Working capital management and profitability of UK firms : a contingency theory approach

Abstract

While the direct impact of working capital management (WCM) and its components (accounts receivable in days (AR), accounts payable in days (AP) and inventory holding period (INV)) on firms’ profitability has been examined in the previous literature, the underlying channels of influence have remained largely unexplored. This study adopts a contingency theory approach to investigate the relationship between WCM and profitability controlling for selected corporate governance and company characteristics. The study has three main objectives. The first objective is to determine the relationship between working capital management and its components (AR, AP and INV) and profitability as per extant research. The second objective of the research is to determine whether the effect of working capital management on profitability of UK firms is contingent on the interaction of environmental (E), resource (R) and management (M) variables. The final objective is to determine whether the effect of the components of working capital management (AR, AP and INV) on profitability of UK firms is contingent on the interaction of ERM variables. These three objectives were met by the use of a panel data methodology on a series of interactive models. The data for the study is based on the annual financial reports of 225 London Stock Exchange listed firms for the period 2001-2011. In terms of the first objective, the study found a significant relationship between WCM and two of its components (AR and AP) and profitability. However, no relationship was found between WCM component (INV) and profitability. In terms of the second objective, the results indicate that the effect of WCM on profitability is significantly moderated by the interaction with ERM variables of the firm. Finally, the results of the third objective indicate that the effect of WCM components (AR, AP and INV) on profitability is significantly moderated by the interaction with ERM of the firm. In terms of the control variables, the study found a statistically significant relationship between the corporate governance factors (Chief Executive Officer (CEO) tenure and board size) and profitability. On the other hand, company specific characteristics variables (company size, financial leverage, assets tangibility liquidity ratio, cash flow and sales growth) were also found to have statistically significant effect on the profitability of firms. On the basis of this, the study concludes that firms can maximise the benefits and minimise the cost of investment in working capital by aligning their working capital management policies with their environment and also arrange their resources internally to support such alignment as postulated in the contingency framework as any misalignment could significantly affect the firms’ performance. As a result, the study suggests the need for policy makers to match organisational resources with opportunities and threats in the general business environment in order to improve their financial performance.

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