Effects of financial characteristics on working capital management

The size of a firm (here, measured as natural logarithm of sales) brings to the firm a number of benefits.

For instance, empirical studies that reveal a negative correlation between size and Cash Conversion Cycle (CCC) show that large firms have shorter CCCs.

The outcomes are an increase or a decrease in size, and that would have a decreasing or an increasing effect on CCC in that order.

In this wise, the larger the size, the shorter the CCC, as large firms can negotiate for better trading conditions with their suppliers, such as bargaining for discounts and longer payment terms.

When a firm is large, the prices of its products are low due to economies of scale from large productions, and economies of scope (as those large firms are capable of offering more than one product most often).

Such firms’ customer bases are also large, and as a result, they could dictate how quick customers pay for products given them (receivables).

Also, due to low prices of their products, the companies do not keep inventories for long as their products are patronised more often, thereby cutting down on storage costs and tied up capital in inventories.

More importantly, size could enable the firms to buy raw materials from their suppliers in very large quantities at lower prices and since the companies become large and key customers to their supplier, the companies could negotiate for flexible payment terms.

This makes the firms delay in paying for supplies made to them (payables). All these shorten the CCC indicating efficient and effective management of working capital.

Paying suppliers a bit late is a source of free and cheap capital as those moneys are injected back into the business operations which eventually generates more profit.

Nonetheless, delayed payments come with some costs in some circumstances and the company has to weigh the associated costs and benefits of deferring the payments.

Relationships

Sales Growth is the percentage change in sales value of the current year and the prior year. Studies have shown that when the rate of growth in sales increases, companies will try to seek for additional funding in order to support the growth.

This will result in the firms trying to efficiently manage their inventories, receivables and payables so as to generate internal funds to aid operations and avoid seeking for external funding.

Increased growth rate may encourage more expansion in order to augment the growth.

Thus, as sales growth increases, working capital also increases significantly.

Current ratio is computed as current assets divided by current liabilities. It indicates how much current assets are available to settle current debts when they are due for payment.

Empirical evidence [Ansah (2021); Zalaghi et al. (2019); Al-Shubiri and Aburumman (2013); Rimo and Panbunyuen (2010)] indicate that working capital (represented by cash conversion cycle) increases when current ratio (CR) goes up thus signalling the firm’s strength in its liquidity position.

The increase in the CR suggests that there are more than enough current assets available to pay off current liabilities when they fall due.

In another perspective, a reduction in CR results in a decrease in CCC indicating no much tying up of capital in current assets.

Debt ratio, in this write up, is defined as Total Debts divided by Total Assets. Studies, such as Ansah (2021), Al-Shubiri and Aburumman (2013), Naser et al., (2013), Valipour et al., (2012), and Rimo and Panbunyuen (2010) have established positive correlation between DR and CCC.

This implies that a decrease in DR causes the CCC to also fall signifying that the less debt the firm obtains, the less finance cost it incurs and this shortens the CCC.

A well-managed working capital makes the firm more profitable as it spends less on interests on loans, thus reducing expenditure that decreases profit.

Liquidity will also be enhanced as cash will be available to fund daily operations and thus, the firm may not necessarily need external funding.

As a result, the debts utilised by very profitable firms are minimal.

When debt ratio is positively correlated with WCM, it implies the usage of less debts by profitable firms to fund operations and positive NPV projects since they are able to pile up huge amounts of profit.

Firms are therefore advised to avoid making excessive investments in working capital (receivables, payables, inventory) but instead maintain an optimal working capital level.

By so doing, firms will not encounter insolvency and its related issues that will harm their quest for continuing in operation for an indefinite time period.

Thus, shareholders’ (owners’) wealth will experience significant increase if working capital management is rigorously pursued.

The writer is a member, The Chartered Institute of Tax Law and Forensic Accountants–Ghana (CITLFAG)/employee, Ghana TVET Service.

Email: ekornunye@gmail.com