CHAPTER 2 LITERATURE REVIEWINTRODUCTION The purposeof this chapter is to link to working capital management and firm’sperformance.
The topic is the effect of working capital management on firm’sperformance toward economic growth. However, the previous study has examined indifferent country, different manufacturing sector, and different year gap. Thetheory that was using on firm’s capital management is Baumol cash managementmodel, operating cycle theory, keynesian theory and cash conversion cycle. Furthermore, the better working capital managementgives the benefit of firm’s performance. Thus, the important of the workingcapital management are the cash, collection, sales, and inventory. On otherhand, the cash cycle is the cash, payables, stock, and receivables.
Figure 2.0 shows the working capitalcycle Asusual, the literature review is divided into five parts, which introduction,theoretical review, hypotheses, main variable, the determinant of firmperformance and theoretical framework.THEORICALREVIEWBAUMOL’S CASH MANAGEMENT MODELPioneer study of Baumol’s cash management is about theinventory model (Githinji, 2015). The Baumol model ofcash management helps in deciding a company’s optimum cash balance undercertainty (Baumol Model of Cash Management).
This model used widely and very beneficial to the objective of cash andinventory management. Kumar (2017) stated that Economic Order Quantity (EOQ) ininventory management involves a trade-off between opportunity cost (i.e holdingcost, borrowing cost) and transaction cost (cost of converting marketsecurity). In term of optimum, the cash balance is minimized total cost. Figure 2.1 shows the optimum cashbalance Inthis model, the financial manager has to decide on the refraction of liquidfunds of cash and marketable securities (Pandey, 2008) and (Githinji, 2015).
Plus, the Baumolmodel enables the firm to know their desired level of cash balance undercertainty (Baumol Model of Cash Management).Back to the trade-off, the opportunity cost can increase the level of cashwhile the trading cost that occurs to transaction cost can decrease if thelevel of cash increases (Cornet et al., 2009) and (Githinji, 2015).
But the Baumol’s cash management model has alimitation; the cash flow cannot be fluctuating, not consider the overdraft andthere are uncertainties in the pattern of future cash flows (Baumol Model of Cash Management). KEYNESIAN THEORY OF MONEY Keynesiantheory is the theory that to encourage economic growth especially duringrecession economy with government intervention. This theory is more suitablefor economic on the supply side. During the recession, the government has tocut down the tax and increase government expenditure. Due to this, the economicgrowth will be reactivated again. Hence, the government can avoid the inflationconflict by increasing the tax and reduce expenditure of economic growth.
Moreover,Keynesian theory indicates cash flow in an investment. The Keynesian theorycame out with general theory of employment, interest, and money (Keynes, 1935)that have reason why an individual would hold money, to handle dailytransaction in business operations; for safeguard (debt payments, liabilitiesand other rebellion that can rise up during business); market trends pressurein determined the increasing shareholder’s wealth at the least possible cost (Duale, 2016). TheKeynesian theory is a significant theory of financial managers involvesmanagement of working capital ways to improve the organization in order tobusiness operation. OPERATINGCYCLE THEORY Theoperating cycle is the average time taken between the revenue of inventory andcash from selling inventory. In order words, the operating cycle is related toinventories turnover and account receivable turnover. The account receivableturnover is average time taken receivables investment to convert into cashwhile inventories turnover is average time taken from firms convert their cumulativestock of raw material, work-in-process, and finished goods into product sales (Githinji, 2015). More importantly,the operating cycle is significant to account receivable and inventoriesturnover in order to generate high profitability and liquidity.
Basedon the findings of Raheman (2010), higher inventories and receivables canaffect the lower profitability of the firm. The shorter time took the operationcycle, the faster the return to investment of inventory of the firm. Ttheoperating cycle was last longer than in periods during recession economy (Nordmeyer, 2017). The writer furthersaid this theory was the method on business to reduce the cost of inventoryholding and made the high in liquidity. Inoperating cycle measurement, the longer the operating cycle, the largest theworking capital business needs. Due to this, when the largest the workingcapital, the higher the inventory holding cost and the larger the opportunitycost.
This because the interest payments and disability to invest money. Hence,the lower operating cycle, the higher the net profit for the firm. CASHCONVERSION CYCLE Thecash conversion cycle (CCC) is apart of working capital management. It’s measurement of time for cash flow fromsales and a cash outflow of payment. The CCCis very helpful method to be used for the company evaluate the performance.Plus, the CCC is very important tocreate value of the shareholder (Shin & Soenen, 1998, and Raheman, 2015).
According to (Duale, 2016), the CCC is about purchase productivities sources andwhen the fund is recovered though inflows of form of revenue and profits,financial managers can form suitable WCM Policies. The researcher further saida longer cash conversion cycle might be affecting the expense of cashcommitment to the optimal between liquidity and profitability.