The Relationship Between Wcm and Profitability

Topics: Regression analysis, Accounts receivable, Generally Accepted Accounting Principles Pages: 28 (9288 words) Published: March 24, 2013

1.1 Introduction

Working capital is an important issue during financial decision making since it is being a part of investment in asset that requires appropriate financing investment (Zariyawati et al, 2009). However it is always being ignored by companies because it is related to short term period. The companies or managers should understand that items or transactions in short term period may give significant impact in future if the responsible managers does not concern about it. Thus, it is actually has the same essential with financing or investing activities in longer term period. Working capital measures how much in liquid assets a company has available to build its business. The number can be positive or negative, depending on how much debt the company is carrying. In general, companies that have a lot of working capital will be more successful since they can expand and improve their operations. Companies with negative working capital may lack the funds necessary for growth. One of the main advantages of looking at the working capital position is being able to foresee any financial difficulties that may arise. Even a business that has billions of dollars in fixed assets will quickly find itself in bankruptcy court if it cannot pay its monthly bills. Under the best circumstances, poor working capital leads to financial pressure on a company, increased borrowing, and late payments to creditor. All of which result in a lower credit rating. A lower credit rating means banks charge a higher interest rate, which can cost a corporation a lot of money over time. Subsequently, companies that have high inventory turns and do business on a cash basis such as a grocery store need very little working capital. These types of businesses raise money every time they open their doors, then turn around and plow that money back into inventory to increase sales. Since cash is generated so quickly, managements can simply stockpile the proceeds from their daily sales for a short period of time if a financial crisis arises. Since cash can be raised so quickly, there is no need to have a large amount of working capital available. A company that makes heavy machinery is a completely different story. Because these types of businesses are selling expensive items on a long-term payment basis, they cannot raise cash as quickly. Since the inventory on their balance sheet is normally ordered months in advance, it can rarely be sold fast enough to raise money for short-term financial crises, by the time it is sold, it may be too late. It is easy to see why companies such as this must keep enough working capital on hand to get through any unforeseen difficulties. Instead of that, there are a lot of reasons for the importance of working capital management. For a typical manufacturing firm, the current assets account for over half of its total assets. For a distribution company, they account for even more. Excessive levels of current assets can easily result in a firm’s realizing an inferior return on investment. However, Van Horne and Wachowicz (2004) pointed out that excessive level of current assets may have a negative effect of a firm’s profitability, whereas a low level of current assets may lead to lowers of liquidity and stock-outs, resulting in difficulties in maintaining smooth operations.

Moreover, the corporate finance literature has traditionally focused on the study of long-term financial decisions, particularly investments, capital structure, dividends or company valuation decisions. However, current assets and liabilities are also important components of total assets and need to be carefully analyzed (Nazir and Afza, 2009). This is not a simple task as it needs expertise to ensure both current assets and current liabilities match as expected. For this reason, the main objective of working capital management is to maintain a finest balance between each of the working capital components. Accounts...
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