Working Capital Management

Essay by katib_1980 December 2006

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Efficient working capital management is an integral component of the overall corporate strategy to create shareholder value. Working capital is the result of the time lag between the expenditure for the purchase of raw materials and the collection for the sale of the finished product. The continuing flow of cash from suppliers to inventory to accounts receivable and back into cash is usually referred to as the cash conversion cycle. The way in which working capital is managed can have a significant impact on both the liquidity and profitability of the company. Smith (1980) first signaled the importance of the trade-offs between the dual goals of working capital management, i.e., liquidity and profitability. In other words, decisions that tend to maximize profitability tend not to maximize the chances of adequate liquidity. Conversely, focusing almost entirely on liquidity will tend to reduce the potential profitability of the company.

Measures of Working Capital Management Efficiency and Their Relationship to Corporate Profitability

The (Weighted) Cash Conversion Cycle

The most conventional measures of corporate liquidity are the current ratio and the quick ratio.

Because of the static nature, their adequacy in examining a firm's efficiency in managing its working capital has been questioned by many authors (see, for example, Emery, 1984; and Kamath, 1989). Liquidity for the on-going firm is not really dependent on the liquidation value of its assets but rather on the operating cash flow generated by those assets. Gitman (1974) introduced the cash cycle concept as a crucial element in working capital management. The total cash cycle is defined as the number of days from the time the firm pays for its purchases of the most basic form of inventory to the time the firm collects for the sale of its finished product. Richards and Laughlin (1980) operationalized the cash cycle...