The Relationship Between Profitability And Working Capital Management

Published Date: 02 Nov 2017

Contents

1. Chapter 01

1.1 Introduction

Investors to earn profit and to maximize their wealth invest funds in various business activities; there are many forms of business activities available for the investments, such as sole proprietorship, partnership and limited liability companies. However, identifying actual components, related to the profitability, is a difficult task; in general corporate finance researchers focus on the finance literature such as long-term investment, capital structure and different valuation methods, because they mainly believe on long term financial planning (Afza & Nazir, 2008) . On the other hand, most of the financial researchers point out that the Management policy on short-term assets and liabilities will have great impact on the profitability of any organizations (Lamberson, 1995). The short-term financial decisions are very much relevant, as it will demonstrate the financial position of the organization and perception of the company (Afza & Nazir, 2008).

Capital structure and working capital management are the key elements to evaluate a firm’s profitability (H.Biorman, K.Chopra, and J.Thomas, 1975) and ( H.Jamal Zubairi, 2011) . Most of the empirical studies on working capital management mainly focused only on the management of inventory and the accounts receivable, but the working capital management concern not only these two area it is moreover concern on current liabilities (Lazaridis & Trfonidis, 2006).

Working capital management simply deals with short term financial requirements of business enterprises. Even though it is deals with the financial requirements of day-to-day running of business activities, it is highly contributes to the long run results of the enterprises. It is concern to manage the time lag between the expenditure or the payment due to the suppliers for the raw material purchases and the cash collection from its debtors for its credit sales. The basic components of working capital are inventories, amounts to be paid to suppliers and cash to be received from its customers from the credit sales. Any business needs finance it inventories and debtors net of its payables. The proportions of the working capital components always vary in several stage of the trade cycle. The working capital management is decides how low the liquidity is to manage in order increase the profitability of the business, which will leads to the financing and investing decisions. The lower the working capital requirement will leads to reduction in the cost of capital by the way will bring more profitability to the business, on the other hand poor estimation on working capital will directly results lost sales due to the reason of lowers level of inventory and lesser offer of credit sales which will surly results less profitability. Therefore, the balance and careful management on working capital components is crucial for any industry or the business. (Afza & Nazir, 2008).

Working capital management has been looked at in various manners; any form of businesses simply cannot ignore the gravity of the working capital management (Afza & Nazir, 2008). That’s the reason many researchers all over the world such as(Uyar, 2009; Vishnani and Shah, 2007; Teruel and Solano, 2007; Lazaridis & Tryfonidis,2006;Padachi,2006; Deloof, 2003; Shin and Soenen,1998) mainly concentrated on this issue of working capital component and profitability, and deeply discuss in relation to many nations. Especially they consider in developing countries such as India, Pakistan, Taiwan and Sri Lanka the working capital Management is lifeblood centre of any business entities, as they consider the working capital is the most important factor that determine the profitability of the business (Koperunthevi, 2010).

One main area of working capital policy is to make sure the liquidity position of the current asset to meet the current liabilities (Eljelly, 2004). The amount of liquidity always shows how much the business healthier to meet its short-term liabilities. A business always should maintain a balance in between its current liquidity and short-term liabilities as the liquidity above the required level will not bring any value to the business and if the liquidity maintained below the required level, which will leads to a financial default to its current liabilities (Vishnani & Shah 2007).

The working capital policy is always concentrate on the breakeven position by maintain a balance in between the cash inflow and outflow. Such level of breakeven cash flow only will manage the business transactions in a highly professional manner (Brain, 2009). However, on the other hand this policy of balancing the cash flow is not an easy task as it is require a thorough knowledge of element of working capital. It is a major challenge of finance departments to understand these drivers and relevant level of working capital. A sound knowledge of these basic elements will always help the finance managers successfully manage the risk associated with defaulting current obligations, as well as to achieve higher values to the business by maintaining a proper balance (Lamberson, 1995). Many business entities in Sri Lanka that are profitable which are forced to cease there operations due to the reason they fail to meet their short-term financial obligations (Koperunthevi,2010) If any organization wish to sustain its business in the long run has to understand the components of the working capital and to manage these elements systematically. When a business is growing and its sales are rising, its needs more stock up with more finished goods and materials for their production. In order to accommodate more sales they need offer more discounts and longer credit periods, on the other hand its develops supplier relationship which will sometimes allow differed payment or in some other occasions need advance payments all these circumstances directly affect the cash flow of the firms and which need a careful management of working capital. Having review this concepts this research will analysis the affiliation among the variable of sales volume, profitability and working capital management.

1.2 Research Problem:

Implementing a suitable working capital policy is an essential element for any type of organization as it is not possible to operate a business without clearly identifying the elements of working capital (Mukhopadhyay, 2004), while Smith et,al (2007) emphasized that profitability and liquidity are the salient goals of working capital management. Even though there are many research has been in the literature of the working capital management and its components, but according to the best of my knowledge, there is no direct or empirical research to see the direct affiliation in between sales, profitability and various working capital management policy such as aggressive policy, Defensive policy and Conservative policy (Brian, 2009) . Hence, this research will fill the gap to the existing finance literature by using cash conversion (CCC) as a tool to measure the working capital policy and the profitability over the sales policy such as holding additional stocks and additional debtors or credit days to increase the sales of the listed manufacturing firms of Sri Lanka.

Therefore, the research problem will be is there any association in betweens sales policy, profitability and working capital management of Sri Lankan manufacturing companies.

1.3 Justification:

The outlook of the Sri Lankan economy has very much improved with ending the conflict, Manufacturing the largest sub-sector of the industry sector recorded a significant growth to economy (Central Bank report,2011). Therefore, in this study, specially manufacturing companies were taken into consideration since those are playing very important role in Sri Lankan economy in order to enhance the economic growth. On the other it is justify there were very limited studies has been carried out on the topic of working capital management and profitability for the manufacturing sector of Sri Lanka, therefore, it is need for this sector to do further research on this topic due to the importance of the sector to the economy.

1.4 Research Objectives:

This study has the following objectives:

To identify the nature and the extent of the association in betweens sales, profitability and working capital management of the Sri Lankan manufacturing companies.

To find out the factors other than the sales which are influences the profitability and working capital management.

1.5 Significance of this Research:

It seems obvious that working capital policy has some impact on the profitability of the Sri Lankan Manufacturing firms. There exist a relationship between working capital policy and profitability of the firms, but still diminutive research had conducted to find out this relationship in the Sri Lankan Manufacturing companies, CCC is a useful tool to measure of degree of aggressiveness of working capital policy. Therefore, the purpose of the study is to find out the relationship between sales, profitability and working capital management of Sri Lankan Manufacturing firms by using the cash conversion cycle as a tool to measure aggressiveness of working capital policy.

Furthermore, I will try to develop better and practical understanding of the association between the variables and will try to meet the gap in the academic literature over this issue.

1.6 Scope:

Minimizing the losses and increasing profitability in the short run as well as in long run is the major goal of any profit oriented business enterprises. Researchers all over the world established the concept that working capital management policy is the way of achieving high profitability. Any enterprises should have a strong policy in order to manage properly their working capital. There are many ways to measure the profitability of a business entity. Return on equity, return on assets, and return on capital employed ect, are some of the methods employed to measure the profitability of a business. However, here in this study the gross operating profit will utilized to measure the profitability, as it will correlate the operating profit to operating assets of the businesses and cash conversion cycle employed to find out the aggressiveness of the working capital policy entire manufacturing sector (38 public listed companies) listed at Colombo Stock Exchange.(CSE).

2. Chapter 02

2.1 Literature Review

Financial researchers many part of the world have approached the working capital management with different view and different environments. Here in this study few of relevant researchers finding which has contributed to the literature taken into consideration.

Koperunthevi (2010) studied working capital management and firm’s performance: an analysis of Sri Lankan Manufacturing companies by panel data analysis. Her study concluded that working capital management very much influences profitability of manufacturing companies and increase of cash conversion cycle leads to less profitability. Current ratio and quick ratio are positively related to the profitability. Lingesiya and Nalini (2011) also concluded by analyzing 30 Sri Lankan listed manufacturing that there is a strong negative relationship between the cash conversion cycle and profitability.

At the same time Chiou and Chenge (2006) studied the factors, which determine the working capital and can affect the management of working capital, for which they used the quarterly data for the period of 1998 – 2004. Their conclusion was that both internal and a few external factors affect decision of the management of WC. It must be noted that the internal factors such as debt ratio, size of the company, profitability, growth and operating cash flow have more influence regarding this decision.

Rehman and Nasr (2007) focused on 94 companies which were listed on Karachi Stock Exchange to study the trend of Pakistani companies regarding the working capital and impact of their practice on the profit from 1999 – 2004. For this analysis, the variables were size of the company, current ratio, debt ratio, net operating profit, cash conversion cycle and component of CCC; the control variable was financial asset to total asset ratio; the techniques used were regression analysis and Pearson’s correlation. They concluded that cash makes the major part of the current asset of Pakistani firms and there is a negative relationship between profitability and components of CCC. Based on their study they inferred that shareholder wealth can be increased by reducing the length of CCC.

Nazir and Talat (2008) studied 204 non financial firms which were listed on the Karachi Stock Exchange to identify the trend in Pakistani firms towards WC policy from 1998 – 2005. They found out three things from their studies: Value can be created by following the conservative approach. Investors prefer firms which have aggressive policy towards current liabilities management. Only the shareholders’ wealth can be increased by following the aggressive policy and not the accounting performance.

On a separate study Talat and Nasr (2008) focused on 208 companies listed on Karachi Stock Exchange to find out the relationship between the aggressive and conservative WC policies. Their conclusion was that there is no significant relationship between the aggressive WC policy and profitability, which contradicts the results of studies conducted before.

Vishnani and Shah (2007) studied 23 listed companies in the consumer electronics industry from 1995 - 2005 to find out the impact on profitability by different WC policies. Their motive was to find out the relationship between profitability (i.e. ROCE) and liquidity (i.e. current ratio). They detected a very weak positive relationship as 9 out of 23 companies showed negative relationship, and therefore, concluded that there is no significant relationship between profitability and liquidity. Further, they also found inverse relationship between collection period, holding period and ROCE. Deloff (2003) studied Belgian firms for 4 years (1992 – 1996) and found out that there is a negative relationship between WC and profitability. He said that by decreasing the number of days AR , number of days inventory held and the amount invested in the current assets to a reasonable level the firms can create value.

Lazaridis and Tryfonidis (2006) investigated 131 Athens Stock Exchange listed companies for 3 years (2001 – 2004) to identify the impact of efficient WC management on profitability. Gross operating profit was used as a measure of profitability. Size of the company, CCC, fixed financial assets and financial debt ratio were used as independent variables. They concluded that CCC and profitability are negatively related

Uyar (2009) investigated the relationship between (1) CCC and profitability and (2) CCC and size of the firm. For this he studied 166 Istanbul Stock Exchange listed firms from 7 different industries for the period of one year (2007). Total asset and net sales were used as variables to measure the size and ROE as a variable to measure profitability. ANOVA and Pearson’s correlation were used for the analysis. They found out that there exist negative relationships between (1) CCC and profitability and (2) CCC and size of the firm.

Lamberson (1995) tried to identify the impact of change in economic activity on the WCMP. For this he studied 50 small US firms from 1980 – 1991. He concluded that there is very little impact on WC practice of small firms by the change in economic activities as the firms were consistent with their investment in WC and did not increase it during the period of economic expansion/ boom. Jose and Lancaster (1996) studies 2,718 firm form different sectors from 1974 – 1993 to detect any relationships between aggressive WCP and profitability. They concluded that, (1) there is inverse relationship between ROA and WCMP and (2) the size of the company have no impact on such a relationship, which contradicts Uyar (2009).

Weinraub and Vissoher (1998) analyzed 216 firms from 10 different industries to find out the practice of WC in different industries. They used quarterly data for the analysis. The result shows that there are different approaches towa worldrd WC in different industries and there is an inverse relationship between liability and asset management. Further, they said that conservative WC financial management always balanced the effects of relative aggressive WC asset management.

Even though there is very little literature available in connection with Sri Lankan manufacturing companies, the above all studies done in all over the world in different environments give me a strong and clear literature review to build up a methodology to my study area.

3. Chapter 03

3.1Research Design

This research will try to explore relationship between working capital policy and profitability of Sri Lankan manufacturing companies, so it will be a longitudinal study and will follow explanatory research strategy, as it will find out the relationship between working capital policy and profitability over a period of five years (2007-2012). I will use the secondary data, which is quantitative in nature, of the selected companies for the statistical analysis in the SPSS, which is consistent with the research strategy.

3.2 Research approach:

In this study, I follow the inductive approach because it will develop the hypothesis at the first stage and than in order to test the hypothesis it will analyze the data. Moreover, deductive approach used to explain the relationship between two variables, as this research investigates the relationship between two variables.

3.3 Research criteria:

This research wants to find out the relationship between two variables, which is impossible to explain in an artificial environment. Therefore, it is an explanatory research in nature, which will conduct in a natural environment without any influence. Secondary data used for this research, which will collect from articles, websites, books and financial reports.

3.4 Research method:

Quantitative method will be follow in this study because the collected data will be in the form of numerical digits and I will use statistical tools for analysis, for example, regression analysis in SPSS to explain the relationship between working capital policy and firm’s profitability.

3.5 Data collection and sample:

Various manufacturing companies listed at Colombo Stock Exchange were selected for this study, the main reason for selecting only the listed companies is the reliability and accuracy of the information given by them, then compare to other. Thirty Eight Manufacturing companies selected out of 287 companies listed at CSE as at 31.12.2012. Convenient sampling methods used to choose the sample and availability of financial reports set as a standard to select a company for sample.

3.5 Variables:

The relationship between profitability and working capital management can establish by analyzing the explanatory variables and control variables. Explanatory variables are liquidity ratio, working capital cycle and components of current assets. Profitability measured by return on total assets (ROTA), which defined as profit before interest and tax divided by total assets.

3.5.1 Explanatory Variables

Liquidity ratio of current ratio (cr) is defined as current assets divided by current liabilities, and quick ratio (qr) defined as current assets other than inventories divided by current liabilities. Working capital cycle is the cash conversion cycle (CCC), which used as a comprehensive measure of working capital as it shows the time lag between expenditure for the purchase of raw materials and the collection of sales of finished goods.

CCC=INP_days+AR_daya-AP_days

Where:

IN_days= Number of inventory days is (stock *365)/cost of sales

AR_days= Number of days account receivables is (Account receivable *365)/ Sales

AP_days= Number of days account payable is (Account payable *365)/ cost of sales

Working capital component of inventory is defined as inventory to total current assets (skca).

3.5.2 Control Variables

Control variables include assets management system and financial policies. In order to

Include the firm size as control variable sales, a proxy for size (The natural logarithm of

Sales-(Insales)), the gearing ratio (financial debt to total assets – (gear)), the gross working

Capital turnover (sales to assets – (ca_turn)), current assets to total assets (ca_ta) and

Current liability to total assets (cl_ta) is included as control variables

3.6 Hypotheses

The working capital management has great importance in financial system, to Maximize the profit and smooth run of the business, working capital management is a vital factor. Increasing profits need more liquidity and it can bring liquidity cost of the firms. Therefore, there must be a trade- off between these two objectives of the firms. For this reason, working capital management should give proper consideration and will ultimately affect the profitability of the firm. In this concept the hypotheses are:

Hypothesis 1

H1: there exist a relationship between GOP and CCC.

H0: There exist no relationship between GOP and CCC

Hypothesis 2

H1: There exist a relationship between GOP (Profitability) and days Account receivables of an organization.

H0: There exist no relationship between GOP (profitability) and days account receivables.

Hypothesis 3

H1: There is association between GOP (profitability) and days account payables.

Alternative approach to this hypothesis is

H0: There is no association between GOP (profitability) and days account payables.

Hypothesis 4

H1: There is association between GOP (profitability) and day’s inventory held.

H0: There is no association between GOP (profitability) and day’s inventory held.

Hypothesis 5

H1: There is an association between sales volume and working capital management.

Ho: There is no association between sales volume and working capital management.