CHAPTER 2

REVIEW OF LITERATURE
Every business needs funds for two purposes basically; they are for establishment and to carry
day-to-day operations. Long term funds are required for establishment of the organization, it is
required for production facility through purchase of fixed assets and it needs fixed capital and the
funds which are needed for short term purposes for the purchase of raw materials, payment of
wages, payment of day to day expenses etc, the funds required for these are known as
WORKING CAPITAL. Working capital refers to that part of the firm's capital which is required
for financing short term or current assets such as cash, marketable securities, debtors and
inventories. Funds, thus, invested in current assets keep revolving fast and are being constantly
converted into cash and this cash flow out in exchange for other current assets. Hence it is also
known as CIRCULATING CAPITAL or REVOLVING CAPITAL or SHORT TERM
CAPITAL.
According to GENESTENBERG:-
"Circulating capital means current assets of a company that are changed in the ordinary course of
business from one form to another, as for example, from cash to inventories, inventories to
receivables into cash." Need for working capital cannot be over emphasized. Every business
needs some amount of working capital. The need of working capital arises due to the time gap
between production and realization of cash from sales. Thus, the working capital is needed for
the following purposes:-
a) For the purchase of raw materials, components and spares.
b) To pay wages and salaries.
c) To incur day-to-day expenses and overhead costs such as fuel, power and office expenses etc.
d) To met the selling costs as packing, advertising etc.
e) To provide credit facility to customers.
f) To maintain the inventories of raw material, work-in-progress, stores and spares and finished
stock.
For studying the need of working capital in a business, one has to study the business under
varying circumstances such as a new concern, as a going concern and as one which has attained
maturity. Many researchers have studied working capital from different views and in different
environments. The following ones were very interesting and useful for our research
According to Eljelly, in 2004:-
Elucidated that efficient liquidity management involves planning and controlling current assets
and current liabilities in such a manner that eliminates the risk of inability to meet due short-term
obligations and avoids excessive investment in these assets. The relation between profitability
and liquidity was examined, as measured by current ratio and cash gap (cash conversion cycle)
on a sample of joint stock companies in Saudi Arabia using correlation and regression analysis.
The study found that the cash conversion cycle was of more importance as a measure of liquidity
than the current ratio that affects profitability. The size variable was found to have significant
effect on profitability at the industry level. The results were stable and had important
implications for liquidity management in various Saudi companies. First, it was clear that there
was a negative relationship between profitability and liquidity indicators such as current ratio
and cash gap in the Saudi sample examined. Second, the study also revealed that there was great
variation among industries with respect to the significant measure of liquidity.
According to Deloof, in 2003:-
Discussed that most firms had a large amount of cash invested in working capital. It can
therefore be expected that the way in which working capital is managed will have a significant
impact on profitability of those firms. Using correlation and regression tests he found a
significant negative relationship between gross operating income and the number of days
accounts receivable, inventories and accounts payable of Belgian firms. On basis of these results
he suggested that managers could create value for their shareholders by reducing the number of
days accounts receivable and inventories to a reasonable minimum. The negative relationship
between accounts payable and profitability is consistent with the view that less profitable firms
wait longer to pay their bills.
According to Ghosh and Maji, in 2003:-
In this paper made an attempt to examine the efficiency of working capital management of the
Indian cement companies during 1992 1993 to 2001 2002. For measuring the efficiency of
working capital management, performance, utilization, and overall efficiency indices were
calculated instead of using some common working capital management ratios. Setting industry
norms as target-efficiency levels of the individual firms, this paper also tested the speed of
achieving that target level of efficiency by an individual firm during the period of study.
Findings of the study indicated that the Indian Cement Industry as a whole did not perform
remarkably well during this period.
According to Shin and Soenen, in 1998:-
highlighted that efficient Working Capital Management (WCM) was very important for creating
value for the shareholders. The way working capital was managed had a significant impact on
both profitability and liquidity. The relationship between the lengths of Net Trading Cycle,
corporate profitability and risk adjusted stock return was examined using correlation and
regression analysis, by industry and capital intensity. They found a strong negative relationship
between lengths of the firms net trading Cycle and its profitability. In addition, shorter net trade
cycles were associated with higher risk adjusted stock returns. The Effect of Working Capital
Management on Firm Profitability: Evidence from Turkey
F. Samiloglu and K. Demirgunes (2008)
The aim of this study is to analyze the effect of working capital management on firm
profitability. In accordance with this aim, to consider statistically significant relationships
between firm profitability and the components of cash conversion cycle at length, a sample
consisting of Istanbul Stock Exchange (ISE) listed manufacturing firms for the period of 1998-
2007 has been analyzed under a multiple regression model. Empirical findings of the study show
that accounts receivables period, inventory period and leverage affect firm profitability
negatively, while growth (in sales) affects firm profitability positively. All the above studies
provide us a solid base and give us idea regarding working capital management and its
components. They also give us the results and conclusions of those researches already conducted
on the same area for different countries and environment from different aspects. On basis of
these researches done in different countries, we have developed our own methodology for
research.
According to Smith and Begemann 1997:-
Emphasized that those who promoted working capital theory shared that profitability and
liquidity comprised the salient goals of working capital management. The problem arose because
the maximization of the firm's returns could seriously threaten its liquidity, and the pursuit of
liquidity had a tendency to dilute returns. This article evaluated the association between
traditional and alternative working capital measures and return on investment (ROI), specifically
in industrial firms listed on the Johannesburg Stock Exchange (JSE). The problem under
investigation was to establish whether the more recently developed alternative working capital
concepts showed improved association with return on investment to that of traditional working
capital ratios or not. Results indicated that there were no significant differences amongst the
years with respect to the independent variables. The results of their stepwise regression
corroborated that total current liabilities divided by funds flow accounted for most of the
variability in Return on Investment (ROI). The statistical test results showed that a traditional
working capital leverage ratio, current liabilities divided by funds flow, displayed the greatest
associations with return on investment. Wellknown liquidity concepts such as the current and
quick ratios registered insignificant associations whilst only one of the newer working capital
concepts, the comprehensive liquidity index, indicated significant associations with return on
investment. All the above studies provide us a solid base and give us idea regarding working
capital management and its components. They also give us the results and conclusions of those
researches already conducted on the same area for different countries and environment from
different aspects. On basis of these researches done in different countries, we have developed our
own methodology for research.
According to Marc Deloof 25th April 2003:-
The relation between working capital management and corporate profitablity is investigated for a
sample of 1,009 large Belgian non-financial firms for the 1992-1996 period. Trade credit policy
and inventory policy are measured by number of days accounts receivable, accounts payable and
inventories, and the cash conversion cycle is used as a comprehensice measure of working
capital management. The results suggest that managers can increase corporate profitablity by
reducing the number of days accounts receivable and inventories. Less profitable firms wait
longer to pay their bills.
M. A., Zariyawati a, M. N., Annuar b and A.S., Abdul Rahim c a ,b & c
Univeristi Putra Malaysia, Malaysia. Working capital management is important part in firm
financial management decision. An optimal working capital management is expected to
contribute positively to the creation of firm value. To reach optimal working capital management
firm manager should control the trade off between profitability and liquidity accurately. The
purpose of this study is to investigate the relationship between working capital management and
firm profitability. Cash conversion cycle is used as measure of working capital management.
This study is used panel data of 1628 firm-year for the period of 1996- 2006 that consist of six
different economic sectors which are listed in Bursa Malaysia. The coefficient results of Pooled
OLS regression analysis provide a strong negative significant relationship between Amber
Collins University of Phoenix:- Working Capital Management Concepts Worksheet Concept
Application of Concept in the Simulation Reference to Concept in Reading Describe the firm's
cash conversion cycle: Cash inflow "Most firms keep track of the average time it takes customers
to pay their bills. From this they can forecast what proportion of a quarter's sales is likely to be
converted into cash in that quarter and what proportion is likely to be carried over to the next
quarter as accounts receivable" (Allen, Brealey, & Myers 2005). Lawrence having a positive
cash balance would have help in the event of emergencies as well as unplanned outflow of
money. Cash flow comes from collections on accounts receivable (Allen, Brealey, & Myers
2005). Examine the effects of credit policy on cash conversion cycle and revenue: Commitment
Lawrence had a commitment to the bank, Mayo, Murray, and Gartner.
According to Carole Howorth and Paul Westhead March 2003:-
Working capital management routines of a large random sample of small companies in the UK
are examined. Considerable variability in the take-up of 11 working capital management routines
was detected. Principal components analysis and cluster analysis confirm the identification of
four distinct types of companies with regard to patterns of working capital management. The
first three types of companies focused upon cash management, stock or debtors routines
respectively, whilst the fourth type were less likely to take-up any working capital management
routines. Influences on the amount and focus of working capital management are discussed.
Multinomial logistic regression analysis suggests that the selected independent variables
successfully discriminated between the four types of companies. The results suggest that small
companies focus only on areas of working capital management where they expect to improve
marginal returns. The difficulties of establishing causality are highlighted and implications for
academics, policy-makers and practitioners are reported.
According to Maynard E. Rafuse, (1996):-
Argues that attempts to improve working capital by delaying payment to creditors is counter-
productive to individuals and to the economy as a whole. Claims that altering debtor and creditor
levels for individual tiers within a value system will rarely produce any net benefit .Proposes that
stock reduction generates system-wide financial improvements and other important benefits.
Urges those organizations seeking concentrated working capital reduction strategies to focus on
stock management strategies based on lean supply-chain techniques.