Measures of Working Capital Management Efficiency and Their Relationship to Corporate Profitability - Essay Example

Smith (1980) first signaled the importance of the trade-offs between the dual goals of working capital management, i.e., liquidity and profitability. In other words, decisions that tend to maximize profitability tend not to maximize the chances of adequate liquidity. Conversely, focusing almost entirely on liquidity will tend to reduce the potential profitability of the company. The most conventional measures of corporate liquidity are the current ratio and the quick ratio. Because of the static nature, their adequacy in examining a firm's efficiency in managing its working capital has been questioned by many authors (see, for example, Emery, 1984; and Kamath, 1989).

Liquidity for the on-going firm is not really dependent on the liquidation value of its assets but rather on the operating cash flow generated by those assets. Gitman (1974) introduced the cash cycle concept as a crucial element in working capital management. The total cash cycle is defined as the number of days from the time the firm pays for its purchases of the most basic form of inventory to the time the firm collects for the sale of its finished product. Richards and Laughlin (1980) operationalized the cash cycle concept by reflecting the net time interval between cash expenditures on purchases and the ultimate recovery of cash receipts from product sales.

The Cash Conversion Cycle (CCC) is an additive measure of the number of days funds are committed to inventories and receivables less the number of days payments are deferred to suppliers. Gentry, Vaidyanathan, and Lee (1990) developed a modified version of the CCC called the Weighted Cash Conversion Cycle (WCCC), which scales the timing by the amount of funds in each step of the cycle. The weights are calculated by dividing the amount of cash tied up in each component by the final value of the component.

Therefore, the WCCC includes both the number of days and the amount of funds that are tied up at each stage of the cash cycle. The Net Trade Cycle Although the WCCC provides a better appreciation of the complexities of the cash cycle, in this study, we use the Net Trade Cycle (NTC). First, the break-up of inventories into its three main components, i.e., raw materials, work-in-progress, and finished goods, is not readily available for the outside investigator; consequently we cannot calculate the WCCC.

Second, the CCC is an additive concept, but unfortunately the denominators for the three components (i.e., number of days inventories, accounts receivable, and accounts payable) are all different, making addition not really useful. In contrast, the NTC is basically equal to the CCC whereby all three components are expressed as a percentage of sales. The NTC actually indicates the number of "days sales" the company has to finance its working capital under ceteris paribus conditions. This instrument provides an easy estimate for additional financing needs with regard to working capital expressed as a function of the projected sales growth.

For example, assuming that Wal-Mart's sales would again grow with 13% during 1996 as they did over 1995, and assuming the same 40 days NTC, this would imply a $1.19 billion financing need just for