Measuring impact of working capital efficiency on financial performance of a firm

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.

Working capital management and firm’s profitability: Evidence from Czech certified firms from the EFQM excellence model

“…Earlier research on WCM has been extensively examined the impacts on firm profitability at empirical levels (Högerle et al, 2020;Sharma et al 2020;Singh & Kumar, 2017). WCM has gained importance in recent years, as academicians, managers, and policymakers have known the relevance of efficient WCM in the survival of a firm, specifically after the global financial crises (Prasad et al, 2018). Therefore, in the last two decades, the empirical literature analysing the relationship between firm profitability and WCM has become exceedingly popular among academics.…”

“…The final Section discusses the conclusions and implications. Prasad et al (2018) examined profitability as a proxy to measure the performance of a firm, which estimates the efficiency that transforms equipment, plant, and net current assets into profits. In previous literature, many proxies have been considered for the profitability of firms including return on asset (ROA), return on capital employed (ROCE), return on equity (ROE), and net operating income (NOI).…”

“…ROE is also used to measure profitability (Rezaei & Pourali, 2015;Wang, 2002). Many scholars addressed more than one proxies for the same purpose Kayani et al (2020); Prasad et al (2018); Afza and Nazir (2008). However, we employed ROA to investigate the relationship between WCM and firm profitability in the current research.…”

Financial Performance and Audit Quality: Comparative Study of Investor Reaction

“…Adopting the research of Maqbool & Bakr [19], Prasaad et al, [20], Majanga [21], Yu et al, [22], Ganvir & Dwivendi [23], Bhat & Bhattacharya [24], Oyewobi et al, [25], Hall [26], Anwar [2], Afrifa & Padachi [27], financial performance in this study was measured using ROCE (Return on Capital Employed).…”

Working capital and financial performance in MENA region

“…A similar study context was conducted earlier by Jose et al (1996) using both OROA and pre-tax ROE on a big sample of 2,718 corporations from 1974 to 1993. Besides, Prasad et al (2019) have developed a multiplier of working capital efficiency that directly measures the WCM's profitability and is a product of three elements, namely, a ratio of the sum of trade receivables and inventories to trade payables, the ratio of NWC to net sales and weighted average cost of capital.…”