Workingworking Capital Management and Firm's Profitability

Topics: Accounts receivable, Generally Accepted Accounting Principles, Working capital Pages: 16 (4447 words) Published: March 24, 2011
Working Capital Management and Firm's Profitability: An Optimal Cash Conversion Cycle Haitham Nobanee Department of Banking and Finance, The Hashemite University, P.O. Box 150459, Zarqa, 13133, Jordan. E-mail:

Abstract The traditional link between the cash conversion cycle and the firm's profitability is that shortening the cash conversion cycle increases firm's profitability. On the other hand shortening the cash conversion cycle could harm the firm’s operations and reduces profitability. This could happen when taking actions to reduce the inventory conversion period, a firm could face inventory shortages; when reducing the receivable collection period a firm could lose its good credit customers; and when lengthening the payable deferral period a firm could harm it’s own credit reputation. However, identifying optimal levels of inventory, receivables, and payables where total holding and opportunities cost are minimized and recalculating the cash conversion cycle according to these optimal points provides more complete and accurate insights into the efficiency of working capital management. In this regard, we suggest an optimal cash conversion cycle as more accurate and comprehensive measure of working capital management.

Keywords: Working Capital Management; Optimal Cash Conversion Cycle; Cash Conversion Cycle; Receivable Collection Period; Inventory Conversion Period; Payable Deferral Period; Weighted Cash conversion Cycle; Net Trade Cycle JEL classification: G30:G32:L25:O25

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Efficiency of working capital management is based on the principle of speeding up cash collections as quickly as possible and slowing down cash disbursements as slowly as possible. This working management principal based on the traditional concepts of operating cycle, cash conversion cycle, weighted cash conversion cycle, and net trade cycle. The operating cycle of a firm is the length of time between the acquisition of raw materials and the collections of receivables associated with the

sales of finished goods. Although the operating cycle conceders the financial flows comes from receivables and inventory, it ignores the financial flows comes from account payables, in this regards, Richards and Loughlin (1980) suggest the cash conversion cycle that considers all relevant cash flows comes from the operations. The cash conversion cycle can be defined as the length of time between cash

payments for purchase of raw materials and the collection of receivable associated with the sale of finished goods. However, the cash conversion cycle focuses only on the length of time financial flows engaged in the cycle and does not consider the amount of fund committed to a product as it moves through the cash conversion cycle. Therefore, Gentry, Vaidyanathan, and Wai (1990) suggest a weighted cash conversion cycle that takes into consideration both the timing of financial flows and the amount of fund committed to each stage of the cycle. The weighted cash conversion cycle can be defined as the weighted number of days funds are committed in receivables, inventories and payables, less the weighted number of days financial flows are deferred to suppliers. In addition to its' complexity, another limitation of the weighted cash conversion cycle is the brake up of inventory into three components of raw materials, work in process, and finished goods is not available for outside investigators; hence, Shin and Soenen (1998) suggest the net trade cycle as an alternative measure for working capital management. They argue that the cash

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conversion cycle is an additive concept wares the denominators for the inventory conversion period, the receivable collection period, and the payable deferral periods are all different, making the addition of the cash conversion cycle components not really useful. They...
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