Working Capital and Profitability—Establishing the Causality

Working capital (WC) management has a marked impact on the liquidity of a firm. It is also widely observed that WC is closely associated with profitability—declared by many correlation studies. Furthermore, the financial performance data of scores of manufacturing, trading and service firms indicate that a negative relationship seems to exist between the constituents of WC—inventories, accounts receivable, cash and bank deposit and accounts payable—and the firm’s net operating profitability (NOP). However, such inferences are almost all correlation-based—a statistical procedure that quantifies association but does not establish causality. The present study takes a different path to probe this conjectured dependency—it sets up a first-principles model and statistical experiments. The model is crafted to represent the cost of net working capital with which the factors hypothesized to be influencing NOP can be varied systematically and the consequent effect on it examined. Thus conducted, the results establish statistically valid affirmation of causation of WC, if any, on NOP. We conclude, unlike earlier studies, that there is no exclusive prescription for managing WC to raise NOP, as “it depends!”