The Impact of Working Capital Management on the Profitability of the Listed Companies in the London Stock Exchange

Abstract

For the successful working of any business organization, fixed and current assets play a vital role. Management of working capital is essential as it has a direct impact on profitability and liquidity. Conventionally, it has been seen that, if a company desires to take a greater risk for bigger profits and losses, it reduces the size of its working capital in relation to its sales. If it is interested in improving its liquidity, it increases the level of its working capital. However, this policy is likely to result in a reduction of the sales volume, therefore of profitability. Hence, a company should strike a balance between liquidity and profitability. This study analyzes the impact of working capital on the profitability for a sample of 30 UK companies listed in London Stock Exchange for a period of 3 years from 2006-2008. The effect of different variables of working capital management include the Average collection period or the receivable days, Inventory turnover in days, Average payment period or the payable days, Cash conversion cycle, Current ratio and Quick ratio on the Net operating profitability of the UK companies. Debt ratio and the size of the firm (measured in terms of natural logarithm of sales) have also been used as a comprehensive measure of the working capital management. Pearson’s correlation is used for this analysis.

The results show that, there is a strong negative relationship between variables of the working capital management and the profitability of the firm. It means that, as the cash conversion cycle increases it will lead to decreasing profitability of the firm, and managers can create a positive value for the shareholders by reducing the cash conversion cycle to a possible minimum level. It is also found that, there is a significant negative relationship between the liquidity and the profitability of the UK firms. However, there exists a positive relationship between size of the firm and its profitability. Furthermore, there is also a significant negative relationship between debt used by the firm and its profitability. The results suggest that, the managers can increase corporate profitability by reducing the number of day’s accounts receivable and inventories. Less profitable firms wait longer to pay their bills.