Working Capital Management

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EFFECT OF WORKING CAPITAL MANAGEMENT ON PROFITABILITY OF FIRMS IN MALAYSIA

( M. A., Zariyawati a, M. N., Annuar b and A.S., Abdul Rahim c a ,b & c Univeristi Putra Malaysia, Malaysia.

ABSTRACT
Working capital management is important part in firm financial management decision. An optimal working capital management is expected to contribute positively to the creation of firm value. To reach optimal working capital management firm manager should control the trade off between profitability and liquidity accurately. The purpose of this study is to investigate the relationship between working capital management and firm profitability. Cash conversion cycle is used as measure of working capital management. This study is used panel data of 1628 firm-year for the period of 1996-2006 that consist of six different economic sectors which are listed in Bursa Malaysia. The coefficient results of Pooled OLS regression analysis provide a strong negative significant relationship between cash conversion cycle and firm profitability. This reveals that reducing cash conversion period results to profitability increase. Thus, in purpose to create shareholder value, firm manager should concern on shorten of cash conversion cycle till accomplish optimal level.

Keywords: Working Capital Management, Cash Conversion Cycle, Profitability and Liquidity

INTRODUCTION

Working capital is an important issue during financial decision making since its being a part of investment in asset that requires appropriate financing investment. However, working capital always being disregard in financial decision making since it involve investment and financing in short term period. Further, also act as a restrain in financial performance, since it does not contribute to return on equity (Sanger, 2001). Though, it should be critical for to a firm to sustain their short term investment since it will ensure the ability of firm in longer period.

The crucial part in managing working capital is required maintaining its liquidity in day-to-day operation to ensure it’s smooth running and meets its obligation (Eljelly, 2004). Yet, this is not a simple task since managers must make sure that business operation is running in efficient and profitable manner. There are the possibilities of mismatch of current asset and current liability during this process. If this happens and firm’s manager cannot manage it properly then it will affect firm’s growth and profitability. This will further lead to financial distress and finally firms can go bankrupt.

In traditional view of relationship between cash conversion cycle (as measure of working capital management) and profitability is ceteris paribus. The shorter firm cash conversion cycle, the better a firm profitability. This shows that less of time a dollar tied up in current asset and less external financing. While, the longer cash conversion cycle will hurt firm’s probability. The reason is that firm having low liquidity that would affect firm’s risk. However, if firm has higher level of account receivable due to the generous trade credit policy it would result to longer cash conversion cycle. In this case, the longer cash conversion cycle will increase profitability. Thus, the traditional view cannot be applied to all circumstances.

Dilemma in working capital management is to achieve desired trade off between liquidity and profitability (Smith, 1980; Raheman & Nasr, 2007). Referring to theory of risk and return, investment with more risk will result to more return. Thus, firms with high liquidity of working capital may have low risk then low profitability. Conversely, firm that has low liquidity of working capital, facing high risk results to high profitability. The issue here is in managing working capital, firm must take into consideration all the items in both accounts and try to balance the risk and return.

The purpose of this study is hopefully to contribute towards a crucial element in...
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