Liquidity and profitability:Liquidity and profitability are two of your business’s most important key performance
indicators. In their own way and together, they demonstrate whether your business currently
is or can be successful and they indicate firm potential for growth and sustainability. Firm
liquidity has an impact on firm profitability and firm profitability will have an impact your
liquidity—so while the two are not one-in-the-same, they do go hand in hand.
Working capital is calculated simply by subtracting current liabilities from current assets.
Calculating the metric known as the current ratio can also be useful. The current ratio, also
known as the working capital ratio, provides a quick view of a company's financial health.
The success of any business/firm depends on its profitability, liquidity, and solvency. Liquidity
plays an important role in the successful running of a business. Many prior studies have been
conducted to measure the relationship between working capital and profitability. The results
showed that the high investment in inventories and receivables is associated with lower
financial performance. They found a negative relationship between Return on Assets and
Inventory turnover and Cash conversion cycle the present study is designed to know the direct
impact of working capital on profitability by choosing the days of collection, days of payment,
days inventory converts to sales and finally the cash conversion cycle.
The working capital should be maintained at a desired level depending upon the size of the
firm, excessive working capital leads to the unnecessary accumulation of inventories causing
losses and wastages. The large debtors indicate the defective credit policy which might lead
to bad debts. On the other hand, with the inadequate working capital, the firm will not be in a
position to pay short-term liabilities. The firm may not be able to pay its day-to-day expenses
which creates inefficiencies and reduces profits.
Working capital is a prevalent metric for the efficiency, liquidity and overall health of a
company. It is a reflection of the results of various company activities, including revenue
collection, debt management, inventory management and payments to suppliers. This is
because it includes inventory, accounts payable and receivable, cash, portions of debt due
within the period of a year and other short-term accounts.
The needs for working capital vary from industry to industry, and they can even vary among
similar companies. This is due to several factors, including differences in collection and
payment policies, the timing of asset purchases, the likelihood of a company writing off some
of its past-due accounts receivable, and in some instances, capital-raising efforts a company
is undertaking.
When a company does not have enough working capital to cover its obligations,
financial insolvency can result and lead to legal troubles, liquidation of assets, and
potential bankruptcy.
Working capital management is essentially an accounting strategy with a focus on the
maintenance of a sufficient balance between a company’s current assets and liabilities. An
effective working capital management system helps businesses not only cover their financial
obligations but also boost their earnings.
Working Capital Can Change Daily
The exact working capital figure can change every day, depending on the nature of a
company's debt. What was once a long-term liability, such as a 10-year loan, becomes a
current liability in the ninth year when the repayment deadline is less than a year away.
Current Assets Can Be Written Off
Working capital (as current assets) cannot be depreciated the way long-term, fixed assets are.
Certain working capital, such as inventory, may lose value or even be written off, but that isn't
recorded as depreciation.
Assets Can Be Devalued
While it can't lose its value to depreciation over time, working capital may be devalued when
some assets have to be marked to market. That happens when an asset's price is below its
original cost, and others are not salvageable. Two common examples involve inventory and
accounts receivable.
Inventory obsolescence can be a real issue in operations. When that happens, the market for
the inventory has priced it lower than the inventory's initial purchase value as recorded in a
company's books. To reflect current market conditions and use the lower of cost and market
method, a company marks the inventory down, resulting in a loss of value in working capital.
Accounts Receivable May Be Written Off
Meanwhile, some accounts receivable may become uncollectible at some point and have to
be totally written off, representing another loss of value in working capital.
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Working capital is the amount of available capital that a company can readily use for
day-to-day operations.
It represents a company's liquidity, operational efficiency, and short-term financial
health.
To calculate working capital, subtract a company's current liabilities from its current
assets.
A positive amount of working capital means a company can meet its short-term
liabilities and continue its day-to-day operations.
The current ratio (current assets divided by current liabilities) is a liquidity ratio often
used to gauge short-term financial well-being; it's also known as the working capital
ratio.
The negative relationship between the profitability and the average collection period, the lower
the average collection period higher will be the profitability. The correlation between average
payment period and profitability should be low, which shows a positive relationship if there is
an increase in payment period it leads to an increase in profitability. It is found that the cash
conversion cycle decreases it will lead to an increase in profitability of the firm, and managers
can create a positive value for the shareholders which indicates that it has been maintained.
The results of this study show that there is a strong relationship between the working capital
and profitability of the firms. It means if the financial managers keep an eye on the liquidity it
will lead to profitability. So, it is recommended that Companies should always maintain a sound
collection policy and it is further suggested that managers can create value for their
shareholders by reducing the number of days accounts receivable, increasing the number of
days accounts payable and inventories to a reasonable minimum.