The effect of working capital on profitability in computer and electrical equipment industry

Although working capital is one of the key issues in managing day-to-day operations, it has not gained sufficient emphasis in financial literature until the late 1990s. Since then, efficient working capital management has been highlighted more in both academic research and managerial decision-making, thus raising acknowledgement of competitive advantage it can create. This master's thesis studies the impact of working capital on corporate profitability and shareholder value in 1,683 publicly listed US computer and electrical equipment companies in 1990−2013. Using fixed effects regression methodology in a relatively homogenous sample of 16,481 observations, this thesis contributes to existing literature by presenting an in-depth analysis of working capital management in a specific industry. Previous research mainly supports the theoretical assumption of a negative impact of working capital on profitability. However, unlike most prior papers solely assuming a linear effect of working capital on profitability, this thesis also addresses a quadratic relationship. The empirical results show a concave impact of cash conversion cycle on return on assets, which indicates that there exists an optimal level of working capital, resulting in a balance between risks and returns, hence maximizing profitability. Accordingly, deviations from the optimum reduce return on assets as a too low level of working capital increases the risk of illiquidity and distress costs, whereas too high level increases tied-up capital and thus opportunity costs. By contrast, cash conversion cycle is found to have a negative impact on return on equity and stock return. Consistent with previous studies, this indicates that an in increase in the level of working capital reduces the company value for equity holders. In that way, investors prefer excess funds to be used in long-term investments or paid out as dividends. The findings accentuate the contradiction of different benefits for the company itself and its shareholders regarding working capital management. Different time frames for different measures need also to be taken into account since profitability reflects the magnitude of current earnings, whereas market value shows the future expectations of shareholders. However, shareholders are also more interested in short-term returns, whereas holding a sufficient level of working capital may ensure long-term profitability. Consequently, the level of working capital maximizing return on assets does not necessarily lead to high stock returns and vice versa. Above all, managers in computer and electrical equipment industry can increase returns and market value by paying more attention on effective working capital management and acknowledging the difference of benefits for the company and its shareholders. In any case, working capital is a particularly important topic in computer and electrical equipment industry due to the continuous development of technology and rapid changes in business environment. However, as this thesis is limited to one industry and country only, caution is needed when generalizing the results to different kinds of samples.