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Working
Measuring impact of working capital
capital efficiency on financial efficiency

performance of a firm
An alternative approach 75
Punam Prasad and Narayanasamy Sivasankaran Received 4 February 2018
Revised 21 March 2018
Indian Institute of Management Ranchi, Suchana Bhawan, Ranchi, India Accepted 1 April 2018

Samit Paul
Indian Institute of Management Calcutta, Joka Kolkata, West Bengal, India, and
Manoharan Kannadhasan
Indian Institute of Management Raipur, Sejbahar, Raipur, India

Abstract
Purpose – The purpose of this study is to introduce working capital efficiency multiplier (WCEM) as a
direct profitability measure of working capital management. The existing accounting measures in the
literature establish an indirect approach to study the relationship between working capital efficiency and
profitability of the firms.
Design/methodology/approach – Using the help of a set of companies from CMIE Prowess database,
the study introduces WCEM as a direct profitability measure of working capital efficiency.
Findings – In this study, a new direct measure of working capital efficiency is introduced which is
multiplicative in nature. WCEM is a product of three components, namely, WACC, ratio of the sum of trade
receivables and inventories to trade payables and ratio of net working capital (NWC) to net sales.
Practical implications – The importance of direct measure like WCEM could be enormous in
performance evaluation of a firm. It can be used as an indicator for choosing a suitable investment
opportunity by an investor. This is due to the fact that the firm that is highly efficient in managing working
capital is less exposed to liquidity risk. At the same time, the firm is less dependent on external financing.
Therefore, such firms eventually create more value for their shareholders. Another indication that WCEM
provides is to gauge the bargaining power of the firm and its competitive position in the market. Lower
WCEM indicates higher bargaining power of a firm across the value chain, and its superior position relative
to its competitors.
Originality/value – Most of the studies on WCM are of the empirical type and there is a complete dearth
on theoretical framework. Researchers hereafter can consider WCEM as one of the financial performance
variables in place of the existing measures such as return on asset (ROA), return on invested capital (ROIC),
return on equity (ROE), gross operating income (GOI) and net operating income (NOI) and thereby can
contribute new empirical insights through their research outcomes.
Keywords WCM, Direct profitability measure, WCEM, Working capital efficiency
Paper type Conceptual paper

1. Introduction
In today’s ever-changing business environment, survival of the business is the driving force Journal of Indian Business
Research
for a firm to excel among its peers. Survival in the modern world (continuing to be in Vol. 11 No. 1, 2019

business) is possible, only, when apart from other things, a firm has sufficient amount of
pp. 75-94
© Emerald Publishing Limited
financial resources to meet its long-term (fixed capital) and short-term commitments 1755-4195
DOI 10.1108/JIBR-02-2018-0056
JIBR (working capital). The management of working capital is equally important as the
11,1 management of long-term financial investment because efficient utilization of fixed assets is
possible only when the company has adequate amount of working capital and it affects not
only short-term financial performance, i.e. profitability (Raheman and Nasr, 2007; Samiloglu
and Demirgunes, 2008), but also long-term financial performance, i.e. maximization of firm
value (Samiloglu and Demirgunes, 2008). Working capital efficiency is a measure that
76 indicates how a firm balances the amount of capital blocked in receivables and inventories
with its payables on purchase of inventories. To be more specific, this measure differentiates
the firms of similar nature (e.g. similar size, nature of business etc.) based on the portion of
the funds mobilized to meet their day-to-day operating requirements (Dong and Su, 2010).
Besides, working capital efficiency of a firm denotes the firm’s creditworthiness and creates
an investor’s opinion on the firm’s financial health. The firm with high working capital
efficiency minimizes the need for borrowed capital in the short-run and thus helps the
business to plan for long-term borrowing while expanding or investing in new projects.
Maintaining a desired level of working capital efficiency drives firm managers to take
timely decisions relating to investment in current assets and short-term financing. Such
decisions are important features of working capital management (WCM) (Nimalathasan,
2010). WCM has become one of the non-trivial issues in organizations, where many finance
managers find it difficult to distinguish the important drivers of working capital and to
decide on the optimal level of working capital (Smith, 1987; Lamberson, 1995). Most of the
studies have focused on working capital practices of firms belonging to developed countries
and very few studies reflect the same of firms operating in emerging economies, such as
India (Saravanan et al., 2017).
Cash conversion cycle (CCC) is the most popular and widely used measure of
working capital efficiency. It is the sum of days’ inventories and days’ receivables
minus days’ payables. The longer the CCC, the larger is the investment in working
capital (Deloof, 2003; Abuzayed, 2012). According to the WCM Report 2014, released by
consulting firm Ernst & Young, the top 500 Indian companies had an average CCC of 67
days compared with 42 days for US firms, 41 days for European companies and 39 days
for the firms in the rest of Asia. The report concludes that the top Indian firms might
have increased their cash flows by Rs. 5.3tn in the financial year 2014 if they had
effectively managed their working capital cycle. Therefore, it is imperative to find a
suitable and innovative performance (outcome) measure which clearly and directly
reports the impact of working capital efficiency of the firms.
As of now, there are a number of studies that have reported the impact of CCC on the
profitability of companies (Wang, 2002; Deloof, 2003; Samiloglu and Demirgunes, 2008;
Falope and Ajilore, 2009; Mathuva, 2009; Dong and Su, 2010; Banos-Caballero et al., 2012;
Saravanan et al., 2017). These studies, in general, have used return on asset (ROA), return
on invested capital (ROIC), return on equity (ROE), gross operating income (GOI) and net
operating income (NOI) as a proxy for profitability of firms. It is quite logical to state that
the profit earned by a firm is generated from its investment in both non-current assets
and current asset or working capital. Therefore, if one needs to capture the relationship
between working capital efficiency and profitability of a firm accurately, he/she needs to
consider only that part of profit which is generated by efficient WCM. However, the
above-stated profitability measures such as ROA, ROIC and ROE do not segregate the
return earned by firms on their non-current assets and working capital. The other two
measures (GOI and NOI) also fail to distinguish between the profit earned on net working
capital (NWC) and that of using the non-current assets, and hence, there is a need to
develop a direct outcome measure to exclusively assess the impact of a firm’s investment Working
in working capital. capital
We, in this study, introduce a direct performance measure of working capital efficiency,
namely, working capital efficiency multiplier (WCEM). Contribution of this study to the
efficiency
existing literature is of many folds. Firstly, to the best of our knowledge, this is the first
study which proposes WCEM as an effective direct measure of performance while
expressing the logical relationship between firms’ working capital efficiency and their
working capital cost (WCC). Secondly, although the evidences in favor of this direct measure
77
have been provided on the basis of Indian firms, it can be widely applied to firms from any
other country. Lastly, the WCEM is easy to compute and hence not much expensive in
decision making.
The remainder of the paper is structured in the following manner. Section 2 deals with a
review of the literature on the management of working capital. Section 3 presents the
rationale for the development of a direct performance measure to investigate the impact of
working capital efficiency on the financial performance of firms. WCEM as a direct outcome
measure of working capital efficiency is presented in Section 4. Finally, Section 5 concludes
and provides the scope for future research.

2. Review of literature
A significant portion of earlier research on WCM has been extensively investigated at
empirical levels (Singh and Kumar, 2014; Enqvist et al., 2014; Aktas et al., 2015). Corporate
finance literature traditionally focuses on long-term financial decisions and their impact on
the profitability of firms. However in recent years, WCM has gained importance, as
managers and academicians have recognized the relevance of efficient management of
working capital in the survival of a firm, especially after the global financial turmoil
(Uremandu et al., 2012; Ramiah et al., 2014). Improper management of working capital is a
major reason for the failure of small- and medium-sized firms compared to large firms in
developed economies like USA and UK (Dunn and Cheatham, 1993; Peel and Wilson, 1996).
Management of working capital involves the manager’s time, attention and skills in
handling short-term investments and the objective of WCM is to increase the liquidity and
profitability of the firms and thereby increase their shareholders’ value (Chang, Dandapani
and Prakash, 1995; Nilsson, 2010; Aktas et al., 2015).
Operational working capital is mainly used to measure the cycle times or turnover times
of various components of WCM such as inventories, accounts receivables, accounts
payables, etc. and is designed to assess managerial decision making (Filbeck and Krueger,
2005). The operational working capital measures can be used to quantify the working
capital efficiency of firms and their managers (Hofmann and Kotzab, 2010). The CCC, as
discussed earlier, is the basic measure of operational working capital (Richards and
Laughlin, 1980). There are several variations of CCC in the academic literature. Richards and
Laughlin (1980) calculate CCC as presented below:

Inventories Notes and accounts receivables

CCC ¼ * 360 þ * 360
COGS Net sales
Accounts payables  Salaries; benefits and payroll tax
 * 360 (1)
COGS þ Selling; general and Administrative expense

Theodore Farris and Hutchison (2002) as well as Ding et al. (2013) use a simpler equation for
CCC as presented below:
JIBR Inventories Accounts receivables Accounts payables
CCC ¼ * 365 þ * 365  * 365 (2)
11,1 COGS Net sales COGS

The simplest variation of CCC is net trade cycle (NTC) which was developed by Shin and
Soenen (1998). NTC uses net sales as the denominator for all the three components of
working capital.
78
Inventories þ Accounts receivables  Accounts payables
NTC ¼ * 365 (3)
Net Sales

CCC deals with three major components of working capital, namely, inventory, accounts
receivables and accounts payables, in such a way that it reveals composite performance of a
firm in terms of its working capital efficiency. The weighted cash conversion cycle (WCCC)
provides more detailed information than the original CCC (Gentry, 1990). WCCC connects
the monetary values of operational working capital components to their cycle times. WCCC
can be concluded as weighted operating cycle less weighted days in accounts payables.
WCCC is extended into adjusted cash conversion cycle (ACCC) (Viskari et al., 2012). The
calculation logic of ACCC is based on WCCC, but it could be used on customer or product
levels. The modifications present the efficiency of WCM in days which is similar to the
original CCC.
The existing literature consists of a number of studies which employ CCC as the measure
of working capital efficiency and conclude that a firm can improve its efficiency in WCM by
reducing its CCC (Emery, 1987; Blinder and Maccini, 1991; Deloof and Jegers, 1996; Raheman
and Nasr, 2007; Nobanee, Abdullatif and AlHajjar, 2011). Therefore, a firm can acquire
competitive advantage through proper WCM.
Profitability is used as a measurement for financial performance because it evaluates the
efficiency with which plant, equipment and net current assets are transformed into profits
(Kamal and MohdZulkifli, 2004). There are a number of past studies that describe the
relationship between working capital efficiency and profitability of firms using ROA as a
proxy for profitability (Jose et al., 1996; Shin and Soenen, 1998; Wang, 2002; Samiloglu and
Demirgunes, 2008; Falope and Ajilore, 2009; Mohamad and Saad, 2010; Charitou et al., 2010;
Vahid et al., 2012a, 2012b; Saravanan et al., 2017). Instead of ROA, few studies prefer ROIC
as a measure of profitability which reports the profits earned by the firms on their long term
capital invested or long-term capital employed (Mohamad and Saad, 2010; Nobanee et al.,
2011). ROE which reports the profits earned by a firm for its equity shareholders is another
widely used measure of profitability (Jose et al., 1996; Wang, 2002). Moreover, researchers
often use GOI which reveals the gross operating profits earned by a firm on its total assets
(Deloof, 2003; Gill et al., 2010; Dong and Su, 2010; Banos-Caballero et al., 2012; Abuzayed,
2012). In addition, NOI which indicates the net operating profit earned by a firm on its total
assets (Deloof, 2003 for the difference between GOI and NOI) has also been used for the same
purpose (Shin and Soenen, 1998; Banos-Caballero et al., 2012).
Academic research work carried on the relationship between CCC and profitability of
firms have reported a mixed evidence where few of them have reported a positive
relationship (Shin and Soenon,1998; Padachi, 2006; Mathuva, 2009; Dong and Su, 2010;
Banos-Caballero et al., 2010; Raheman et al., 2010) and many of them have reported a
negative relationship (Kim et al., 1998; Wang, 2002; Deloof, 2003; Zariyawati et al., 2009;
Ching et al., 2011; Akinlo, 2012; Abiodun and Samuel, 2014; Saravanan et al., 2017) between
the two variables.
 Soenen (1993) investigates the relationship between NTC and return on investment in the Working
US firms and find a negative relationship between the two variables. Jose et al. (1996) capital
examine the relationship between CCC and profitability by considering a large number of
the American firms and report a significant negative relationship between CCC and
efficiency
profitability. They also observe that more aggressive WCM is associated with higher
profitability. Shin and Soenen (1998) report a strong negative relationship between NTC and
the firm’s profitability and they suggest that one possible way for managers to create
shareholder value is to reduce their firms’ NTC. 79
Wang (2002) examines the relationship between CCC and profitability (measured by
ROA and ROE) of 1555 Japanese firms and 379 Taiwanese firms and concludes that
reducing CCC enhanced operating performance in spite of differences in the structural
characteristics of both these countries. Deloof (2003) used a sample of 1,009 large Belgium
firms for the period of 1992 to1996 and concludes that firms can improve their profitability
by reducing the number of days of accounts receivable and inventories to a reasonable
minimum. This negative relationship between CCC and profitability is consistent with the
view that more profitable firms are efficient in managing their working capital.
Lazaridis and Tryfonidis (2006) study the relationship between firms’ profitability
(through gross operating profit) and the working capital efficiency (through CCC) for the
listed firms in Athens Stock Exchange and report that if CCC is kept at the optimal level it
may positively affect the shareholders’ wealth. Garcia-Teruel and Martinez-Solano (2007)
analyze small and medium size European companies and observe that shortening the CCC
improves a firm’s profitability.
Falope and Ajilore (2009) analyze a sample of 50 Nigerian quoted non-financial firms
using panel data regression and document a significant negative relationship between net
operating profitability and CCC, the average collection period, inventory storage days and
average payment period. Further, they show no significant variation in the effects of WCM
between large and small firms. A significant and positive relationship between the CCC and
firms’ profitability has been established by Gill et al. (2010) using a sample of 88 firms listed
on New York stock exchange. This means that longer the CCC, higher is the profitability of
the firm.
From the above discussion, we can conclude that a firm can generate an additional
amount of cash by reducing its CCC which in turn can be used for investment in operating
assets and thereby increasing the profitability of the firm. Hence the studies reported in the
literature on WCM postulate an indirect relationship between CCC and profitability of the
firms as shown in Figure 1.
However, the literature is very silent about any sort of direct and explicit relationship
between working capital efficiency and financial performance of firms which leads us to the
following research question:
RQ. Is it possible for a firm to directly measure the impact of its working capital
efficiently on its financial performance?

Figure 1.
Indirect relationship
between working
capital efficiency and
profitability of the
firms assumed by
existing literature
JIBR 3. Rationale for the development of a direct performance measure in assessing
11,1 the impact of working capital efficiency
Capital structure theories (Modigliani and Miller, 1958; Modigliani and Miller, 1963; Miller,
1977; Jensen and Meckling, 1976; Titman and Wessels, 1988; Myers and Majluf, 1984; Harris
and Raviv, 1991) state that firms can optimally design their capital structure in order to
increase their value. In other words, a firm can change its value by changing its financing
80 mix.
It is logically apparent that if firms can have differences in their capital structure then
they can also have differences in their asset structure i.e. proportion of non-current assets
and NWC. If this is true, then the differences in the asset structure of firms in general, and
the differences in the working capital efficiency of firms in particular, should lead to
differences in financial performance of the firms. However, the existing profitability
measures such as ROA, ROIC, ROE, GOI and NOI do not explicitly reveal the differences in
the asset structure of firms in general and the differences in their efficiency in using
investments in particular (see Table I). Hence, the question that comes to our mind is that
whether the impact of working capital efficiency on financial performance of firms can be
measured in a direct manner by developing a new financial outcome measure?

Does the measure explicitly Reason for non-suitability in measuring

report the impact of working the impact of working capital efficiency
Profitability measure capital efficiency of firms of firms

Return on Asset (ROA) No Reports the return made on

Jose et al. (1996), Shin and employment of total assets and does
Soenen (1998), Wang (2002), not segregate the return on NWC and
Samiloglu and Demirgunes return on non-current assets from the
(2008), Falope and Ajilore composite measure of ROA
(2009), Mohamad and Saad
(2010), Charitou et al. (2010),
Vahid et al. (2012), Saravanan
et al. (2017)
ROIC No Reports the return on invested capital
Mohamad and Saad (2010), but does not decompose ROIC into
Nobanee et al. (2011) return on NWC and return on non-
current assets
Return on equity (ROE) No Reports return on shareholders’ funds
Jose et al. (1996), Wang (2002) but fails to report return on NWC and
return on non-current assets
GOI No Reports gross operating profit as a
Deloof (2003), Gill et al. (2010), percent of total assets but fails to
Dong and Su (2010), Banos- disclose the return on NWC and return
Caballero et al. (2012), on non-current assets
Abuzayed (2012)
Net operating income (NOI) No Reports net operating profit as a
Shin and Soenen (1998), Deloof percent of total assets but fails to
Table I. (2003), Banos-Caballero et al. disclose the return on NWC and return
Rationale for (2012) on non-current assets
development of new
Notes: This table lists the existing literature that have used different profitability measures such as return
financial on assets (ROA), return on invested capital (ROIC), return on equity (ROE), gross operating income (GOI)
performance and net operating income (NOI); further it explains the reasons why such studies are not suitable in
measure, WCEM measuring the impact of working capital efficiency of firms
To verify our point presented in the preceding paragraph, we have collected the sample data Working
from Prowess database, created by the Centre for Monitoring Indian Economy (CMIE). This capital
database contains detailed information on the financial indicators of Indian firms, compiled
from various sources such as profit and loss accounts, balance sheets, cash flow statements
efficiency
and annual reports. This is a reliable source of information which many researchers have
used extensively in other empirical works in financial economics (Bertrand et al., 2002;
Sarkar and Sarkar, 2000; Saravanan et al., 2016).
In this study, we have used NTC as the proxy for measuring the working capital 81
efficiency due to the following reasons (Shin and Soenen,1998; Ganesan,2007 and Raheman
et al.,2010). First, WCCC which is a modified version of CCC and developed by Gentry et al.
(1990) scales the timing by the amount of funds tied up in each step of the cash cycle but the
break-up of the components of inventories (raw materials, work-in progress and finished
goods) is not readily available in the annual reports and hence we cannot calculate WCCC.
WCCC is extended into ACCC (Viskari et al., 2012). The calculation logic of ACCC is based
on WCCC but it could be used on customer or product levels. Second, CCC is an additive
measure and the denominators of days’ inventories, days’ accounts receivables and days’
accounts payables are all different, making it difficult to compute. Whereas, NTC is
basically CCC wherein all the three components (days’ inventories, days’ accounts
receivables and days’ accounts payables) are expressed as a percentage of sales. This
measure is easy to compute and can be expressed as a function of the projected sales growth.
Hence, NTC is used as a measure of working capital efficiency in this study.
We have computed the NTC, ROA, ROIC [or ROCE], ROE, GOI and NOI (please see Note
at the end for formulae) for a pair of firms operating in the same industry as the working
capital practices and the profitability of firms may get affected by the industry
characteristics (Weinraub and Visscher, 1998). The results are presented in Table II.
From Table II, it is evident that two companies, namely JSW Energy Ltd. and
RattanIndia Power Ltd., operating in the conventional electricity industry have reported the
same ROA of 11 per cent. However, JSW Energy Ltd. has a NTC of 22 days while
RattanIndia Power Ltd. has a NTC of 123 days. This indicates that the two firms operating
in the same industry with same ROA figures differ with reference to their efficiency in
managing working capital. Similarly, we spot differences in working capital efficiency
(measured by NTC) between a pair of firms across industries in spite of reporting the same
ROCE or ROE or GOI or NOI. For instance, Ambalal Sarabhai Enterprises Ltd. with a NTC
of 64 days is relatively efficient in WCM compared to its competitor, Andrew Yule and Co.
Ltd. (with a NTC of 90 days) even though both of these firms have generated the same GOI
of 9 per cent.
From the above discussion, we can recognize that the existing profitability measures do
not explicitly reflect the impact of working capital efficiency of firms. For instance, literature
has used Return on Asset (ROA) (Shin and Soenen, 1998; Padachi, 2006; Mohamad and Saad,
2010), Return on Invested Capital (ROIC) (Vishnani and Shah, 2007; Mohamad and Saad,
2010) Return on Equity (ROE) (Afza and Nazir, 2008; Akoto et al., 2013), gross operating
income (GOI) (Deloof, 2003;Ganesan, 2007; Alipour, 2010) and net operating income (NOI)
(Raheman and Nasr, 2007; Zairyawari et al., 2009) as a proxy for profitability of firms
(outcome measure of WCE of firms). Hence, there arises a need to replace the traditional
measures of profitability with a new measure which can describe an explicit and direct
relationship between working capital efficiency and financial performance of the firms as
indicated in Figure 2.
From Figure 2, it can be stated that firms with higher working capital efficiency (lower
NTC) may generate higher financial performance. Financial performance of firms could be
 82
11,1
JIBR

financial
Table II.

performance
Comparison of

of sample firms
measures with NTC
traditional and naïve
(a)
Traditional RONWC using the contents of balance sheet and income statement
performance Performance NTC NWC (in CE (in Rs. RONWC = ROCE 
Company name Industry group measures (in %) (in days) Rs. million million NWC/CE ROCE (NWC/CE)

JSW Energy Ltd. Conventional electricity ROA 11 22 4,860 120,980 0.04 47 1.88
RattanIndia Power Ltd. Conventional electricity ROA 11 123 4,518 917,60 0.05 14 0.7
JK Lakshmi Cement Ltd. Cement ROCE 6 13 1,005 2,300 0.44 6 2.64
KCP Ltd. Cement ROCE 6 84 2,933 7,573 0.39 6 2.34
Parnax Lab Ltd. Drugs and ROE 8 57 150 263 0.57 4 2.28
pharmaceuticals
Parenteral Drugs (India) Ltd. Drugs and ROE 8 128 775 5,572 0.14 3 0.42
pharmaceuticals
Ambalal Sarabhai Enterprises Ltd. Diversified GOI 9 64 249 588 0.42 67 28.14
Andrew Yule and Co. Ltd. Diversified GOI 9 90 1,033 2,402 0.43 23 9.89
Prakash Constrowell Ltd. Industrial construction NOI 11 157 967 1,105 0.88 63 55.44
B L Kashyap and Sons Ltd. Industrial construction NOI 11 276 6815 10,835 0.63 24 15.12

Notes: This table compares traditional and naïve financial performance measures with net trade cycle (NTC) of sample firms. The four traditional measures
which gauge the effect of working capital efficiency of firms are: (a) return on net working capital (RONWC) using the content of balance sheet and income
statement; RONWC = ROCE  (NWC/CE) (b) return on net working capital (RONWC) using the content of balance sheet, income statement and annual report;
RONWC = (working capital profit/NWC)  100 (c) working capital expenses using the content of annual report; and (d) working capital cost (WCC) using
contents from balance sheet and CMIE Prowess database; WCC = WACC  NWC; Log WCC is logarithm of WCC
(continued)
 (b) (c) (d)
Working capital
RONWC using the contents of balance sheet, income statement and annual report expenses WCC
Total operating revenue Total operating revenue from working WC loss/ profit (in WACC WCC = WACC  Log
Company name (in Rs. million) capital (in Rs. million) Rs. million RONWC (in Rs. million) (in %) NWC (Rs. million) (WCC)

JSW Energy Ltd. 79,694 3,188 705 14.5 2,483 10.28 49960 4.70
RattanIndia Power Ltd. 53,315 2,666 1219 26.98 1,447 14.85 67107 4.83
JK Lakshmi Cement Ltd. 45,930 20,209 670 66.67 19,539 7.85 7887 3.90
KCP Ltd. 9,082 3,542 1288 43.92 2,254 12.10 35494 4.55
Parnax Lab Ltd. 2,820 1,607 17 11.63 1,590 9.80 1467 3.17
Parenteral Drugs (India) Ltd. 20,010 2,801 201 25.99 2,600 16.43 12733 4.10
Ambalal Sarabhai Enterprises Ltd. 4,949 2,079 179 71.69 1,900 14 3403 3.53
Andrew Yule and Co. Ltd. 5,047 2,170 590 57.16 1,580 18 18354 4.26
Prakash Constrowell Ltd. 7,115 6,261 823 85.09 5438 11.99 11595 4.06
B L Kashyap and Sons Ltd. 8,985 5,661 1271 18.64 4,390 20.43 139208 5.14
efficiency
capital

83

Table II.
Working
JIBR proxied by the cost of capital blocked in NWC of a firm which can be measured through
11,1 WCEM as proposed by the authors in this study. We argue that firms with higher working
capital efficiency have lower cost of capital for their investments in working capital. Lower
the WCEM, lower is the cost of capital blocked in NWC and therefore higher is the financial
performance of a firm (refer Table III).

84 4. Working capital efficiency multiplier as a direct outcome measure of

working capital efficiency
In this section, we first present the naive approaches that may be used in quantifying the
impact of the efficiency of firms in managing their investments in working capital. The
naïve approaches have serious limitations such as being additive in nature besides not
capturing behavioral impacts in an objective manner. We end our discussion with the
formulation of WCEM, which we argue to be the right outcome measure of working capital
efficiency of firms.

4.1 Naive approaches

To gauge the effect of working capital efficiency of firms, one may consider the following
four alternatives:
(1) Return on net working capital (RONWC) using the content of balance sheet and
income statement;
(2) Return on net working capital (RONWC) using the content of balance sheet, income
statement and annual report;
(3) Working capital expenses using the content of annual report; and
(4) WCC using the content of balance sheet and annual report.

4.1.1 Return on net working capital using the contents of balance sheet and income
statement. As discussed in the previous section, companies differ in their asset structures. In
the extant literature, return on capital employed (ROCE) is used extensively as a proxy for
profitability of firms. ROCE reflects the return on the total capital employed by firms, which
can be decomposed into return on net working capital (RONWC) and return on non-current
assets (RONCA). As a naive approach, we may compute the RONWC by multiplying the
ROCE by the proportion of NWC in the total capital employed by a firm.
For instance, the ROCE of JK Lakshmi Cement Ltd. (Table II) is 6 per cent, NWC is Rs.
1,005m and capital employed is Rs. 2,300m, and its NWC/capital employed is 0.44 and then
its RONWC = 6  (0.44) = 2.64 per cent.
This is a very simple approach as we can easily get the ROCE and proportion of NWC in
total capital used from the balance sheets of firms. However, this approach has a major
drawback as the actual proportion of ROCE from the employment of NWC may differ
substantially from the theoretical proportion (proportion of NWC in the total capital

Figure 2.
Proposed direct
relationship between
working capital
efficiency and
financial performance
of the firms
 Traditional Trade Trade
performance Performance NWC NTC WACC Receivables Inventories Payables
Company Name Industry group measures (in %) (Rs. million) (in days) (in %) (Rs. million) (Rs. million) (Rs. million) WCEM (in %)

JSW Energy Ltd. Conventional electricity ROA 11 4860 22 10.28 21827.5 5967.4 22934.5 0.74
RattanIndia Power Ltd. Conventional electricity ROA 11 4518 123 14.85 7915.9 833.8 4231.4 10.39
JK Lakshmi Cement Ltd. Cement ROCE 6 1005 13 7.85 924.6 3212 3132 0.36
KCP Ltd. Cement ROCE 6 2933 84 12.10 1034.6 2799.6 901.4 11.87
Parnax Lab Ltd. Drugs and pharmaceuticals ROE 8 150 57 9.80 201 79.4 130.8 3.31
Parenteral Drugs (India) Ltd. Drugs and pharmaceuticals ROE 8 775 128 16.43 750.2 450.5 425.8 16.21
Ambalal Sarabhai Enterprises Diversified GOI 9 249 64 14 378.7 146.1 275.7 4.57
Ltd.
Andrew Yule and Co. Ltd. Diversified GOI 9 1033 90 18 1562 479.2 1008.6 8.84
Prakash Constrowell Ltd. Industrial construction NOI 11 967 157 11.99 516.9 822 371.5 18.56
B L Kashyap and Sons Ltd. Industrial construction NOI 11 6815 276 20.43 3966.6 4411.2 1562.9 82.91

Notes: This table compares traditional and proposed financial performance measures, i.e. working capital efficiency multiplier (WCEM), with net trade cycle (NTC)
of sample firms. It also identifies trade receivables, inventories, trade payables, net trade cycle and weighted average cost of capital (WACC) as a determinant of
WCEM. WACC has been calculated from cost of debt (COD) and cost of equity (COE) which are calculated from annual reports of the companies and using CAPM
respectively. WACC = after-tax COD  proportion of Debt þ COE  proportion of Equity. Pretax COD = (interest expenses/ (short-term borrowing þ long-
term borrowing)  100. Posttax COD  pretax COD  (1  tax rate). COE = risk-free rate þ beta (market risk premium). Risk-free rate is taken as 6.9% and
market risk premium is 6.06%. Beta values are taken from CMIE Prowess database for the firms. WCEM has been calculated as WACC  (trade receivables þ
inventories)/trade payables  (NTC/365)
EBIT ð1  tÞ
Return on assets ðROAÞ ¼
Total assets

EBIT ð1  tÞ
Return on Capital EmployedðROCE Þ ¼
Invested Capital

Profit after tax

Return on EquityðROE Þ ¼
Owners’ Equity

Sales  Cost of sales þ Depreciation & Amortization

Gross Operating Income ðGOI Þ ¼
Total Assets

Sales  Cost of Sales

Net Operating Income ðNOI Þ ¼
Total Assets

Table III.

sample firms
WCEM with NTC of
Comparison of

measures and
efficiency
capital

traditional
85

performance
Working
JIBR employed using the balance sheet). This is due to the differences that may exist in the
11,1 efficiency of managers in managing non-current and net-current assets of their firms, and it
is not possible for us to trace out the same. Hence, this approach may not be the right one in
our attempt to truly reflect the working capital efficiency of firms.
4.1.2 Return on net working capital using the contents of balance sheet, income statement
and annual report. We may compute RONWC by dividing the amount of working capital
86 profit of a firm by its investment in NWC. We may compute working capital profit as stated
below:

Working capital profit ¼ Operating revenue from usage of working capital

 Working capital expenses (4)

where:

Operating revenue from working capital ¼ Total Operating Revenue

 
NWC
*
Total Capital Employed
(5)

Working Capital Expenses ¼ ð Raw material consumed

6 Changes in work in progress and finsihed goods inventory
þ consumption of stores and spare parts
þ Damaged material; Obsolescence;
write down of inventories þ Bad DebtsÞ (6)

Net Working Capital ¼ Inventories þ Trade Receivables  Trade Payables (7)

We can collect the data for the above-stated variables from the annual reports of firms as
well from CMIE Prowess database. For instance, total operating revenue of JK Lakshmi
Cement Ltd. is Rs. 45,930m, its NWC/CE is 0.44, working capital expenses is Rs. 19,539m
and NWC is Rs. 1,005m then its working capital profit is (45,930  0.44)  19,539 =
Rs. 670m. The RONWC of the firm is [(670/1,005)  100] = 66.67 per cent (Table II).
This approach considers the working capital expenses that are explicit and are
related to inventories and trade receivables. However, we are finding out the revenue
from working capital using the proportion of working capital in total capital employed
which has the same drawback as that of the previous approach. Therefore, this is also
an inappropriate approach to report the effect of the working capital efficiency of
managers.
4.1.3 Working capital expenses using the contents of annual report. The limitation of the
previously discussed naive approaches is that they are based on the theoretical proportion of
NWC in the total capital employed by firms. Further, the second approach focuses on
computing the profit from the employment of working capital which requires us to calculate
the revenue and expenses related to a firm’s investment in working capital. Instead of
considering the revenue and profit as the outcome of the working capital efficiency of firms, Working
we may consider the working capital expenses as the proxy for the financial performance of capital
firms in our attempt to measure the impact of working capital efficiency of managers. The
efficiency
advantage of this approach is that one may easily get the data on the working capital
expenses of firms from their annual reports or from the databases such as CMIE. Working
capital expenses is computed as stated in equation (6) earlier:

Working Capital Expenses ¼ ð Raw material consumed

87
6 Changes in work in progress and finsihed goods inventory
þ consumption of stores and spare parts
þ Damaged material; Obsolescence;
write down of inventories þ Bad DebtsÞ

For instance, the working capital expense of JK Lakshmi Cement Ltd. is Rs. 19,539m where
the raw material consumed is Rs. 15,813m, changes in work in progress and finished goods
inventory is Rs. 169.9m, consumption of stores and spare parts is Rs. 3,896m, damaged
material, obsolescence, written-down inventories and bad debts is zero.
The drawback of this approach is that the working capital expenses is computed by
collecting the expenses related to two of the working capital components, namely,
inventories and trade receivables that are reported by firms in their annual reports and the
cost of delaying payment to suppliers is implicit and not reported by firms in their annual
reports. Hence, this approach may not be the right one to reveal the impact of working
capital efficiency of managers.
4.1.4 Working capital cost using the contents of balance sheet and annual report. NWC is
the excess of the sum of inventories and trade receivables over the trade payables of a firm.
The amount of investment made by a firm in its inventories and receivables can be
considered as wastage of capital (blockage of capital) by the managers of firms as these two
current assets do not earn any return on their investments. However, a firm may reduce the
ill-effect of its investments in inventories and trade receivables by increasing its dues to
suppliers of materials and other services (trade payables). For instance, JK Lakshmi Cement
Ltd. has the following figures: inventories at Rs. 805m, trade receivables at Rs. 600m and
trade payables are at Rs. 400m. The amount of mobilized capital wasted by the firm is Rs.
1,005m = Rs. 805m þ Rs. 600m  Rs. 400m.
This Rs. 1,005m investment made by a firm is sourced from short-term borrowings,
long-term borrowings and equity capital of the firm. Every one rupee mobilized in the
form of short-term borrowing, long-term borrowing and equity capital has a weighted
cost. We may compute the weighted average cost of capital (WACC) of the firm using its
annual reports (for computing cost of debt) and databases (for computing cost of equity
using its equity beta from CMIE Prowess database, risk-free rate of 6.9 per cent and risk
premium at 6.06 per cent) . For instance, the weighted average cost of capital for this firm
is 7.85 per cent (Table II).
It is rational to state that the cost of the firm’s investment in working capital is the
product of its investment in working capital and its WACC. We may term this as working
capital cost (WCC). For instance, the WCC for J K Lakshmi Cement Ltd. is Rs. 78.89m =
Rs. 1,005m  0.0785.
JIBR We can observe from Table II that two firms operating in the same industry with
11,1 differences in their working capital efficiency (measured through NTC) have reported
different WCC. For instance, Parnax Lab Ltd. is relatively efficient in its WCM (NTC of 57
days) compared to Parenteral Drugs (India) Ltd. (NTC of 128 days) operating in the same
industry. Both the firms have reported same ROE of 8 per cent, while the absolute and log
values of WCC of Parnax Lab Ltd. is quite lower (absolute WCC at Rs. 1,467m and log of
88 WCC at 3.17) compared to that of Parenteral Drugs (India) Ltd. (with an absolute WCC of Rs.
12,733m and log of WCC at 4.10). Similarly, we can find differences among firms across
industries in the working capital efficiency which is getting reflected in the absolute and log
value of WCC of the respective firms.
Therefore a firm can reduce its working capital cost by reducing its NWC by improving
its efficiency in managing NWC. However this measure gives us an absolute figure for WCC
[say, for instance, Rs. 12,733m for Parenteral Drugs (India) Ltd.] and if we assume that the
WCC for the same firm as Rs. 10,733m in the previous year, then we may conclude that the
firm’s WCC has increased in the current year compared to that of the previous year, that is
all. We are unable to compare firms on inter-firm and intra-firm basis using WCC as it is an
absolute figure. The problem still remains even after conversion of the absolute figure of
WCC into logarithm form. Hence there is a need to look for an appropriate outcome measure
for assessing the impact of working capital efficiency of firms.

4.2 Working capital efficiency multiplier – the right financial performance metric to measure
the impact of working capital efficiency of firms
In this study we introduce a new and direct measure of working capital efficiency which is
multiplicative in nature. It is similar like the DuPont multiplier. We term it as WCEM and
express it as:

Working Capital Efficiency Mutiplier ðWCEM Þ

Trade Receivables þ Inventories NTC
¼ WACC * * (8)
Trade Payables 365

where:
WACC refers to weighted average cost of capital
NTC is:

Inventories þ Accounts receivables  Accounts payables

NTC ¼ * 365
Net Sales

Substituting the value of NTC in WCEM, we get:

Inventories þ Trade Receivables

WCEM ¼ WACC *
Trade Payables
Trade Receivables þ Inventories  Trade Payables
* (9)
Net Sales

WCEM reflects the portion of WACC that is expensed by a firm for its investment in
NWC. As formulated above, lower the value of WCEM of a firm, higher is its working
capital efficiency. From Table III, we can observe that two firms, namely, JK Lakshmi
Cement Ltd. and KCP Ltd. have reported same ROCE at 6 per cent for their latest financial Working
year (2017). However, we can observe the differences in their NWC investments and capital
working capital efficiency measured through NTC. We argue that traditional efficiency
performance measures are aggregates in nature which fail to segregate the profits earned
by a firm from the employment of NWC, and these measures do not reflect the differences
in their working capital efficiency of firms. The naïve approaches as described in the
section do a comparatively better job to that of the traditional measures used by the 89
extant literature. However the naïve approaches have serious limitations and hence may
not use them in our attempt to assess the working capital efficiency of firms. WCEM for
JK Lakshmi Cement Ltd. (with an NTC of 13 days) is computed to be 0.36 per cent, while
that of KCP Ltd. is 11.87 per cent (with an NTC of 84 days). Similarly, we can find the
WCEM for all other sample firms and see the reflection of differences in working capital
efficiency of firms (see Table III).
Further, WCEM is simple to compute, and it is easy to explain the outcome of the
working capital efficiency of firms. Hence, WCEM is a simple and flawless financial
performance measure which reveals the true impact of the working capital efficiency of
firms. Academics and practitioners may consider using WCEM in measuring the
relationship between working capital efficiency and financial performance of firms in their
empirical work.

4.2.1 Determinants of working Capital efficiency multiplier. From the above-stated

formulation, we can arrive at the determinants of WCEM of a firm. They are: (Figure 3).
 trade receivables;
 inventories;
 trade payables; and
 WACC
 ratio of NWC to net sales

Figure 3.
Determinants of
WCEM
JIBR Keeping other variables constant, a decrease (increase) in trade receivables, inventories,
11,1 WACC and ratio of NWC to net sales, decrease (increase) the WCEM for firms, while an
increase (decrease) in trade payables, decrease (increase) the WCEM for firms.

5. Conclusion and scope for future research

90 Academic literature that explores the relationship between working capital efficiency and
profitability of firms has so far considered CCC or NTC as a proxy for working capital
efficiency, and accounting measures such as ROA, ROE, ROCE, GOI and NOI as the
measure of profitability of the firms. The limitation of these studies is that the profitability
(outcome) measure considered by them does not directly measure the impact of the working
capital efficiency of firms as the measures (ROA, ROE, ROCE, GOI and NOI) report the
aggregate return earned by firms from the employment of both the non-current assets and
net current assets. Our study introduces WCEM as a direct financial performance (outcome)
measure of working capital efficiency which can be widely used by academicians and
practitioners.
If firms can change their profits by employing different proportion of financing mix, then
they can also vary their profits by employing different proportion of asset mix and improve
their financial performance by improving their efficiency in managing non-current and net
current assets. In other words, asset structure and asset management efficiency determines
the financial outcomes of a firm.
The importance of WCEM could be enormous in performance evaluation of a firm. It
can be used as an indicator for choosing a suitable investment opportunity by an
investor. This is due to the fact that the firm that is highly efficient in managing
working capital is less exposed to liquidity risk. At the same time, the firm is less
dependent on external financing. Therefore, such firm eventually creates more value for
their shareholders. Another indication that WCEM provides is to gauge the bargaining
power of the firm and its competitive position in the market. Lower WCEM indicates
higher bargaining power of a firm across the value chain and its superior position
relative to its competitors.
The researchers hereafter can consider WCEM as the financial performance variable in
place of the existing measures and thereby contribute new theoretical insights through their
research outcomes. Researchers can also test empirically the relationship between CCC/NTC
and log of WCEM in both developed and developing markets. The relationship between the
liquidity and WCEM and between working capital utilization and WCEM can also be
studied by the researchers in the future.

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About the authors

Punam Prasad is a Doctoral Research Fellow in the area of Accounting and Finance at the
Indian Institute of Management Ranchi,India. The core research work of the author is on
working capital management. Punam Prasad is the corresponding author and can be contacted
at: punam.prasad15fpm@iimranchi.ac.in
Narayanasamy Sivasankaran is an Assistant Professor in the area of Accounting and Finance at
the Indian Institute of Management Ranchi, India. He teaches courses such as management
accounting, financial reporting and analysis, corporate finance and business valuation.
Samit Paul is an Assistant Professor in the area of Finance and Control at the Indian Institute of
Management Calcutta, India. He teaches courses such as managerial accounting and financial risk
management.
Manoharan Kannadhasan is an Associate Professor of Finance at Indian Institute of Management
Raipur, India. He teaches courses such as Financial Accounting, corporate finance, Security Analysis
and Portfolio Management, Financial Derivatives and Fixed Income Securities. He has published
research articles in the journals of repute, like Finance Research Letters, Management Decisions,
International Journal of Managerial Finance, International Journal of Corporate Governance, Applied
Economic Letters etc., and three cases published with Ivey Publishing, Canada.

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