Traditionally Focus Of Corporate Finance

Published Date: 02 Nov 2017

IMPACT OF WORKING CAPITAL MANAGEMENT ON CORPORATE PROFITABILITY: AN EMPIRICAL STUDY OF NON-FINANCIAL LISTED FIRM LISTED ON KARACHI STOCK EXCHANGE PAKISTAN

Name: MUHAMMAD WAQAS KHAN

Roll No: MBE-O9-16

SESSION: 2009-2012

Supervisor: ASSIT. Prof. DR NADEEM AHMAD SHEIKH

Institute of Management Sciences

Bahauddin Zakariya University Multan

DEDICATION

I dedicated this study to my adoring parents and my admirable teacher Dr. Nadeem Ahmad Sheikh. Without their knowledge, wisdom, and guidance, I would not be able to complete it…………….

ACKNOWLEDGMENT

First of all, I am thankful to almighty ALLAH who gives me courage and patience to complete this project. This research has been carried out under the kind supervision and guidance of Dr. Nadeem Ahmad Sheikh, Institute of Management Sciences, Bahauddin Zakariya University, Multan. I would like to express my profound gratitude and special thanks to our project supervisor Assistant Professor Dr. Nadeem Ahmad Sheikh, who generously helped in the accomplishment of this research. I look him as a source of encouragement thr`oughout the work and found him a helping hand in overcoming all the hurdles during the research work. Finally, I wish my entire colleagues, friends and my family members who extended their invaluable support during working on this project.

M. Waqas Khan

CERTIFICATE

The project report entitled "IMPACT OF WORKING CAPITAL MANAGEMENT ON CORPORATE PROFITABILITY: AN EMPIRICAL STUDY OF NON-FINANCIAL LISTED FIRM LISTED ON KARACHI STOCK EXCHANGE PAKISTAN at IMS-BZU MBA (3.5) / MS conducted by M.Waqas Khan Roll No. MBE-09-16, Registration No. 2007-ly Session 2009-12 has been completed under my guidance and I am satisfied with the quality of student’s research work.

Supervisor,

Dr. Nadeem Ahmad Sheikh

Date: ________________

ATTESTATION OF AUTHORSHIP

I, M. Waqas Khan Roll No. MBE-09-16 Registration No. 2006-duc-12. A student of IMS MBA (3.5) /MS Program in B.Z. University, solemnly declare that my Research Report entitled

"IMPACT OF WORKING CAPITAL MANAGEMENT ON CORPORATE PROFITABILITY: AN EMPIRICAL STUDY OF NON-FINANCIAL LISTED FIRM LISTED ON KARACHI STOCK EXCHANGE PAKISTAN" Is my own work and that, to the best of my knowledge and belief, it contains no material previously published or written by another person. This report is not submitted already and shall not be submitted in future for obtaining a degree from same or another University or Institution. If it is found to be copied/plagiarized at later stage of any student enrolled in the same or any other university, I shall be liable to face legal action before Unfair Mean committee (UMC), as per BZU/HEC Rules and Regulations, and I understand that if I am found guilty, my degree will be cancelled.

Signature

Name: M.Waqas Khan

Program: MBA( 3.5)/MS

Table of Contents

Introduction

Overview:

Traditionally the focus of the corporate finance literature is on the study of long term financial decisions. Previously the major focus of many studies is on the investment decisions, firm capital structure, and dividend and company valuation. But in real the investments that company made in the acquisition of the current assets and the resources having less than one year maturity represents the major portion in the balance sheet. Working capital management is crucial because of its impact on the firm profitability and firm value(García-Teruel and Martínez-Solano 2007). In today environment when global competition is eroding the prices of the products and the firm margins are getting lower and lower due to price competition and increase in the prices of inputs, firms required cash for the expansion of the business at national and international level or to acquire new technology or in order to pay the outstanding debts. There are many companies using working capital management as a competitive advantage tool in order to enhance the corporate profitability(Ching, Novazzi et al. 2011). Managing working capital effectively and efficiently is essential for most firms. In context of this study working capital management refers to the management of short term assets and short term liabilities of the firm. By definition working capital is the difference between the current assets and current liabilities commonly known as net working capital management. Short terms assets are the major investments of the most firms represented in the company balance sheet. The current financial distress and world- wide recession brought more focus of the firms in the management of the short term assets and other short term resources which possesses less than one year maturity(Abuzayed 2012). The components of working capital consist of account receivables, accounts payables, inventory and cash is required to be used efficiently and effectively for day to day operations of the company. The working capital requirement may also be reduced by optimal use of working capital resources, which in turn leads to enhance cash available to the firms(Gill and Biger 2012). There are growing numbers of companies which are taking working capital management as a strategic tool to enhance the corporate profitability as in the case of Dell Corporation; dell provides quality products at low costs(Ching, Novazzi et al. 2011). Extensive investments in company short term assets and global competition inflamed the importance of the working capital management in companies and stimulates the researcher’s and practitioner’s attention. Some researchers and practitioners believes in efficient use of short term resources is essential during the booming economic periods and can be strategically managed in order to enhance the corporate profitability and the competitive position of the company while others believe in that it is more important in the economic downturn as compare to economic boom period(Abuzayed 2012).

Prior studies reveals that working capital management impacts directly on the corporate profitability, firm liquidity and the solvency of the firm (Enqvist, Graham et al. 2011). In case of firm profitability it helps firms to reduce costs by reducing inventory levels or by limiting the credit policies. Liquidity of the firm is affected if the firm invests in the less liquid assets and it becomes difficult for the firm to meets its short term obligations. If in the long run the firm unable to meets its obligations due to shortage of liquid assets then it can creates solvency problems.

1.2 Motivation of study:

Much of empirical research regarding the impact of working capital management on firm profitability made using the data derived from developed countries whereas no has attention been paid to explore the issue using the data of firms in developing economies. And less literature is available about working capital management and its impact on corporate profitability of Pakistani firms. In the previous studies conducted in Pakistan relevant to this topic unable to explain in depth about the working capital management and its impact on profitability. There is substantial gap in the previous studies conducted in Pakistan which this study seeks to fill.

1.3 Objectives of study:

The prime objective of this study is to explore whether the working capital management affect the profitability of non-financial firms listed on the Karachi Stock Exchange Pakistan.

1.4 Unique points of the study:

The prior studies were mostly conducted in the developed economies and the less attention has been paid in the developing countries like Pakistan. In order to bridge the gap in the literature this study looks at the issue from developing economy by focusing on firms listed on Karachi stock exchange (KSE) in Pakistan. Latest data sets from 2006 to 2011 have been used to analyze the impact of working capital management on corporate profitability of non-financial listed firms in Pakistan. This study will prove to be a milestone for future researchers on working capital and its impact on corporate profitability of the companies. This study defines the return on assets which is dependent variable as ratio of net profit after tax to total assets. Another dependent variable Earnings per share is defined as the ratio of net profit after tax to outstanding shares of common stock. The independent variables include average age of inventory, average collection period, average payment period, operating cycle and cash conversion cycle. Firm size and leverage are used as control variables. The results show statistically significant and negative relationships between return on assets and average age of inventory, average collection period, average payment period and operating cycle. The results show significant and positive association between return on assets and cash conversion cycle.

The organization of this study is as follows. Section 2 exhibits selected previous studies, Section 3 reveal data and methodology. Section 4 demonstrates the regression results, Section 5 contains discussion on empirical results, and finally, the overall conclusions and suggestions are given in Section 6.

Literature review:

Theoretically the concepts regards the working capital management may be very simple and easy but in reality it is very difficult for the firms to manage its working capital and many financial executives’ struggles to find the optimum level of working capital components and the key drivers of the working capital. There incompetency regarding the working capital requirements and its impact on the profitability, and the lack of ability to plan and control working capital components may leads firms towards bankruptcy(Gill 2011).

Working capital management deals with the management of the current assets and the current liabilities and the interrelationship between them and if the firm fails to maintain the satisfactory level of the working capital then it is more likely that the firm become insolvent may forced to the bankruptcy(Abuzayed 2012). So the firm should hold the optimum level of the current assets to ensure a reasonable safety margin against the short term liabilities.

Working capital is a trading capital and it is not retain in the business for more than one year. Working capital fulfills the short term needs of the business and in business it is just like a circulation blood in the human body which is very necessary for the life, in business the flow of the capital is necessary to efficiently run the business and generating profits. And if it becomes weak then it will be difficult for the business to prosper or survive. In adequate working capital is a major reason of the failure of many businesses(Padachi 2006)

Working capital management is an important area of corporate finance and managing short term assets and resources is as equally important as managing long term assets and resources, the administration of short term resources have an significant affect on the corporate profitability and the liquidity of the firm(Shin and Soenen 1998; Deloof 2003; García-Teruel and Martínez-Solano 2007; Mathuva 2009). So the firm has to choose from the two basic types of the working capital strategies in order to optimize its profits by making a tradeoff between the expected profitability and the risk before deciding the optimal level of the investments in the current assets.

To maximize the shareholders value Corporations may have an optimal level of working capital. Hefty inventory and liberal trade credit policy may direct to high sales. The superior inventory also reduces the risk of a stock-out. Trade credit may increase sales because it allows a firm to access product quality before paying. Another component of working capital is accounts payables. Raheman and Nasr (2007) state that delaying payment of accounts payable to vendors allows firms to access the quality of bough products and can be inexpensive and flexible source of financing. On the other hand, delaying of such payables can be expensive if a firm is offered a discount for the early payment. By the same token, uncollected accounts receivables can lead to cash inflow problems for the firm. (Long, Malitz et al. 1993; Raheman and Nasr 2007)

A well known measure of working capital management is the cash conversion cycle, that is, the time taken between the expenditure for the purchases of inventory and the collection of sales of finished goods. Deloof (2003), for example, found that the longer the time lag, the larger the investment in working capital. A long cash conversion cycle might increase profitability because it leads to higher sales. However, corporate profitability might decrease with the cash conversion cycle, if the costs of higher investment in working capital rise faster than the benefits of holding more inventories and/or granting more trade credit to customers(Deloof 2003).

Aggressive working capital policies leads to minimize working capital investments would improve the profitability of the firm by reducing the total assets in shape of current assets but if the firm reduces the amount of inventory too much than this shortages may leads firms to lose sales from those customers who requires credit(García-Teruel and Martínez-Solano 2007).

On the other side if the firm adopts the conservative working capital policies and investing heavily in the current assets, it may also result in the higher profits. In that situation firm holds too much inventory reduces the cost of possible interruptions in the production processes and loss of customers due to shortages of the products, it will reduce the cost of supply and saves firm from the price changes. Firm can extend more credit to the customers and the trade credit act as an effective price cut tool and these incentives helps firm to increase its sales and strengthen its relationships with the customers. But these incentives will reduce the profitability because of increase in the investments in the current assets.

Deloof (2003) states that the investments that the firms made in the acquisition of the short term assets represents the major portion in the balance sheet of the most companies and the way in which the firm manages its working capital will have a significant impact on the firm profitability. His empirical results also indicates that there is a significant negative relationship among the average age of inventory, average collection period, average payment period and corporate profitability of the Belgian firms. And on basis of his findings he suggests that the firms should maximize its corporate profitability by using optimum level of inventory and trade credit.

García-Teruel and Martínez-Solano (2007) conducted a study of 8872 Spanish firms to find out the impact of working capital management on the corporate profitability of the small and medium sized firms for the period 1996-2002. Their results indicates that profitability can be increased by shortening the operating period by reducing the inventory levels and by shortening the period of credit sales.

Prior studies like (Jose, Lancaster et al. 1996; Shin and Soenen 1998; Lazaridis and Tryfonidis 2006; Raheman and Nasr 2007) stated that there is a significant relationship between the working capital management and corporate profitability, they measured working capital management with cash conversion cycle. They revealed that heavy investments in the working capital reduces the corporate profitability due to the longer cash conversion cycle(Baños‐Caballero, García‐Teruel et al. 2010).

Falope and Ajilore (2009) on other hand conduct their research using a sample of 50 Nigerian quoted non-financial firms for the period 1996 -2005. Their study utilized the panel data econometrics in a pooled regression, where the time-series and cross-sectional observations were both merged and estimated. They found a significant negative relationship between net operating profit and the receivable days, inventory turnover days, payable days and the cash conversion cycle. Furthermore, they found no significant variations in the effects of working capital management between large and small firms. This observation contradicts the ideologies (García-Teruel and Martínez-Solano 2007)

Petersen and Rajan (1997) elucidated that, trade credits can also play an important role by effective price cutting and act as motivation to customers to acquire merchandise at times of low demand. As the suppliers may have significant advantages on cost on the financial institutions for providing credit to their customers, it can also be a cheaper source of credit for customers(Petersen and Rajan 1997) by (Deloof, 2003, p.2). The other side of granting trade credit and storing inventories is that, the money is tied up in the form of WC. However, firms that usually devote heavily in the inventory and account receivable can suffer from lower profits. Thus, the greater the investment in CA, the lower the risk, and hence, profitability would be obtained. Another component of WC is accounts payable. On one hand, delaying in payments for suppliers allows a firm to assess the quality of the purchased products and it can be an inexpensive and flexible source of financing for the company. On the other hand, late payment of invoices might be very costly if the firm is offered an early payment discount. In fact, the opportunity cost might surpass 20% depending on the percentage of discount percentage for the period granted Wilner (2000).

Another researcher (Svensson 1997) agreed Wilner’s statement by saying that, 75% of the firms at Belgian offered an average early payment discount of 3%. For all European firms in his survey, the average PD was 61 days and 54% of the firms offered a discount of 4%. An important measure of WCM is the CCC, which can be outlined as, the time difference between the expenditure incurred on the purchase of inventory, the collection from the receivables and the payment of the payables. The longer this time difference is; the larger is the investment in the WC. A longer CCC might increase profitability because it leads to higher revenues and thereby increasing the profitability and this statement contradicts the observation made by (Falope and Ajilore 2009). The three different components of CCC are accounts are; ITR, PD and RD, which can be managed in different ways so as to maximize the profitability or to enhance the growth of the company(Shin and Soenen 1998)

Uyar (2009) investigate the fact that, cash conversion cycle has a negative relationship with the Return on Assets and no connection among the Return on Equity ratio and he also emphasized on the fact that firms with shorter cash conversion cycle have more profitability than firms with longer cash conversion cycle.

Wang (2002) find out that if there is any fairly relationship between liquidity management and company profitability and value for Japanese and Taiwanese firms for the period of 11 years. His outcome showed that, a negative significant bond was observed between the cash conversion cycle and corporate profitability. In addition he believes that, a well-built liquidity management caused by decreasing the cash conversion cycle would create improved company performance and affect the value of the corporation, and it would increase as a result.

To examine the impact of current ratio and the cash conversion cycle on the corporate profitability and the liquidity (Eljelly 2004) conduct a study of 929 joint stock companies listed in the Saudi Arabia. After employing regression and the correlation analysis he founds significant negative relationship between the corporate profitability and the liquidity as measured by the current ratio. He found significant relation between the firm size and the corporate profitability at the industrial level. He also found the at the industry level the cash conversion cycle tan the current ratio as a measure of the liquidity that affects the corporate profitability.

Raheman and Nasr (2007) select a sample of 94 firms listed on the Karachi stock exchange Pakistan for the period 1999-2004 in order to investigates the impact of different working capital components (average age of inventory, average payment period, average collection period, cash conversion cycle and current ratio ) on the corporate profitability. They find out that cash conversion cycle has inverse relationship with the firm profitability and that managers can enhance shareholder value by reducing the cash conversion cycle time.

Mathuva (2009) conducted a study consisting of a sample of 30 firms listed on the Nairobi Stock Exchange Kenya for the period 1993-2008. And to investigate the impact of working capital management components on the corporate profitability he used Pearson and Spearman’s correlation matrix, the pooled OLS and the fixed effects regression modes. His results indicates the significant positive association between the fir profitability and the average age of inventory, average payment period and the significant negative association between the average collection period, cash conversion cycle and the corporate profitability.

The above mentioned studies provide solid foundations on basis of which our study is based on and the ideas to investigate the impact of the working capital management on the corporate profitability can easily be understand from the view points of these researchers. Their understandings help us to develop the current framework.

2.1 Inventory

Inventory is define as inventories are lists of stock raw material, work in progress or finished goods which are waiting to be used in production or to be sold. Inventory reflects the average number of days of stock held by a company. More storage the value, the more firms take to balance their payment commitment to their supplier. Inventory management in a multinational setting Is more complex than In a purely domestic setting because of logistical problems that arise with handling inventories. The no of days of inventory was calculated as (inventory/cost of goods sold)*360 (García-Teruel and Martínez-Solano 2007)This variable reflects the average no of days of stock held by the companies. Longer storage times show a greater investment in inventory for an important level of operation. Large inventory and generous trade credit policy may lead to higher sales and greater inventory decrease the risk of stock out. Trade credit may increase sales because it allows customers to reach product quality before paying (Deloof and Jegers 1996), because supplier may have significant cost advantages over financial institution in achieving credit to their customers. It can also be cheaper source of credit for customers (Petersen and Rajan 1997) The source of granting trade credit and keeping inventories is that money is saved in working capital. Reducing stock produces large financial benefits by continuously increasing cash flow, decreasing operating cost level, lowering the asset base and decreasing capital spending.

2.2 Account Receivable

Account receivable is customers who are not yet payment for goods or service, which the company has, perform. The main purpose of debtor management is to decrease the time laps among completion of sales and collect of payment. If you ask financial managers whether they would prefer to sell their products for cash or for credit, you would expect them to respond by saying something like this if sales levels are not affected, cash sales are preferred because payment is certain and immediate and because the costs of granting credit and maintain accounts receivable would be eliminated. Ideally then firms would prefer to sell for cash only. Average collection period calculate of the average size of time it takes customer to pay off their credit purchases. According to (García-Teruel and Martínez-Solano 2007) number of days account receivable is measures as (account receivable/sales)*365. This variable shows the average no of days that the firm takes to receive payment from its customer, the larger the value, the larger its investment in account receivable. Firms would, in general, rather sell for cash than on account, but competitive pressures force most companies to offer credit. Receivable management starts with the decision of whether or not to grant credit.

2.3 Account Payable

Account payable is defining as the supplier whose invoices for goods or services have been processed but who have not yet been paid. Statements about the flexibility, cost, and riskiness of short term debt versus long term debt depend, to a large extent, on the type of short term credit that actually is used short term credits measure as any liability for payment within one year. Accrual improves increase automatically, as a firms operation expand. According to (García-Teruel and Martínez-Solano 2007) the no of days account payable reflects the average time it brings firms to pay their supplier. This was measured as account (payable/purchase)*365. The larger the value the higher firms take to maintain their payment commitment to their supplier. Delaying payments to suppliers allows a firm to reach the quality of the products budget and can be cheaper and flexible sources of financing for the firms. Delaying payment of invoices can be very expensive if the firm is offered a discount for early payment. In a 2001 survey by the institute for credit management of the Vlerick Leuven Ghent School for management of trade credit policies of Belgian companies, it was showed that the median Belgian companies offered a 2/10n30 discount for quickly payments. Fisman and Love (2001) demonstrate that trade creditors reduce weak creditor protection and imperfect information better than formal lenders and find that firms in countries with low developed financial markets use informal credit provided by their supplier to finance growth. Account payable or trade credit, is the highest single type of short term debt, indicating about 40 percent of the current liabilities of the average non- financial firms. Trade credit is a spontaneous source of financing in the sense that it increases form ordinary business transaction.

2.4 Profitability

Choiu et al, (2006) and Wu (2001) showed that a firm’s return also affects measures of working capital management. First, Wu (2001) showed that the working capital requirement and the performance of the firm have mutual effects, subsequently, Chiou et al, (2006) found that the return on assets (ROA) has a negative influence on calculate of working capital management. This can be explained in two ways. First, as companies with good performance can get outside capital more easily, they can invest in other large profitable investments (Chiou et al., 2006). According to (Shin and Soenen 1998), firms with greater returns have good working capital management because of their market dominance, because they have larger bargaining power with supplier and customers. (Petersen and Rajan 1997)also showed that companies with higher profitability receive significantly more credit from their suppliers. Thus, the variable return on assets, which is calculated by the ratio earnings before interest and tax over total assets, was introduced into the analysis and it is expected that this factor will have a negative effect on the cash conversion cycle.

2.5 Size of the firms

Size was calculated as the logarithm of assets. Chiou et al., (2006) demonstrate that the working capital requirement has greatly affects on size of firms. This is may be due to cost of funds which is invested in short term assets decrease with the size of firms, as low level companies have large information asymmetries (Jordan et al., 1998; Berger et al., 2001), high level information power (Berger and Udell, 1998) and that are not adopted by analysis. If we see the tradeoff theory, they have a high rate of bankruptcy, because firms tend to be more diversified and less chances of failure. Which is affect on trade credit granted, because to (Petersen and Rajan 1997), companies have good capital market which improve trade credit. In addition the average firm size has positively affected the trade credit improving. WHITED (1992)and Fazzari and Petersen (1993) demonstrated that smaller firms have larger financial problems, which also can improve their trade credit received, because they use that type of credit when other forms are not available (Petersen and Rajan 1997) or had already been exhausted ( (Petersen and Rajan 1997); (Cunat 2007)). In particular the cost of funds invested in current asset is very low in lower firms so that why they have might lower account receivable and inventories. Moreover, these types of firms use higher credit from their supplier. It is estimated that, as in previous research, size will affect the firm’s performance. This factor is calculated by the variable size defined as the natural logarithm of assets.

2.6 Leverage

The expenditure of the finances invested in the cash conversion cycle is superior in firms with high leverage, because in accordance with theories, they have a superior risk premium. Prior empirical evidence shows, a reduction in the measure of working capital management when firms get better their leverage (Chiou et al., 2006). Therefore, it indicated a negative association between the leverage ratio and cash conversion cycle. Leverage is calculated as the ratio of the total debts to total assets.

Data, Variables and Methodology:

3.1 Data:

This study investigates the impact of working capital management on profitability using the data of non- financial firms listed on the Karachi Stock Exchange (KSE) Pakistan during 2006-2011. For this purpose the data was taken from the annual reports. In Pakistan, every company is bound to prepare its financial statements in accordance with approved accounting standards. These standards are generally known as International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). The sample consists of 76 companies for the period 2006-2011. The description of the companies according to the classification of State Bank of Pakistan in relation to their affiliation with different industrial groups is given in the below table.

Table: 3.1: sector-wise distribution of sample firms

Number

Sector

Companies

%

1

Cement

8

10.53

2

Chemicals

13

17.12

3

Engineering

12

15.79

4

Fuel & energy

8

10.53

5

Others(tobacco, jute, miscellaneous)

13

17.12

6

Paper &Board

3

3.95

7

Sugar & allied

3

3.95

8

Textile

16

21.01

Total

76

100%

3.2 Variables:

Variables are selected on basis of the research objectives and their definitions are opting from the existing literature and previous empirical studies in order to assure comparison with previous empirical researches. In this study we take return on assets () and earnings per share () as dependent variables. The dependent variables are taken as a proxy for the corporate profitability. The independent variables are average age of inventory (), average collection period (), average payment period (), operating cycle () and cash conversion cycle (). The control variables are size () and the leverage (). The definitions of the variables are given in the below mentioned table.

Variables

Definition

Dependent

Return on Assets ()

Ratio of Net profit after tax to Total assets

Earnings per share ()

Ratio of Net profit after tax to outstanding shares

Independent

Average Age Of Inventory ()

360 to inventory turnover

Average Collection Period ()

Ratio of Trade Debtors to average credit sales per day

Average credit sales per day = (credit sales / 360)

Average Payment Period ()

Ratio of Accounts payable (Creditors) to average credit purchases per day.

Average credit purchase = (Cr. Purchases / 360)

Operating Cycle ()

Average Age of inventory plus Average collection period

Cash Conversion Cycle ()

Operating cycle less Average Payment Period

Control

Size()

Natural log of sales

Leverage()

Ratio of Total Liabilities to total Assets

3.3 Methodology:

This study investigates the impact of working capital management on the profitability of the firms in context of non-financial firms listed in Karachi stock exchange Pakistan, this study is based on secondary data collected from annual reports of the firms. The sample size is of 76 firms listed in Karachi stock exchange. For the sake of the study database was developed from the annual reports from the concerned firms and the historical database of the Karachi stock exchange for the period 2006-2011. Firms were selected on basis of availability of data and only those firms are selected whose data was available for the restricted period 2006-2011. The convenient sampling technique has been used as the data of as much firms was easily available that include in the sample. The regression analysis has been done in this study. By using this regression model each variable is being added to the model in view of estimation power over the dependent variable. Every time the variable enters in to the model, all the others are reexamined and some variables restricted out of study due to negative values. Data for this research was collected from the websites of the concerned firms and from the Karachi stock exchange websites, some companies also helps us by sending their missing annual reports in this study.

3.4 Model

In this study we employed panel data analysis procedures because the sample contained data across firms over time. The use of panel data increases the sample size considerably and is more appropriate for this type of study to study the dynamics of change. A panel econometric technique namely ordinary least squares (OLS) is used to investigate the most significant factors that can affect the firm’s profitability. Accordingly the basic regression equation is expressed as

i = 1,…………………,76; t = 1,…........,6

Where i stands for the ith cross sectional unit and t for the tth time period. is performance measure for the ith firm at time t and is the intercept. is a 1* K vector of observations on K explanatory variables for the ith firm in the tth period, is a K *1 vectors of parameters, it is a disturbance term and is defined as

Where denote the unobservable individual effects and denote the remaining disturbance. The description of three estimation models (i.e., pooled OLS, fixed effects and random effects) is given in the below equations.

Where is return on assets for the ith firm at time t, is the average age of inventory of ith firm for time t, is the earning per share for the ith firm at time t, is the average collection period for the ith firm at time t, is the average payment period, is the operating cycle for the ith firm at time t, is the cash conversion cycle for the ith firm at time t, is the sales growth for the ith firm at time t, is the leverage of the ith firm at time t. 0 is the intercept , is the random error term for the ith firm at time t, 1 – 3 are the coefficients of the concerned variables. In the above equations the and are the dependent variables,, , , and are independent variables, and are control variables for the ith firm at time t.

Empirical Results

4.1 Descriptive statistics:

Table 4.1 shows the descriptive statistics for all the regression variables. This table shows the average indicators of variables computed from the financial statements of the sample companies. This table presents the mean, standard deviation, minimum value and maximum values of the given variables. Mean is the measure of the center of tendency and it shows the average of the variables or central value. Standard deviation is the measure of dispersion; it indicates the possible variations in the data from mean value. Minimum and Maximum values indicates the highest and the lowest values of the variables. These results indicates some huge variations in average age of inventory, average payment period, operating cycle and cash conversion cycle. These variable having higher standard deviations and possesses some outliers. This may occur because of different sectors different credit policies and inventory policies. Another reason of that problem is the small sample size for limited time period.

Table: 4.1

Variables

Observations

Mean

Std. deviation

Minimum

Maximum

456

0.0704

.0850

-0.2300

0.4400

456

18.4820

39.0510

-89.3700

306.8700

456

95.4542

68.9388

0.7000

1025.7000

456

31.4833

41.3157

0

324.9900

456

169.8741

229.2036

5.0400

1882.6600

456

126.9375

75.1865

12.8600

1031.4300

456

-42.9369

248.4238

-1833.2800

940.5400

456

22.5904

1.4897

18.6100

27.4300

456

0.5652

0.1952

0.0300

0.9999

4.2 Correlation of variables:

In this study we test for the possible degree of multi-co linearity among the variables in Table 4.2. Earnings per share show significant positive correlation with return on assets. Average age of inventory shows significant negative correlation with return on assets, it shows negative correlation with earnings per share but relation is insignificant. Average collection period shows negative significant correlation with return on assets and average age of inventory, its correlation with earnings per share is negative but the relationship is insignificant. Average payment period shows negative significant correlation with return on assets, earnings per share and average age of inventory, its correlation with average collection period is negative insignificant. Operating cycle shows negative significant correlation with return on assets and average payment period, it shows positive significant correlation with average age of inventory and average collection period. Cash conversion cycle shows positive significant correlation with average age of inventory, average collection period and operating cycle, its correlation with return on assets and earnings per share is also positive but it is insignificant. Cash conversion cycle shows negative significant correlation with average payment period. Firm size shows positive significant correlation with return on assets, earnings per share, average collection period, average payment period, operating cycle and negative significant correlation with average age of inventory and cash conversion cycle. Leverage shows negative significant correlation with return on assets, average age of inventory, operating cycle and cash conversion cycle, however its correlation with average collection period, average payment period and size is positive significant.

Table: 4.2

Var.

1.0000

0.4918***

1.0000

-0.0929**

-0.0637

1.00000

-0.1382***

-0.0327

-0.1416***

1.0000

-0.1254***

-0.1065**

-0.0791*

-0.0542

1.0000

-0.1611***

-0.0764

0.8391***

0.4197***

-0.1023**

1.0000

0.0669

0.0752

0.3270***

0.1770***

-0.9536***

0.3971***

1.0000

0.1500***

0.2016***

-0.3371***

0.1149**

0.2242***

-0.2460***

-0.2813***

1.0000

-0.4072***

-0.0627

-0.2182***

0.1637***

0.1040**

-0.1101**

-0.1293***

0.1900***

1.0000

4.3 Regression results:

Pooled OLS estimation model is used to analyze the impact of key explanatory variables such as average age of inventory, average collection period, average payment period, operating cycle, and cash conversion cycle on firm profitability (i.e. return on asset and earnings per share) whereas leverage and firm size used a control variables in the model. In this study we use two proxies for corporate profitability return on assets and earnings per share. Table 4.3 to 4.7 indicates the impact of explanatory variables on return on assets and from table 4.8 to 4.12 earnings per share is taken as dependent variable. The results presented in table 4.3 indicate that average age of inventory is highly significant and negatively related to return on assets. The negative relationship indicates that as the average age of inventory increases the profitability of the firms declines. Firm size is also highly significant and is positively related to the return on assets. The positive relationship indicates the larger firms enjoy more profits as compare with smaller firms. However leverage is highly significant and is negatively related to the return on assets, the negative relationship suggests that the firms relying on more external debts are less profitable when compare with the firms which have less leverage. In the table 4.3 the other key indicators like the R2 and F- statistics are also quite satisfactory.

Table 4.3

Dependent variable:

Variables

Coefficient

Std. error.

t-statistics

Prob.

C

-0.0516

0.0582

-0.8861

0.3760

-0.0002

0.0000

-2.8982

0.0039

0.0112

0.0025

404836

0.0000

-0.2053

0.0184

-11.1549

0.0000

R2

0.2352

Mean Dependent Variable

0.0706

Adjusted R2

0.2301

F- statistic

4603253

S.E of Regression

0.0742

Prob.( F-statistic)

0.0000

The Table 4.4 indicates that the average collection period is also highly significant and is negatively related to the return on assets, it indicate that as the collection from the debtors is delayed than the firms needs to employ more capital to meet their current working capital needs due to which firms to spend more money on collection of debts and the chances of bad debts may increases and the profitability of the firms reduces.

Table 4.4

Dependent variable:

Variables

Coefficient

Std. error.

t-statistics

Prob.

C

-0.1304

0.0531

-2.4534

0.0145

-0.0002

0.0000

-2.3486

0.0193

0.0139

0.0024

5.8182

0.0000

-0.1901

0.0184

-10.3325

0.0000

R2

0.2303

Mean Dependent Variable

0.0706

Adjusted R2

0.2252

F- statistic

45.0914

S.E of Regression

0.0744

Prob.( f-statistic)

0.0000

Table 4.5 indicates that average payment period is also highly significant and is negatively related to the return on assets it indicates that the firm relying on delaying of payments to their suppliers facing financial problems and these may be because of delaying payments from debtors or it may be because of low sales.

Table 4.5

Dependent variable:

Variables

Coefficient

Std. error.

t-statistics

Prob.

C

-0.1535

0.0535

-2.8648

0.0044

-0.0000

0.0000

-3.2952

0.0011

0.0151

0.0024

6.2331

0.0000

-0.1924

0.0181

6.2331

0.0000

R2

0.2392

Mean Dependent Variable

0.0706

Adjusted R2

0.2342

F- statistic

47.3775

S.E of Regression

0.0740

Prob.( f-statistic)

0.0000

Table 4.6 indicates that the operating cycle is also highly significant and is negatively related to the return on assets, it indicates that as the operating cycle time is increasing the profitability of the firms decline and vice versa.

Table4.6

Dependent variable:

Variables

Coefficient

Std. error.

t-statistics

Prob.

C

-0.0468

0.0559

-0.8369

0.4031

-0.0002

0.0000

-3.8944

0.0001

0.0113

0.0024

4.6440

0.0000

-0.2011

0.0180

-11.1402

0.0000

R2

0.2462

Mean Dependent Variable

0.0706

Adjusted R2

0.2412

F- statistic

49.2206

S.E of Regression

0.0737

Prob.( f-statistic)

0.0000

Table 4.7 indicates that the cash conversion cycle is also highly significant and is positively related to the profitability. The increase in cash conversion cycle leads to maximize profits; it can be possible if the firm uses negotiated liability to meet the working capital need, due to which the company bears the explicit cost for the use of funds, explicit costs gives firms the tax advantage and the profits of the firm’s increases.

Table 4.7

Dependent variable:

Variables

Coefficient

Std. error.

t-statistics

Prob.

C

-0.01505

0.0552

-2.7257

0.0067

0.0001

0.0000

1.8900

0.0594

0.0146

0.0024

5.9234

0.0000

-0.1935

0.0183

-10.5752

0.0000

R2

0.2271

Mean Dependent Variable

0.0706

Adjusted R2

0.2219

F- statistic

44.2599

S.E of Regression

0.0746

Prob.( f-statistic)

0.0000

In this model we take earnings per share as a dependent variable and it indicates that average age of inventory has negative but insignificant relation with the profitability but in previous case with return on assets as a dependent variable the relationship was negative significant. So this model explains the negative relationship but insignificant results are not sufficient to explain the scenario.

Table 4.8

Dependent variable:

Variables

Coefficient

Std. error.

t-statistics

Prob.

C

-97.2449

29.9234

-3.2488

0.0012

-0.0079

0.0279

-0.2829

0.7774

506958

1.2856

4.4303

0.0000

-21.5392

9.4619

-2.2764

0.0233

R2

0.0515

Mean Dependent Variable

18.4956

Adjusted R2

0.0452

F- statistic

8.1860

S.E of Regression

38.1532

Prob.( f-statistic)

0.0000

Table 4.9 also indicates the negative relationship between the average collection period and profitability but its insignificant relationship is insufficient to explain the relationship.

Table 4.9

Dependent variable:

Variables

Coefficient

Std. error.

t-statistics

Prob.

C

-102.4122

27.2205

-3.7623

0.0002

-0.03997

0.0440

-0.9083

0.3642

5.9044

1.2265

4.8140

0.0000

-19.8473

9.4915

-2.1070

0.0357

R2

0.0531

Mean Dependent Variable

18.4956

Adjusted R2

0.0468

F- statistic

8.4478

S.E of Regression

38.1218

Prob.( f-statistic)

0.0000

Table 4.10 confirms the negative significant relationship between the average payment period and profitability with the results taken in table 4.5.

Table 4.10

Dependent variable:

Variables

Coefficient

Std. error.

t-statistics

Prob.

C

-116.7602

27.2965

-4.2775

0.0000

-0.0262

0.0079

-3.3019

0.0010

6.6625

0.0079

-3.3019

0.0000

-19.1148

9.2371

-2.0693

0.0391

R2

0.0737

Mean Dependent Variable

18.4956

Adjusted R2

0.0675

F- statistic

11.9889

S.E of Regression

37.7046

Prob.( f-statistic)

0.0000

Table 4.11 also indicates the negative but insignificant relationship between the operating cycle and profitability.

Table 4.11

Dependent variable:

Variables

Coefficient

Std. error.

t-statistics

Prob.

C

-93.2116

28.9583

-3.2188

0.0014

-0.0186

0.0246

-0.7562

0.4499

5.5890

1.2561

4.4497

0.0000

-21.5693

1.2561

4.4497

0.0000

R2

0.0526

Mean Dependent Variable

18.4956

Adjusted R2

0.0463

F- statistic

8.3588

S.E of Regression

38.1325

Prob.( f-statistic)

0.0000

Table 4.12 indicates the positive significant relationship between the cash conversion cycle and profitability.

Table 4.12

Dependent variable:

Variables

Coefficient

Std. error.

t-statistics

Prob.

C

-122.4656

27.9939

-4.3747

0.0000

0.0213

0.0075

2.8550

0.0045

6.7541

1.2566

5.3748

0.0000

-18.9332

9.2760

-2.0411

0.0418

R2

0.0682

Mean Dependent Variable

18.4956

Adjusted R2

0.0620

F- statistic

11.0222

S.E of Regression

37.8172

Prob.( f-statistic)

0.0000

Finally, on basis of our empirical results we take return on assets as a better proxy for corporate profitability because it gives us better understandings about our study.

Discussion on empirical results

This study investigates the impact of working capital management on the profitability of non financial companies listed on Karachi Stock Exchange (KSE) Pakistan during 2006-2011. Empirical results indicates that the average age of inventory, average collection period, average payment period and operating cycle are highly significant and negatively related with profitability. Cash conversion cycle is also significant but it is positively related with profitability.

The negative relationship between the average age of inventory and the profitability is consistent with the results found by (García-Teruel and Martínez-Solano 2007), (Abuzayed 2012), (Napompech), (Silva 2011), (Vahid, Elham et al. 2012), (Ching, Novazzi et al. 2011) and (Deloof 2003), (KARADUMAN, AKBAS et al. 2010) which indicates that as the average age of inventory increases the profitability of the firms diminishes because of high inventory holding costs. Investing heavily in the inventory can enhance the performance of the firm because of the availability of the raw material for production and firms also gets discounts from the vendors on purchasing in the bulk but in case of economic downturn or low sales the high inventories have adverse impact on the profitability of the firms. Another reason of negative relationship is that with the increase in the inventory levels and the average age of inventory may increase the pilferage costs or obsoleteness of the technology.

The negative relationship between the average collection period and profitability is congruent with results found by (García-Teruel and Martínez-Solano 2007), (Abuzayed 2012), (Napompech), (Deloof 2003), (Silva 2011), (Vahid, Elham et al. 2012) and (Ching, Novazzi et al. 2011), (KARADUMAN, AKBAS et al. 2010) which indicates that increase in average collection period leads to decrease in the profits, it may be due to that the customer wants more time to assess the quality of the product and to settle their dues with the firm. Lengthening the deadline to the clients for settlement of dues may also improve the profitability because of increase in the sales but it also negatively affects the profitability because of more capital required to meet the working capital requirements and it may also increases the amount of the bad debts. To improve the profitability firm should adopt restrictive credit policy and avoiding extensive credit to the customers. Trade credit received from the suppliers is a major source of working capital financing, and the firms with the low profits relying heavily on the trade credit from the suppliers in order to meet the working capital needs. In that case the firm should avoid offering extensive credit to these firms because of high credit risks. However, this empirical finding is conflicting with some trade credit theories; these theories prefer trade credit on the marketable securities due to high return. These theories suggest that profitable firms and highly liquid firms should transfer relatively high amounts in trade credit to customers, because liquidity theories demonstrates that liquid firm have less dependency on external credit but they have sufficient resources to offer it. Another similar empirical finding suggests that negative relationship between the average collection period and profitability may be the result of decline in the sales volume and increase in the inventory levels of the firms (Padachi 2006).

This study investigates the negative relationship between the average payment period and the firm profitability. It indicates that delay in settlement of dues with vendors leads to decline in the profitability. This empirical finding is consistent with the findings of (Abuzayed 2012), (KARADUMAN, AKBAS et al. 2010), (Padachi 2006), (García-Teruel and Martínez-Solano 2007), (Deloof 2003), (Silva 2011), (Vahid, Elham et al. 2012). In general there is a positive relationship between the average payment period and the profitability. But in this study the reasons of negative relationship may be, that the less profitable firms delay their payments to their vendors due to shortage of the cash(Abuzayed 2012). In long term they loosing trust and credit worthiness and their vendors limiting their credit limits, which in turn affect their production due to non availability of the materials. Another reason may be the low sales in which the firm has insufficient resources to meet their credit obligations with their suppliers due to which the profitability may be diminishes. Another possible reason for that negative relationship may the interest charge imposed by the vendors due to the inability of the firm to pay its outstanding amount within the admissible time period(Cheng, Lou et al. 2010). (Padachi 2006) explains the possible reason for the negative average payment period is the decreasing profitability, in that situation the decline in profits leads to the decline in cash generated by the companies from the operations and these firms relying on delaying payments to the suppliers.

Empirical results shows the negative relationship between the operating cycle and the profitability, in the operating cycle we analyze the cumulative impact of average age of inventory and the average collection period on the corporate profitability. The negative relationship between the operating cycle and the profitability indicates that profitability will reduce as the operating cycle time will be increased. So in order to maximize the profits the firm should reduces the inventory holding period and increase the inventory turnover. In order to increase the inventory turnover and reducing the average age of inventory the firm has to reduce its inventory levels and fix its consumption pattern. It requires strong coordination with the vender. The operating cycle can also be improved with the help of reducing the number of days of the credit sales or we can say by improving the collection period. In order to improve the collection period firm should impose credit restrictions or by minimizing the delaying payments from the debtors.

Empirical results also investigate the positive relationship between the cash conversion cycle and the profitability which is consistent with the prior empirical study by (Abuzayed 2012), (Gill, Biger et al. 2010). This indicates that the firms running in profits are less motivates to manage their working capital. These Firms are engaging in extending excessive trade credit or these firms hold excessive inventory level due to which their profitability erodes. Larger firms tends to extend more trade credit in order to increase the sales volume to enhance the profitability and to overcome the problem of stock out or getting the purchase discounts from the vendors they buy material in bulk. These bulk purchases reduce the inventory turnover and also increase the inventory holding and pilferage costs. Another reason is that the market failure to penalize these firms for inefficient use of short term resources (Abuzayed 2012). In that situation firms have facing less competition in the market and they are enjoying good profits and because of low competition in the market and heavy profits they are less motivated to manage working capital efficiently.

s

Ch: 6. Conclusion

Recent financial crisis enforces firms to efficiently manage and utilize their resources. Previously the firms focus on the long term financing and long term investments, but the competition and economic conditions force firms to efficiently manage their short term finances and investments. In order to fund the daily business requirement the working capital is used. Current assets are the major investments of any firm which is heavily financed by the current liabilities. With huge investments in the current assets, it can be expected that if current assets manage properly and efficiently than the profitability will be increased. And in order to attain the optimum level of working capital firm should reduce its average age of inventory, average collection period, average payment period, operating cycle and cash conversion cycle by collecting bills quickly and delayed the bills payable and by turning over inventories quickly(Enqvist, Graham et al. 2011). Previous literature demonstrates that if firm maintain good liquidity than its profits will improve but focusing too much on the liquidity on the cost of profitability is a dilemma to make a tradeoff between liquidity and profitability in order to maximize the return. Especially in the third world country like Pakistan the firms should manage their short term resources and they should make a balance between the profitability and liquidity. This study investigates the impact of working capital management on profitability of non financial firms listed on Karachi Stock Exchange (KSE) Pakistan for the period 2006-2011. The analysis is performed using the data derived from the financials of the selected companies. Pooled ordinary least squares (OLS) technique was used in order to analyze the impact of key explanatory variables (average age of inventory, average collection period , average payment period, operating cycle and cash conversion cycle on the dependent variables return on assets and earnings per share. In this study we investigates the positive relationship between the working capital management and profitability which is congruent with the prior empirical studies(Abuzayed 2012). This study investigates the negative relationship between the average ages of inventory, average collection period, average payment period and operating cycle. This indicates that each component of cash conversion cycle is equally important to manage. And the firms should restrict its credit policies to improve the collection period in order to maximize it profits and minimize its costs. Other component like average age of inventory is also very crucial and to improve profitability the firm should not heavily rely on heavy stocks. In this research the results indicates the positive relationship between cash conversion cycle and profitability which demonstrates the firms running in profits are less motivated to manage their short term resources, this situation also reflects that the market failure to penalize these firms for the inefficient utilization of the short term resources(Abuzayed 2012). In this study we also use operating cycle as a cumulative effect of average age of inventory and average collection period in order to investigate its impact on the profitability, and its negative relationship with the profitability indicates that firms should reduce the number of days of inventory held and improve its collection period of debts. The most prominent aspect of this study is that the Pakistani firms unable to manage the average payment period. The higher average payment period and its negative relationship with the corporate profitability affects the cash conversion cycle. And the positive relationship between the cash conversion cycle and profitability demonstrates the in efficient use of the short term resources. And to become more profitable firms need to manage their average payment period and cash conversion cycle.

The overall results indicates that the investing in working capital and efficient use of short term resources is very crucial for the corporate profitability and the firms should include the working capital management in their financial planning process.

Suggestions for future research:

In this study we examine the impact of working capital management on profitability, for this purpose the sample of 76 companies was selected from the Karachi stock exchange for the period 2006-2011. In this study we are unable to use the economic indicators like GDP and business cycle etc. like economic indicators some market indicators like Tobbins-Q are also not used in this study because of unavailability of required data. So for the future research, it can be extended by adding these economic and market indicators in this study or it can be, by increasing the sample of the firms. For further research sector wise analysis can also done.

Limitations of study:

This study is limited up to a small sample of 76 financial firms listed in Karachi stock exchange Pakistan. So this study should be generalized to non financial firms as used in that study. I intended to incorporate the maximum number of firms in that analysis but non availability of data enforces me to work with small sample of 76 firms over a period of six year. Since the availability of financial data relevant to market prices of the firms was not available, so I cannot use Tobbins-Q as a proxy of profitability as used by (García-Teruel and Martínez-Solano 2007). So I use earning per share as a second proxy of profitability after return on assets.