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This article is address the theoretical gap exists on how working capital management
affect on the profitability of a firm. This re search is done by Pedro Juan Garcia-Teruel
and Pedro Martinez-Solano, collecting data relating to 8872 Small to Medium-sized
Enterprises (SMEs) in Spain, over seven years from 1996 to 2002.

Working capital is the amount of an organization requires, ensuring smooth functioning

of its day to day operations, ‘running cash’ is the business term using by organizations. It
is calculated by obtaining the net difference between current assets and current liabilities
in an organization (current assets – current liabilities).

The corporate finance literature traditionally focused with study of long term financial
decisions. Analyzing investments, capital structure, dividends and company valuation
were the favourite topics among the researchers. As we study investments, two types of
investments can be identified. Short term and long term are sub-categories of the

A short term investment consists with, inventories and instruments carrying a maturity
period less than one year. In current assets definition we include the same items that we
have discussed under the short term investments. Therefore short term investments and
current assets are two words that can be used interchangeably.

In the empirical study conducted to do this article, researchers have observed the current
assets were 69% of assets and current liabilities represent more than 52% of liabilities. As
we concern on these figures we can realize how important it is to manage the working

The importance of working capital has been identified even by the early researchers.
Working capital management is important because of its effects on the firm’s profitability
and risk, and consequently its value (Smith, 1980). Through this research author has


conveyed the fact that, working capital involves a tradeoff between risk and profit. In
other words, there is a positive relationship between risk and profitability of a given
organization. This results, decisions tend to increase profitability tend to increase risk,
and conversely decisions tend to reduce to the risk tend to decline the profit of that

Gitman (1974) argued that cash conversion cycle was a key factor in working capital
management. Cash conversion cycle represents how long investment being as inventory,
how long you give credit sales to be settled and how long accounts are carried as
creditors (credit period granted by creditors). The cash conversion cycle indicates 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 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).

Then we have to think, if researchers have already done research with regard to working
capital management, what is the use of doing this article or else what new knowledge has
been addressed by this article? Though these seminal works has been done in relation to
working capital management, almost all the articles have done involving large scale
firms. Through this article researchers have contributed to the literature in two aspects,
First, no such evidence exists for the case of SMEs in earlier studies. The second
contribution is that, unlike the previous studies (Jose et al., 1996; Shin and Soenen, 1998;
Deloof, 2003; Wang, 2002) in the current work robust tests for the possible presence of
endogeneity problems have been applied. 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.


Theoretical Foundations

Shin and Soenen in 1998 indicated that the administration of working capital may have
an important impact on the profitability and liquidity of the firm. Firms can choose
between the relative benefits of two basic types of strategies for net working capital
management: they can minimize working capital investment or they can adopt working
capital policies designed to increase sales. Thus, the management of a firm has to
evaluate the trade-off between expected profitability and risk before deciding the optimal
level of investment in current assets.

Wang (2002) points out that if the inventory levels are reduced too much, the firm risks
losing increases in sales. Also, a significant reduction of the trade credit granted may
provoke a reduction in sales from ustomers requiring credit. Similarly, increasing
supplier financing may result in losing discount for early payments. In fact, the
opportunity cost may exceed 20 percent, depending on the discount percentage and the
discount period granted (Wilner, 2000; Ng et al., 1999).

Contrary to traditional belief, investing heavily in working capital (conservative policy)

may also result in higher profitability. In particular, maintaining high inventory levels
reduces the cost of possible interruptions in the production process and of loss of business
due to the scarcity of products, reduces supply costs, and protects against price
fluctuations, among other advantages (Blinder and Maccini, 1991).

Granting trade credit favors the firm’s sales in various ways. Trade credit can act as an
effective price cut (Brennan et al., 1988; Petersen and Rajan, 1997), incentivizes
customers to acquire merchandise at times of low demand (Emery, 1987), allows
customers to check that the merchandise they receive is as agreed (quantity and quality)
and to ensure that the services contracted are carried out (Smith, 1987), and helps firms to
strengthen long-term relationships with their customers (Ng et al., 1999). However, these
benefits have to offset the reduction in profitability due to the increase of investment in
current assets.

Most empirical studies relating to working capital management and profitability support
the fact that aggressive working capital policies enhance profitability. In particular, Jose


et al. (1996) provide strong evidence for US companies on the benefits of aggressive
working capital policies.

Shin and Soenen (1998) analyze the relation between the net trade credit and profitability
for a sample of firms listed on the US stock exchange during the period 1974-1994. Their
results also show strong evidence that reducing the net trade credit increases firms’

However, this relationship is not found to be very strong when the analysis is at the level
of a specific industry (Soenen, 1993). More recently, Deloof (2003) analyzes a sample of
large Belgian firms during the period 1992-1996. His results confirm that Belgian firms
can improve their profitability by reducing the number of days accounts receivable are
outstanding and reducing inventories. Moreover, he finds that less profitable firms wait
longer to pay their bills.

Finally, Wang (2002) analyzes a sample of Japanese and Taiwanese firms from 1985 to
1996, and finds that a shorter cash conversion cycle is related to better operating

Theses results can be partially explained by the fact that there are industry benchmarks to
which firms adhere when setting their working capital investment policies (Hawawini et
al., 1986). Thus, firms can increase their profitability by reducing investment on accounts
receivable and inventories to a reasonable minimum, indicated by the benchmarks for
their industry. Furthermore, as pointed out by Soenen (1993), cash conversion cycle
management tries to collect cash inflow as quickly as possible, and to postpone cash
outflow as long as possible. The result will be the shortening of the cash conversion

The above mentioned seminal works have contributed to the existing knowledge in
working capital management literature.

Data and Variables