This chapter aims to analyze the impact of working capital management on firm's profitability, considering economic downturn and boom periods. Analyzing Portuguese firms from 2006-2019 results show that cash conversion cycle, as well as days sales outstanding, days sales inventories, and days payment outstanding decreased after 2009 due to the international financial crisis. When the length of cash conversion cycle increases, firm return on assets also increases. This situation happens especially in recession periods, when sales decrease. Results also exhibit singularities across industries. In some sectors, the impact of working capital management in firm return is positive, while in industries with greater cash conversion periods, the impact is negative. The findings also reveal the impact of financial debt and economic growth on operational profitability. Managers need to focus on short-term financing practices to increase firm profits and create value.
TopIntroduction
Traditional theory on corporate finance usually focuses on long-term financial decisions, especially firm’s capital structure and dividend payout (Baños-Caballero, García-Teruel, and Martínez-Solano, 2014). Although, short-term financial decisions, namely working capital management has impact on firm’s liquidity, risk, and performance, with greater influence on its value.
In Portugal, in 2019, accounts receivable and inventories were 11.7% and 12.4% of total assets, respectively, while accounts payable were 10.5% and financial debt 33.3% (all Portuguese firms' mean value). These percentages, except financial debt, increase to small-size firms, showing the dependence of this type of firms in working capital management to guarantee their survival. These facts suggest that the way firms manage working capital impacts their financial management and, in turn, their operational performance.
Deloof (2003) argues that to maximize their value, firms should have an optimal level of working capital. Firms need to manage credit grant to customers and stocks to avoid the increase of current assets that rises its needs for finance. If for one side, enlarging days sales outstanding may increase sales, for another side, it can contribute to increase bad debts. Large inventory also can reduce the risk of a stock-off but, add more costs to firms. Thus, managing these current assets is crucial. To finance their assets, firms specially the small-size ones, use current liabilities, specially through suppliers’ credit. Small and medium enterprises (SME) have less fixed assets that can be used as collateral to long-term debt, so the main source of financing is short-term liabilities (Demigurc-Kunt and Maksimovic, 2002). Moreover, these firms have no access to financial markets to obtain funding (Petersen and Rajan, 1997). Therefore, managing working capital is crucial, especially for SMEs (Baños-Caballero, García-Teruel, and Martínez-Solano, 2010).
Working capital management is usually analyzed through cash conversion cycle (CCC) - the period of time between the collection of cash from customers and the payment to the suppliers. The longer this lag, the higher the investment in working capital, and in turn there is more need of other financial sources, which can impact the firm’s performance (Deloof, 2003).
Moreover, macroeconomic factors, with special relevance to crisis periods, impact working capital. Several firms do not survive during downturn periods, leading to bad debts and to an increase of financial needs (Mielcarz, Osiichuk, and Wnuczak, 2018). Although, the difficulty to access to banks increases in these periods since more debt covenants are added. With less alternative of financing, firm are more dependent on commercial credit, but they need to manage it to pay credits on time. Thus, in crisis periods firms need to be more efficient in managing working capital since it will impact its cost of debt, operational performance, and its survival (Enqvist, Graham and Nikkinen, 2014).
This chapter aims to analyze the evolution of several financial ratios to understand the impact of business cycles on firm’s characteristics, mainly with regards to working capital items. Moreover, to understand the impact of working capital management on firm’s operational performance a model will be regressed. By analyzing the interrelation between working capital management and firm’s profitability, this work aims to summarize the principles of financial management across economic cycles.
The sample includes means values for all Portuguese firms available in database from 2006 till 2019. Moreover, differences across sectors will be also analyzed. With these analyses, this work aims to give insights about the impact of business cycles on working capital management, giving some suggestions about how managers should deal, especially during crisis periods, to increase the firm’s performance and assures its survival.
This chapter is organized into six sections. After this first introductory section, the second one presents a theoretical context about working capital and its impact in firm’s profitability. The sample and methodology are present in section three. Section four presents and discuss the main results. The main conclusion of the study is presented in section five, and in the last section future lines of research are addressed.