Impact of Working Capital Management on Profitibility of Firms

Topics: Natural gas, Inventory, Balance sheet Pages: 14 (3523 words) Published: July 25, 2010
EFFECT OF WORKING CAPITAL MANAGEMENT ON PROFITABILITY OF FIRMS - A study on the Indian Oil Drilling & Exploration industrY

[1]Dr. Anupam Jain

ABSTRACT

Efficient management of working Capital is one of the pre-conditions for the success of an enterprise. Efficient management of working capital means management of various components of working capital in such a way that an adequate amount of working capital is maintained for smooth running of a firm. 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’s profitability.

In this study, we have selected a sample of 4 Indian Oil Drilling and Exploration firms and taken their financial data for a period of 5 years from 2005 – 2009 and studied the effect of different variables of working capital management including the Cash conversion cycle and Current ratio on the profitability of the firms.

The study shows that there is a negative significant relationship between cash conversion cycle & firm profitability and positive relationship between Current Ratio & profitability of firms. This reveals that reducing cash conversion period and increasing the current ratio results into profitability increase. Thus, in purpose to create shareholder value, firm manager should concern on shorten of cash conversion cycle till accomplish optimal level.

1. Introduction

The working capital is the life-blood and nerve centre of a business firm. The importance of working capital in any industry needs no special emphasis. No business can run effectively without a sufficient quantity of working capital. It is crucial to retain right level of working capital. Working capital management is one of the most important functions of corporate management. A business enterprise with ample working capital is always in a position to avail advantages of any favorable opportunity either to buy raw materials or to implement a special order or to wait for enhanced market status. Working capital can be utilized for the payment of lease, employee's payroll, and pretty much any other operating costs that are involved in the everyday life of business. Even very successful business owners may need working capital funds when the unexpected circumstances arise. The overall success of the company depends upon its working capital position. So, it should be handled properly because it shows the efficiency and financial strength of company.

Working capital management is highly important in firms as it is used to generate further returns for the stakeholders. When working capital is managed improperly, allocating more than enough of it will render management non-efficient and reduce the benefits of short term investments. On the other hand, if working capital is too low, the company may miss a lot of profitable investment opportunities or suffer short term liquidity crisis, leading to degradation of company credit, as it cannot respond effectively to temporary capital requirements. Efficient management of working capital means management of various components of working capital in such a way that an adequate amount of working capital is maintained for smooth running of a firm and for fulfillment of objectives of liquidity and profitability. But, it is very difficult for the management too to estimate working capital properly because, amount of working capital varies across firms over the periods depending upon the nature of the business, nature of raw material used, process technology used, nature of finished goods, degree of competition in the market, scale of operation, credit policy etc. Therefore, a significant amount of fund is required to invest permanently in the form of different current assets.

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