Effects of working capital management

on firms' profitability: evidence from

cheese‐producing companies
By Sara, David and Lucia 10 August 2020

• The field of corporate finance has primarily focused on studying long-term financial
decisions, while neglecting the importance of short-term finances (Baños‐Caballero, García‐
Teruel, & Martínez‐Solano, 2014; Nazir & Afza, 2009).
• However, short-term finances play a crucial role in the performance of small and medium-
sized enterprises (SMEs). SMEs have a higher proportion of current assets, lower liquidity,
and more unpredictable cash flows compared to larger companies (Peel, Wilson, & Howorth,
2000).
• Consequently, SMEs face challenges in obtaining bank loans, leading them to rely more on
short-term debt through current liabilities.
• During economic crises, SMEs experience significant difficulties due to limited financial
resources and their reliance on bank lending (Carbó‐Valverde, Rodríguez‐Fernández, & Udell,
2016). To address this issue, European governments have implemented policies to improve
SMEs' access to finance, including promoting timely payments in commercial transactions
and emphasizing the importance of working capital management for SMEs.
• This situation highlights the importance of working capital management (WCM) as a
potential driver of SMEs' success. However, studies examining the impact of WCM on firms'
profitability are relatively recent, and no study has specifically addressed this issue in the
dairy sector.
• This study aims to fill this research gap by analyzing the effects of WCM policies on the
profitability of Spanish cheese manufacturing companies.
• The study utilizes a sample of 444 Spanish cheese manufacturing companies and applies a
dynamic panel data methodology.
• Data from the period 2010-2016 is used for analysis.
• The study examines the impact of different components or periods of WCM, including days
sales outstanding (DSO), days inventory outstanding (DIO), days payable outstanding (DPO),
and cash conversion cycle (CCC), on firms' profitability.
• Firm profitability is measured as the ratio of earnings before interest, tax, depreciation, and
amortization (ROA_DA).
• The independent variable is selected from the most representative variables of working
capital management.
• Control variables considered include firm leverage, firm size, firm growth, and a dichotomous
variable indicating whether the company has an ecological focus.
• The average profitability of the sampled firms ranged between 5.6% and 8.1%, showing a
decreasing trend until 2013, followed by an increase. DSO and DIO were between 70 and 75
days, remaining stable throughout the analyzed period. In contrast, DPO slightly decreased
to 42 days in 2016. Consequently, CCC ranged between 94 and 101 days from 2010 to 2016.
 Over the period 2010–2014, the CCC and firms' profitability seem to follow an opposite trend
however, after 2015, both variables seem to show the same path
 The scatterplots and Spearman's rank correlation analysis indicate a strong negative
relationship (p < .05) between firm profitability and working capital management (WCM).To
facilitate the testing,
 4 hypotheses were formulated which are:
 Hypothesis 1a. There is a negative relationship between DSO and firm profitability
 Hypothesis 1b. There is an inverted U‐shaped relationship between the DSO and firm
profitability.
 Hypothesis 2a: There is a negative relationship between the DIO and firm
profitability.
 Hypothesis 2b: There is an inverted U‐shaped relationship between the DIO and firm
profitability.
 Hypothesis 3a: There is a positive relationship between the DPO and firm
profitability.
 Hypothesis 3b: There is an inverted U‐shaped relationship between the DPO and
firm profitability.
 Hypothesis 4a: There is a negative relationship between the CCC and firm
profitability
 Hypothesis 4b: There is an inverted U‐shaped relationship between the CCC and firm
profitability
 Data from the Bureau Van Dijk SABI database was used to test these hypotheses.
 The empirical results did not confirm Hypotheses 1a and 1b, indicating no evidence
supporting the notion that an increase in DSO decreases firm profitability.
 Regarding Hypotheses 2a and 2b, the results confirmed a negative relationship between DIO
and firm profitability, suggesting that cheese-manufacturing companies experience a
decrease in profitability as their DIO increases.
 Contrary to expectations in Hypotheses 3a and 3b, the empirical results showed a weak
negative relationship, significant at the 10% level, between DPO and firm profitability. This
suggests that deferring payment to creditors and suppliers may decrease firm profitability.
Another potential explanation for this negative relationship is the reverse causality argument
proposed by Deloof (2003), which suggests that less profitable companies tend to pay later.
To test this, DPO was regressed against firm profitability and other independent variables,
yielding weak evidence in favor of a negative effect of profitability on DPO. Therefore, it
cannot be concluded that reverse causality explains the negative relationship between DPO
and firm profitability.
 In relation to Hypotheses 4a and 4b, the results indicated a negative influence of CCC on firm
profitability (Hypothesis 4a), but this relationship displayed weak statistical significance (p
< .10). Therefore, the estimated results suggest that longer CCCs decrease firm profitability.
 The Hausman test was conducted to assess the robustness of the results, and it indicated
that fixed-effects estimations should be used due to systematic differences in coefficients
between fixed effects and random effects.
 The estimated coefficients for DSO were significantly negative, supporting Hypothesis 1a and
indicating that a longer collection period has a negative effect on profitability.
 The empirical evidence obtained from the fixed-effects model clearly confirms the negative
relationship between DIO and firm profitability (Hypothesis 2a)In addition, the estimated
coefficients seem to show a U‐shaped relationship between the two variables that is, firm
profitability decreases as the DIO increases, but from a certain DIO onwards, the firm
profitability increases.
 The estimated coefficients for DPO confirm a negative impact on firm profitability. Similarly,
the fixed-effects estimation results support the negative association between CCC and firm
profitability (Hypothesis 4a). Moreover, the estimated coefficients indicate a U-shaped
relationship between these variables.
 The main objective of this paper was to analyze the impact of working capital management
(WCM) on the economic profitability of Spanish cheese-manufacturing companies.
 The study found that firm profitability was negatively associated with DIO, DPO, and CCC.
 The findings suggest that reducing inventory investment, as indicated by DIO and CCC, can
improve firm profitability. On the other hand, the negative relationship between DPO and
firm profitability may indicate high financing costs borne by companies that defer payments
to suppliers. However, no significant relationship was found between DSO and firm
profitability. As cheese is predominantly sold through supermarkets, retailers have significant
power to extend collection periods, resulting in long DSO for the sampled firms. Hence, the
lack of significance in the relationship between DSO and firm profitability.
 This study has limitations that point to areas for further research. Firstly, the sample size and
composition, consisting of mostly SMEs comprising 444 cheese-manufacturing companies,
may limit the generalizability of the findings. Therefore, conducting similar studies in
different countries and sectors would enhance the validity of the results. Secondly, the
limited number of ecological firms in the sample hinders a comprehensive analysis of
profitability differences for non-ecological firms. Additionally, the study treats the ecological
nature of production as a static dummy variable, without differentiating partially ecological
production cases. Moreover, the impact of subsidies on firms' profitability, especially in
ecological production, could not be analyzed due to missing information. Finally, further
research is needed to explore the reverse causality argument between firm profitability and
DPO.
 This study contributes to the understanding of how WCM decisions can affect the
profitability of livestock firms. Considering that investments in inventories and accounts
receivable consist a significant portion of firms' total assets, it is very important to consider
how these WCM decisions may influence the profitability of SMEs.