Determinants of Effective Working Capital Management - A Discriminant Analysis Approach

Currently, many financial analysts rely on traditional financial ratios for assessing the effectiveness of the working capital management. They correlate corporate performance in this area with the so-called “ideal” ratios. The present study sough to examine the validity of such practices and a. to identify a method of classifying those companies which manage their working capital more effectively than others; b. to determine the factors which lead to the effectiveness of working capital management process; c. to make recommendations for managers in this area. The primary method adopted for the study was the well known statistical tool – Multivariate Discriminant Analysis – based on computer processing of financial data obtained from the balance sheets of the 72 large Indian companies which participated in the study. This was supplemented by an analysis of the responses of these companies to a questionnaire relating to their managers’ perceptions of the effectiveness of the working capital management process in their respective organizations. The discriminant analysis showed that the prime determinants of effectiveness of the working capital management, in order of relative importance, were: 1. Profit After Tax as a percentage of sales 2. Sales as number of times of total assets 3. Quick assets as a percentage of current liabilities 4. Receivables as number of days’ sales This was in significant contrast to the current practice which emphasizes the organization’s performance in relation to current ratio and debt-equity relationship. The authors recommend that the financial managers in the companies and the analysts in the financial institutions and commercial banks should pay more formal and explicit attention to these factors in their financial analysis. Also, they recommend that these variables should be reflected in the planning and information system of companies for keeping a track of the effectiveness of the working capital management.