Does financial flexibility affect profitability and working capital management in small and medium enterprises: evidence from Central and Eastern Europe

Abstract

Abstract

Purpose This study aims to identify the relationship between the financial flexibility of small and medium-sized enterprises (SMEs) and their profitability and working capital management. Design/methodology/approach The empirical study is based on a statistical analysis of 15,079 firms from 9 Central and Eastern European (CEE) countries from 2014–2022. Findings SMEs from CEE build their financial flexibility on debt capacity, and accumulating a stock of financial flexibility increases their profitability. Financially flexible SMEs are characterised by a higher share of working capital in total assets. However, increasing the stock of financial flexibility does not change their cash conversion cycle. The relationship between working capital management and SMEs' profitability is negative and linear. Financial flexibility significantly moderates it. In more financially flexible SMEs, the increase in working capital reduces profitability to a lesser extent. Practical implications SME managers must be aware that investing in liquidity generally reduces profitability. They can mitigate this negative effect by building financial flexibility. By increasing financial flexibility, SMEs can improve profitability and adjust the working capital levels without either shortening or excessively extending the cash conversion cycle. By improving SMEs' access to capital, policymakers can increase opportunities for them to build financial flexibility, thereby improving profitability and the conditions for working capital management. Originality/value The study confirms that SMEs' financial flexibility affects profitability and working capital management differently than in large enterprises. The diagnosed dependencies provide evidence for extending the financial flexibility theory to the context of short-term SME activity.