that imposed constraints on the working capital due to poor inventory management significantly distorted operational decisions of businesses and eventual performance in terms of profitability. Therefore, it is important to assess the inventory levels in a business to ensure an appropriate balance in available capital that can be used to run a business without interruption due to financial constraints.
Cash
Cash is another important component of working capital, and one of the most known measures of WCM is the cash conversion cycle (CCC). Singh and Kumar (2017) defined CCC as the time between disbursement of raw materials and collection of sales. The prolonged period between the disbursement and collection increases the levels of working capital investment, and the prolonged CCC can result in more profits due to increased sales. However, as Bendavid, Herer, and Yucesan (2016) argue, CCC may also lead to diminished corporate profitability in situations when the expenses of huge investments in working capital grow faster compared to the benefits of holding additional inventory or when businesses are yielding more trade credits to customers. However, most of the existing literature on WCM has identified CCC as a comprehensive measure of determining the efficiency of WCM compared to other traditional liquidity measures such as quick ratio and current ratio. As Singh and Kumar (2017) have observed, CCC serves as a powerful measure of performance, particularly for assessing how well a firm is managing its working capital. In its complete definition, the authors describe CCC as the time lag between cash outflows for purchases and production of raw materials and the cash inflows that result from the sale of finished products and the collection of accounts receivable (Karadag, 2018). While CCC remains to be a critical measure of a firm's WCM, other studies such as Bendavid, Herer, and Yucesan (2016) have found that it can negatively impact business profitability. Overall, literature has presented conflicting empirical evidence to associate WCM and the profitability levels in firms due to varying sample sizes, proxy measures for variables investigated, and the levels of economic development in different countries (Charitou, Elgfani, and Lois, 2010). Out of these contradicting findings, it is not conclusively clear about the role of WCM in increasing a firm's profitability in the long run.
Case Study: Coca-Cola HBC AG (CCH)
Coca-Cola HBC AG is a bottler of Coca-Cola products company listed under FTSE350. The company is based in Switzerland with segments including established, developing, and emerging markets in Cyprus, Croatia, and Armenia, among many other countries worldwide. The company deals with the production, sale, and distribution of beverage brands, including Coca-Cola and its variety of brand names under the name "Coca-Cola" such as Zero and Light, Fanta, and Sprite, as well as other beverages such as juice, water, and energy drinks (Hargreaves Lansdown, 2021). Like many other firms around the world, Coca-Cola company was impacted by the COVID-19 pandemic during the 2020 financial year.
From the company's official ...