Impact of the Management of Working Capital on the Profitability of a Firm - Research Paper Example

Working Capital Management Impact of the Management of Working Capital on the Profitability of a Firm Introduction Managing Working Capital is a strategy of managerial accounting that aims at maintaining efficient levels of the working capital components, current liabilities, and current assets, in respect to each other (Nazir & Afza, 2009). To help in meeting its obligations in the short-term and operating expenses, it is the work of management of working capital to ensure that a company has sufficient cash flow. When there is adequate management, working capital is capable of construing growth on the financial performance of firms. Objective of the Research To determine the impact of managing working capital on the profitability of firms. Literature Review Reports from previous studies show that there is a possibility of working capital management creating an important effect on the profitability of a firm. Raheman and Nasr (2007) among other researchers carried out research that used cash conversion cycles to measure working capital. This consisted of debtors collection period, creditors payment period and the stockholding period (Raheman & Nasr, 2007). The researchers found out that, the greater investment in working capital that translates to extended cash conversion cycle reduces the profitability of a firm (Banos-Caballero S, et al., 2010). According to another study carried out by Deloof (2003) using a sample of firms from Belgium, it was found that reducing debtors collection period and the days-in-inventory contributes to increasing the profitability of the firms (Deloof, 2003). The research also discovered that firms, which were less profitable, had to wait for longer periods to pay their bills. A sample of Japanese and Taiwanese firms were also studied by Wang (2002) where he found out that better-operating performance of a firm depended on shorter cash conversion cycles (Wang, 2002). With the small and medium-sized Spanish firms that were sampled and studied by Teruel and Solano (2007) a deduction was made that through reducing the debtors collection period and days-in-inventory period, firms were able to create value, thereby reducing the cash conversion cycle (Teruel & Solano, 2007). Other researchers, on the other hand, supported the fact that investing more on cash conversion cycle had a possibility of leading to increased profitability. The reason that backs this up is the fact that, maintaining high inventory levels would reduce supply costs, protect against price fluctuations, increase sales, and reduce the cost of possible production interruption (Blinder & Maccini, 1991). The relationship with customers can also be strengthened by a higher debtors collection period which then leads to an increase in sales revenue (Ng, et al., 1999). In a research by Deloof (2003), relatively huge amounts of the assets of the firms are set out for the working capital. Summers and Wilson (2000) estimated that 80% of the transactions in the UK corporate sector on a daily basis were carried out on credit terms (Summers & Wilson, 2000). Research Philosophy, Approach and Strategy The data set consisted of the interview results from four sampled industrial firms of Oman. All the data, which were used were obtained from the annual reports of these companies through questionnaires submitted and filled by the company representatives (Shin & Soenen, 1998). Cash conversion cycle, just as has been discussed in the literature review above, is a measure of working capital management (Nazir & Afza, 2003). Cash Conversion Cycle = Stockholding Period + Debtors collection period – Creditors collection Period As has been discussed, the longer the cash conversion cycle, the more reduced is the profitability of the firm. Likewise, when the cash collection period is shorter, the profitability of the firm increases (Lazaridis & Tryfonidis, 2006). In analyzing the impact of managing working capital on a firms profitability, we will therefore consider comparing the cash conversion cycles of different firms from Oman to show how their profitability changes with the changes in their cash conversion cycles (Hill & Highfield, 2010). The interpretation would, therefore, be that, the firms, which depict longer cash conversion cycles, will obviously have reduced profits. On the other hand, the firms that will show shorter cash conversion cycles, will have concurrently increased profits. The comparison was done using pie charts after the data analysis shall have been completed (Garcia-Teruel & Martinez, 2007). Pie charts are good at showing distinctive differences in sizes of different samples, and that is mainly the reason it got used in this study. Ethical Implication of the Research The main aim of the research is determining the impact of working capital management for various firms in Oman. In as much as the research will compare results from various firms, it is not intended to display any data that any firm considers confidential to its competitors or to the public. The study will, therefore, intend to maintain the ethical considerations upheld by various firms whose information was used to enable the study become a success. Research Methodology and Design Sampling Technique Random sampling method got employed where a list of 20 industrial firms in Oman got arrived. Out of the 20 firms, four firms were selected randomly by picking the small papers with the names of the firms from a basket. The four sampled firms then got used for the study. Sampling Unit The firms, that got selected, include Oman Cement Co., Oman Marble Co., Jabal Oman and Voltamp Manufacturing Co. It, therefore, means that data will only be collected from the companies to get used for the study. Data collection The study used a qualitative approach where a questionnaire was designed and submitted to the various respondents of each firm selected to obtain the data. Primary data was obtained by providing the questionnaire to the respondents who filled them. The questionnaire questions got designed in such a way to contain both open-ended and restricted questions. A sample of a blank questionnaire that got administered gets attached as an appendix to this study. It was very important to use a random sampling method to choose the firms that would participate in providing a response to this study so that cases of personal attitudes towards various firms could not arise during the selection. The method was also important in ensuring that this particular study could be carried out on any firm regardless of its size or age. The selected firms were then named using alphabetical letters to avoid any personal likeness or affiliations to the firm during the study. It also helped in protecting the direct image of the real firm as the representative name made it hard to know exactly which firm got represented. The firms were named A, B, C and D to represent Oman Cement, Oman Marble, Jabal and Voltamp Companies respectively. Analysis and Finding The following data got obtained from the four companies about the various questions that were asked. The collected data then got used in calculating the Cash Collection Cycle using the formula that got provided above, and the results recorded as in the table. Company A Company B Company C Company D Stockholding Period 66 54 53 56 Debtors’ Collection Period 48 51 52 49 Creditor’ Payment Period 40 43 41 44 Cash Collection Cycle 74 62 64 61 Stockholding Period According to the results represented in the chart above, it is clear that Company A has the longest stockholding period when compared to the other companies. This would imply that the companys cash conversion cycle would also be longer. As we already know, the longer the cash conversion cycle, the more reduced the profitability of the company would be. In this case, the stockholding period, which would increase the profitability of a company would be the smallest one. Therefore, that of Company C in this case would be considered to be most preferable. Debtors’ Collection Period Similarly, the longer the debtors collection period, the longer the cash conversion cycle. Hence, the more reduced would be the profitability of the firm. In this case, company C has the longest debtors collection period hence it would be the one with more reduced profitability. The shortest debtors collection period like that of Company A in this case would be the one that would increase the companys profitability. Creditors’ Payment Period On the other hand, the longer the creditors payment period, the shorter the cash conversion cycle. This would mean that a company with the longest creditors collection period like Company D is the one that would be having a shorter cash conversion period. It would, therefore, mean that this company would have a more increased profitability unlike company A that has the least creditors payment period. Cash Conversion Cycle Coming to the cash conversion cycle, a company with a longer cash conversion cycle usually has the more reduction in its profitability. It, therefore, means that, the longer the cash conversion cycle like in Company A that has 28% cash conversion cycle, there is less profitability or the company experiences a more reduced profitability. When the companies are compared, company D will have more increased profitability or the company is more profitable as it has the least cash conversion cycle. Research Evaluation: Validity and Reliability In this research, the intended objective has finally been achieved which was to determine the impact of managing working capital on the profitability of a firm. Since cash conversion cycle is used as a measure of working capital management, it was easy to determine how working capital management impact the profitability of a firm through the cash conversion cycle. This validates the research method and philosophy that was used in this study. Through the use of questionnaires to collect the data, the study was made to look more reliable and valid as it uses primary data that are considered to be more reliable. From this study, I have learned that one can begin from the unknown and get somewhere. What only matters is the design of the research that would give clear direction to where one would like to go. It is also important to clearly choose appropriate data that would let you use appropriate analysis method to help you achieve the set objectives. I would, therefore, recommend this particular research, its design and the appropriateness of the data collection used as a valid and very reliable one. Conclusion The main aim of the study was to determine the impacts of working capital management on the profitability of a firm. To collect primary data, questionnaires were used and the data obtained was analyzed through calculation. Pie chart was used to present the data, and the answer to the research question was finally obtained. Bibliography Banos-Caballero S, Garcia-Teruel, P. & Martinez-Solano, P., 2010. Accounting and Finance. Journal of Business, Accounting and Finance, 50(12), pp. 511-527,. Blinder, A. & Maccini, L., 1991. The Resurgence of Inventory Research: What Have We Learned?. Journal of Economic Survey, 5(2), pp. 291-328. Deloof, M., 2003. Does Working Capital Management Affect Profitability of Belgian Firms?. Journal of Business, Finance and Accounting, 30(3 & 4), pp. 573-587.. Garcia-Teruel, P. & Martinez, S. P., 2007. Effects of Working Capital Management on SME Profitability. International Journal of Managerial Finance, 3(2), pp. 164-177. Hill, M. K. G. & Highfield, M., 2010. Net Operating Working Capital Behavior: A first Look,. Financial Management (forthcoming). Lazaridis, I. & Tryfonidis, D., 2006. The Relationship between Working Capital Management and Profitability of Listed Companies in the Athens Stock Exchange. Journal of Financial Management and Analysis, 19(1), pp. 26-35. Nazir, M. & Afza, T., 2003. The focus of Working Capital Management in UK Small Firms,. Managerial Accounting Research, 14(2). Nazir, M. & Afza, T., 2009. Impact of Aggressive Working Capital Management Policy on Firm’s profitability. The IUP Journal of Applied Finance, 15(3). Ng, C., Smith, J. & Smith, R., 1999. Evidence on the Determinants of Credit Terms Used in Interfirm Trade. Journal of Finance, 54(5), pp. 1109-1129. Raheman, A. & Nasr, M., 2007. Working Capital Management and Profitability – Case of Pakistani Firms. International Review of Business Research Papers, 3(1), pp. 279-300. Shin, H. & Soenen, L., 1998. Efficiency of Working Capital and Corporate Profitability. Financial Practice and Education, 8(2), pp. 37-45. Summers, B. & Wilson, N., 2000. Trade Credit Management and the Decision to Use Factoring: An Empirical Study. Journal of Business, Finance and Accounting, 27(1 & 2), pp. 37-68. Teruel, P. & Solano, P., 2007. Effects of Working Capital Management on SME Profitability. International Journal of Managerial Finance, 3(2), pp. 164-177. Wang, Y., 2002. Liquidity Management, Operating Performance, and Corporate Value: Evidence from Japan and Taiwan. Journal of Multinational Financial Management, 12(3), pp. 159-169. Appendix Questionnaire: Please respond to all the questions provided. 1. Kindly explain what you think managing working capital mean to you…… 2. What was the Stockholding period of the firm for the 2013 financial year? …….. 3. What was the Debtors’ collection period of the firm for the 2013 financial year? ......... 4. What was the Creditors’ Payment Period of the firm for the 2013 financial year? …….. 5. Please explain what you think is the impact of managing working capital on the profitability of the firm…… Read More