working capital management term paper

• Search Search Please fill out this field.
• Working Capital Management
• How It Works
• Why Manage Capital?

Working Capital Cycle

• Limitations

The Bottom Line

• Corporate Finance
• Financial statements: Balance, income, cash flow, and equity

Working Capital Management Explained: How It Works

Investopedia / Sydney Saporito

What Is Working Capital Management?

Working capital management is a business strategy designed to manage a company's working capital. A company's working capital refers to the capital it has left over after accounting for its current liabilities. Working capital management ensures that a company operates efficiently by monitoring and using its current assets and liabilities to their most effective use. The efficiency of working capital management can be quantified using ratio analysis .

Key Takeaways

• Working capital management requires monitoring a company's assets and liabilities to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations.
• Managing working capital primarily revolves around managing accounts receivable, accounts payable, inventory, and cash.
• Working capital management involves tracking various ratios, including the working capital ratio, the collection ratio, and the inventory ratio.
• Working capital management can improve a company's cash flow management and earnings quality by using its resources efficiently.
• Working capital management strategies may not materialize due to market fluctuations or may sacrifice long-term successes for short-term benefits.

Understanding Working Capital Management

Working capital is a key metric used to measure a company's short-term financial health and well-being. It is the difference between a company's current assets and current liabilities. As such, it is the capital that is left after accounting for its current liabilities. Working capital management is a strategy that companies use to manage their leftover cash.

Current assets include anything that can be easily converted into cash within 12 months. These are the company's highly liquid assets. Some current assets include cash, accounts receivable (AR), inventory, and short-term investments. Current liabilities are any obligations due within the following 12 months. These include accruals for operating expenses and current portions of long-term debt payments.

The primary purpose of working capital management is to enable the company to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations. A company's working capital is made up of its current assets minus its current liabilities.

Working capital management monitors cash flow, current assets, and current liabilities using ratio analysis, such as working capital ratio , collection ratio, and inventory turnover ratio .

Working Capital Management Components

Certain balance sheet accounts are more important when considering working capital management. Though working capital often entails comparing all current assets to current liabilities, there are a few accounts that are more critical to track.

The core of working capital management is tracking cash and cash needs. This involves managing the company's cash flow by forecasting needs, monitoring cash balances, and optimizing cash flows (inflows and outflows) to ensure that the company has enough cash to meet its obligations.

Because cash is always considered a current asset, all accounts should be considered. However, companies should be mindful of restricted or time-bound deposits .

Receivables

To manage capital, companies must be mindful of their receivables. This is especially important in the short term as they wait for credit sales to be completed. This involves:

• Managing the company's credit policies
• Monitoring customer payments
• Improving collection practices

At the end of the day, having completed a sale does not matter if the company is unable to collect payment on the sale.

Accounts Payable

Accounts payable refers to one aspect of working capital management that companies can take advantage of that they often have greater control over. While other aspects of working capital management may be uncontrollable, such as selling goods or collecting receivables, companies often have a say in how they pay suppliers, what the credit terms are, and when cash outlays are made.

Companies primarily consider inventory during working capital management as it may be the most risky aspect of managing capital. When inventory is sold, a company must go to the market and rely on consumer preferences to convert inventory to cash.

If this cannot be completed quickly, the company may be forced to have its short-term resources stuck in an illiquid position. Alternatively, the company may be able to quickly sell the inventory but only with a steep price discount.

Types of Working Capital

In its simplest form, working capital is the difference between current assets and current liabilities. However, different types of working capital may be important to a company to best understand its short-term needs.

• Permanent working capital: Permanent working capital is the amount of resources the company will always need to operate its business without interruption. This is the minimum amount of short-term resources vital to a company's operations.
• Regular working capital: Regular working capital is a component of permanent working capital. It is the part of the permanent working capital that is required for day-to-day operations and makes up the most important part of permanent working capital.
• Reserve working capital: Reserve working capital is the other component of permanent working capital. Companies may require an additional amount of working capital on hand for emergencies, seasonality , or unpredictable events.
• Fluctuating working capital: Companies may be interested in only knowing what their variable working capital is. For example, companies may opt to pay for inventory as it is a variable cost . However, the company may have a monthly liability relating to insurance it does not have the option to decline. Fluctuating working capital only considers the variable liabilities the company has complete control over.
• Gross working capital: Gross working capital is simply the total amount of current assets of a business before considering any short-term liabilities.
• Net working capital: Net working capital is the difference between current assets and current liabilities.

Why Manage Working Capital?

Working capital management can improve a company's cash flow management and earnings quality through the efficient use of its resources. Management of working capital includes inventory management as well as management of accounts receivable and accounts payable. 

Working capital management also involves the timing of accounts payable like paying suppliers. A company can conserve cash by choosing to stretch the payment to suppliers and make the most of available credit .

In addition to ensuring that the company has enough cash to cover its expenses and debt, the objectives of working capital management are to minimize the cost of money spent on working capital and maximize the return on asset investments.

Working Capital Management Ratios

Three ratios that are important in working capital management are the working capital ratio, the collection ratio, and the inventory turnover ratio.

Working Capital Ratio

The working capital ratio or current ratio is calculated by dividing current assets by current liabilities. This ratio is a key indicator of a company's financial health as it demonstrates its ability to meet its short-term financial obligations.

A working capital ratio below 1.0 often means a company may have trouble meeting its short-term obligations. That's because the company has more short-term debt than short-term assets. To pay all of its bills as they come due, the company may need to sell long-term assets or secure external financing .

Working capital ratios of 1.2 to 2.0 are considered desirable as this means the company has more current assets compared to current liabilities. However, a ratio higher than 2.0 may suggest that the company is not effectively using its assets to increase revenues. For example, a high ratio may indicate that the company has too much cash on hand and could be more efficiently utilizing that capital to invest in growth opportunities.

Collection Ratio (Days Sales Outstanding)

The collection ratio, also known as days sales outstanding (DSO) , is a measure of how efficiently a company manages its accounts receivable. The collection ratio is calculated by multiplying the number of days in the period by the average amount of outstanding accounts receivable.

This product is then divided by the total amount of net credit sales during the accounting period. To find the average amount of average receivables, companies most often simply take the average between the beginning and ending balances.

The collection ratio calculation provides the average number of days it takes a company to receive payment after a sales transaction on credit. Note that the DSO ratio does not consider cash sales. If a company's billing department is effective at collecting accounts receivable, the company will have quicker access to cash which it can deploy for growth. Meanwhile, if the company has a long outstanding period, this effectively means the company is awarding creditors with interest-free, short-term loans.

Inventory Turnover Ratio

Another important metric of working capital management is the inventory turnover ratio. To operate with maximum efficiency, a company must keep sufficient inventory on hand to meet customers' needs. However, the company also needs to strive to minimize costs and risk while avoiding unnecessary inventory stockpiles.

The inventory turnover ratio is calculated as the cost of goods sold (COGS) divided by the average balance in inventory. Again, the average balance in inventory is usually determined by taking the average of the starting and ending balances.

The ratio reveals how rapidly a company's inventory is used in sales and replaced. A relatively low ratio compared to industry peers indicates a risk that inventory levels are excessively high, meaning a company may want to consider slowing production to ease the cost of insurance, storage, security, or theft. Alternatively, a relatively high ratio may indicate inadequate inventory levels and risk to customer satisfaction.

In addition to the ratios discussed above, companies may rely on the working capital cycle when managing working capital. Working capital management helps maintain the smooth operation of the net operating cycle, also known as the cash conversion cycle (CCC) .

This is the minimum amount of time required to convert net current assets and liabilities into cash. The working capital cycle is a measure of the time it takes for a company to convert its current assets into cash, or:

Working Capital Cycle in Days = Inventory Cycle + Receivable Cycle - Payable Cycle 

The working capital cycle represents the period measured in days from the time when the company pays for raw materials or inventory to the time when it receives payment for the products or services it sells. During this period, the company's resources may be tied up in obligations or pending liquidation to cash.

Inventory Cycle

The inventory cycle represents the time it takes for a company to acquire raw materials or inventory, convert them into finished goods, and store them until they are sold. During this stage, the company's cash is tied up in inventory.

Though it starts the cycle with cash on hand, the company agrees to part ways with working capital with the expectation that it will receive more working capital in the future by selling the product at a profit.

Accounts Receivable Cycle

The AR cycle represents the time it takes for a company to collect payment from its customers after it has sold goods or services. During this stage, the company's cash is tied up in accounts receivable.

Though the company can part ways with its inventory, its working capital is now tied up in accounts receivable and still does not give the company access to capital until these credit sales are received.

Accounts Payable Cycle

The AP cycle represents the time it takes for a company to pay its suppliers for goods or services received. During this stage, the company's cash is tied up in accounts payable.

On the positive side, this represents a short-term loan from a supplier meaning the company can hold onto cash even though they have received a good. On the negative side, this creates a liability that needs to be managed.

Limitations of Working Capital Management

With strong working capital management, a company should be able to ensure it has enough capital on hand to operate and grow. However, there are downsides to the approach. Working capital management only focuses on short-term assets and liabilities.

It does not address the long-term financial health of the company and may sacrifice the best long-term solution in favor of short-term benefits.

Even with the best practices in place, working capital management cannot guarantee success. The future is uncertain, and it's challenging to predict how market conditions will affect a company's working capital.

Whether there are changes in macroeconomic conditions and customer behavior, or there are disruptions in the supply chain, a company's forecast of working capital may simply not materialize as expected.

While effective working capital management can help a company avoid financial difficulties, it may not necessarily lead to increased profitability. Working capital management does not inherently increase profitability, make products more desirable, or increase a company's market position.

Companies still need to focus on sales growth, cost control, and other measures to improve their bottom line. As that bottom line improves, working capital management can simply enhance the company's position.

Working capital management aims at more efficient use of a company's resources by monitoring and optimizing the use of current assets and liabilities. The goal is to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations while maximizing its profitability. Working capital management is key to the cash conversion cycle, or the amount of time a firm uses to convert working capital into usable cash.

Why Is the Current Ratio Important?

The current ratio or the working capital ratio indicates how well a firm can meet its short-term obligations. It's also a measure of liquidity . If a company has a current ratio of less than 1.0, this means that short-term debts and bills exceed current assets, which could be a signal that the company's finances may be in danger in the short run.

Why Is the Collection Ratio Important?

The collection ratio, also known as days sales outstanding, is a measure of how efficiently a company can collect on its accounts receivable. If it takes a long time to collect, it can be a signal that there will not be enough cash on hand to meet near-term obligations. Working capital management tries to improve the collection speed of receivables.

Why Is the Inventory Ratio Important?

The inventory turnover ratio shows how efficiently a company sells its inventory. A relatively low ratio compared to industry peers indicates a risk that inventory levels are excessively high, while a relatively high ratio may indicate inadequate inventory levels.

Working capital management is at the core of operating a business. Without sufficient capital on hand, a company is unable to pay its bills, process its payroll, or invest in its growth. Companies can better understand their working capital structure by analyzing liquidity ratios and ensuring their short-term cash needs are always met.

Dr. Ajay Tyagi, via Google Books. " Capital Investment and Financing for Beginners ," Page 3. Horizon Books, 2017.

Dr. Ajay Tyagi, via Google Books. " Capital Investment and Financing for Beginners ," Page 4. Horizon Books, 2017.

Dr. Ajay Tyagi, via Google Books. " Capital Investment and Financing for Beginners ," Pages 4-5. Horizon Books, 2017.

• Terms of Service
• Editorial Policy
• Privacy Policy

Working capital management and firm profitability

• Short survey paper
• Published: 09 May 2013
• Volume 24 , pages 77–87, ( 2013 )

Cite this article

• Thorsten Knauer 1 &
• Arnt Wöhrmann 1  

10k Accesses

48 Citations

Explore all metrics

Managing a firm’s current assets and liabilities (working capital management) is highly relevant to the success of that firm. While the short-term liquidity effects of working capital management are straightforward to derive, it is an empirical question how it affects firm profitability. This short survey paper consolidates the empirical literature on the association between working capital management and firm profitability. This state of the art analysis provides evidence of positive effects of accounts receivable management and inventory management on profitability. However, results for the effects of accounts payable management on profitability are driven by reverse causality. Finally, this paper highlights critical aspects of prior research and points to avenues for future research.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Subscribe and save.

• Get 10 units per month
• Download Article/Chapter or eBook
• 1 Unit = 1 Article or 1 Chapter
• Cancel anytime

Price includes VAT (Russian Federation)

Instant access to the full article PDF.

Rent this article via DeepDyve

Institutional subscriptions

Lazaridis and Tryfonidis ( 2006 ) use the term gross operating profit (GOP) instead of GOI. Since the definition of GOP is equivalent to the GOI measure, we use only one term.

Since most studies report a negative relationship between CCC and profitability while the isolated effect of DPO on profitability is less clear, using gross instead of net working capital in empirical studies is unlikely to affect the inferences for working capital management and profitability.

Baños-Caballero, S., García-Teruel, P. J., Martínez-Solano, P. (2010). Working capital management in SMEs. Accounting and Finance , 50 , 511–527.

Google Scholar  

Baños-Caballero, S., García-Teruel, P. J., Martínez-Solano, P. (2012). How does working capital management affect the profitability of Spanish SMEs? Small Business Economics , 39 , 517–529.

Berens, W., Schmitting, W., Wöhrmann, A. (2005). Instrumente zur Senkung des Kapitaleinsatzes: eine Analyse unter Berücksichtigung von Unternehmensbeispielen. Zeitschrift für Planung und Unternehmenssteuerung , 16 , 1–26.

Chiou, J., Cheng, L. (2006). The determinants of working capital management. Journal of American Academy of Business , 10 , 149–155.

Deloof, M. (2003). Does working capital management affect profitability of Belgian firms? Journal of Business Finance and Accounting , 30 , 573–587.

Enqvist, J., Graham, M., Nikkinen, J. (2012). The impact of working capital management on firm profitability in different business cycles: evidence from Finland. Working paper.

García-Teruel, P. J., Martínez-Solano, P. (2007). Effects of working capital management on SME profitability. International Journal of Managerial Finance , 3 , 164–177.

García-Teruel, P. J., Martínez-Solano, P. (2010). Determinants of trade credit: a comparative study of European SMEs. International Small Business Journal , 28 , 215–233.

Gitman, L. J. (1974). Corporate liquidity requirements: a simplified approach. The Financial Review , 9 , 79–88.

Harbula, P. (2011). Operating performance, valuation, leverage and corporate governance of leveraged buyout transactions: a continental European perspective. Working paper.

Hawawini, G., Viallet, C., Vora, A. (1986). Industry influence on corporate working capital decisions. Sloan Management Review , 27 , 15–24.

Holthausen, R. W., Larcker, D. F. (1996). The financial performance of reverse leveraged buyouts. Journal of Financial Economics , 42 , 293–332.

Howorth, C., Westhead, P. (2003). The focus of working capital management in UK small firms. Management Accounting Research , 14 , 94–111.

Jose, M. L., Lancaster, C., Stevens, J. L. (1996). Corporate return and cash conversion cycles. Journal of Economics and Finance , 20 , 33–46.

Karaduman, H. A., Akbas, H. E., Ozsozgun, A., Durer, S. (2010). Effects of working capital management on profitability: the case of selected companies in the Istanbul Stock Exchange. International Journal of Economics and Finance Studies , 2 , 47–54.

Kestens, K., Van Cauwenberge, P., Bauwhede, H. V. (2012). Trade credit and company performance during the 2008 financial crisis. Accounting and Finance . doi: 10.1111/j.1467-629X.2011.00452.x .

Kieschnick, R. L., LaPlante, M., Moussawi, R. (2011). Working capital management and shareholder wealth. Working paper.

Kim, C. S., Mauer, D. C., Sherman, A. E. (1998). The determinants of corporate liquidity: theory and evidence. Journal of Financial and Quantitative Analysis , 33 , 335–359.

Knauer, T., Sommer, F. (2010). Die operative Entwicklung deutscher Leveraged Buyouts—Wertsteigerung durch Effizienzsteigerung? Die Betriebswirtschaft , 70 , 389–404.

Lazaridis, I., Tryfonidis, D. (2006). Relationship between working capital management and profitability of listed companies in the Athens Stock Exchange. Journal of Financial Management and Analysis , 19 , 26–35.

Long, M. S., Malitz, I. B., Ravid, S. A. (1993). Trade credit, quality guarantees, and product marketability. Financial Management , 22 , 117–127.

Malmi, T., Ikäheimo, S. (2003). Value based management practices—some evidence from the field. Management Accounting Research , 14 , 235–254.

Meyer, S., Lüdtke, J. P. (2006). Der Einfluss von Working Capital auf die Profitabilität und Kreditwürdigkeit von Unternehmen. Finanz Betrieb , 8 , 609–614.

Moss, D. J., Stine, B. (1993). Cash conversion cycle and firm size: a study of retail firms. Managerial Finance , 19 , 25–34.

Niskanen, J., Niskanen, M. (2006). The determinants of corporate trade credit policies in a bank-dominated financial environment: the case of Finnish small firms. European Financial Management , 12 , 81–102.

Opler, T., Pinkowitz, L., Stulz, R., Williamson, R. (1999). The determinants and implications of corporate cash holdings. Journal of Financial Economics , 53 , 3–46.

Pass, C., Pike, R. (1987). Management of working capital: a neglected subject. Management Decision , 25 , 18–24.

PwC (2012). European Annual Working Capital Review 2012. http://www.pwc.co.uk/strategy/publications/european-working-capital-annual-review-2012.jhtml . Accessed 08 Oct 2012.

Raheman, A., Nasr, M. (2007). Working capital management and profitability—case of Pakistani firms. International Review of Business Research Papers , 3 , 279–300.

Richards, V., Laughlin, E. (1980). A cash conversion cycle approach to liquidity analysis. Financial Management , 9 , 32–38.

Schall, L. D., Haley, C. W. (1991). Introduction to financial management . New York: McGraw-Hill.

Schilling, G. (1996). Working capital’s role in maintaining corporate liquidity. TMA Journal , 16 , 4–7.

Shin, H., Soenen, L. (1998). Efficiency of working capital management and corporate profitability. Financial Practice and Education , 8 , 37–45.

Smith, K. V. (1980). Profitability versus liquidity tradeoffs in working capital management. In K. V. Smith (Ed.), Readings on the management of working capital (pp. 549–562). Saint Paul: West Publishing.

Trochim, W. (2000). The research methods knowledge base (2nd ed.). Cincinnati: Atomic Dog Publishing.

Van Horne, J. C., Wachowicz, J. M. (2005). Fundamentals of financial management . England: Harlow.

Wang, Y. J. (2002). Liquidity management, operating performance, and corporate value: evidence from Japan and Taiwan. Journal of Multinational Financial Management , 12 , 159–169.

Wilner, B. S. (2000). The exploitation of relationships in financial distress. Journal of Finance , 55 , 153–178.

Wöhrmann, A., Knauer, T., Gefken, J. (2012). Kostenmanagement in Krisenzeiten: Rentabilitätssteigerung durch Working Capital Management? Zeitschrift für Controlling und Management (Sonderheft 3) , 56 , 80–85.

Download references

Author information

Authors and affiliations.

Münster School of Business and Economics, University of Münster, Universitätsstrasse 14-16, 48143 , Münster, Germany

Thorsten Knauer & Arnt Wöhrmann

You can also search for this author in PubMed   Google Scholar

Corresponding author

Correspondence to Thorsten Knauer .

Rights and permissions

Reprints and permissions

About this article

Knauer, T., Wöhrmann, A. Working capital management and firm profitability. J Manag Control 24 , 77–87 (2013). https://doi.org/10.1007/s00187-013-0173-3

Download citation

Published : 09 May 2013

Issue Date : May 2013

DOI : https://doi.org/10.1007/s00187-013-0173-3

Share this article

Anyone you share the following link with will be able to read this content:

Sorry, a shareable link is not currently available for this article.

Provided by the Springer Nature SharedIt content-sharing initiative

• Management accounting
• Working capital management
• Cash conversion cycle
• Profitability

JEL Classification

• Find a journal
• Publish with us
• Track your research

• DOI: 10.1108/QRFM-04-2013-0010
• Corpus ID: 153713912

Working capital management: a literature review and research agenda

• H. Singh , Satish Kumar
• Published 29 August 2014
• Business, Economics
• Qualitative Research in Financial Markets

96 Citations

A systematic literature review on working capital management – an identification of new avenues, the effect of working capital management on the profitability of small and medium enterprises: meta-analysis, thematic literature review of working capital management in the construction industry: trends and research opportunities, review of literature on working capital management and future research agenda.

• Highly Influenced

Conceptual review study of working capital management practices in the construction industry: trends and research prospects in Ghana

Empirical studies on the performance of banks: a systemic literature review for future research, working capital management practices in india: survey evidence, a systematic literature review on sme financing: trends and future directions, economic downturns and working capital management practices: a qualitative enquiry, working capital management and corporate performance: evidence from indonesia, 93 references, effects of working capital management on sme profitability, working capital requirements and the determining factors in pakistan, working capital management efficiency of cement sector of pakistan, working capital management and firms’ performance in emerging markets: the case of jordan, working capital management and corporate profitability: evidence from iran, effective working capital management and profitability: a study of selected quoted manufacturing companies in nigeria, influence of working capital management on profitability: a study on indian fmcg companies, factors that influence working capital requirements in canada, working capital management: the effect of market valuation and profitability in malaysia, state of the art of short-run financial management, related papers.

Showing 1 through 3 of 0 Related Papers

The global body for professional accountants

• Search jobs
• Find an accountant
• Technical activities
• Help & support

Can't find your location/region listed? Please visit our global website instead

• Middle East
• Cayman Islands
• Trinidad & Tobago
• Virgin Islands (British)
• United Kingdom
• Czech Republic
• United Arab Emirates
• Saudi Arabia
• State of Palestine
• Syrian Arab Republic
• South Africa
• Africa (other)
• Hong Kong SAR of China
• New Zealand
• Our qualifications
• Getting started
• Your career
• Apply to become an ACCA student
• Why choose to study ACCA?
• ACCA accountancy qualifications
• Getting started with ACCA
• ACCA Learning
• Register your interest in ACCA
• Learn why you should hire ACCA members
• Why train your staff with ACCA?
• Recruit finance staff
• Train and develop finance talent
• Approved Employer programme
• Employer support
• Resources to help your organisation stay one step ahead
• Support for Approved Learning Partners
• Becoming an ACCA Approved Learning Partner
• Tutor support
• Computer-Based Exam (CBE) centres
• Content providers
• Registered Learning Partner
• Exemption accreditation
• University partnerships
• Find tuition
• Virtual classroom support for learning partners
• Find CPD resources
• Your membership
• Member networks
• AB magazine
• Sectors and industries
• Regulation and standards
• Advocacy and mentoring
• Council, elections and AGM
• Tuition and study options
• Study support resources
• Practical experience
• Our ethics modules
• Student Accountant
• Regulation and standards for students
• Your 2024 subscription
• Completing your EPSM
• Completing your PER
• Apply for membership
• Skills webinars
• Finding a great supervisor
• Choosing the right objectives for you
• Regularly recording your PER
• The next phase of your journey
• Your future once qualified
• Mentoring and networks
• Advance e-magazine
• Affiliate video support
• About policy and insights at ACCA
• Meet the team
• Global economics
• Professional accountants - the future
• Supporting the global profession
• Download the insights app

Can't find your location listed? Please visit our global website instead

• Working capital management
• Study resources
• Financial Management (FM)
• Technical articles and topic explainers

This article covers the following syllabus areas:

• C1 – the nature, importance and elements of working capital
• C2a – explain the cash operating cycle and the role of accounts payable and accounts receivable’ and
• C2b – explain and apply relevant accounting ratios.  

Working capital management is a core area of the syllabus and can form part, or the whole of, a 20-mark question in the exam, as well as being examined by objective test questions. It is, however, essential to study the whole syllabus and not only the specific areas covered in this article.

Importance of working capital management

Working capital represents the net current assets available for day-to-day operating activities. It is defined as current assets less current liabilities and, in exam questions, the components are usually inventory and trade receivables, trade payables and bank overdraft.

Many businesses that appear profitable are forced to cease trading due to an inability to meet short-term obligations when they fall due. Successful management of working capital is essential to remaining in business.

Working capital management requires great care due to potential interactions between its components. For example, extending the credit period offered to customers can lead to additional sales. However, the company’s cash position will fall due to the longer wait for customers to pay, potentially leading to the need for a bank overdraft. Interest on the overdraft may even exceed the profit arising from the additional sales, particularly if there is also an increase in the incidence of bad debts.

Working capital management is central to the effective management of a business because:

• current assets comprise the majority of the total assets of some companies
• shareholder wealth is more closely related to cash generation than accounting profits
• failure to control working capital, and hence to manage liquidity, is a major cause of corporate collapse.

Objectives of working capital management   

One of the two key objectives of working capital management is to ensure liquidity. A business with insufficient working capital will be unable to meet obligations as they fall due, leading to late payments to employees, suppliers and other providers of credit. Late payments can result in lost employee loyalty, lost supplier discounts and a damaged credit rating. Non-payment (default) can lead to the compulsory liquidation of assets to repay creditors.

The other key objective is profitability. Funds tied up in working capital tend to earn little, or no, return. Hence, a company with a high level of working capital may fail to achieve the return on capital employed (Operating profit ÷ (Total equity and long-term liabilities)) expected by its investors.   

Therefore, when determining the appropriate level of working capital there is a trade-off between liquidity and profitability:

The trade-off is perhaps most obvious with regards to the holding of cash. Although cash obviously provides liquidity it generates little return, even if held in the form of cash equivalents such as treasury bills. This is particularly true in an era of low interest rates (for example, in November 2016 the annualised yield on three-month US dollar treasury bills was approximately 0.4%).

Although an optimal level of working capital may exist it may not be achievable due to factors beyond management’s control, such as an unreliable supply chain influencing inventory levels. However businesses must at least avoid the extremes:

• Overtrading – insufficient working capital to support the level of business activities. This can also be described as under-capitalisation and is characterised by a high and rising proportion of short-term finance to long-term finance
• Over-capitalisation – an excessive level of working capital, leading to inefficiency.

Liquidity ratios

If the current ratio falls below 1 this may indicate problems in meeting obligations as they fall due. Even if the current ratio is above 1 this does not guarantee liquidity, particularly if inventory is slow moving. On the other hand a very high current ratio is not to be encouraged as it may indicate inefficient use of resources (for example, excessive cash balances).

The level of a firm’s current ratio is heavily influenced by the nature if its business for example:

• Traditional manufacturing industries require significant working capital investment in inventory (comprising raw materials, work in progress and finished goods) and trade receivables (as their business customers expect to be offered generous credit terms). Therefore companies operating in such industries may reasonably be expected to have current ratios of 2 or more.
• Modern manufacturing companies may use just-in-time management techniques to reduce the level of buffer inventory and hence reduce their current ratios to some extent.
• In some industries, a current ratio of less than 1 might be considered acceptable. This is especially true of the retail sector which is often dominated by ‘giants’ such as Wal-Mart (in the US) and Tesco (in the UK). Such retailers are able to negotiate long credit periods with suppliers while offering little credit to customers leading to higher trade payables as compared with trade receivables. These retailers are also able to keep their inventory levels to a minimum through efficient supply chain management. 

The quick ratio is particularly relevant where inventory is slow moving.

Efficiency ratios

This shows how quickly inventory is sold; higher turnover reflects faster-moving inventory.

However, working capital ratios are often easier to interpret if they are expressed in ‘days’ as opposed to ‘turnover’:

Note that exam questions may tell you to assume there are 360 days in the year. Furthermore, many exam questions only provide information about inventory as at the year-end, in which case this must be used as a proxy for the average inventory level.

Inventory days estimates the time taken for inventory to be sold. Everything else being equal a business would prefer lower inventory days. 

In exam questions you may have to assume that:

(i) year-end receivables are representative of the average figure; and (ii) all sales are made on credit.

Receivables days estimates the time taken for customers to pay. Everything else being equal a business would prefer lower receivables days. 

• Year-end payables are representative of the average figure
• Cost of sales approximates annual credit purchases
• All purchases are made on credit.

Payables days estimates the time taken to pay suppliers. A business would prefer to increase its payables days, unless this proves expensive in terms of lost settlement discounts or leads to other problems such as a damaged reputation – a ‘good corporate citizen’ is expected to pay promptly.

In this ratio working capital is defined as the level of investment in inventory and receivables less payables. In exam questions you may have to assume that year-end working capital is representative of the average figure over the year.

The sales to working capital ratio indicates how efficiently working capital is being used to generate sales. Everything else being equal the business would prefer this ratio to rise.

Cash operating cycle

The cash operating cycle (also known as the working capital cycle or the cash conversion cycle) is the number of days between paying suppliers and receiving cash from sales.

Cash operating cycle = Inventory days + Receivables days – Payables days.

In the manufacturing sector inventory days has three components:

(i) raw materials days (ii) work-in-progress days (the length of the production process), and (iii) finished goods days.

However, exam questions tend to be based in the retail sector where no such sub-analysis is required.

The longer the operating cycle the greater the level of resources ‘tied up’ in working capital. Although it is desirable to have as short a cycle as possible, there may be external factors which restrict management’s ability to achieve this:

• Nature of the business – a supermarket chain may have low inventory days (fresh food), low receivables days (perhaps just one to two days to receive settlement from credit card companies) and significant payables days (taking credit from farmers). In this case the operating cycle could be negative (ie cash is received from sales before suppliers are paid). On the other hand a construction company may have a very long operating cycle due to the high levels of work-in-progress.
• Industry norms – if key competitors offer long periods of credit to their customers it may be difficult to reduce receivables days without losing business.
• Power of suppliers – an attempt to delay payments could lead to the supplier demanding ‘cash on delivery’ in future (ie causing payables days to actually fall to zero rather than rising).

Interpretation of ratios

For a meaningful evaluation to be made of a firm’s working capital management it is necessary to identify:

• Trends – the change in a ratio over time. If an exam question provides two, or more, years of financial statements then appropriate ratios should be calculated for each year.
• External benchmarks – industry average (sector) ratios are commonly published by business schools or consultancies. If an exam question provides industry average data then you are expected to use this to benchmark the performance of the firm in the scenario. However do not assume that the only relevant ratios are those for which industry average data is available.

The following table is provided for reference purposes:

Topple Co has the following forecast figures for its first year of trading:

Sales $3,600,000

Purchases expense $3,000,000

Average receivables $306,000

Average inventory $495,000

Average payables $230,000

Average overdraft $500,000

Gross profit margin 25%

Industry average data:

Inventory days  53

Receivables days  23

Payables days  47

Current ratio  1.43

Assume there are 365 days in the year.

REQUIRED: Calculate and comment on Topple Co’s cash operating cycle, current ratio, quick ratio and sales to working capital ratio.

The length of the cash operating cycle indicates that there will be 70 days between Topple Co receiving cash from sales and paying cash to suppliers. This is significantly longer than the industry average of 29 days (53 + 23 – 47) and likely to lead to liquidity problems, as evidenced by the size of the overdraft.

Topple Co expects to take approximately the same credit period from its suppliers as is taken by its own customers, whereas the industry norm is to take a significantly longer credit period from suppliers (47 days) than is taken by customers (23 days). Therefore, slow inventory turnover is the main cause of Topple Co’s long working capital cycle. This may be inevitable in the first year of trading but is it important that systems are implemented to ensure efficient inventory management. The extent of future reductions in inventory days may be limited by the nature of the business as the industry average is 53 days.

It is perhaps unsurprising that Topple Co’s receivables days is also above the industry average as the firm may have been forced to offer generous terms of trade in order to attract customers away from its more established competitors, In addition Topple Co may still be in the process of establishing and implementing credit control procedures.

On the other hand Topple Co is paying its own suppliers much more quickly than the industry norm. Although this puts pressure on liquidity, Topple Co may be taking advantage of settlement discounts offered by suppliers or, as a new firm without an established trading history, it may simply not be offered extended credit periods by suppliers.

The above comparisons to sector data must be treated with caution as working capital management may be poor across the sector, leading to benchmarks which Topple Co should not endeavour to replicate. As a long-term target Topple Co should benchmark its performance against the leader in the sector.  

The current ratio indicates that, over the year, there will be $1.10 of current assets per $1 of current liabilities, which does not compare favourably with the industry average of 1.43 and may not be sufficient as Topple Co’s inventory appears to be slow moving. More relevant, therefore, is the quick ratio which indicates only $0.42 of liquid assets per $1 of current liabilities, although no industry average data is available to benchmark this figure.

The overdraft would need to be continuously monitored to ensure it remains within any agreed limit, and contingency plans put into place for refinancing. However if Topple Co is started up with an appropriate level of long-term finance then an overdraft may be avoided entirely.

Each $1 invested in working capital is expected to generate $6.30 of revenue. Although this may not appear to be a particularly efficient use of resources, the first year’s trading may not be representative. Once Topple Co becomes more established it should benchmark its sales to working capital ratio against sector data if available.

This article has covered the foundations of working capital management, focusing on the analysis of current assets and current liabilities. The Financial Management syllabus also demands detailed knowledge of specific models and techniques for each component of working capital – cash, inventory, receivables and payables – and a well-prepared candidate must also be competent in using these.  

References: PwC Global Working Capital Survey 2015

Mike Ashworth, a subject matter expert in financial management

Related Links

• Student Accountant hub

Advertisement

• ACCA Careers
• ACCA Career Navigator
• ACCA Learning Community

Useful links

• Make a payment
• ACCA-X online courses
• ACCA Rulebook
• Work for us

Most popular

• Professional insights
• ACCA Qualification
• Member events and CPD
• Supporting Ukraine
• Past exam papers

Connect with us

Planned system updates.

• Accessibility
• Legal policies
• Data protection & cookies
• Advertising

Role of working capital management in profitability considering the connection between accounting and finance

Asian Journal of Accounting Research

ISSN : 2459-9700

Article publication date: 25 August 2020

Issue publication date: 7 December 2020

The study aims to explain the relationship between accounting and finance through measuring the effect of rational working capital management on profitability.

Design/methodology/approach

Employing the methodology of semi-structured interviews with sixteen financial managers.

The findings pointed out the relationship between accounting and finance is complementary, since it supports the accountant by the critical skills and information, like project evaluation, managing the company funding resources and working capital management. These skills put the accountant up to the financial manager stage. The working capital investment and financing policies have the most significant impact on profitability. These policies related to risk and return theory; since the conservative policy will reduce both the risk and return and the aggressive one will have the opposite impact.

Originality/value

It recommends accountants to be in professional stage and increase the profitability of the company to grab both accounting and finance information and skills.

• Working capital
• Profitability
• M4 Accounting and Auditing

Morshed, A. (2020), "Role of working capital management in profitability considering the connection between accounting and finance", Asian Journal of Accounting Research , Vol. 5 No. 2, pp. 257-267. https://doi.org/10.1108/AJAR-04-2020-0023

Emerald Publishing Limited

Copyright © 2020, Amer Morshed

Published in Asian Journal of Accounting Research . Published by Emerald Publishing Limited. This article is published under the Creative Commons Attribution (CC BY 4.0) licence. Anyone may reproduce, distribute, translate and create derivative works of this article (for both commercial and non-commercial purposes), subject to full attribution to the original publication and authors. The full terms of this licence may be seen at http://creativecommons.org/licences/by/4.0/legalcode

1. Introduction

Despite the strong correlation between accounting and finance, each of them influences the management of operations in a different direction ( Brief and Peasnell, 2013 ). This link leads some people, who are not experienced and do not have the relevant knowledge, to confuse these two terms and connect some unrelated job duties to accountants ( Droms and Wright, 2010 ). Cleary and Quinn (2016) mentioned that accounting is an essential component of financing operations since finance is a term that includes accounting information.

Thus, the information provided by accountants is the primary element in decisions made by managers in general and financial managers in particular. However, in this context, Fields (2016) added that financing incorporates more subjects than only accounting. It contains statistics, economics, mathematics and any matters which are required for financing.

The main objective of the company, in common, is to achieve the most significant profits. The company aims to gain the maximum profit, and this can be done by multiplying the volume of production or the operation. One of the essential portions of production, trading and providing service is the working capital. Therefore, companies provide liquidity for working capital to achieve business continuity. In obtaining the purposes of the company, most often, business and financial directors are entitled to implement relevant working capital management policies. These policies are needed for financing because errors in working capital management may lead the commercial operations to withdrawn. Consequently, the sequence follows up on the status of working capital. It is significant and in touch with the entire business position ( Muhammad et al. , 2016 ).

Accordingly, the study aims to explain the relationship between accounting and finance through measuring the effect of rational working capital management on profitability and discussing the financial managers' responsibility. This article applies different procedures than those applied by other studies related to working capital management. The methodology adopts the qualitative method by conducting interview via Skype with financial managers from various territories in Europe and Asia to collect the data. These data reflect the best practices of working capital management from different economies, industries and sizes of capital. Hence, the results will be more generalisable.

The article found that the corporate finance skills put the accountant up to the financial manager stage. The working capital models play a significant role in advancing the profitability. Moreover, investment and financing policies have a substantial impact on profitability. These policies are related to risk and return theory since the balance between conservative and aggressive policies will contribute positive results.

Section 2 discusses a literature review of the working capital management. Section 3 discusses the methodology. Section 4 is the findings and discussion. In the end, Section 5 points out the conclusion.

2. Literature review

Explaining the profitability importance, Cakici et al. (2017) concluded that the companies use profitability as one of the four segments applied for the analysis of financial statements and performance. The other three are efficiency, solvency and market prospects. Managers, creditors and investors use these crucial impressions to analyse the company performance and its future potential if operations are suitably achieved. Vintilă and Nenu (2016) added that resources such as cash, overdraft and liabilities are used to cover the variable and fixed costs of the production process and to purchase the stock for resale operations. Profitability is the relationship between revenue and expenses and how well the company is performing and the potential future growth of the company and how it manages its working capital.

To explore the working capital management's effects on the profitability, Anwar (2018) examined the influence of the length of the operation cycle and the turnover of receivables and inventory on the profitability index of listed firms in Indonesia. The article concluded that reducing the turnover of both receivables and inventory leads to a decrease in the operation cycle and an increase the companies' profitability. Lazaridis and Tryfonidis (2006) reached results which show a relation between profitability and the operating cycle. Further, directors are able to generate gains for their businesses by controlling the operating cycle carefully and maintaining every different factor of the working capital to the most appropriate level. Pais and Gama (2015) pointed out many outcomes that inform the drop in the period of collecting the trade receivables and the rise in the number of days to settle their commercial liabilities are related to higher profitability. Additionally, the profitability is also an advance in return on assets with a reduction of the working capital amount.

The role of working capital management policies arose when Padachi (2006) concluded that excellent working capital control and policy affect the formulation of a company's value. This conclusion came from the investigation of the working capital control policy objectives and its relation to companies' achievement and profitability. This was done by applying statistical methods using the return on total assets ratio. The results show that focussing heavily on investments in high capital causes low profitability ratios. Muhammad et al. (2016) added that firms can use working capital management, which is one of the essential determinants to influence their profitability. The result reveals that there is an association between working capital elements and profitability. This is defined as the increase in the cash conversion cycle influences the profitability negatively. Additionally, directors can produce a definite amount for the company by minimising the cash conversion cycle at the most suitable level and performing a proper working capital policy and by taking care of each element of it at a sharp level. The findings of the study of Singh et al. (2017) confirmed that working capital management is linked with profitability, which indicates that aggressive working capital investment and finance policies drive higher profitability. Moreover, the cash conversion cycle is observed to be related to profitability negatively. The paper examined the working capital management variations and profitability by analysing the connection among changes in working capital management and firm profitability.

The previous literature review provides evidence of the significant roles of working capital management on the accounting profitability and assures that both accounting and finance are strongly associated. This article will apply different procedures than those applied in other studies related to working capital management to provide a deep discussion of the role of working capital management in profitability with the connection between accounting and finance.

3. The methodology

Aiming to approach practical information related to the study purpose and find practical generalised implications, this paper examines the opinions of interviewees gathered from semi-structured interviews with a group of participants consisting of sixteen financial managers. All the interviewed persons are actively involved in the financial decisions of their companies. Those interviewed found a strong desire to study objects and thus produced a fruitful penetration in this article. The respondents were selected depending on the country, industry and the size of capital as in the following table (see Table 1 ):

The researcher conducted semi-structured interviews to gain relevant data for the research objective. The meetings were carried within a reasonably free connection. Therefore, some questions proposed were not planned. Only the main questions to start the conversation were planned.

Numerous questions were automatically asked through the interview, providing elasticity to both the interviewer and the participant. This elasticity helped to examine and explain additional features or to recognise other vital details. This is unlike a structured interview, where questions are designed and arranged beforehand.

The key questions of the interviews were:

Do you find corporate finance important to accounting?

How do working capital management models improve profitability?

How do working capital management policies affect the profitability?

The meetings were in the structure of a dialogue. The interviews were conducted via Skype during the period of May 2019 until February 2020. The meetings were in Arabic and English, and the Arabic interviews were translated into English. They were recorded, transcribed and coded manually by the researcher. Finally, the researcher compared the interview proceeds with related literature in order to find the results.

The method proceeded by including the analysis of discussion records and applying qualitative coding and manual recoding by the researcher. This technique depends on the researcher's qualifications of the subject since the researcher has an eleven years' experience in accounting and auditing and, additionally, professional certificates in accounting.

4. Findings and implications

For the purpose of exploring the connection between the accounting and finance, the conversation started by the question:

4.1 Do you find corporate finance important to accounting?

If you do not understand how to use corporate finance, you will pass as a simple accountant. It is called financial management. How can any manager take a financial decision without it?.

Accordingly, using hermeneutic analysis, financial management supports and advances the accountant to be a financial manager.

I have completed my master's degree in accounting and finance, and there were two compulsory subjects related to corporate finance. There are many universities that have departments named finance and accounting, that means the instructors have information on both accounting and finance.

I am a CMA holder; the second part of this certificate is ultimately about corporate finance. The association of chartered certified accountant providing the ACCA, and this certificate include two critical papers about corporate finance which are financial management and advanced financial management.

These abstracted sentences provide tangible evidence for the connection between accounting and finance. This realisation came from the point that professional accounting bodies consider financial management as an essential part in their certifications.

On the other hand, the participants provided valuable information related to accounting education. Universities provide the junior accountant to the market. Therefore, they should consider the financial management as a vital part of the accounting curriculum that improves the new graduates' skills.

Investment decision skills

The previous literature shows that investment decision skills are essential for the accountant to be a financial manager. They point out some of these skills, like the net present value (NPV), internal rate of return (IRR), payback method and the equivalent annual cost method ( Gardiner and Stewart, 2000 ; Hung and Liu, 2005 ; Daunfeldt and Hartwig, 2014 ).

Imaging yourself in a meeting with the CEO, and he asks you to appraise a project. Without investment appraisal skills, you are in an embarrassing situation. As a financial manager at a manufacturing company, I have to decide when the underlying machine should be replaced. Therefore, I use the equivalent annual cost method since it could be applied to compute a maximum replacement cycle.

Where I work, we do many projects in one year, and it is essential to predict the profitability of these projects and the time when the initial cost payback, so you have to be familiar with the NPV and payback methods.

I know many accountants are still doing the usual accounting occupation since they do not have investment appraisal skills like NPV and IRR.

(2)Funding from external sources

Many ways to source funds from external resources were mentioned during conversations, like bonds, deep discount bonds, convertible bonds and long-term bank loans ( Kiyama and Rios-Aguilar, 2017 ).

It is valuable to each accountant to be a professional financial manager to know how he can find the sources of funds for the company; especially the external funds. There are many types of funds available for any firm; some of them are internal and others are external, but the vital thing for the financial decision is the gearing. If you are a professional financial manager, you have to keep the WACC in optimal value.

The researcher, using hermeneutic analysis with meeting proceeds, found that gearing and capital structure have a vital impact on profitability. Four theories explain this impact. The quoted sentences were identical to the literature. Therefore, both were combined to avoid redundant wording.

Traditional view: Under the traditional view, the ideal capital combination leads to minimising the average cost of capital. The cost of debt remains fixed up to a particular percentage of gearing. Passing this scale leads to a higher debt cost. The financial risk increase if gearing raises this relationship causes the equity cost to increase ( Berry et al. , 1993 ).

Modigliani and Miller (MM): The firm operating level and its profits only specify the market value of the firm in the position of no tax. The risk is attached to these profits, so there is no relation to the gearing. In the case of tax, a high level of gearing decreases the cost of capital since the interest is taxable. ( Brusov et al. , 2011 ).

Market imperfections: In a high level of gearing, the company is unable to perform its interest obligation, leading to bankruptcy ( Sanstad and Howarth, 1994 ).

Pecking order theory: Firms favour retained earnings as the optimal source of finance and then straight debt, convertible debt, preference shares and equity shares ( De Jong et al. , 2011 ).

To discuss the second key question:

4.2 How do working capital management models improve profitability?

The participators mentioned that working capital management deals with the root of the operation and the daily transactions that include cash, receivables, trade payables and inventory.

Da Costa Moraes et al. (2015) and Righetto et al. (2016) mentioned that the Baumol model and the Miller–Orr model are critical to run the cash in the optimal value to keep the liquidity and earn a profit.

(4)Inventory

Previous studies mentioned the impact of inventory management on profitability and showed that models are being used to improve inventory management.

Economic order quantity:

The professional stock administration can be divided into three sections: (EOQ), discounts for bulk purchases, it could be more economical to purchase inventories in significant order quantities to achieve discounts, buffer inventories to reduce the stock-out risk.

(EOQ) is the ordering amount for an inventory item which reduces the costs of stocking and damage.

Just-in-time system:

(5)Accounts receivable

Braun et al. (2018) supported that a higher balance of bad debt improves sales size. Given that, when the progress of the sales passes the total addition to the cost of fixed expenses and bad debts and discounts, the policy of mitigating credit requirements is profitable.

Providing credit possesses a cost; the amount of the interest imposed on an overdraft to finance the credit time; additionally, the not collected cash misses the interest of the bank deposit. Improvement in profit of increased sales following from granting credit could balance this loss.

One of the methods mentioned to keep the accounts receivable as a profitable behaviour is a credit rating system.

Credit score:

Ajanaku and Ekundayo (2017) and Richard and Kabala (2019) mentioned that points are granted according to client efficiency components, the credit amount relay on their credit score.

The interviews contributed that “the institution may establish a credit rating scheme for different customers based on personal client characteristics (such as whether the client is the owner of a state, the customer, age and profession).”

The second method is factoring; it was coded from the transcript of many interviews.

Factoring is an agreement to possess debts gathered by a factoring firm, which prepays a balance of the money it is due to settle ( Van der Vliet et al. , 2015 ).

(6)Trade accounts payable

Attempting to receive a satisfying credit of suppliers. Endeavouring to enlarge credit times of cash deficit. Keeping relations with frequent and significant suppliers.

Accordingly, the researcher comprehended from the interviews that these models of working capital management are effective since almost the entire sample apply them.

The third key question during the meetings was:

4.3 How do working capital management policies affect the profitability?

(7)Working capital investment policy

Organisations must ascertain the significant risks linked to working capital and hence whether to adopt a conservative, aggressive or moderate method to investing in working capital.

The conservative working capital investment policy aims to decrease the risk of operation failure by maintaining high levels of working capital.

The aggressive working capital investment strategy aims to overcome this financing cost and improve profitability. That could be by using the method of lowering inventories, advancing recovering credit time of customers and lingering instalments to suppliers.

(8)Working capital financing policy

Working capital financing policies are divided into conservative, aggressive and moderate approaches to financing working capital. It is classified according to the size of working capital financing from short-term assets and long-term assets ( Mohamad and Saad, 2010 ; Wasiuzzaman and Arumugam, 2013 ; Kwenda and Holden, 2014 ).

Almost all the participators expressed the opinion “the relation between the selected policy and the profitability is ‘high-risk, high-return’”. That means that aggressive policies increase profitability. This opinion is supported by ( Pais and Gama, 2015 ; Baños-Caballero et al. , 2016 ; Gonçalves et al. , 2018 ; Chand et al. , 2019 ).

On the other hand, opinions expressed based on practical experiences prefer the moderate policies, “moderate policies meet the targets of higher profitability, that come by avoiding risk losses.” This opinion could be supported by studies by Sharma and Kumar (2011) and Abuzayed (2012) showing a positive relationship between an increasing cash conversion cycle (CCC) and increased profitability, since the increase in the CCC means moves to moderate and conservative policies.

5. Conclusion

The results of the conversations support the literature review of the article. There is consistency between what the participants contributed and the previous studies interpreted. This consistency provides results that the relation between accounting and finance is vital. It can be described as a complementary relationship.

The financial manager starts as an accountant. By getting experience, he can make critical accounting decisions. When he gains corporate finance knowledge and skill, he starts providing financial management decisions. Ultimately, by the continuous improvement in finance management and the experience, he achieves the position of the chief financial manager.

On the other hand, the relationship between working capital management and profitability is similar to the relationship between finance and accounting in many aspects. For example, the accountant needs to be familiar with financial models which provide practical methods to handle working capital elements like cash and inventory.

Additionally, many strategies can help them to manage the accounts receivable to avoid more interest that arises from the cash matching and to decrease the bad debt expense. All of the methods mentioned contribute to avoiding expenses to gain the maximum profit.

The working capital investment and financing policies have the most significant impact on profitability. These policies are related to risk and return theory since the conservative policy reduces both the risk and return and the aggressive one has the opposite impact.

The article recommends accountants to be in professional stage and increase the profitability of the company to grab both accounting and finance information and skills.

Despite the positive interview aspect, the challenges that were encountered with the meeting comprised the severe limitation of the study. When setting up the meetings with the participants, most of the sample apologised in the first attempt, and later many efforts the acceptance to conduct the meeting has been awarded. This situation has complicated the research timetable and forced the researcher to extend the research time plan to keep the methodology flow. Some meetings were time-restricted. Therefore, gaining information to suggest other research paths was not in a perfect manner.

However, the author suggests some topics for future research, for example, conducting research to provide more models to manage the working capital elements. Moreover, measuring the consequences of linking accounting with strategic management, governance and control management in education and practical experience should be done.

Sample (own sources)

Abuzayed , B. ( 2012 ), “ Working capital management and firms' performance in emerging markets: the case of Jordan ”, International Journal of Managerial Finance , Vol. 8 No. 2 , pp. 155 - 179 , doi: 10.1108/17439131211216620 .

Aguswahyudi , F.D. , Cokrodewo , A. and Sin , L.G. ( 2018 ), “ Analysis of the effectiveness of probabilistic economic order quantity (EOQ) method using model (q,r) in medication industry (case study: apotek griya medika malang) ”, Journal of International Conference Proceedings , Vol. 1 No. 1 , pp. 12 - 19 .

Ajanaku , E.A. and Ekundayo , O.A. ( 2017 ), “ Working capital management and organization performance: the relationship between working capital management and account receivable ”, Journal of Management and Corporate Governance , Vol. 9 No. 2 , pp. 59 - 84 .

Anwar , J. ( 2018 ), “ The effect of working capital management on profitability in manufacturing company listed in Indonesia stock exchange ”, The Accounting Journal of Binaniaga , Vol. 3 No. 1 , pp. 1 - 14 , doi: 10.33062/ajb.v3i1.173 .

Baños-Caballero , S. , García-Teruel , P.J. and Martínez-Solano , P. ( 2016 ), “ Financing of working capital requirement, financial flexibility and SME performance ”, Journal of Business Economics and Management , Vol. 17 No. 6 , pp. 1189 - 1204 .

Berry , A.J. , Faulkner , S. , Hughes , M. and Jarvis , R. ( 1993 ), “ Financial information, the banker and the small business ”, The British Accounting Review , Vol. 25 No. 2 , pp. 131 - 150 .

Braun , M. , Briones , I. and Islas , G. ( 2018 ), “ Interlocking directorates, access to credit, and business performance in Chile during early industrialization ”, Journal of Business Research , Vol. 105 , pp. 381 - 288 , doi: 10.1016/j.jbusres.2017.12.052 .

Brief , R.P. and Peasnell , K.V. ( 2013 ), Clean Surplus: A Link between Accounting and Finance , Routledge , Moscow .

Brusov , P. , Filatova , T. , Orehova , N. , Brusov , P. and Brusova , N. ( 2011 ), “ From modigliani–miller to general theory of capital cost and capital structure of the company ”, Research Journal of Economics, Business and ICT , Vol. 2 , pp. 16 - 21 .

Cakici , N. , Chatterjee , S. and Tang , Y. ( 2017 ), “ Alternative profitability measures and cross section of expected stock returns: international evidence ”, Working Paper , SSRN 2969687 , Springer , New York, NY , doi: 10.2139/ssrn.2969687 .

Chand , A. , Akram , S. , Akram , H. , Murad , A. and Kareem , L. ( 2019 ), “ The impact of working capital management on firm profitability: a comparison between seasonal and non-seasonal businesses ”, Research Journal of Finance and Accounting , Vol. 10 No. 15 , pp. 8 - 12 .

Cleary , P. and Quinn , M. ( 2016 ), “ Intellectual capital and business performance: an exploratory study of the impact of cloud-based accounting and finance infrastructure ”, Journal of Intellectual Capital , Vol. 17 No. 2 , pp. 255 - 278 .

Da Costa Moraes , M.B. , Nagano , M.S. and Sobreiro , V.A. ( 2015 ), Stochastic Cash Flow Management Models: A Literature Review Since the 1980s , Decision Models in Engineering and Management , Springer , pp. 11 - 28 , doi: 10.1007/978-3-319-11949-6_2 .

Daunfeldt , S.O. and Hartwig , F. ( 2014 ), “ What determines the use of capital budgeting methods?: evidence from Swedish listed companies ”, Journal of Finance and Economics , Vol. 2 No. 4 , pp. 101 - 112 .

De Jong , A. , Verbeek , M. and Verwijmeren , P. ( 2011 ), “ Firms' debt–equity decisions when the static tradeoff theory and the pecking order theory disagree ”, Journal of Banking and Finance , Vol. 35 No. 5 , pp. 1303 - 1314 .

De Wet , J. and Du Toit , E. ( 2007 ), “ Return on equity: a popular, but flawed measure of corporate financial performance ”, South African Journal of Business Management , Vol. 38 No. 1 , pp. 59 - 69 .

Droms , W.G. and Wright , J.O. ( 2010 ), Finance and Accounting for Nonfinancial Managers: All the Basics You Need to Know , Basic Books .

Fields , E. ( 2016 ), The Essentials of Finance and Accounting for Nonfinancial Managers , Amacom .

Gardiner , P.D. and Stewart , K. ( 2000 ), “ Revisiting the golden triangle of cost, time and quality: the role of NPV in project control, success and failure ”, International Journal of Project Management , Vol. 18 No. 4 , pp. 251 - 256 .

Gonen , L.D. , Weber , M. , Tavor , T. and Spiegel , U. ( 2016 ), “ A modified Baumol approach — optimal withdrawal and holding of cash liquid assets ”, Review of European Studies , Vol. 8 No. 2 , pp. 8 - 21 , doi: 10.5539/res.v8n2p8 .

Gonçalves , T. , Gaio , C. and Robles , F. ( 2018 ), “ The impact of working capital management on firm profitability in different economic cycles: evidence from the United Kingdom ”, Economics and Business Letters , Vol. 7 No. 2 , pp. 70 - 75 .

Grüter , R. and Wuttke , D.A. ( 2017 ), “ Option matters: valuing reverse factoring ”, International Journal of Production Research , Vol. 55 No. 22 , pp. 6608 - 6623 .

Hung , J.H. and Liu , Y.C. ( 2005 ), “ An empirical comparison of the capitalized cost and equivalent annual cost methods for evaluating mutually exclusive projects ”, International Journal of Management , Vol. 22 No. 2 , pp. 242 - 248 .

Jawad , H. , Jaber , M.Y. and Bonney , M. ( 2015 ), “ The economic order quantity model revisited: an extended exergy accounting approach ”, Journal of Cleaner Production , Vol. 105 , pp. 64 - 73 .

Kiyama , J.M. and Rios-Aguilar , C. ( 2017 ), “ The future of funds of knowledge in higher education ”, Funds of Knowledge in Higher Education: Honoring Students' Cultural Experiences and Resources as Strengths , Routledge , p. 68 .

Krumrey , L. , Moeini , M. and Wendt , O. ( 2017 ), “ A cash-flow-based optimization model for corporate cash management: a Monte-Carlo simulation approach ”, International Conference on Computer Science, Applied Mathematics and Applications , Springer , pp. 34 - 46 , doi: 10.1007/978-3-319-61911-8_4 .

Kwenda , F. and Holden , M. ( 2014 ), “ Determinants of working capital investment in South Africa: evidence from selected JSE-listed firms ”, Journal of Economics and Behavioral Studies , Vol. 6 No. 7 , pp. 569 - 580 .

Lazaridis , I. and Tryfonidis , D. ( 2006 ), “ Relationship between working capital management and profitability of listed companies in the Athens stock exchange ”, Journal of Financial Management and Analysis , Vol. 19 No. 1 , pp. 26 - 35 .

Mohamad , N.E.A.B. and Saad , N.B.M. ( 2010 ), “ Working capital management: the effect of market valuation and profitability in Malaysia ”, International Journal of Business and Management , Vol. 5 No. 11 , p. 140 .

Muhammad , H. , Rehman , A.U. and Waqas , M. ( 2016 ), “ The relationship between working capital management and profitability: a case study of tobacco industry of Pakistan ”, The Journal of Asian Finance, Economics and Business (JAFEB) , Vol. 3 No. 2 , pp. 13 - 20 .

Nahum-Shani , I. , Smith , S.N. , Spring , B.J. , Collins , L.M. , Witkiewitz , K. , Tewari , A. and Murphy , S.A. ( 2017 ), “ Just-in-time adaptive interventions (JITAIs) in mobile health: key components and design principles for ongoing health behavior support ”, Annals of Behavioral Medicine , Vol. 52 No. 6 , pp. 446 - 462 .

Padachi , K. ( 2006 ), “ Trends in working capital management and its impact on firms' performance: an analysis of mauritian small manufacturing firms ”, International Review of Business Research Papers , Vol. 2 No. 2 , pp. 45 - 58 .

Pais , M.A. and Gama , P.M. ( 2015 ), “ Working capital management and SMEs profitability: Portuguese evidence ”, International Journal of Managerial Finance , Vol. 11 No. 3 , pp. 341 - 358 .

Richard , E. and Kabala , B. ( 2019 ), “ Account receivable management practices of SMEs in Tanzania: a qualitative approach ”, Business and Management Review , Vol. 22 No. 2 , pp. 51 - 66 .

Righetto , G.M. , Morabito , R. and Alem , D. ( 2016 ), “ A robust optimization approach for cash flow management in stationery companies ”, Computers and Industrial Engineering , Vol. 99 , pp. 137 - 152 , doi: 10.1016/j.cie.2016.07.010 .

Sanstad , A.H. and Howarth , R.B. ( 1994 ), “ ‘Normal’ markets, market imperfections and energy efficiency ”, Energy Policy , Vol. 22 No. 10 , pp. 811 - 818 , doi: 10.1016/0301-4215(94)90139-2 .

Sharma , A.K. and Kumar , S. ( 2011 ), “ Effect of working capital management on firm profitability: empirical evidence from India ”, Global Business Review , Vol. 12 No. 1 , pp. 159 - 173 , doi: 10.1177/097215091001200110 .

Singh , H.P. , Kumar , S. and Colombage , S. ( 2017 ), “ Working capital management and firm profitability: a meta-analysis ”, Qualitative Research in Financial Markets , Vol. 9 No. 1 , pp. 34 - 47 , doi: 10.1108/QRFM-06-2016-0018 .

Van der Vliet , K. , Reindorp , M.J. and Fransoo , J.C. ( 2015 ), “ The price of reverse factoring: financing rates vs. payment delays ”, European Journal of Operational Research , Vol. 242 No. 3 , pp. 842 - 853 , doi: 10.1016/j.ejor.2014.10.052 .

Vintilă , G. and Nenu , E.A. ( 2016 ), “ Liquidity and profitability analysis on the Romanian listed companies ”, Journal of Eastern Europe Research in Business and Economics , Vol. 2016 , Art. ID , 161707 , doi: 10.5171/2016.161707 .

Wang , Z. , Xu , G. , Zhao , P. and Lu , Z. ( 2016 ), “ The optimal cash holding models for stochastic cash management of continuous time ”, Journal of Industrial and Management Optimization , Vol. 14 No. 1 , pp. 1 - 17 , doi: 10.3934/jimo.2017034 .

Wasiuzzaman , S. and Arumugam , V.C. ( 2013 ), “ Determinants of working capital investment: a study of Malaysian public listed firms ”, Australasian Accounting, Business and Finance Journal , Vol. 7 No. 2 , pp. 63 - 83 .

Zhang , G.M. and Bao , Y. ( 2018 ), Decision Analysis of Conditional Risk Method Based on Accounts Receivable Financing Mode , CCNT 2018 DEStech Publications , pp. 632 - 636 , doi: 10.12783/dtcse/CCNT2018/24769 .

Further reading

Bolton , P. and Freixas , X. ( 2000 ), “ Equity, bonds, and bank debt: capital structure and financial market equilibrium under asymmetric information ”, Journal of Political Economy , Vol. 108 No. 2 , pp. 324 - 351 .

Goncharov , I. , Mahlich , J. and Yurtoglu , B.B. ( 2018 ), “ Accounting profitability and the political process: the case of R&D accounting in the pharmaceutical industry ”, Working Paper, AF2014/15WP05 , Lancaster University Management School , SSRN 2531467 , doi: 10.2139/ssrn.2531467 .

Grundy , B.D. and Verwijmeren , P. ( 2016 ), “ Disappearing call delay and dividend‐protected convertible bonds ”, The Journal of Finance , Vol. 71 No. 1 , pp. 195 - 224 .

Martynova , N. and Perotti , E. ( 2018 ), “ Convertible bonds and bank risk-taking ”, Journal of Financial Intermediation , Vol. 35 Part B , pp. 61 - 80 , doi: 10.1016/j.jfi.2018.01.002 .

Moldovan , P.C. , Van den Broeck , T. , Sylvester , R. , Marconi , L. , Bellmunt , J. , Van den Bergh , R.C. , Bolla , M. , et al. ( 2017 ), “ What is the negative predictive value of multiparametric magnetic resonance imaging in excluding prostate cancer at biopsy? A systematic review and meta-analysis from the European association of urology prostate cancer guidelines panel ”, European Urology , Vol. 72 No. 2 , pp. 250 - 266 , doi: 10.1016/j.eururo.2017.02.026 .

Corresponding author

Related articles, all feedback is valuable.

Please share your general feedback

Report an issue or find answers to frequently asked questions

Contact Customer Support

Working Capital Management

Activities performed by a company to make sure it got enough resources for day-to-day operating expenses

What is Working Capital Management?

Working capital management refers to the set of activities performed by a company to make sure it got enough resources for day-to-day operating expenses while keeping resources invested in a productive way.

Understanding Working Capital

Working capital is the difference between a company’s current assets and its current liabilities.

Current assets include cash, accounts receivable, and inventories.

Current liabilities include accounts payable, short-term borrowings, and accrued liabilities .

Some approaches may subtract cash from current assets and financial debt from current liabilities.

Why Working Capital Management is Important

Ensuring that the company possesses appropriate resources for its daily activities means protecting the company’s existence and ensuring it can keep operating as a going concern. Scarce availability of cash, uncontrolled commercial credit policies, or limited access to short-term financing can lead to the need for restructuring, asset sales, and even liquidation of the company.

Factors That Affect Working Capital Needs

Working capital needs are not the same for every company. The factors that can affect working capital needs can be endogenous or exogenous.

Endogenous factors include a company’s size, structure, and strategy.

Exogenous factors include the access and availability of banking services, level of interest rates , type of industry and products or services sold, macroeconomic conditions, and the size, number, and strategy of the company’s competitors.

Managing Liquidity

Properly managing liquidity ensures that the company possesses enough cash resources for its ordinary business needs and unexpected needs of a reasonable amount. It’s also important because it affects a company’s creditworthiness, which can contribute to determining a business’s success or failure.

The lower a company’s liquidity, the more likely it is going to face financial distress, other conditions being equal.

However, too much cash parked in low- or non-earning assets may reflect a poor allocation of resources.

Proper liquidity management is manifested at an appropriate level of cash and/or in the ability of an organization to quickly and efficiently generate cash resources to finance its business needs.

Managing Accounts Receivables

A company should grant its customers the proper flexibility or level of commercial credit while making sure that the right amounts of cash flow in via operations.

A company will determine the credit terms to offer based on the financial strength of the customer, the industry’s policies, and the competitors’ actual policies.

Credit terms can be ordinary, which means the customer generally is given a set number of days to pay the invoice (generally between 30 and 90). The company’s policies and manager’s discretion can determine whether different terms are necessary, such as cash before delivery, cash on delivery, bill-to-bill, or periodic billing.

Managing Inventory

Inventory management aims to make sure that the company keeps an adequate level of inventory to deal with ordinary operations and fluctuations in demand without investing too much capital in the asset.

An excessive level of inventory means that an excessive amount of capital is tied to it. It also increases the risk of unsold inventory and potential obsolescence eroding the value of inventory.

A shortage of inventory should also be avoided, as it would determine lost sales for the company.

Managing Short-Term Debt

Like liquidity management, managing short-term financing should also focus on making sure that the company possesses enough liquidity to finance short-term operations without taking on excessive risk.

The proper management of short-term financing involves the selection of the right financing instruments and the sizing of the funds accessed via each instrument. Popular sources of financing include regular credit lines, uncommitted lines, revolving credit agreements, collateralized loans , discounted receivables, and factoring.

A company should ensure there will be enough access to liquidity to deal with peak cash needs. For example, a company can set up a revolving credit agreement well above ordinary needs to deal with unexpected cash needs.

Managing Accounts Payable

Accounts payable arises from trade credit granted by a company’s suppliers, mostly as part of the normal operations. The right balance between early payments and commercial debt should be achieved.

Early payments may unnecessarily reduce the liquidity available, which can be put to use in more productive ways.

Late payments may erode the company’s reputation and commercial relationships, while a high level of commercial debt could reduce its creditworthiness.

• Working capital management involves balancing movements related to five main items – cash, trade receivables, trade payables, short-term financing, and inventory – to make sure a business possesses adequate resources to operate efficiently.
• The levels of cash should be enough to deal with ordinary or small unexpected needs, but not so high to determine an inefficient allocation of capital.
• Commercial credit should be used properly to balance the need to maintain sales and healthy business relationships with the need to limit exposure to customers with low creditworthiness.
• Managing short-term debt and accounts payable should allow the company to achieve enough liquidity for ordinary operations and unexpected needs, without an excessive increase in financial risk.
• Inventory management should make sure there are enough products to sell and materials for its production processes while avoiding excessive accumulation and obsolescence.

More Resources

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

• Accounts Payable vs Accounts Receivable
• Liquidity Event
• Quality of Accounts Receivables
• Working Capital vs Investing Capital
• See all accounting resources

Free Accounting Courses

Learn accounting fundamentals and how to read financial statements with CFI’s free online accounting classes . These courses will give the confidence you need to perform world-class financial analyst work. Start now!

Building confidence in your accounting skills is easy with CFI courses!  Enroll now for FREE to start advancing your career!

• Share this article

Create a free account to unlock this Template

Access and download collection of free Templates to help power your productivity and performance.

Already have an account? Log in

Supercharge your skills with Premium Templates

Take your learning and productivity to the next level with our Premium Templates.

Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI's full course catalog and accredited Certification Programs.

Already have a Self-Study or Full-Immersion membership? Log in

Access Exclusive Templates

Gain unlimited access to more than 250 productivity Templates, CFI's full course catalog and accredited Certification Programs, hundreds of resources, expert reviews and support, the chance to work with real-world finance and research tools, and more.

Already have a Full-Immersion membership? Log in

Term Paper on Working Capital Management | Management

Here is a term paper on ‘Working Capital Management’ for class 11 and 12. Find paragraphs, long and term papers on ‘Working Capital Management’ especially written for school and management students.

Term Paper on Working Capital Management

Term Paper Contents:

• Term Paper on the Working Capital Management Policies

Term Paper # 1. Meaning and Definition of Working Capital Management:

One of the most important areas in the day-to-day management of the firm is the management of working capital. Working capital management is the functional area of finance that covers all the current accounts of the firm. It is concerned with the management of the level of individual current assets as well as the management of total working capital. Procurement of funds is firstly concerned for financing working capital requirement of the firm, secondly for financing fixed assets.

ADVERTISEMENTS:

Working capital refers to the funds invested in current assets, i.e., investment in stocks, sundry, debtors, cash and other current assets. Current assets are essential to use fixed assets profitably.

Working capital management is concerned with the problems that arise in attempting to manage the current assets, the current liabilities and interrelationship that exist between them. The term current assets refer to those assets which in the ordinary cause of business can be, or will be converted into cash within one year, without undergoing a diminution in value and without disrupting the operations of the firm.

The major current assets are cash, marketable securities, accounts receivable and inventory. Current liabilities are those liabilities which are intended at their inception to be paid in the ordinary course of business, within a year, out of the current assets or earnings of the concern. The basic current liabilities are accounts payable, bills payable, bank overdraft and outstanding expenses.

“The goal of working capital management is to manage the firm’s current assets and liabilities in such a way that a satisfactory level of working capital is maintained.” This is so because if the firm cannot maintain a satisfactory level of working capital. It is likely to become investment and may even be forced into bankruptcy.

The current assets should be large enough to cover its current liabilities in order to ensure a reasonable margin of safety. Each of the current assets must be managed efficiently in order to maintain the liquidity of firm while not keeping too high a level of any one of them.

Each of the short-term sources of financing must be continuously managed to ensure that they are obtained and used in the best possible way.

“The interaction between current assets and current liabilities is therefore the main theme of the theory of working capital management.”

The basic ingredient of the theory of working capital management may be said to include its definition, need, optimum level of current assets, the tradeoff between profitability and risk which is associated with the level of current assets and liabilities, financing-mix strategies and so on.

The requirements of current assets are usually greater than the amount of funds payable through current liabilities. In other words, the current assets are to be kept at a higher level than the current liabilities.

Term Paper # 2. Classification of Working Capital:

There are many classifications in use out of which a few important areas are as below:

1.  From the point of view of concept

2. From the point of view of time.

1. From the Point of View of Concept:

From the point of view of concept the term working capital can be used in two different ways:

(a) Gross Working Capital (GWC).

(b) Net Working Capital (NWC).

(a) Gross Working Capital (GWC):

The term gross working capital refers to investment in all the current assets taken together. The total of investments in all current assets is known as gross working capital.

The term net working capital can be defined in following two ways:

1. The most common definition of net working capital (NWC) is the difference between current assets and current liabilities.

NWC = CA — CL

CA = Current Assets

CL = Current Liabilities

(b) Net Working Capital (NWC):

The alternate definition of NWC is that portion of current assets which is financed with long-term funds. (Means part of those current assets whose liability does not lie with current liabilities).

NWC is commonly defined as the difference between current assets and current liabilities. Efficient working capital management requires that firms should operate into same amount of NWC, the exact amount varying from firm to firm and depending among other things, on the nature of industry.

The justification for the use of NWC to measure liquidity is based on the premise that the greater the margin by which the current assets cover the short-term obligations, the more is the ability to pay obligations when they become due for payment.

The NWC is necessary because the cash outflows and inflows do not coincide. In other words, it is the non-synchronous nature of cash flows that makes NWC necessary.

In general, the cash outflows resulting from payment of current liabilities are relatively predictable. The cash inflows are, however, difficult to predict.

a. The more predictable the cash inflows are the less -NWC will be required.

b. Where cash inflows are uncertain, it will be necessary to maintain current assets at a level adequate to cover current liabilities that are there must be NWC.

The task of the financial manager in managing working capital efficiently is to ensure sufficient liquidity in the operations of the enterprise. The liquidity of a business firm is measured by its ability to satisfy short-term obligations as they become due.

The three basic measures of a firm’s overall liquidity are:

(i) Current ratio.

(ii) Acid test ratio.

(iii) Net working capital.

The first two measures are very useful in inter-firm comparison of liquidity. Net Working Capital (NWC) as a measure of liquidity is not very useful for comparing the performance of different firms but it is quite useful for internal control.

The NWC helps in comparing the liquidity of the same firm overtime. For the working capital management, NWC can be said to measure the liquidity of the firm. In other words, the goal of working capital management is to manage the current assets and current liabilities in such a way that an acceptable level of NWC is maintained.

2. From the Point of View of Time:

From the point of view of time, working capital can be divided into following two categories:

(a) Permanent working capital.

(b) Temporary working capital.

(a) Permanent Working Capital:

It also refers to the hard core working capital. It is that minimum level of investment in the current assets that is carried by the business at all times to carry out minimum level of its activities.

(b) Temporary Working Capital:

It refers to that part of total working capital which is required by a business over and above permanent working capital. It is also called variable working capital.

Since the volume of temporary working capital keeps on fluctuating from time to time according to the business activities it may be financed from short-term services.

Term Paper # 3. Working Capital Cycle :

Working capital cycle refers to the length of time between the firms paying cash for materials, etc., entering into the production process/stock and the inflow of cash from debtors i.e., sales.

Suppose a company has a certain amount of cash it will need raw materials. Some raw materials will be available on credit but, cash will be paid out from the other part immediately. Then it has to pay labour costs and incurs factory overheads. These three combined together will constitute work-in-progress. After the production cycle is complete, work-in-progress will get converted into finished products.

The finished products when sold on credit get converted into sundry debtors. Sundry debtors will be realized in cash after the expiry of credit period. This cash can again be used for financing of raw materials, work-in-progress etc.

Thus there is a complete cycle from cash to cash wherein cash gets converted into raw materials, work-in-progress, finished goods, debtors and finally into cash again.

a. Short-term funds are required to meet the requirements of funds during this time period.

b. This time period is dependent upon the length of time within which the original cash gets converted into cash again.

c. This cycle is also known as operating cycles or cash cycle.

Working capital cycle indicates the length of time between a company’s paying for materials, entering into stock and receiving the cash from sales of finished goods. It can be determined by adding the number of days required for each stage in the cycle.

A company holds raw-material on an average for 60 days, it gets credit from the supplier for 15 days, production process needs 15 days, finished goods are held for 30 days and 30 days credit is entered to debtors.

Then, total no. of days = 60 – 15 + 15 + 30 + 30 = 120 days means 120 days is the total working capital cycle.

The determination of working capital cycle helps in the forecast, control and management of working capital. It indicates the total time lag and the relative significance of its constituent parts. The duration of working capital cycle may vary depending on the nature of the business.

The operating cycle (working capital cycle) consists of the following events which are continuing throughout the life of business:

1. Conversion of cash into raw materials.

2. Conversion of raw materials into work-in-progress.

3. Conversion of work-in-progress into finish stock.

4. Conversion of finished stock into account receivables through sales.

5. Conversion of accounts receivables into cash.

The duration of the operating cycle for the purpose of estimating working capital is equal to the sum of the durations of each of the above said events, less (-) the credit period allowed by the supplier.

In the form of an equation, the operating cycle process can be expressed as follows:

Operating cycle = R + W + F + D – C

R = Raw material storage period

W = Work-in-progress holding period

F = Finished goods store period

D = Debtors collection period

C = Credit period availed

Various components of the operating cycle can be calculated:

Above figure illustrates:

1. Level of current assets and cost of liquidity increases while cost of it illiquidity decreases.

i. A and B are financed by long-term financing.

ii. C are financed by short-term financing,

2. Conservative Approach:

This approach suggests that the estimated requirement by total funds should be met from long-term sources, the use of short-term funds should be restricted to only emergency situation or when there is an unexpected outflow of funds. In other words, under this approach a firm finances its permanent assets and also a part of temporary current assets with long-term financing. If relies heavily on long-term financing and is less risky so far as solvency is concerned, however the funds may be invested in such investment which fetch small returns to build up liquidity. Thus deviously affecting profitability.

Aggressive Approach :

The firm uses more short-term financing than is justified in this approach. The firm finances a part of its permanent current assets with short-term financing. This is more risky but may add to the return on assets.

Comparison of Hedging Approach with Conservative Approach :

The comparison of these two approaches can be done on the basis of following two attributes:

(a) Cost consideration

(b) Risk consideration

(a) Cost Consideration:

The cost of these financing plans has a bearing on the profitability of the enterprise. If in the previous example, the cost of short-term funds and long-term funds be 3% and 8% respectively.

Cost of financing under hedging plan can be estimated as:

(i) Cost of Short-Term Funds:

The cost of short-term funds is equal to average annual short- term loan × interest rate.

cookielawinfo-checkbox-functional11 monthsThe cookie is set by GDPR cookie consent to record the user consent for the cookies in the category "Functional".cookielawinfo-checkbox-necessary11 monthsThis cookie is set by GDPR Cookie Consent plugin. The cookies is used to store the user consent for the cookies in the category "Necessary".cookielawinfo-checkbox-others11 monthsThis cookie is set by GDPR Cookie Consent plugin. The cookie is used to store the user consent for the cookies in the category "Other.cookielawinfo-checkbox-performance11 monthsThis cookie is set by GDPR Cookie Consent plugin. The cookie is used to store the user consent for the cookies in the category "Performance".viewed_cookie_policy11 monthsThe cookie is set by the GDPR Cookie Consent plugin and is used to store whether or not user has consented to the use of cookies. It does not store any personal data.

Spotify is currently not available in your country.

Follow us online to find out when we launch., spotify gives you instant access to millions of songs – from old favorites to the latest hits. just hit play to stream anything you like..

Listen everywhere

Spotify works on your computer, mobile, tablet and TV.

Unlimited, ad-free music

No ads. No interruptions. Just music.

Download music & listen offline

Keep playing, even when you don't have a connection.

Premium sounds better

Get ready for incredible sound quality.