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1. Introduction
Early in 1980, Smith suggested that working capital management (WCM) is essential because it affects firm profitability and risk, and consequently its value. It is argued that working capital is regarded as a life, philanthropic figure for any economic activity that plays a pivotal role in corporate management (Tahir and Anuar, 2016). In addition, the investments in current assets and current liabilities represent an important share of items on a firm’s balance sheet. The data from our sample reveals that the median value of current assets (current liabilities) to total assets is about 50 percent (30 percent) for Indian companies. Given the pivotal role of WCM, a firm may adopt either an aggressive or conservative working capital policy. An aggressive working capital policy is a high-risk, high-return approach and is associated with low investment in working capital. On the other hand, a conservative working capital policy is a low-risk, low-return approach and is associated with high investments in working capital.
Studies on working capital management and firm profitability (see recent studies e.g. Singhania and Mehta, 2017; Bhatia and Srivastava, 2016; Tahir and Anuar, 2016; Baños-Caballero et al., 2012; Nazir and Afza, 2009; Juan García-Teruel and Martinez-Solano, 2007; Deloof, 2003; among others) argue that by the adoption of aggressive WCM policy a firm may reduce the investments in working capital and this reduction will result in minimum investments in inventories as well as accounts receivable. Minimizing the investment in inventories may reduce the storage and insurance cost and thus increase profitability. In a similar vein, maintaining lower investments in accounts receivable may also increase the firm profitability because these funds can be invested elsewhere. Other set of arguments revolve around a conservative WCM policy. It is argued that a conservative working capital strategy is aimed at increasing sales through increased investments in inventories and receivables (Tauringana and Adjapong Afrifa, 2013). An increased investment in inventories enhances firm profitability because it prevents production disruptions (Juan García-Teruel and Martinez-Solano, 2007), reduces the risk of stock-out (Deloof, 2003) and also reduces the supply costs and price fluctuations (Blinder and Maccini, 1991). With regard to the increased investments in accounts receivable, it is argued that an increase in accounts receivable increases the sales of the firm because...