Essay on Relationship Between Working Capital Management and Profitability of an Organization

The chapter will focus on the general overview of the relationship between working capital management and profitability of an organization. It will describe the different perceptions of authors as they give their views on the existence of a relationship between the two factors or its absence thereof. It will also highlight the components of working capital management, which are the accounts receivables, accounts payable, and inventory. A conclusion at the end of this chapter will summarize the information discussed in the paper.

1.1 Introduction

Every organization strives to maintain a balance between the current assets and liabilities as it affects the success of the firm both in the short-term and in the long-term. A firms liquidity depends on its ability to meet the short-term obligations. A well-managed firm should be in a position to pay all its debts and still make a considerable amount in profits reported at the end of each financial year. Different authors in the field of accountancy have had diverse views on the existence of a relationship between the working capital of an organization and its profitability. Various results from experiments by different scholars on organizations to prove whether there exists a relationship or not are represented in this paper.

1.2 Overview of Working Capital Management

Working capital management is a strategy adopted by organizations in monitoring its current assets and current liabilities. The current assets and current liabilities are the main components of working capital. The management of an organization is interested in the functionality of the working capital as it reflects its financial strength. The main reason to maintain a working capital management aspect in the organization is to ensure that the firm has enough cash flow that allows it to meet its operating costs and obligations that must be fulfilled within a short time. Working capital is a monitoring strategy applied by an organization. It focuses on the assets, cash flow, and liabilities by conducting a ratio of the key indicators. A ratio of current assets to the current liabilities reflects the working capital. A positive ratio between the two reveals a healthy and stable organization while a negative ratio shows that a firm has issues that need urgent attention.

A working capital management has a positive impact on the profitability of the firm. This is because a positive working capital means that the firm has enough float to meet its daily obligations. It also means that an organization operates smoothly with no major disruptions due to unavailable amounts of money to pay the short-term creditors and expenses of the organization. Another impact of working capital management on a firms profitability is that it reflects the ability of an organization to maximize its production activities so that it can generate more profits.

Different policies exist on the management of working capital in organizations in that every firm should monitor the levels so that it can keep itself updated on the performance of the business. Lack of proper attention or ignoring the elements of a working capital might affect the organization when it needs to make a major decision involving a large amount of money. An aggressive policy in the working capital dictates that the management attempts to reduce the investments in the current asset while maximizing on the liabilities by paying them on time. A conservative working capital approach happens where the organization aims to have high levels of the amount reflected in the current assets meaning that it has an unlimited amount of the working capital.

1.3 Components of Working Capital Management

Three main components of working capital management include the accounts receivables, accounts payable, and inventory. Each of the components affects the profitability of an organization in its unique way. An organization must learn how to maintain the level of each component to the required amount so that it can balance with the other two. When the three elements are combined, they reflect the financial stability and health of the organization.

1.3.1 Accounts Receivables Management

Accounts receivables are the amounts debtors owe the organization. The firm expects to receive them at some time in the future since they delivered services or products to them. They are reflected in the income statement as assets since a firm expects to gain some amount of cash after the customers pay their arrears. Patatoukas (2011 p363) states that there is a positive relationship between the accounts receivable and the performance of a firm because an organization must be able to pay the short-term obligations before it moves to the long-term obligations. Mohamad and Saad, (2010 p140) argue that there is the negative relationship between accounts receivables and firm performance because the valuation of each component is different from the other. This is evident from the capital markets performance of organizations that had high returns on the stock exchange. A firm can be in a position to meet the short-term obligations but is not making profits. Accounts receivables and firm performance are independent activities that occur at different times in a financial year. There is a high chance that account receivables might turn into bad debts, but a stable organization will be in a position to recover from the negative setback, hence no direct relationship between the receivables and profitability or performance of an organization (Gunny, 2010 p888).

Empirical evidence conducted on Indian companies revealed that there is a relationship between account receivables and firm profitability. A study of sixty firms was conducted, and out of the sample, 95% of the organizations revealed that account receivables are the main backbone of an organization as they allow it meet the daily obligations and prepare for the future (Sharma and Kumar, 2011 p 172). Mathuva (2015 p56) agrees with the above sentiments by presenting the influence a working capital management has on the profitability of the firm. He states that financial lending institutions shy away from extending help to organizations that are unable to pay their daily expenses. Due to the high risks that organizations face before making any significant profit, receivables do not affect the profitability of a firm. It is negative, as the more people owe the organization, the higher the chance that the firm will have high returns (Michalski, 2008 p67). A sample of thirty firms was used from the Czech Republic. However, Jackson and Liu (2015) believe that there is no relationship between the accounts receivables and profitability of the firm because organizations have some form of allowances for uncollectible accounts. The authors used a sample of organizations from Japan. A study on the manufacturing sector in Pakistan reveals that as long as firms are in a position to make high profits during their peak seasons, then failure by debtors to pay on time does not affect the amounts of profits earned during a period. This means that there is a negative relationship between receivables and firm performance (Raheman et al., 2010)

1.3.2 Accounts Payable Management

Accounts payable management are methods an organization adopts to ensure it keeps a healthy list of its creditors. They are short-term liabilities that the organization must pay within a period of three months to one year. The stability of a firm depends on its ability to push through hard economic times as opposed to some payables it owes it, creditors, Dudin et al., 2014). The authors studied Iranian firms and concluded that being innovative helps create a good amount of cash before competition sets to copy. Bougheas, Mateut, and Mizen (2009) state that there is a positive relationship between accounts payable and firm profitability because a firm has to use some of the resources to pay off its debts which reduces the amount of money at hand. This was from the evidence of eight firms in Florida. However, Soana (2011) studied the banking sector in the United States and revealed that accounts payable have no impact on the firm profitability because the public actions of the organization determine the relationship an entity enjoys with its creditors.

A positive relationship between accounts payable and firm profitability exist because an organization must control the amount of money it has on debts so that it can have an operating amount that will help generate profits (Vural, Sokmen, and Cetenak, 2012). The authors took a sample of Turkish firms to prove their assumptions. However, Pais and Gama (2015) studied Portuguese industries and argued that most SMEs were making super-normal profits while operating on a negative balance since they maintained an open communication with their creditors. They also had attractive repayment periods that gave them ample time to plan for their profits at the end of each period. A study on infant industries in Asia revealed that there is no impact on accounts payable and firm performance since the management skills of a leader enable the firm operates positively irrespective of the amounts they owe their creditors. The authors revealed that outsourcing is a cheaper option when it comes to offsetting account payables.

The working capital of an organization plays an important role in the profits released at the end of the financial period. Reducing a number of debts means in a period means that an organization made profits within that period (Tauringana and Adjapong Afrifa, 2013). The European market depends on the reputation of an organization to enter into a business relationship with the organization, meaning that there is a negative relationship between accounts payable and firm profitability (Van den Bogaerd and Aerts, 2015). A firm might have a significant outstanding balance with creditors and still make profits if they maintain a positive image in public. Saeed, Gull, and Rasheed (2013) argue that accounts payable have no impact on the firm performance as an organization arranges before taking debts on how they will offset the bill without relying on the available stock. A case study of Pakistan was conducted to confirm the relationship between accounts payable and firm performance.

1.3.3 Inventory Management

Inventory management is the act of overseeing the stock maintained in an organization. A firm keeps these items so that it can sell to customers at a profit. It involves ordering, storing, and additional raw materials that add value to the final product. The management of an organization understands that stock is a resource as it is transformed into cash at the end of purchase. Napompech (2012) studied seventy firms in Thai and concluded that inventory management has a positive relationship with the firm profitability because it was transferred to cash at the end of each financial period. Zang (2011) disagrees and states that there is a negative relationship between inventory and firm performance as the management of an organization has the option of manipulating the amount of stock to represent a high value. This is after studying eighteen firms in China. There is no impact on inventory and firm performance as sales have not been realized (Sadikoglu and Zehir, 2010). An empirical study on Turkish firms revealed that an organization should not reflect the stock in a financial statement using a specific amount, as they are not sure how much loss or profits they might get in the future.

Evidence from a study undertaken in Turkey reveals that inventory affects the firm profitability. This is because a firm regulates the price of its in...