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Go Back       IAR Journal of Business Management | IAR J Bus Mng; 2020; 2(2): | Volume:2 Issue:2 ( March 22, 2021 ) : 40-46
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DOI : 10.47310/iarjbm.2021.v02i02.006       Download PDF       HTML       XML

Working Capital Determinants and Profitability: Empirical Evidence from an Emergent Economy



Article History

Received: 05.03.2021; Revision: 08. 03.2021; Accepted: 17. 03.2021; Published: 22. 03.2021

Author Details

Santiago Hernandez, Davide Migliaro, Pablo Suarezm & Arnaldo Arnaldi

Authors Affiliations

1School of Business, UC, Santiago, Chile, Italy

2Department of Management and Innovation Systems, University of Salerno , Italy

3Business Economics Laboratory, Buenos Aires, Argentina, Italy

4Department of Management and Innovation Systems, University of Salerno, Italy


Abstract: This paper aims to investigate the relationship between working capital and profitability in the context of an emerging economy, such as the Chilean one. For this purpose, we analyzed data from a sample of manufacturing companies in the Santiago metropolitan region. The data concern the period 2016-2018 and were collected through the use of a questionnaire. To develop the research, we used the generalized least squares method, as it allows for more reliable results. The empirical results showed that the relationship between the single determinants of working capital and profitability is not linear, suggesting that, until the optimal size is reached, the relationship between working capital and profitability is positive. However, once the optimal size is exceeded, the relationship becomes negative.


Keywords: Working capital management, Profitability, Emerging Economy, Cash, Current Ratio.


Introduction

Working capital management (WCM) concerns how a company manages its main components, namely liquidity, credits, inventories and debts. The management policies of each component of working capital can influence the economic and financial dimension of the company contexts (Smith, 1980; Khoury et al., 1999; Deloof 2003; Filbeck and Krueger, 2005; Chen and Sensini, 2014; Aktas et al., 2015).


For example, an increase in customer lending could favour sales but at the same time lead to a liquidity crisis and greater credit losses (Chen et al., 2014; Mannetta et al., 2020). Therefore, the management of the individual items of working capital requires the utmost attention from all companies, of any size.


Especially in the current economic context, characterized by high and global competition, companies are more exposed to environmental, economic and financial risks that can lead to bankruptcy or exit from the market (Chalmers et al., 2020a; Campos et al., 2014; Sensini, 2015).


Therefore, financial decisions affecting working capital are critically important to the survival, development and profitability of any business (Parisi et al., 2014; Marino and Sensini, 2014).


Although this research topic has been extensively studied in different economic contexts, the literature on the subject is still highly controversial (Emery, 1987; Fazzari and Petersen, 1993; Wilner, 2000; Wang, 2002; Zariyawati et al., 2009; Erasmus, 2010; Alipour, 2011; Karaduman et al., 2011; Sensini, 2020; Mannetta et al., 2014).


However, most previous studies have focused on publicly traded firms or large firms in developed economies, with only more recently paying attention to emerging economies and small and medium-sized enterprises (Deloof, 2003; Filbeck and Krueger, 2005; Afrifa, 2013; Ukaegbu, 2014; Chen et al., 2020; Chalmers et al., 2020b; Boisjoly et al., 2020)


Therefore, the studies that address this issue concerning SMEs in the context of developing economies must be further investigated, to provide further empirical evidence of the relationship between the determinants of working capital and profitability. Among other things, considering that in emerging economies SMEs are the main growth engine of the country and make an important contribution to employment and GDP (Scognamillo et al., 2016), this theme needs to be adequately investigated.


Furthermore, due to the less developed financial systems, these firms have financial constraints that affect the ability to access credit, increasing business risk (Amendola et al., 2017; Diaz and Sensini, 2020; Alvarez et al., 2021).


Therefore, this paper aims to investigate the relationship between the determinants of working capital and profitability in the context of the Chilean economy. In this perspective, the results can provide useful and further empirical evidence in the literature. Furthermore, empirical findings can help SME managers to manage working capital more effectively and efficiently, favouring the survival, development and profitability of the company.


The paper is organized as follows. The next section contains the literature review. The third section illustrates the research methodology, while the fourth highlights and comments on the results. Finally, the last section contains the concluding remarks.


Literature Review

The literature on the relationship between working capital and firm performance is very extensive. The effective and efficient management of working capital necessarily requires focusing attention on its determinants, i.e. liquidity, credits, inventories and debts (Brennan et al., 1988; Chalmers et al., 2014; Chen et al., 2014; Sanchez and Sensini, 2017; Mannetta et al., 2013).


In general, the management of current assets and current liabilities should allow the company to meet its short-term obligations, optimizing the relationship between risk and profitability (Lee and Stowe, 1993; Filbeck and Krueger, 2005; Sensini, 2017; Mannetta, 2014; Bello and Sensini, 2020; Chalmers et al., 2020a; Boisjoly et al., 2020).


The credit extensions can help increase sales and acquire new customers, with a clear impact on profitability. However, granting more credit to businesses also leads to an increase in the level of risk, as customers could experience financial difficulties and cause a slowdown or reduction in collections (Amendola et al., 2013; Sensini, 2016; Diaz and Vazquez, 2019).


The inventory represents the link between production and the sale (Cohen et al., 2013; Alvarez et al., 2014; Campos et al., 2015; Sensini, 2020). Inventory management has a decisive impact on liquidity and sales policies. Finally, debts also represent an important determinant of working capital (Chalmers et al., 2014; Chen et al., 2014; Mannetta and Zhang, 2014; Mueller and Sensini, 2021). The extension of the maturity of the debts can help the company to recover liquidity, but it can involve the loss of discounts or a deterioration in the relationship with suppliers (Campos et al., 2014).


The relationship between the determinants of working capital and profitability is controversial, with negative, positive and non-linear relationships being found.


Some authors have pointed out that there is a negative relationship between working capital and profitability.


In particular, Jose et al., (1996) found a negative relationship between the Cash Conversion Cycle (CCC) and profitability, measured by ROA and ROE. In different developed countries, different authors (Wang, 2002; Deloof, 2003; Nobanee et al., 2011; Garcia-Teruel and Martinez-Solano, 2007; Mansoori and Muhammad, 2012; Tauringana and Afrifa, 2013) have shown that there is a negative relationship between the CCC and some of its determinants, such as account receivables (AR), account payables (AP) and inventory. Likewise, also in emerging economies and in developing countries, other authors have confirmed the existence of a negative relationship between WCM and profitability (Mathuva, 2010; Ching et al., 2011; Afeef, 2011; Mannetta and Zhang, 2014: Diaz and Vazquez).


Compared to what has just been highlighted, other studies have indicated a positive relationship between working capital management and business profitability. In the United States, Gill et al., (2010) found a positive relationship between CCC and profitability.


In developing countries, Sharma and Kumar (2011) and Akinlo and Olufisayo (2011) found a positive relationship between some elements of the WCM (AR, CCC) and the company's profitability.


Finally, other studies have highlighted a non-linear relationship between the determinants of working capital and profitability. In this perspective, until the working capital has reached an optimal level, the investments in working capital have positive effects on the company profitability. However, once the optimal level is exceeded, investments in working capital have a negative effect on profitability as they involve an increase in costs with the consequent possibility of financial difficulties (Banos-Caballero, et al., 2010, 2012; Diaz and Vazquez, 2019).


Research Methodology

The data was collected through a questionnaire which made it possible to obtain all the balance sheet data necessary for our survey. Overall, we analyzed data from 123 manufacturing companies in the Santiago metropolitan region. The observation time horizon is five years and runs from 2014 to 2018.


The variables were determined as shown in Table 1.


Tab. 1 –Variables of interest

Dependent Variable



Profitability

ROA

Net income/Average Total Assets

Independent Variables



Inventory

INV

Log (Average ages of inventories x 365/Cost)

Account Receivables

AR

Log (AR x 365/Turnover)

Account Payables

AP

Log (AP x 365/Cost)

Cash Conversion Cycle

CCC

Log (INV + AR) - AP

Control Variables



Firm Size

SIZE

Log (Total Assets)

Current Ratio

CR

Total Current Assets/ Total Current Liabilities

Assets Turnover Ratio

ATR

Total Fixed Assets/Total Assets


To answer the research questions, we used two models. The first (Model 1) investigates the impact of each element of working capital (independent variables) on profitability (ROA), and can be summarized as follows:


(1a)

(2a)

(3a)

(4a)


The second (Model 2) analyzes the relationship between working capital and profitability, looking for the presence of a possible non-linear relationship by using a quadratic relationship.


(1a)

(2a)

(3a)

(4a)


To develop the analysis, we used the Generalized Least Squares method, as it allows for more reliable results. Table 2 shows the results of the descriptive statistics.

Table 2 – Descriptive statistics

Variables

Mean

Std. Dev.

Min

Max

ROA

0.065

0.069

-0.190

0.372

INV

4.181

1.987

-4.432

6.151

AR

4.347

1.198

1.241

7.569

AP

3.527

1.129

-3.816

5.928

CCC

4.673

1.146

-3.163

7.673

SIZE

9.691

0.672

7.272

13.198

CR

2.087

1.927

0.385

14.865

ATR

0.193

0.231

0.000

0.949

Table 3 shows the correlation analysis, highlighting that there are no particular multicollinearity problems.


Table 3 – Correlation matrix


ROA

INV

AR

AP

CCC

SIZE

CR

ATR

ROA

1








INV

-0.231

1







AR

-0.310

0.235

1






AP

-0.291

0.291

0.475

1





CCC

-0.231

0.639

0.691

0.257

1




SIZE

-0.093

0.147

0.103

0.198

0.109

1



CR

0.291

-0,121

-0.041

-0.027

0.027

-0.161

1


ATR

0.049

-0.257

-0.291

-0.012

0.031

0.037

-0.141

1

Empirical Findings and Discussion

The results of the first regression model are shown in Table 4.

Table 4 – Model 1

Variables

1a

1b

1c

1d

INV

-0.00463***

-

-

-

AR

-

-0.0195***

-

-

AP

-

-

-0.0919***

-

CCC

-

-

-

-0.0137***

SIZE

0.00989***

0.0119***

0.0109***

0.0113

CR

0.00159***

0.00183***

0.00009

0.00219***

ATR

0.00000

-0.0216***

0.0007

0.0223***

C

0.0345**

0.0841***

0.0431***

0.0616***

Significance levels: * < 0.05; **p < 0.01; ***p < 0.001.


Model 1 regression results showed that individual determinants and WCM have a significant (1%) negative impact on profitability. In particular, the Cash Conversion Cycle highlights that companies that manage to reduce the cycle have greater profitability. These results confirm the results obtained in previous researches (Jose et al., 1996; Shin and Soenen, 1998; Wang, 2002; Dang and Tran, 2019).


The results of model 2 are shown in table 5.

Table 5 – Model 2

Variables

2a

2b

2c

2d

INV

0.00118**

-

-

-

INV(2)

-0.00693***

-

-

-

AR

-

0.0137***

-

-

AR (2)

-

-0.0371***

-

-

AP

-

-

0.00583***

-

AP (2)

-

-

-0.00251***

-

CCC

-

-

-

0.0119***

CCC(2)

-

-

-

-0.00289***

SIZE

0.0115***

0.0116***

0.0107***

0.0135***

CR

0.00169***

0.00187***

-0.00105**

0.00229***

ATR

-0.00579

-0.0235***

-0.00541

-0.0263***

C

0.0231

0.0122

0.0251

-0.00493

Significance levels: * < 0.05; **p < 0.01; ***p < 0.001.


Empirical findings are statistically significant and show that an increase in each element of working capital determines an increase in profitability, as is evident from the previous table. However, the quadratic variables show a non-linear relationship between the individual components of working capital and profitability. In this perspective, an investment in working capital produces a positive effect until the optimal level is reached, which corresponds to the curvature point evaluated at –β1 / 2β2. After this level, the investment in working capital produces a negative effect on the profitability of the company.


Consequently, expansive working capital policies produce positive effects until the firm reaches the optimal size, i.e. the curvature point (Brennan et al., 1988; Peterson and Rajan, 1997; Emery, 1984; Smith, 1987). However, once the optimal level is exceeded, investment in working capital causes an increase in the costs and risks of financial difficulties, reducing profitability (Kim & Chung, 1990; Amendola et al., 2020; Kieschnick et al., 2013).


Concluding Remarks

This paper aimed to investigate the relationship between working capital and profitability in the context of an emerging economy, such as the Chilean ones.


For this purpose, we have selected a sample of manufacturing companies in the metropolitan region of Santiago. The data concerned the 2014-2018 period and were collected through the use of a questionnaire that allowed us to obtain all the balance sheet data necessary to calculate the variables being analyzed. To develop the research, we used the Generalized Least Squares method, as it allows for more reliable results.


The empirical findings showed that the relationship between the individual determinants of working capital and profitability is not linear, as it had emerged in other previous research that concerned companies from different developed and emerging countries.


The results, therefore, suggest that, until the optimal size is reached, the relationship between working capital and profitability is positive. However, once the optimal size has been exceeded, the relationship turns negative due to increased costs and the risk of financial distress.


The research results are important from several points of view. Firstly, empirical findings contribute to enriching the existing literature on the subject, offering a further contribution to an emerging economy that is still little studied. Secondly, the results can guide the choices of SME managers in defining the optimal level of working capital.


The results must, however, be interpreted according to the area investigated and the number of companies involved. In the future, to consolidate the results of this research, we will consider a larger geographical area of the country and a greater number of companies. However, data collection in emerging economies is much longer and more complex than in developed countries, where access to data is easier and more immediate.


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