УДК 33

The role of working capital management and its relation with profitability and liquidity of a company

Потапова Юлия Дмитриевна – студент магистратуры Российского экономического университета им. Г.В. Плеханова.

Иванова Яна Яковлевна – кандидат экономических наук, доцент кафедры Финансового менеджмента Российского экономического университета им. Г.В. Плеханова.

Abstract: The article describes the importance of working capital management for a financial state of a company. Trade-off between profitability and liquidity is studied. Two methods for working capital turnover calculation are considered and the results are interpreted.

Аннотация: В статье рассматривается важность управления оборотным капиталом для стабильного финансового состояния предприятия. Изучен компромисс между прибыльностью и ликвидностью. Рассмотрены два метода расчета оборачиваемости оборотных средств и интерпретированы полученные результаты.

Keywords: management, working capital, financial state, efficiency.

Ключевые слова: управление, оборотный капитал, финансовое состояние, эффективность.

The role of working capital management and its relation with maintaining the profitability and liquidity of any company is fundamental. According to PricewaterhouseCoopersReport Working Capital Report 2019/20: Creating value through working capital : “Working capital is the cash tied up in the everyday running of a business” [9]. By its nature, working capital is intermediate stage, where money is locked until customers pay their bills. Its proper management is a necessary conditions for the successful operation of the company, as it creates the prerequisites for rapid growth of the business and increase the financial capacity of the company. Furthermore, working capital has an influence on any company’s value, as it is a part of such a crucial indicator as Free Cash Flow.

Efficient working capital management (further - WCM) should be aimed at preserving working capital in acceptable volumes with predictable dynamics. Since working capital analysis gives an understanding of a company liquidity position, turnover analysis is needed. It is usually expanded by assessment of the turnover impact on the company's health condition.

The urgency of the topic is revealed in the fact that the financial position of the enterprise, liquidity and solvency indicators as well as overall investment attractiveness directly depend on how quickly the funds in receivables, payables and inventories are converted into real money, and how effectively the company's debts are managed.

The goal of this article would be to consider two main problems, which arise in the process of conducting WCM analysis. One of them is related to the preparation stage of the analysis – choice of proper formulas to calculate current assets and liabilities turnover in order to fulfill analysis purpose. The second issue is interpretation of results and inaccurate representation of WCM turnover impact on a company financial condition.

Working capital management refers to current (operational) decisions. The result of thoughtful and efficient management of working capital is a good financial state of the organization, characterized by liquidity, financial stability and growing business activity [3,p.146]. According to Ben Le, a professor of College of Business and Public Management of New Jersey, USA, there is a strong negative relationship of working capital, risk, profitability and firms value [4, p.200]. Thus, efficient managing of working capital becomes especially important for a firm performance.

Proceeding with the analysis itself, first absolute volumes are being studied. Here, the question of an optimal current assets value exists. There is no correct answer for this, “optimal level of each current asset will be determined by management’s attitude to the trade-off between profitability and liquidity, as profitability varies inversely with liquidity” [2, p. 500]

The next thing to discuss is turnover ratio and turnover period


The speed of asset turnover is directly related to profitability indicators. The growth of the turnover ratio in dynamics indicates an increase in the efficiency of usage in terms of growth of return on capital. Lower asset turnover contributes to lower return on equity. Consequently, one of the reserves for increasing the company's profitability is an increase in turnover. This relation is visible in ROE and Du Pont equation:


Turnover ratio is not informative in economic terms. It would be more useful to use the same coefficient in days:


There are two main ways to calculate turnover periods. Sales revenue or cost of goods sold (Purchases) are used as a calculation base in denominator of turnover formula [7]. In particular, cost of goods sold is used for inventory and payables turnover period. As for inventory turnover, some non-stock forming elements are excluded, while commercial and administrative expenses are added.

Dealing with WCM analysis, the following question often arises: which one of these 2 calculation bases is better? There is no correct answer, since each calculation method is used for its own purpose and serve as a solution to specific task. We will try to have a closer look at them and see the differences.

We will now consider both the methods and calculate Days Inventory Outstanding for a French Dairy corporation “Danone”. To perform analysis Balance Sheet and P&L Statement are required. As we can see, 2 results vary greatly (Table 1).

Table1. Calculation of inventory turnover period for Danone using 2 calculation bases.













Turnover period:

based on sales


based on COGS


Source: created by the author based n data from Danone annual report [8]

When calculating turnover period in relation to sales revenue, we get a characteristic of how many days of sales the company's inventory cover. It reflects the Danone ability to maintain the current level of the asset. In this example, the available inventory can be financed by twenty-six-day sales.

If the calculation of the turnover period is carried out in relation to cost of sales, then turnover period will assess the feasibility of the current level of assets. In the example, the existing volume of inventories covers 50 days cost of production. If we take into account that the cost of production includes non stock-forming elements (wages, energy, depreciation, services), we can say that the created stock covers more than 50 days. In terms of effective working capital management, this amount of inventory may be considered excessive.

So, this resolves the question, raised in the beginning about proper usage of turnover formulas: solving the problem of assessing the company's financial capabilities to maintain current inventory level, it makes sense to calculate turnover periods in relation to sales revenue. To characterize the effectiveness of working capital management (evaluation of the effectiveness of procurement policy, sales, terms of settlements with suppliers and customers), a person should use turnover periods calculated in relation to COGS.

We will know consider each calculation method in details. We will start with calculation of turnover period based on sales. Here 3 elements play crucial role: turnover period for current assets, turnover period for current liabilities and the difference between these two.

Current assets turnover period (excluded cash) is called “expense cycle” [1, p.40]. The longer is this cycle, the more tome money is tied up in current assets. The growth of the expense cycle indicates an unfavorable change in the working capital management - decrease in the efficiency of current assets usage. It is also a decline in the return on capital. The growth of the cost cycle also contributes to a decrease in liquidity and financial stability indicators (as it stands for the growth of current liabilities as sources of financing for asset growth). Inventory creation requires appropriate sources of funding. The larger the cost cycle, the greater the company's need to finance its production process.

Short-term liabilities (current liabilities) are internal sources of financing that arise as a result of conducting production activities. In particular, these sources are current debt to suppliers (accounts payable), current debt to the budget and staff, and advance payments to customers. Debt to the budget (arising due to the established frequency of payment of taxes) and debts related to salary payment (arising due to the frequency of salary payments) are often called stable liabilities. Turnover period of all the current liabilities (excluding short-term loan) is called “credit cycle” [1, p. 45]. Growth of the credit cycle indicates a favorable change in working capital management: there are more sources of financing received during the current production process. The above statement is true if the turnover periods of components of current liabilities have acceptable values, i.e. the organization does not create excess debts to suppliers, budget, and staff. The scheme is represented in Figure 1.


Figure 1. Scheme of turnover cycles using sales.

Funds in the process of turnover go through successive stages. Initially, cash is "transferred" to advances to suppliers, which are sequentially turned into production inventory, work in progress, finished products, accounts receivable, and then into new money (for different enterprises, some stages in the presented chain may be missing). The turnover periods give a time characteristic of each of the specified stages. The longer is the credit cycle, the more funds a company has for internal financing.

Below we will consider changes in expense and credit cycles for Danone. Table 2 shows that Danone expense cycle improved by 2019 by 2 days. While customer discipline and inventory management has deteriorated by 3 days in total, other current assets turnover period declined by 5 days. This produced positive change of 2 days in expense cycle. Credit cycle demonstrated favorable dynamics as well – it stretched up to 110 days. But improvement was not due to payables management, so this leaves a space for improvement. We cannot say about the influence of working capital turnover period on return on capital, since although expense cycle declined, net profit declined as well and it is required to evaluate its influences on ROE further.

Table 2. Working capital cycles calculation for Danone (2015-2018).






Balance Sheet

Current assets

7 998

19 113

9 641

10 334






Currents assets without cash

4 965

5 493

5 541

5 296







Expense cycle





Calculation for the last period

 = (0,5*(9495+9003)/24651)*365

Including turnover periods:

Raw materials and supplies





Semi-finished goods





Finished Goods





Total trade receivables





Other current assets





Balance Sheet

Current Liabilities





Short-term debt

2 374

2 119

3 221

2 305

Current liabilities without s-t debt

6 828

6 931

7 238

7 660







Credit cycle





Calculation for the last period

 = (0,5*(7660+7238)/24651)*365

Including turnover periods:

Trade payables





Debts related to state and staff





Other current liabilities





Source: created by the author based on data from Danone annual report

It should be remembered that the impact of working capital management conditions on the need for financing is indicated by the change in the net cycle, but not by the value of the net cycle itself. The constant value of the net cycle indicates that in the analyzed period, working capital management conditions did not affect the company's need for financing in any way.

Danone net cycle is presented in Table 3. It is less than zero, so trade credits from suppliers and buyers cover the need to finance the production process in excess, and the company can use the resulting "surplus" for other purposes, such as financing non-current assets. This has decreased which means positive tendency for an organization: extra funds has been revealed. This change brought a positive affect on liquidity, while influence on profitability is not clear.

Table 3. Danone net cycle.





Expense cycle




Credit cycle




Net cycle




For the purposes of working capital management it is better to use not only sales as calculation base. In this case interpretation of each turnover indicator will be different. The efficiency of using an asset is based on its ability to generate revenue, and the efficiency of using a liability is written off to the company's expenses (usually to cost). So, inventory turnover period would be total length of inventory cycle from its supply and up to a storage period. Receivables turnover would mean average collection period or the length of trade credit given. Payables period stands for delay of company payments to its suppliers. In Table 4 calculation base for each element is presented [5]. 

Table 4. Calculation base for WC elements.

WC element

Calculation base

Customers prepayment




COGS+Commercial & Administrative expenses+(Ending Inventory- Beginning Inventory)-Depreciation

Prepayments to suppliers

Stable liabilities

Production stock

COGS -Depreciation

Finished goods

COGS+Commercial & Administrative expenses

Work in progress

It is notable that calculation base for inventories and payables is COGS adjusted. COGS in not the only element of operating expenses, these also include administrative and commercial expenses. They together accumulate expense on materials purchased from suppliers. But not all the purchased materials are consumed. Moreover, COGS includes non-cash expenses – since it is not related to payables to suppliers, this should be excluded [6].

So we can make a conclusion that growth of the expense cycle (the sum of the periods of turnover of current assets) leads to a reduction in the return on capital and also contributes to a decrease in the indicators of stability and overall liquidity (due to the need for additional sources of financing for asset growth). Reducing the turnover periods of current assets is a driver to increase the return on capital, optimize the financial stability and overall liquidity of the company. In practice, reducing the turnover periods of current assets means reducing the deferral of customers to pay bills, minimizing the volume of finished products and raw materials in the warehouse (in particular, production planning with a sales plan in mind).

The growth of the net cycle creates an additional need for financing, while its reduction, on the contrary, creates additional sources of financing for current production activities. Reducing the net cycle is possible both through the measures listed above to optimize the turnover of current assets, and by increasing the turnover periods of short — term liabilities-attracting more advance payments from buyers, increasing the deferral on payment of suppliers bills.

All in all, working capital management makes it possible to influence the most important characteristic of an organization's business processes, namely time, which is characterized by the duration of production, operational, commercial, and financial cycles and the period of working capital turnover.


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