The Management of Working Capital and Profitability of SMEs in the Euro Area

Abstract

Short-term financial management involves the management of current assets and liabilities, which directly affect an organisation’s liquidity and profitability. This study aims to examine the relationship between the operating performance and short-term financial management of small and medium-sized enterprises in Europe. Return on assets is used as a proxy for profitability and the cash conversion cycle is used as a proxy for working capital management. The analysis in this study is based on non-financial firms in 19 euro area countries, over a six-year period from 2008 to 2013. The negative and significant relationship between profitability and each of its determinants, such as average collection period, average payment period, average inventory period, cash conversion cycle and profitability, was found using the GLS and OLS methods. This means that managers may create value for shareholders through shorter collection periods, a guarantee of fast moving inventories and longer payment periods (provided this does not affect their credit risk). In addition, the governance structure of a firm affects how it reacts to external factors and influences its financial performance, for which reason the number of directors variable was included in this study in order to test this relationship. The results indicate that there is an inverse relationship between the number of director and profitability, which can be explained by the fact that a larger board of directors generates communication and decision problems. The positive relationship found between liquidity and profitability can be explained by the fact that firms use first of all the amount generated and accumulated internally before seeking external resources, especially in the case of SMEs, which have difficulties in obtaining external financing.