The Working Capital Management

Published Date: 02 Nov 2017

Abstract …………………………………………………………………………………………………………………………………………………. i

Acknowledgements ………………………………………………………………………………………………………………………………..ii

Tables of Contents …………………………………………………………………………………………………………………………………iii

List of Tables …………………………………………………………………………………………………………………………………….……iv

List of Figures

Chapter 1

Introduction

Assets consist of items which make up the available resources of a company. In a firm, there are two types of assets which are non-current assets and current assets. Non-current assets consist of land and building, intangible assets, plant and equipment and furniture. Investment in these assets represents that part of a firm’s capital, based on a fixed basis generating productive capacity. The form of these assets does not change in the normal course of operation. In contrast, current assets refers to short terms assets including raw materials, accounts receivables, short term investments and cash and bank balances which are expected to be converted into cash in the ordinary course of business within one year or less.

In addition, current asset is also known as working capital and is regarded as the lifeblood of an enterprise. Thus, without sufficient working capital, any enterprise cannot run smoothly or successfully. Filbeck and Kruger (2005), defined working capital as the difference between resources in cash or current assets and organizational commitments for which cash will be required that is, current liabilities. Besides, working capital is crucial to the finance structure of any business organization because it drives the liquidity position of the firm in the short term. Besides, it meets the short term financial requirement of a business enterprise. The money invested changes its form and substance during normal course of business operations. The firm invests in working capital so as to dispose itself in order to ensure timely and obligatory payment for its employees, creditors and other finance providers. The basic objective of working capital management is to manage firm’s current assets and current liabilities in such a way that working capital is maintained at satisfactory level. Besides, working capital should be adequate.

According to Afza and Nazir (2009), a firm may pick an aggressive working capital management policy with low level of current assets as percentage of total assets for financing decisions of the firm in the form of high level of current liabilities as percentage of total liabilities. On the other hand, it should be distinguished between three policies that related directly with the working capital efficiency. The first policy is collection policy, which is measured by Average Receivables Collection Period which relates to the average length of time required to convert the firm receivables into cash. The second policy is inventory policy, which is measured by the Average Conversion Inventory period. This refers to the average length of time needed in order to convert raw materials into finished goods and later sell these goods. The third policy refers to payment policy, which is measured by Average Payment Period meaning the average length of time among the purchase of raw materials and the payment of cash (Weston and Brigham, 1993).

The three policies require company to accelerate the collections of receivables, its inventory, the payment cycle, and also to reduce the cost of the working capital. These policies mentioned above can be grouped as cash conversion cycle (CCC) developed by Richards and Laughlin (1980) which focuses on the length of time when the firm makes payments and when it receives cash inflow. A short cash conversion cycle shows that the firm is collecting the receivables as quickly as possible and delaying payments to suppliers as far as possible. Consequently, this leads to high net present value of cash flow and high firm value.

Moreover, the cash conversion cycle is an important tool of analysis for financial managers of the firm to evaluate when the firm needs more cash to sustain its operations and how it will repay the cash O’zbayrak and Akgün (2006). As per this policy, the firm tried to manage its policies by decreasing the cash conversion cycle without affecting the operations process of the firm, and this will eventually lead to an increase in profits. In other words, Chiou, Cheng and Wu (2006) stated that when working capital is improperly managed, allocating more than required it will obviously lead to non-efficient management and diminish the benefits of short term investments

1.1 Background of the study

Previous studies stated that working capital management may have an important effect on the firm’s profitability. Lazaridis and Tryfonidis (2006), Raheman and Nasr (2007) and others, measured working capital with cash conversion cycle consisting of inventory holding period, receivables collection period and payables payment period. The researchers concluded that greater investment in working capital leads to a reduction in the firm’s profitability (Banos-Caballero et al, 2010, and Nazir and Afza, 2009).

Raheman & Nasr (2007) studied the effect of different variables of working capital management comprising of average receivables collection period, inventory turnover, cash conversion cycle, average payment period and current ratio on the net operating profitability of Pakistani firms. The result implies that there was a significant negative relationship between variables of the working capital management and profitability of the firm, meaning that the cash conversion cycle increases while profitability decreases. Thus, managers create a positive value for the shareholders by reducing the cash conversion cycle to a possible minimum level.

Deloof (2003) on the other hand studied the large Belgian firms for 1992 to 1996 periods to investigate the relation between working capital management and profitability. Consequently, he found that firms can increase their profitability by reducing the number of days of accounts receivables and inventories since there is a negative relationship between working capital management and profitability. He also found that less profitable firms wait longer to settle their bills.

1.2 Research problems

Some companies have positive working capital which implies that current assets are greater than current liabilities. This means that the companies are operating smoothly however; this is not always the case due to the fact that money is tied up in trade receivables. Besides, in the short run the company is unable to settle payment to its creditors if all of them ask for money at the same time. Moreover, creditors might block deliveries of finished goods and raw materials which will affect the company’s goodwill since there will be no production as well as no sales.

Current assets consist of liquid assets such as cash in hand, account receivables, inventories and cash at bank. Hence, account receivables and inventories should normally be converted into cash within one year but this is not so for all companies because when they make sales to companies there are several problems which may crop up. For instance, customers having liquidity problems (can go into liquidation), delaying payments due to their own working capital problems; concerning inventories: there are market inconsistencies, competition, and introduction of substitute products by rival companies.

Companies have cash flow problems also due to mismanagement and other related problems. For instance, there is lack of funds for investment due to uncertainty of refunding amounts own by the company and provided by banks. Besides, there is also written off of bad debts resulting into losses to the company. As a result, the cash flow problem leads to late payment of the company’s creditors which result into lack of trust and less credit facilities.

1.3 Research objectives

The major objective of the present study is to demonstrate the relationship between working capital and profitability. The specific objectives of the study are summarized as follows:

To determine how companies are managing their working capital.

Analyse working capital management components and its impacts on profitability of listed companies.

1.4 Research questions

Many firms suffer from how to manage its working capital in order to reach to the optimum, then to enhance their profitability. Therefore, the study tries to ask the following questions:

How do firms manage their working capital?

How can working capital components such as account receivables, inventories, account payables and cash conversion cycle impact on profitability of listed companies?

1.5 Aims of the study

To show the relationship between working capital management components and profitability within listed firms of Mauritius

1.7 Outline of the study

Chapter 1 introduces background and motives for this study and builds research problem, research questions and research objectives. Afterwards, chapter 2 refers to literature review which defines the topic working capital management and theoretical perspectives to working capital management from recent literatures. Chapter 3 refers to methodology which explains the research design along with variables of the study. Chapter 4 refers to analysis which contains the various statistical analyses of this study. Later, each variable is discussed and what variables are used by various authors and why and how they are operationalized. The chapter ends with conclusion.

1.8 Conclusion

This chapter provides an introduction of Working Capital Management, after that the research problems along with the research objectives are formulated. The next chapter refers to the theories of Working Capital Management.

CHAPTER 2

Literature Review

2.1 Introduction

This chapter looks at the theoretical foundations and is wholly a review of relevant literature on Working Capital Management and impacts of working capital on profitability.

2.2 Definition of key terms and concepts

2.2.1 Profitability

Profitability refers to a financial metric which evaluates business’s ability to generate earnings over expenses and other relevant costs incurred like variable costs including labour and inventory and it also includes fixed costs like repairs and taxes. Profitability also refers to the potential of a company to be successful financially. Besides, Profitability is the primary aim of companies, without it companies will not survive in the long run. There are several measures of profitability which a company can use. The profitability ratios are return on capital employed, operating profit margin, return on assets and return on equity.

2.2.1.1 Return on Capital Employed (ROCE)

ROCE is also known as the ‘Primary Ratio’ because it is the first calculation that a potential investor would calculate before investing in a business. It shows the return that a company is making before the payment of interest and taxes for the providers of capital.

2.2.1.2 Operating Profit Margin (OPM)

It calculates the percentage of sales t after deducting the Cost of Goods sold and all expenses, but before the deduction of income taxes. High return on revenue implies better performance (Gitman, 1999).

2.2.1.3 Return on asset (ROTA)

This ratio explains how efficient a company is to utilize its available assets in order to generate profit. The higher the value of return on asset implies the better performance of the company.

2.2.1.4 Return on Owners’ Equity (ROE)

The return on shareholders’ equity ratio is calculated in order to see the profitability of owners’ investment. However, if the ROE is less than the rate of return on a risk-free investment like bank savings account, the owner would like to sell the company and put the money in the savings instrument.

2.2.2 Working Capital Management

Working capital refers to funds a business requires to run its day to day operations. Besides, Working capital is the net of current assets minus current liabilities. Current assets includes inventory, accounts receivable, marketable securities and cash as well as bank balances whereas current liabilities contain accounts payable, notes payable, accruals and other current liabilities (Emery and Finnerty 1997). Generally, working capital is divided into three parts namely account receivable, account payable and inventory. First, account receivable refers to inflows of the firm and it relates to billing of customers for goods and services received by customers. Second, account payable refers to major source of unsecure short term financing. Third, inventories are kept in the firm in order to generate revenues from sales. According to Weygandt et al, 2005, inventory is the most important current asset. Working Capital Management deals with the administration of current assets and current liabilities and it is very important due to the fact that it affects profitability and liquidity of the firm (Deloof, 2003 and Raheman and Nasr, 2007).

2.3 Cash Management

Cash management refers to the management of cash resource in such a way that business objectives could be achieved. Abel (2008), states that cash is the oxygen to every business which enhances the survival and prosperity. Besides, cash includes both cash in hand and cash at bank. Polak and Kocurek (2007) state that the objectives of cash management are to maximize liquidity, managing cash flows, and maximize the value of funds by reducing their costs. Activities like debt administration, maintaining good relationships with financial institutions, paying suppliers on time and collecting payments from customers are all elements of cash management. The financial manager must ensure that the firm has sufficient cash reserve to safeguard unexpected future events. The objective is also to achieve an optimal balance and turnover of cash which maximizes the market value of the firm (Agrawal, 2007). Achieving such objective implies that effective and efficient management of cash would impact on both liquidity and profitability of the firm (Egbide and Enyi, 2008). Efficient cash management can be helpful in preventing losses from fraud, to hold adequate cash, to settle necessary payments and to have reasonable cash for emergencies.

2.3.1 Motives for holding cash

Any business transactions whether on credit or cash basis eventually results into cash inflows and outflows. According to Keynes, there are four motives for holding cash which are transactions, precautionary, speculative and compensating.

2.3.1.1 The Transaction Motive

Transaction motive refers to cash requirement so as to fund day to day transactions which a firm carries in order to achieve its objectives. Examples of such transactions are payment for wages and salaries, expenses, purchases of materials and other financial charges including interest, taxes and dividends. Similarly, a firm receives cash from collections from receivables, return on investments and cash sales. Thus, such motive denotes to the holding of cash to meet anticipated obligations whose timing is not perfectly synchronized with cash receipts.

2.3.1.2 The Precautionary Motive

A firm has to pay unexpected cash for matters which cannot be predicted or anticipated such as floods, strikes, sudden increase in cost of raw materials and customer failure. Moreover, slowdown in collection of receivables consequently increases the cost of raw material. Therefore, cash needed to meet these unforeseen contingencies is known as precautionary motive. However, if cash flows are unpredictable then a greater amount of cash balance would be required.

2.3.1.3 The Speculative Motive

Keynes’ third motive refers to cash holding for the purpose of speculation. Speculative cash balances are held to take advantage of unexpected investment opportunities. If firms wish to grow by acquiring other firms or to take advantage of a sudden decline in prices of raw materials they may hold cash in reserve waiting for this particular situation. For example, if the firm expects that the price of raw-material will fall, it can delay the purchases and buy it when the price declines.  As with precautionary demand, cash for speculative purposes could be invested in income-earning securities.

2.3.1.4 The Compensating Motive

Banks and other financial institutions may require a minimum compensating balance to be kept in the company’s bank account in order to give loan and other services. Therefore, another motive to keep cash is for the purpose of bank compensating balances, where cash balances are kept at commercial banks to compensate for banking services rendered to the firm such as commission or other fee. HoweverIn addition, this balance cannot be used for transaction purposes in the normal course of the business.

2.4 Inventory Management

Ross et al (2008) defined inventory as: "composed of raw materials to be used in production, work in process, and finished goods." Raw material refers to input the firm uses to start up its production. It also includes purchased parts and all direct materials that go into the final product. The second type of inventory is work-in-progress. This particular inventory is in the process to be completed. The third type of inventory is finished goods. They represent the end product of the manufacturing process (Ross et al 2008).

Inventory management refers to an optimal investment in inventories. Firm should neither keep too high nor too low inventory since it will block unnecessary funds and affect the production negatively. The objectives of inventory management are to ensure that adequate inventories are available for operation while reordering cost of inventories are kept at the lowest possible. Thus, lower inventory will reduce costs due to storage and handling, insurance, damage, and obsolescence. For any firm, additional or insufficient investment is not desirable as it reduce profit margin (Fabozzi and Peterson, 2003 p. 658). Inventory management is also expected to bring high return than the cost of investment and to influence the firm’s profitability positively. (Egbide and Enyi, 2008).

2.4.1 The Economic Order Quantity

The ‘Economic Order Quantity’ (EOQ) model is a simple concept used to calculate a company’s optimal inventory level and order size. The framework used to determine this order quantity is also known as Barabas EOQ Model. An understanding of the EOQ model will facilitate the comprehension of the cash management model as well as the basic issue of working capital management. In order to stay within the scope of this study, only the first step, namely the decision on inventory level, shall be examined. The second stage which deals with order size and inventory usage. The equation is as follows: 

Economic Order Quantity (EOQ)

Where: 

S = Setup costs 

D = Demand rate 

P = Production cost 

I = Interest rate (considered an opportunity cost, so the risk-free rate can be used) 

2.4.2 The underlying assumption of the EOQ model

The following assumptions for the EOQ model are very important and without these assumptions, the EOQ model cannot work to its optimal potential.

The ordering cost is assumed to be fixed

The demand rate for the year is known

The lead time is not fluctuating

No cash or settlement discounts are available

The optimal plan is calculated for only one product

There is no delay in the replenishment of the stock

2.4.3 Optimal Inventory Size

According to Van Horne (1995), the EOQ model is applicable to all types of inventory namely raw materials, work in progress and finished goods. In order to ensure the applicability of the EOQ model, several assumptions must be taken into considerations which are discussed above. The EOQ model in its simplest conception therefore merely takes variable costs into consideration, (Weston, & Copeland, 1986), although it can easily be extended so as to include fixed costs.

2.4.4 Monitoring inventory management

Firms can monitor its inventory through its financial ratio such as Inventory turnover ratio in days. It shows the number of time the stock has been turned over sales and estimates the efficiency during the period. This ratio point out whether investment in inventory is within the limit or exceeded its limit (Brigham and Houston, 2003, p. 691).

2.5 Receivables Management

Ross, Westerfield, Jaffe, and Jordan (2008) define accounts receivable as: "amounts not yet collected from customers for goods or services sold to them." Accounts receivable is one of the series of accounting transactions relating to payments for goods and services received by customers. This is done through generating an invoice and providing it to customers, who should therefore pay it within a time period set by the company which is known as credit or payment terms. Fabozzi and Peterson (2003 p. 651) stated that when a firm allows customers to pay for goods and services at a later date, it refers to trade credit. Account receivables management is also known as credit management. The management of receivables is to increase sales and eventually profits by allowing certain credit to the prospective customers who are not able to make cash purchases.

Allowing credit obviously increases sales but it also includes costs of managing accounts receivable and there is a possibility of bad debts. Therefore, management should implement control mechanisms on credit sale policies and credit given to customers. The controlling mechanism is planned to identify deviations from credit sale policies and to provide indications of deviations from expectations. Thus, the main objective of accounts receivable control and credit is to give indications when (non-random) deviations in sales, expenses, receivables and bad debts occur (Scherr, 1989).

Credit management is primarily based on two questions which are:

What terms of sale should the firm use?

To whom should the firm grant credit?

2.5.1 Terms of Sale decision

A firm should determine the applicable terms of sale based on the buyer’s two common methods of receivables monitoring are:

2.5.1.1 Days Sales Outstanding Statistics

Days sales outstanding (DSO) measures the average amount of time that a company holds its accounts receivable. It is calculated by the following equation:

DSO = Accounts Receivable / Turnover (Ross, S.; Westerfield, R.; Jaffle, J.; Jordan, B. 2008).

2.5.1.2 The Aging Statistics

The Accounts Receivable Age Analysis is also known as the Debtors Book. It is divided into groups for current, 30 days, 60 days, 90 days, 120 days, 150 days and 180 days and overdue that is produced in Modern Accounting Systems.

2.5.1.3 Credit Granting Decision

One of the main features of Accounts Receivables is Credit Granting Decision. If the company is unable to identify its potential customers, it may face difficulties in the long run. There are different approaches to Credit Granting Decisions. The traditional method is 5 C’s of credit which are Capital, Character, Collateral, Capacity and Condition which is very common technique for quick credit granting measuring creditworthiness of applicants.

2.5.2 Credit policies

The first stage of credit sales is to decide variables whether credit sales should be made or not. For instance, what percentage of sales should be made on cash and credit? Credit policies can fluctuate considerably depending on the industry and country of origin. The terms of sale determine the date for gross payment as well as cash discount for payments within the timeframe. For example, terms of sale of ‘3/10, net 30’ means that either the buyer benefits from a 3 percent of cash discount if payment is settled within 10 days from the invoice date or total payment should be made within 30 days. The seller motivation for granting such cash discount is to acquire collections quickly so as to improve cash availability.

2.5.3 Optimal credit policy

Granting credit will not only affect the firm’s turnover positively but also imply cost of holding account receivables, including risk of losses through bad debts. If credit policy is longer, it will have significant positive impact the firm’s revenues and other costs. Consequently, the financial manager should find the optimal credit policy which reduces the total costs of credit. Total costs of credit refer to the addition of opportunity costs arising from lost sales and carrying costs of accounts receivable. Besides, opportunity costs decrease when credit is longer to customers. However, carrying costs increase the credit delay because the costs incurred due to the cash collection delay, the relative cost of capital tied up, the increased probability of bad debt losses and the costs of managing credit, positively related to credit extension.

2.5.4 Collection Policy

Collection policy deals with the issue of collecting unpaid receivables. (Ross S. et al 2008). This policy monitors receivables and takes appropriate measures when the account is overdue (Ross S. et al 2008). Most companies use the average collection period  and the accounts receivable aging schedule to monitor their credit accounts. The average collection period measures the average days required to collect credit accounts. On the other hand, the accounts receivable aging schedule refers to a tool to determine the percentage of late credit accounts and uncollectible accounts. Firms which have an effective collection policy will be able to minimize losses resulting from bad debts as well as minimize the holding costs of account receivables (Ross S. et al 2008). If the company is able to collect its accounts receivable efficiently, it will have a profitable credit policy.

2.6 Account Payable Management

When a company purchase goods on credit from suppliers and other firms and would settle the amount later at a specified date in the future within 12 months’ time is known as account payable. Such transaction for the suppliers is recorded as account receivable while for the buyer as account payable. According to Gitman (2009) and Birt et al., (2011), Accounts Payable Management objective is to settle payment of creditors slowly without damaging its credit rating. In short, account payables are regarded as short term debts whereby the company is obliged to settle the payment at the specified date agreed upon. If payments are settled on due dates, it will benefit from discounts. However, if it fails to do so then, it may face difficulties such as bad company image, loss of market share for its products, bad relationships with suppliers and creditors as well as a fall in its market share. Not only that but, suppliers will no longer supply the company which in turn will affect production adversely and even close down. Therefore, it is vital to monitor account payable in an effective way and the method used is known as Average Payable period (APP).

2.7 The Importance of Working Capital

Adequate amount of working capital is very vital for smooth running of an enterprise. This is so because efficiency in this area will help the enterprise to utilize non-current assets properly, to assure the firm’s long-term success as well as to achieve the goals of the enterprise. Besides, shortage or bad management of cash can result into loss of cash discount and blemish the reputation of the enterprise due to non-payment on due dates. Next, lack of inventories maybe regarded as the main cause of production to be halted and it may force the enterprises to purchase poor raw materials at low rates. As per previous studies, it can be noted that a business failed due to lack of working capital most of the time. Therefore, sufficient working capital is fundamental during bad situations.

According to O’ Donnell et al, sufficient working capital is very crucial to finance inventories and receivables in order to prevent break down in production and sales. The sufficiency of cash along with current asset determines the survival and demise of a concern. Whether it is excessive or insufficient working capital, it will impair the profitability and general health of a concern. Several problems may crop up due to excessive working capital like heavy investment, purchase of poor quality raw materials and liberal credit. Heavy investment refers to a situation of over capitalization which arises due to heavy investment in non-current assets which is not justified by actual sales. Purchase of poor quality raw materials will eventually slow inventory movements or obsolete inventory. Also, liberal credit refers to an increase in receivables and this facility will increase bad debts and delay payments.

2.8 Operating Working Capital Cycle

Working capital cycle refers to the time period between investment in a product and receiving payment for that particular product. The cycle starts when the business purchase raw materials and ends when the customer makes the payment, regardless of pre-paid payment or credit payment. Mcguigan and Krelow (1998) states that working capital cycle comprises of three main activities which are buying raw materials, producing the product and finally sell it to customers. The funds create both cash inflows and outflows which are both uncertain and unsynchronized. They are unsynchronized because when the business buys raw materials it takes place before receiving cash like collection of receivables while on the other hand, they are uncertain as future sales and cost generating receipts does not show complete accuracy. Thus, it is essential to manage working capital for both synchronized and uncertain cash inflows and outflows of materials bought and goods sold.

Figure : Working Capital Cycle

Source: http://www.planware.org/workingcapital.htm

2.8.1 Working Capital Policies

WCM policies are guidelines which help businesses to manage currents assets generally cash and cash equivalents, inventories and receivables and short term financing such as cash flows and returns (Kumar, 2010). Different companies adopt different policies regarding the management of working capital. Most companies embrace aggressive policies, while others adopt conservative policies.

2.8.1.1 Aggressive Working Capital Policy

Aggressive Working Capital Policy is where a firm finances its current asset along with part of its non-current assets by short term debt. This is so because financing investment through short term sources is associated with low interest rate. The policy seeks to reduce excess liquidity while meeting the short term requirements. This means that the firm tries to hold low levels of current assets and high level of current liabilities so as to reduce inventory turnover, cash balances and investment in account receivables. Thus, it is a high risk orientated approach due to the fact that it reduces investment in working capital and the company may hope to gain high returns through investment in long term investment vehicles with higher returns. A company with aggressive working capital policy would provide short credit period to its customers, has minimum cash in hand as well as minimal inventory.

2.8.1.2 Conservative working capital policy

Conservative policy refers to an approach which balances both risks and returns. It is a mixture of both defensive and aggressive working capital policies. Defensive policy involves financing of non-current assets and major part of current asset by using long term financing such as debt and equity. On the other hand, short term financing are used to finance unexpected and emergency situation only.  The larger the long term financing used for financing non-current assets as well as permanent current assets, the more conservative is said to be the working capital policy of the firm. Under such approach, risk and returns are both at lower levels since the long term financing are expensive. According to Paramasivan and Subramanian (2009), this policy is known as "low profit and low risk" concept.

2.8.2 Key Ratios

2.8.2.1 Profitability Ratios

2.8.2.1.1 Return on Capital Employed (ROCE)

It measures a relationship between profit and capital employed. The ROCE is calculated as follows:

ROCE = Profits Before Interest & Tax (PBIT) / Total Capital x 100

2.8.2.1.2 Operating Profit Margin (OPM)

OPM calculates the percentage of profit a company is earning against its revenue. OPM is further calculated as follows:

Operating Profit Margin = Profit before Interest & Tax / Revenue x 100

2.8.2.1.3 Return on asset (ROTA)

It is calculated by the percentage of profit a company is earning against per dollar of assets (Weston and Brigham (1977, P. 101). It can be calculated by the following formula:

ROTA = (Net profit before Interest and Tax/ Total Asset) x 100

2.8.2.1.4 Return on Owners’ Equity (ROE)

It focuses on the percentage of return on funds invested by its owners. The ROE is calculated as follows:

Return on Owners’ Equity = Profit after Tax and preference dividend / Equity Capital x 100

2.8.2.2 LIQUIDITY RATIOS

Liquidity ratios indicate the ease of turning assets into cash including Current Ratio and Quick Ratio.

2.8.2.2.1 Current ratio

It is defined as the relationship between current assets and current liabilities. Besides, it measures of financial strength of the company. It is also used to make analysis for short term financial position of a firm (Fabozzi and Peterson (2003 p. 733). Current ratio can be calculated as:

Current ratio = current asset / current liability

2.8.2.2.2 Acid test ratio or quick ratio

It refers to the ability of a firm to pay its short term obligations as and when they become due. It is the ratio of liquid assets to current liabilities. By excluding inventories, it concentrates on liquid assets namely cash items which can easily be converted into cash. It is calculated by the following ratio:

Quick ratio = Current asset – inventory / Current Liabilities

2.8.2.3 WORKING CAPITAL AND EFFICIENCY RATIOS

2.8.2.3.1 Working Capital

Working Capital is a measure of short-term financial position of a company. The result should be a positive number. Then it is known as ‘Net Current Assets’ which is calculated as follows:

Working Capital = Net Current Assets – Net Current Liabilities

2.8.2.3.2 Inventory Turnover

This ratio determines how well inventory is being managed. It is calculated by the following formula:

Inventory Turnover (Days) = Inventory / Cost of sales x 365

The standards will eventually be different as all firms are not the same but it actually depends on two factors: the nature of business and the business conditions.

2.8.2.3.3 Accounts Receivable Collection Period

This ratio indicates how quickly accounts receivable are being collected. It is calculated by the following:

Receivables Collection Period (Days) = Receivables / Credit Sales x 365

2.8.2.3.4 Accounts Payable Payment Period

This ratio measures the average length of time the company takes to pay its suppliers (Brigham and Houston 2003, p. 720). It is calculated by the following ratio:

Average Payment period (Days) = Payables / Cost of sales x 365

Generally, small APP implies that the company is effecting early payments for unpaid bills and benefit from discounts while large APP implies that the company is taking longer to settle unpaid bills on time due to shortage of funds.

2.9 Empirical studies showing relationship between Working Capital Management and Profitability

Many previous researches have indicated the relationship between working capital management and profitability of companies in different environments. In intention to discover the relationship between working capital management and firm’s profitability, Gill et al (2010) conducted a study to examine the relationship between profitability and cash conversion cycle (CCC) with a sample size of 88 American listed firms on New York Stock Exchange. The sample was randomly selected which eventually represented the whole population and it was for a period from 2005 to 2007. The study was controlled by financial debt ratio, sales and asset ratio. Through regression analysis, they found a positive relationship between cash conversion cycle and profitability which was the reverse of many studies. They further found a negative relationship between account receivables and profitability and on the other hand, he could not find any relationship between account payables and inventory due to poor results. They also propose that directors can generate profit through proper management of cash conversion cycle and through an optimal level of account receivable.

Shin and Soenen (1998) used net-trade cycle (NTC) as a measure of working capital management. NTC is basically equal to the CCC whereby all three components are expressed as a percentage of sales. The reason by using NTC because it can be an easy device to estimate for additional financing needs with regard to working capital expressed as a function of the projected sales growth. This relationship is examined using correlation and regression analysis, by industry and working capital intensity. Using a COMPUSTAT sample of 58,985 firm years covering the period 1975 to 1994, in all cases, they found, a strong negative relation between the length of the firm's net-trade cycle and its profitability. In addition, shorter NTC are associated with higher risk-adjusted stock returns. In other words, Shin and Soenen (1998) suggested that one possible way the firm to create shareholder value is by reducing firm’s NTC.

Padachi (2006) conducted a study on small manufacturing firms in Mauritius consisting of 340 firm-year observations from a period of five years from 1998 to 2003. The study confirms that by increasing the number of days of account payable, profitability will be reduced due to discount for early payment to suppliers. Furthermore, he also found that the number of days in account receivable has significant relationship with the return on total assets; this means that an increase of account receivables by one day will diminish profitability. Besides, the author had conducted a comparative analysis of five industry groups which shown a negative correlation with return on assets.

Dong and Su (2010) examined the relationship between cash conversion cycle and profitability, measured by gross operating profit. The research sample consisted of 130 listed firms in Vietnam stock market for a period from 2006 to 2008. The cash conversion cycle was divided into number of day’s account receivables, number of day’s inventory and number of day’s account payables. They controlled financial debt ratio, sales and asset ratio using regression and correlation analysis. The result has shown a significant relationship between the number of day’s account receivables, number of day’s inventory and cash conversion cycle with profitability. On the other hand, the study has shown a positive relationship between account payables and profitability. They further asserted that managers must reduce the cash conversion cycle in order to create value for shareholders.

In Raheman and Nasr (2007) study, they examined a sample of 94 Pakistani companies listed on Karachi stock exchange market from different sectors of the economy. The research was for a period of six years from 1999 to 2004. The objective of the research was to analyse the different variables of working capital management on profitability. Therefore, both dependent variables and independent were used. The dependent variable was net operating profit while independent variables were the number of day’s account receivables, number of day’s inventory and cash conversion cycle and current ratio. Next, sales, financial debt ratio and asset ratio were used as controlled variables. The researcher asserted that there was a negative relationship between these variables and profitability. This means by increasing the cash conversion cycle, profitability of the firm will be reduced. The results suggest that both size and debt affect profitability.

Deloof (2003) study consisted of 1,009 non listed Belgian firms for a period of four years from 1992 to 1996. The study aimed to show the relationship between working capital management and profitability. He used trade credit and inventory policy which were measured by the number of day’s account receivables, number of day’s inventory / payables and cash conversion cycle as a comprehensive measure of working capital management. Using regression and correlation analysis, he found a negative relationship between gross operating income and the number of day’s inventory, payables and receivables. Therefore, he suggests that directors can minimize the number of days account receivables and inventory in order to create value for shareholders. He further suggests that unprofitable companies delay payments for unpaid bills.

Lazaridis and Tryfonidis (2006) studied the relationship between profitability and working capital management. The sample was based on 131 companies listed on Athens stock exchange for a period of 2001 to 2004. The findings revealed a negative relationship among cash conversion cycle and gross operating profit. Moreover, they suggest that managers can increase profits by handling the cash conversion cycle properly and keep accounts receivables, account payable and inventory at optimal levels.

Increasingly, Afza and Nazir (2009) made an attempt in order to investigate the traditional relationship between working capital management policies and a firm’s profitability for a sample of 204 non-financial firms listed on Karachi Stock Exchange (KSE) for the period 1998 to 2005.The study found significant different among their working capital requirements and financing policies across different industries. Moreover, regression result found a negative relationship between the profitability of firms and degree of aggressiveness of working capital investment and financing policies. They suggested that managers could crease value if they adopt a conservative approach towards working capital investment and working capital financing policies.

Lyroudi and Lazaridis (2000) used food industry in Greek to examined the Cash Conversion Cycle (CCC) as a liquidity indicator of the firms and attempts to determine its relationship with the current and the quick ratios, with its component variables, and investigates the implications of the CCC in terms of profitability, indebtness and firm size. The results of their study indicated that there is a significant positive relationship between the cash conversion cycle and the traditional liquidity measures of current and quick ratios. The cash conversion cycle also positively related to the return on assets and the net profit margin but had no linear relationship with the leverage ratios. Conversely, the current and quick ratios had negative relationship with the debt to equity ratio, and a positive one with the times interest earned ratio. Finally, there is no difference between the liquidity ratios of large and small firms.

In Garcia-Teruel and Martinez-Solano (2007) study, they used a sample of 8,872 Spanish firms for six years from 1996 to 2002. They carried this research so as to investigate the relationship between working capital management on profitability. Consequently, the result stated that profitability increases when the components of working capital management are properly managed. In addition, they assert that companies must keep short cash conversion cycle which would eventually improve profitability of the company.

Chapter 3

Methodology

The purpose of this study is to identify the impacts of working capital management on profitability with reference to listed companies in Mauritius. This chapter provides details about the selected companies included in the sample, the variables used and the statistical techniques applied in the investigation.

3.2 Research Design

3.2.1 Quantitative and Qualitative research

Quantitative research measures variables with some precision using numerical scales. In short, it gathers data in numerical form which can be put into categories or measured in units of measurement.  This type of data can be used to construct graphs and tables of raw data. On the other hand, qualitative research refers to direct observation of behavior or transcripts of unstructured interviews with informants. Besides, qualitative research gathers information that is not in numerical form including open-ended questionnaires, unstructured interviews and unstructured observations.  This study is based on quantitative data.

3.2.2 Sample

The sample consists of 20 listed companies operating in diverse activities and for which data was available for a six year period, covering the accounting period of 2007 to 2011. The data used in this research was acquired from the Stock Exchange of Mauritius (SEM). The reason why we chose only listed firms is primarily due to the reliability and availability of the financial statements. Furthermore, data was also collected from Registered of companies of Mauritius due to unavailability of annual reports on stock exchange.

3.2.3 Population

Out of 50 listed firms, only 20 companies listed on the SEM were selected for the sample of the study. Others were ignored due to lack of information during that particular period and the activities undertaken by these companies were different. Moreover, insurance and investment companies were also excluded from the sample. The targeted population of 20 listed firms on the stock exchange of Mauritius is as follows:

Table : List of selected listed companies

Forges Tardieu Limited

Livestock Feed Limited

Les Moulins de la Concorde Ltee

ENL Limited

Ciel Textile Limited

Sun Resorts Limited

Ireland Blyth Limited

New Mauritius Hotels Limited

Omnicane Limited

Quality Beverages Limited

Lux Island Resorts Limited

The Medical & Surgical Centre ltd

Medine Limited

Chemco Limited

Air Mauritius Limited

Gamma Civic Limited

Innodis Limited

Bychemex Limited

Air Mauritius Limited

United Basalt Products Limited

3.2.3 Data Collection Procedure

The main source of data used in this study are from secondary data from annual reports of selected companies including income statements, cash flow statements and statements of company position. Data relating to the sales, receivables, payables, inventory, and operating income are processed manually. The selected data was supplemented through personal unstructured interview of senior personnel of accounts department. Moreover, the main information and data have been collected from head office. Secondary data is used for this study because data from such source is accurate, free from bias and provides opportunity for replication.

3.3 The explanatory of variables

The independent, dependent and control variables are explained in this section which will be used in the analysis. Furthermore, the reasons for the choice of these variables are also explained. The independent variable represents the value that is manipulated whereas the dependent variable represents the result of the independent variables which are manipulated. On the other hand, the control variables represent the variables that influence these values.

3.3.1 Dependent variables

Profitability is the dependent variable and it will be measured by the Return on Assets (ROTA). Besides, ROTA is defined as profit before interest and tax divided by total assets. The reason for choosing this variable is that the ROTA represents the ratio of how much a firm has earned on its asset base (Melicher and Leach, 2009). ROTA has been used as dependent variable by Garcia-Teruel and Martinez-Solano (2007), Karaduman et al (2004), Padachi (2006), Enqvist et al (2011) and, Sharma and Kumar (2011). Thus, the ROTA will also be used in this study as dependent variable because according to the net profit in relation to the company asset base is a good way to measure the extent of returns on investments made in the company.

3.3.2 Independent variables

3.3.2.1 Cash Conversion Cycle (CCC)

The CCC will also be used to measure the profitability. The reason to choose the CCC is because, according to Garcia-Tereul and Martinez- Solano (2007), the decision of how much to invest in customer and inventory accounts, and how much credit to accept from suppliers are reflected in the CCC. This measure is determined by the following equation:

CCC = Accounts Receivables(Days) + Inventory(Days) – Accounts Payable(Days)

Moreover, Melicher and Leach (2009) define the CCC as the amount of time taken to buy materials and produce a finished good (the inventory-to-sale conversion period) plus the time needed to collect sales made on credit (sales-to-cash conversion period) minus the time taken to pay suppliers to pay for purchases on credit (the purchase-to-payment conversion period).

3.3.2.2 Accounts Receivable Collection Period (AR)

The AR indicates how long it takes for a company to collect their money from their customers. It can be calculated by:

Receivables Collection Period (Days) = Receivables / Sales * 365

3.3.2.3 Inventory Turnover (INV)

The inventory collection period or inventory conversion period indicates the time of a product between entering the firm as raw materials, and the moment of selling the product. It is calculated by the following formula:

Inventory Turnover (Days) = Inventory / Cost of sales * 365

3.3.2.4 Accounts Payables (AP)

AP measures the length of time that the company takes in order to pay its suppliers. It is further calculated by the following ratio:

Average Payment period (Days) = Payables / Cost of sales * 365

3.4 Control variables

The profitability of a firm is the control variables which are: the firm size, the financial debt ratio and the real Gross Domestic Product.

3.4.1 Firm Size (LOS)

The LOS is considered as a control variable because large companies have bargaining power and consequently, they receive favorable extended credit terms from suppliers. On the other hand, smaller companies may be required to pay their suppliers immediately. Another way where the size of a firm can make a difference is that large companies can purchase large quantities of goods. The firm size will be determined by the natural logarithm of sales. Researchers who have used this variable as control variable are: Deloof, 2003; Padachi, 2006; Lazaridis and Tryfonidis (2006); Dong and Su (2010).

3.4.2 Financial Debt Ratio (LEV)

Financial Debt Ratio (leverage) shows how much firm’s assets are financed through external debt. In case, the financial charges resulting from external financing is greater than the earnings before interest and taxes then, the firm can suffer from great losses. This ratio will be calculated as follows:

Short term Loans + long term loans / Total assets

Studies in which this control variable is used include: Deloof, 2003; Lazaridis and Tryfonidis (2006); Dong and Su, 2010. This variable is used in this study because companies take debt from financial institutions and at specific times the firms have to pay the debt with interests.

3.5 Hypotheses

Based on the previous studies done by researchers in which they determine how the working capital components in firms affect the profitability, the following hypotheses are identified:

Hypothesis H1: The relation between profitability and the average receivables collection period is negative.

This hypothesis affirms that the more credit the company extends to its customers the less profit the company will make and vice versa. Lazaridis et al (2006) concluded in their study that firms with low profits tend to decrease their accounts receivables in order to minimize the cash gap in the cash conversion cycle.

Hypothesis H2: The relation between profitability and the inventory collection period is negative.

This hypothesis denotes that the profitability of a firm will decrease if the firm invests more in, the inventories. Lazaridis and Tryfonidis (2006) found a negative relationship between number of day’s inventory and profitability and they elucidate that if too much capital is tied to inventories in times of low sales, the profitability of the firm will be affected.

Hypothesis H3: The relation between profitability and the average payment period is positive.

This hypothesis states that if the company lengthens the time to pay its suppliers the more profit it will make. According to Deloof (2003) accounts payable is used as a short term source of finance. The company can assess the quality of the products bought. However, with the late payment of the products the firm may miss the opportunity to gain from early payment discounts.

Hypothesis H4: The relation between profitability and the length of the cash conversion cycle is negative.

This hypothesis implies that the longer the cash conversion cycle will be the less profit the company will have. The shorter the cash conversion cycle is, the higher the profit the company will generate. Gill et al (2010) states that a long conversion cycle can increase the profitability because of the higher sales accomplished. On the other hand, the profitability can reduce due to the cash conversion cycle when the investments in working capital is higher than the benefits attained from holding more inventories and extending more trade credit to customers.

3.6 Analysis of the study

In this dissertation, descriptive statistics will be calculated through the statistical software STATA in order to determine the means, standard deviation, minimum and maximum values of the variables used in the study. In addition, the Pearson correlation analysis will also be used in order to determine the relationships between the variables of the study. Furthermore, regression analysis will also be conducted in order to find out the impact of working capital management on the profitability of firms.

3.7 Conclusion

The next chapter refers to data analysis consisting of descriptive statistics, the Pearson correlation analysis and regression analysis of the sample.

Chapter 4

Data Analysis

4.1 The data analysis

After collecting all the data, the data analysis is carried out. The analysis conducted on the data collected consists of the following steps:

4.2 The Descriptive statistics

The descriptive statistics describe the main features of the collected data. In the descriptive statistics a summary of the mean, median, standard deviation, as well as the minimum and the maximum of the selected sample and measures will be given. Table 2 provides the descriptive statistics of the collected variables of 20 listed firms of Mauritius from the accounting period 2007 to 2011. Total observations come to 20 firms * 5 years = 100 observations.

Table : Descriptive statistics of sample companies

Variables

Observations

Mean

Std. Dev.

Min

Max

ROTA

100

0.2304

0.9731

-0.2182

9.64

CCC

100

200.48

708.69

-303

4807

INV

100

59.35

47.21

0

224

AR

100

377.66

1371.36

19

9666

AP

100

236.57

678.94

3

4867

LOS

100

7.3392

1.2055

5.5524

9.6541

LEV

100

0.2365

0.3706

0

3.6734

Source: STATA output from financial statements of sample companies, 2007-2011

ROTA = return on Assets; CCC = number of days of Cash Conversion Cycle; INV = number of days of inventories; AR = number of days of Accounts Receivables; AP = number of days of Accounts Payables; LOS = Natural Logarithm of Sales; LEV = Financial Debt Ratio

The interpretation of the Descriptive statistics is as follows:

The credit period given by these firms to their customers ranged on an average at 378 days with a standard deviation of 1371 days. This means that the minimum time that these firms take to collect the receivables is 19 days and maximum 9666 days. In addition, the firms themselves take an average of 237 days to settle their bills to suppliers and a standard deviation of 679 days. On the other hand, inventories took an average of 59 days to be sold and a standard deviation of 47 days. Overall the Cash Conversion cycle is ranged at an average of 200 days which indicates the average firm collects from their customers 200 days before paying the suppliers.

The average size of a firm is 7 as measured by its natural logarithm of its total turnover while the standard deviation is 1.21. The maximum value of log of sales for the company in a year is 5.55 and the minimum is 9.65. The mean debt ratio is 23.65%.

4.3 Correlation analysis

The correlation analysis describes the relationship between variables of the study. In this study of the relationship between working capital management and the profitability of a firm, the Pearson correlation analysis will be used. Besides, researchers such as Deloof (2003), Kesseven Padachi (2006), Mathuva (2009), Gill et al (2010) and Enqvist et al (2010) have used the Pearson correlation in their studies.

Table : Correlation analysis

ROTA CCC INV AR AP LOS LEV

ROTA 1.0000

CCC -0.0287 1.0000

INV 0.0665* -0.1064* 1.0000

AR -0.0362 0.9802* -0.2015* 1.0000

AP -0.0386 0.9289* -0.2264* 0.9828* 1.0000

LOS 0.1534* 0.1113* 0.1199* 0.1138* 0.1220* 1.0000

LEV -0.0139 -0.0313 0.1396* -0.0385 -0.0352 -0.0018 1.0000

*Correlation is significant at 0.05 level

ROTA = return on Assets; CCC = number of days of Cash Conversion Cycle; INV = number of days of inventories; AR = number of days of Accounts Receivables; AP = number of days of Accounts Payables; LOS = Natural Logarithm of Sales; LEV = Financial Debt Ratio

The interpretation of the Pearson correlation analysis is as follows:

There is a negative relation between the Return on Assets (ROTA) and the working capital components (number of days accounts receivable, accounts payables and cash conversion cycle except inventories). This finding is consistent with the research of Deloof (2003) and Raheman and Nasr (2007). The result of the correlation analysis shows a significant negative coefficient (-0.0362) between Accounts Receivables and ROTA. This means that if the number of days of AR increases, the profitability of the company will decrease. The next correlation results indicate a positive and significant coefficient between inventories and ROTA. This means that if companies take short period of time to sell their inventories, the profitability will consequently increase.

Moreover, there is a significant coefficient of (-0.0386) between AP and ROTA. An explanation according to Deloof (2003) is that firms wait too long to pay their suppliers. Early payment to suppliers might increase the profitability of the company due to large discounts for punctual payments. On the other hand, cash conversion cycle and ROTA also have a negative but insignificant coefficient of -0.0287. This demonstrates that the time lag between the expenditure for the purchases of raw materials and the collection of sales of finished goods can be too long, and that decreasing this time lag increases profitability of the companies (Deloof, 2003). The analysis further shows a significant positive correlation between natural logarithm of sales which is used to measure the size of the firm and the profitability (ROTA). Its coefficient correlation is

0.1534. This implies that as size of the firm increases, it will increase its profitability and vice versa (Dong and Su, 2010). The results show that the financial debt ratio (LEV) has a significantly negative correlation (-0.0139) with the profitability, indicating that an increase in debt is associated with a decrease in the profitability of the firms.

Although the Pearson correlation analysis shows the relationship between the variables however, it does not identify the causes from consequences (Shin and Soenen, 1998; Deloof, 2003; Mathuva, 2009; Dong and Su, 2010). The Pearson correlation does not provide a reliable indicator of association in a manner which controls for additional explanatory variables. According to Mathuva (2009), it is hard to determine whether a shorter accounts collection period leads to higher profitability or a higher profitability is as a result of the short accounts receivable period. Hence, regression analysis is carried out in the next in order to determine the impact of working capital management on corporate’s profitability

4.3 Regression analysis

The regression analysis is used in order to investigate the impact of working capital management on the profitability of firms. In order to do the regression, the determinants of corporate’s profitability is estimated by pooled Ordinary Least Square (OLS). This analysis is consistent with the work of Mathuva (2009) and Deloof (2003). This analysis is conducted for comparison purposes. The impact of working capital management on the profitability is modeled by using the following regression equations:

ROTA= f (AR, INV, AP, CCC, LOS, LEV, λ)

ROTAit = β0 + β1 ARit + β2 LOSit + β3 LEVit + βt λit + εi (Model 1)

ROTAit = β0 + β1 INVit + β2 LOSit + β3 LEVit + βt λit + εi (Model 2)

ROTAit = β0 + β1 APit + β2 LOSit + β3 LEVit + βt λit + εi (Model 3)

ROTAit = β0 + β1 CCCit + β2 LOSit + β3 LEVit + βt λit + εi (Model 4)

ROTA=the Return on Assets; LOS=the company’s size measured by the natural logarithm of sales; LEV=the financial debt ratio; INV=the number of days of inventories, AR=the number of days of accounts receivables; AP=the number of days accounts payables; CCC=the number of days of cash conversion cycle, λ=the time dummy variable; β0=Beta; Subscript i=firms (cross section dimensions) ranging from 1–20; t=years (time-series dimension) ranging from 2007 to 2011 and ε= the error term.

Table : Ordinary Least Square Regression

Model 1

Model 2

Model 3

Model 4

AR

Coefficient

P-value

t-statistic

Prob > F

-0.00004

0.589

-0.54

0.4556

INV

Coefficient

P-value

t-statistic

Prob > F

0.00107

0.614

0.51

0.4624

AP

Coefficient

P-value

t-statistic

Prob > F

-0.00008

0.564

-0.58

0.4485

CCC

Coefficient

P-value

t-statistic

Prob > F

-0.00006

0.645

-0.46

0.4700

LOS

Coefficient

P-value

t-statistic

0.12885

0.119

1.57

0.11878

0.150

1.45

0.