Effects of Working Capital Management on Small and Medium Enterprise Profitability

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IJMF 3,2

Effects of working capital management on SME profitability
´ ´ Pedro Juan Garcıa-Teruel and Pedro Martınez-Solano
Deptartment of Management and Finance, Faculty of Economy and Business, University of Murcia, Murcia, Spain Abstract
Purpose – The object of the research presented in this paper is to provide empirical evidence on the effects of working capital management on the profitability of a sample of small and medium-sized Spanish firms. Design/methodology/approach – The authors have collected a panel of 8,872 small to medium-sized enterprises (SMEs) covering the period 1996-2002. The authors tested the effects of working capital management on SME profitability using the panel data methodology. Findings – The results, which are robust to the presence of endogeneity, demonstrate that managers can create value by reducing their inventories and the number of days for which their accounts are outstanding. Moreover, shortening the cash conversion cycle also improves the firm’s profitability. Originality/value – This work contributes to the literature in two ways. First, no previous such evidence exists for the case of SMEs. Second, unlike previous studies, in the current work robust test have been conducted for the possible presence of endogeneity problems. The aim is to ensure that the relationships found in the analysis carried out are due to the effects of the cash conversion cycle on corporate profitability and not vice versa. Keywords Working capital, Profit, Small to medium-sized enterprises Paper type Research paper


International Journal of Managerial Finance Vol. 3 No. 2, 2007 pp. 164-177 q Emerald Group Publishing Limited 1743-9132 DOI 10.1108/17439130710738718

1. Introduction The corporate finance literature has traditionally focused on the study of long-term financial decisions. Researchers have particularly offered studies analyzing investments, capital structure, dividends or company valuation, among other topics. But the investment that firms make in short-term assets, and the resources used with maturities of under one year, represent the main share of items on a firm’s balance sheet. In fact, in the sample used in the present study, current assets of small and medium-sized Spanish firms represent 69 percent of their assets, and at the same time their current liabilities represent more than 52 percent of their liabilities. Working capital management is important because of its effects on the firm’s profitability and risk, and consequently its value (Smith, 1980). Specifically, working capital investment involves a tradeoff between profitability and risk. Decisions that tend to increase profitability tend to increase risk, and, conversely, decisions that focus on risk reduction will tend to reduce potential profitability. Gitman (1974) argued that the cash conversion cycle was a key factor in working capital management. Actually, decisions about how much to invest in the customer and inventory accounts, and how much credit to accept from suppliers, are reflected in the firm’s cash conversion cycle, which represents the average number of days between the date when the firm must start paying its suppliers and the date when it begins to collect payments from its ´ Financial support from Fundacion CajaMurcia is gratefully acknowledged.

customers. Previous studies have used measures based on the cash conversion cycle to analyze whether shortening this cycle has positive or negative effects on the firm’s profitability. Empirical evidence relating working capital management and profitability in general supports the fact that aggressive working capital policies enhance profitability (Jose et al., 1996; Shin and Soenen, 1998; for US companies; Deloof, 2003; for Belgian firms; Wang (2002) for Japanese and Taiwanese firms). This suggests that reducing working capital investment is likely to lead to higher...
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