Working Capital Management and Profitability: The Relationship between the Net Trade Cycle and Return on Assets

By Erasmus, P. D. | Management Dynamics, January 1, 2010 | Go to article overview

Working Capital Management and Profitability: The Relationship between the Net Trade Cycle and Return on Assets


Erasmus, P. D., Management Dynamics


ABSTRACT

It has long been argued that efficient working capital management should contribute to the creation of shareholder value. This study investigates the relationship between working capital management and firm profitability for a sample containing both listed and delisted South African industrial firms. The results obtained from the full sample revealed statistically significant negative relationships between a firm's profitability (as quantified by the return on assets in the narrower sense) and its net trade cycle (NTC), debt ratio and liquidity ratio. Similar results are observed if the listed firms are investigated separately. In the case of firms that delisted during the period under review, however, the liquidity and debt ratios appear to play a more important role than the NTC. Based on the results of this study, it would appear that management could attempt to improve firm profitability by decreasing the overall investment in net working capital.

INTRODUCTION

In the fields of financial economics and corporate finance it is generally accepted that the primary financial objective of a firm should be to focus on the maximisation of shareholder value. In order to realise this objective, the management of a firm needs to ensure that the firm's capital is invested in value-creating, profitable projects that will generate positive net present values. Extensive empirical research has been conducted to investigate the effect of investment and financing decisions on firm value. More recently, the focus has also increasingly been placed on the effect that working capital decisions exert on firm value (Nazir andAfza, 2008: 293; RaehmanandNasr, 2007: 279; Lazaridis andTryfonidis, 2006: 35; Deloof, 2003 : 575).

The net working capital of a firm represents an investment of the firm's capital in current assets (like trade receivables and inventory) and the use of current liabilities (like trade payables) to finance part of this investment. This investment in net working capital is required to support the operations of the firm, and without sufficient investment it would not be possible to conduct business and generate revenue. It is important, however, that management should ensure that the working capital investment is efficiently utilised, since an overinvestment in unutilised working capital could result in the destruction of value. If a firm is able to reduce its investment in working capital, the capital can be invested in other more profitable projects where value is created.

However, management also faces the problem that an underinvestment in working capital could result in liquidity problems. If an insufficient investment in cash, trade receivables or inventories is made, the firm may struggle to conduct its daily business. As a result, sales may drop, and ultimately, profitability may be compromised. This trade-off between liquidity and profitability was highlighted by Smith (1980), who pointed out that working capital management could play an important role in the profitability, risk propensity, and ultimately, the value of a firm. Johnson and Soenen (2003: 364) also argued that efficient working capital management is one of the key characteristics of financially successful firms. The results of their study revealed that firms with shorter cash conversion cycles (CCCs) seem to outperform the other firms included in their sample in terms of profitability.

Measures of working capital management

The traditional view on evaluating a firm's working capital management was to focus on liquidity measures, such as the current and the quick ratio. These ratios, however, are based purely on balance-sheet values at the end of the financial year, and a number of problems are associated with these static measures (Jose, Lancaster and Stevens, 1996: 34). According to Richards and Laughlin (1980: 33), the incorporation of income statement values would yield a flow measure that focuses on the operating cycle of the firm, and which would be better suited to evaluating working capital management. …

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