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SMEs are a vibrant power for sustaining economic growth and creating job opportunities. They stimulate private ownership and entrepreneurial skills, mobilize local savings, generate employment, help diversify economic activities, make significant contribution to export and trade, and have the ability to react quickly to changes in the marketplace. Thereof, promoting the growth and competitiveness of SMEs will lead to social and economic growth, and, allow the private sector to participate in the economy (Taiwo et al., 2012).
Corporate finance theory focuses mainly on three main areas: capital budgeting, capital structure and Working Capital Management (WCM). Capital budgeting and capital structure decisions are associated with long-term decisions. Capital budgeting is associated with investment decisions while capital structure is associated with financing decisions. WCM is associated with short-term investment and financing decisions of the company. WCM deals with the management of current assets and current liabilities that are vital for running the business management, that’s why they directly affect the liquidity of the firm (Sharma and Kumar, 2011).
SMEs assets are mainly current assets and its sources of finance are mainly short term, because they face difficulties in dealing with long term finance (Banos-Caballero et al., 2010). Therefore, WCM is essential for SMEs existence and evolution. Mokhtar and Abdelwahab (2014) claimed that the most important challenge for SMEs in Egypt is the lack sources of finance. The main causes of SMEs failure are associated with problems in the WCM (Cielen et al., 2004). A huge amount of business failures have been recognized due to financial managers’ inability to plan and control precisely the current assets and current liabilities of their companies (Smith, 1973).
WCM is considered as the main source of internal finance, and it is essential in measuring firms’ liquidity because working capital includes all short term items in the balance sheet (Eljelly, 2004). The main objective of WCM is to make balance between all working capital components and to acquire the optimal level of working capital in the organization (Filbeck and Krueger, 2005). By managing working capital effectively, firms could decrease their dependence on external financing and use the released cash for added investment and for improving the firm’s financial flexibility (De Almeida and Eid, 2014).
The main point of the existing study is the importance of WCM, measured by Cash Conversion Cycle (CCC), and all of its components (inventory, accounts receivables and accounts payables) on firm’s profitability of SMEs in Egypt.
2 Statement of the Problem:
This study indicates that WCM is more important to SMEs than to larger firms (Peel and Wilson, 1996; Baños-Caballero et al., 2010). This is because SMEs lack access to external finance (Whited, 1992; Fazzari and Petersen, 1993; Petersen and Rajan, 1997) and rely heavily on WCM as a vital source of finance (Padachi, 2006). Also, comparatively, SMEs have more current assets and liabilities as a percentage of total assets and total liabilities than larger firms (Padachi, 2006) and therefore proper management is vital for working capital. Thus, there is a need to investigate the relationship between WCM and firm’s financial performance especially in SMEs.
So, the main question of the research is:
Is it possible to measure the effect of Working Capital Management on financial performance of SMEs?
Sub-questions can be extended as follows:
4) What are the components of Working Capital?
5) How can Working Capital be managed in SMEs?
6) What is the effect of WCM on firm’s financial performance?
3 Objectives of the Study:
The main objective of the study is to investigate the effects of WCM on firm’s financial performance of SMEs. Specifically, this study investigates whether WCM improves firm’s financial performance or not?
To achieve the main objective, sub-objectives can be extended as follows:
4) Illustrate the components of working capital.
5) Investigate how SMEs manage their working capital.
6) Examine the different effects of WCM on firm’s financial performance.
4 Importance of the Study:
This study contributes to the existing literature in a number of ways.
First, the study makes a specific contribution by applying the practical part on SMEs. The available literature on the effect of WCM on firm performance almost exclusively focuses on larger firms (Wang, 2002; Deloof, 2003; Hill et al., 2010; Baños-Caballero et al., 2014), with limited studies on SMEs.
Second, limited research has directly addressed the effect of WCM on financial performance of SMEs in developing countries.
Third, the researcher uses Return on Sales (ROS) as a measure of SMEs performance because the definition of SMEs in Egypt involves the volume of sales. Moreover, SMEs depend on the ability of their sales to generate profit in their early years.
5.1 Independent variables:
Working Capital Management (WCM): is primarily related with all management decisions that influence the size and effectiveness of the working capital (Kaur, 2010; Kumar, 2014). Working capital may be regarded as the balance between current assets and current liabilities (Pass and Pike, 1984).
Cash conversion cycle (CCC) is used as a measure of working capital level, which has been used in previous studies (Soenen, 1993; Deloof, 2003; Garcia-Teruel and Martinez-Solano, 2007; Banos-Caballero et al., 2010, 2012; Tauringana and Afrifa, 2013; Padachi, 2016).
5.2 Dependent variables:
Financial performance: refers to the logic and principles underlying the definition, recognition, measurement, presentation, and disclosure of the elements of the financial statements (Mourik & Katsuo, 2015).
In the literature, financial performance uses either accounting-based or market-based measures. Accounting-based measures include financial ratios such as return on assets (ROA), and return on sales (ROS). Market-based measures include market value, market return, and Tobin’s Q.
This study uses the accounting –based measures and financial performance will be measured by ROA and ROS.
H1 There is a significant relationship between managing cash conversion cycle and ROA in SMEs.
H2 There is a significant relationship between managing inventory and ROA in SMEs.
H3 There is a significant relationship between managing accounts receivable and ROA in SMEs.
H4 There is a significant relationship between managing accounts payable inventory and ROA in SMEs.
H5 There is a significant relationship between managing cash conversion cycle and ROS in SMEs.
H6 There is a significant relationship between managing inventory and ROS in SMEs.
H7 There is a significant relationship between managing accounts receivable and ROS in SMEs.
H8 There is a significant relationship between managing accounts payable inventory and ROS in SMEs.
The results of this study reveal that there is no statistically significant relationship between cash conversion cycle measurements and profitability of firms measured as ROA. But, the results show a significant negative relationship between CCC and ROS, number of days of inventories and ROS, and number of days of accounts receivable and ROS. The study finds that there is no statistically significant relation between number of days of accounts payable and ROS. The results indicate that shortening the CCC improves an SME’s profitability.
The researcher recommends the following points based on the study findings:
a. SMEs should use ROS as a measure of financial performance counting on the fact that especially in the early years; SMEs depend on the ability of their sales to generate profit.
b. SMEs should set up appropriate inventory management strategies to guarantee that an optimal level of inventory is kept.
c. Managers should guarantee that sound credit collection policies are set up within the organization.
d. Exertions must also be done to confirm that payments to creditors are not overextended beyond the credit period.
e. Lastly, firms should make intensive efforts to manage their cash, inventories, accounts receivables, and accounts payable with a view to reduce the CCC in order to increase their profitability.