Financial condition, working capital policy and profitability: evidence from Indian companies

Abstract

Purpose The purpose of this paper is to examine the impact of working capital management (WCM) on profitability under different financial conditions (constraint/unconstraint) and WCM policy (aggressive/conservative). Furthermore, the study investigates the existence of optimal working capital levels under different financial conditions and WCM policy. Design/methodology/approach Two-step system generalized method of moments and fixed effect models are used to analyze the data collected from Prowess database from 2011 to 2020 for a sample of 1,104 Indian manufacturing companies. Findings The study finds an inverted U-shaped relationship between working capital and profitability in all financial conditions and working capital policy. This finding advocates the existence of an optimal level of working capital that equates the costs and benefits of holding working capital to maximize the companies’ profitability. However, holding working capital beyond the optimal level negatively affects profitability. Companies under financial constraints with aggressive working capital policies have the lowest optimal cash conversion cycle (CCC). Furthermore, the relationship of working capital with profitability and the optimal CCC varies owing to firm age and industry group. Originality/value To the best of the authors’ knowledge, this is the first paper that incorporates the impact of working capital on firm’s performance from both financial constraint (unconstraint) and aggressive (conservative) working capital policy perspectives in the Indian context. Furthermore, this study also contributes in terms of reflecting the effect of firm age and industry in determining the optimum CCC of the firms.

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“…Conversely, conservative companies tend to use long-term debt, which is less risky and allows them to have sufficient time to settle, despite incurring higher interest costs (Alrahamneh et al 2020;Ahmad et al 2022). According to the trade-off theory, companies try to optimize their working capital policies by weighing the costs and benefits (Ahmad et al 2022;Dash et al 2023;Kayani et al 2023). Since the onset of the COVID-19 crisis, many CFOs have shifted from aggressive to conservative working capital policies (Prša 2020;Arnaldi et al 2021;Yousaf and Bris 2021;Mazanec 2022).…”

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