Literature Review on Working Capital Management - Essay Example

This review is composed of only those studies which have been published and made available through books, journals, magazines and internet. There is no doubt that working capital management is an indispensible part of everyday financial management of a firm. It is commonly understood that working capital requirement is related with the day to day operations of a firm and if the firm finds shortage of working capital, the firm is likely to face liquidity problem, which in turn affect the credit worthiness and the business as a whole.

On the other hand, if the working capital position is too high, it does not sound good. Rather, it is a problem of lack of proper management. In other words, too much of working capital will affect the profitability by unnecessarily blocking funds in the current assets. Therefore, finding a proper balance between shortage and excess working capital is the key element of working capital management. The firm's liquidity and profitability are judged in terms of the working capital position of the firm.

Jin Mcmenamin, in his famous book 'Financial Management: An Introduction', remarks that working capital is an important measure of liquidity and volume of working capital determines the risk level. The more the working capital, less is the chance of a firm's bills are not met for payment (Mcmenamin, 1999). There have been evidences on the failure of firms that have faced either shortage or excess working capital. The short term financial decisions have got little interest among academicians in the past.

However, with modern scholarly and empirical studies, the literature of working capital has grown much than ever before. M. Grass observes that shortage of working capital and excess of working capital have caused many firms to fail and has affected many firm in meeting their short term obligations (Grass, 1972). L.J. Gitman also is of the same argument that working capital management, especially for small firms is the factor that decides success or failure (Gitman, 1982). However, that does not mean that working capital is the only factor that decides the success of otherwise of a firm.

As mentioned in the above paragraph, working capital should neither be excess nor inadequate. Both these conditions are dangerous to a firm. However, working capital shortage is found to be more devastating and therefore, its occurrence should be avoided at all times. An imbalanced working capital position can be expressed through another dimension. Shortage of working capital endangers the liquidity and excess working capital affects the profitability adversely. Studies have been undertaken to empirically prove the evils of these tow danger situations.

K Smith, in his paper remarks that working capital is significant because it directly affects the firm's profitability (Smith, 1980). J. B. Sarkar and Saha S N, in a case study entitled 'Profitability Crisis and Working Capital Management in the Public Sector in India', observe that the profitability of the selected public sector undertakings in India is suffered owing to inefficient working capital management (Sarkar, 1987). In another study by A. K. Mukherjee entitled 'Management of Working Capital in Public Enterprises' concludes that firm's liquidity and profitability are negatively correlated (Mukherjee, 1988).

He further observes that firms should avoid too much of investment in current assets, if