How Does Working Capital Management Affects Firm Profitability?

How Does Working Capital Management Affect Firm Profitability?
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How Does Working Capital Management Affect Firm Profitability?
Introduction
Recent financial crises and uncertainties to business operations have historically resulted in the downfall of gargantuan organizations such as the Lehman Brothers. Besides, the current COVID-19 pandemic has changed the business landscape and peoples' ways of life, which significantly affect profitability. These events have presented a challenge to researchers in the field of capital market research to realize the importance of managing organizational resources such as working capital. Working capital has been described as the available capital that is available to businesses in meeting their daily operations. Based on the type of industry, working capital can comprise a relatively bigger share of an organization's total amount of assets. Owing to the significant impact of working capital on the financial performance of firms, business executives around the world need to emphasize the efficient utilization of available resources. Working capital management (WCM) refers to efficient approaches that executives can employ when dealing with available cash in daily business operations to achieve an optimum impact (Anton and Nucu, 2021). Good WCM results in increased cash flows, a subsequent reduced need for external funding, and reduced chances of a firm defaulting. This review on the impact of working capital management on a firm's profitability explores the benefits of holding working capital and cash conversion cycle, which is one of the key factors in working capital management.
Benefits of holding working capital
Inventory management is one of the critical practices in WCM that have attracted increased empirical research over the past years (Singh and Kumar, 2017). Holding more inventories can significantly affect businesses from the perspective of fluctuations in prices. However, Anton and Nucu (2021) have argued that increasing the cost of working capital investments relative to the benefits gained from holding larger inventories or allowing trade credit to clients can lower the levels of a firm's profits. An increasing amount of studies has supported a non-linear association or a U-shaped relationship between increasing working capital and business profitability. These studies argue that investments in working capital can positively impact a firm's profitability only up to a certain level when this association stops. Above this point, which is also known as the optimum level or the break-even point, working capital becomes a negative determinant of corporate profitability (Herer and Yucesan, 2016). This is known as the inverted U-shaped relationship that accounts for a combination of negative and positive combinations with a break-even point. However, many firms are often exposed to significant risks associated with small inventory levels. In such firms, holding low inventory levels can negatively modify sales and lower profits (Anton and Nucu, 2021). Therefore, increasing the levels of working capital through holding invent...