Working Capital Management And Profitability

Published Date: 02 Nov 2017

Associate Professor

Faculty of Management Studies (FMS)

University of Delhi

Email: [email protected]

Navendu Sharma

M.Sc. (Hons.) Economics Class of 2015

BITS Pilani, Hyderabad Campus,

Andhra Pradesh, India

J. Yagnesh Rohit

M.Sc. (Hons.) Economics Class of 2015

BITS Pilani, Hyderabad Campus

Andhra Pradesh, India

Abstract

Purpose: The purpose of this paper is to examine the relationship between working capital management strategies of a firm and its profitability. The authors also make an attempt to understand the impact of the global macroeconomic conditions on this relationship.

Methodology/Approach: We apply Pearson Correlation analysis and Fixed Effects estimation on our sample of Indian Manufacturing firms. Cash conversion cycle has been utilized as a measure of working capital management, whereas gross operating profit is used as a proxy for a firm’s profitability. Furthermore, interactive dummies are utilized to investigate the impact of global macroeconomic conditions on the relationship under consideration.

Findings: The results reveal that cash conversion cycle of a firm has a negative correlation with its profitability. Our results also suggest that managers can improve the performance of their firms by decreasing the number of days receivables and increasing the number of days payables. Furthermore, our outcomes demonstrate that working capital strategies should be formulated taking global macroeconomic conditions into consideration.

Research limitations: This study does not provide a conclusive relationship between the firm’s profitability and one of the components of the Cash Conversion Cycle namely inventory conversion period. Also, a larger data sample could have been studied and a cross-sectoral analysis could have been performed.

Practical implications: The findings highlight the importance of efficient working capital management practices to improve the profitability of a firm. Financial managers should aim at minimizing the cash conversion cycle of the firm so as to enhance profitability. Also, the conclusions caution the managers’ of firms to develop working capital management strategies while considering the impact of economic downturns.

Keywords: Working capital management; Profitability; Cash conversion cycle; Gross operating profit

Paper type: Research paper.

I. INTRODUCTION

The primary objective of any firm is to maximize its profits. But at the same time, it is also important for the firm to maintain an optimum level of liquidity. An insistence on maximizing profits may lead to a situation of low liquidity, sometimes resulting in insolvency (Śamiloġlo & Demirgũneş, 2008). There is thus a trade-off between profitability and liquidity. Increasing competition among firms necessitates the development of strategies to maximize profitability. This demands a special emphasis on Working Capital Management.

Working capital is a measure of a firm's efficiency and represents the liquid assets available with a firm. It is an indicator of a firm’s short-term financial health and of its ability to meet day-to-day operating expenses.

Mathematically, working capital is given by the expression:

Working capital = Current Assets – Current Liabilities (1)

A positive working capital implies that current assets are greater than current liabilities. This implies that the firm’s operations are financed by long-term funds. The strategy of maintaining positive working capital may reduce the risk of defaulting. But at the same time there is an opportunity cost associated with it, thereby resulting in the reduction in profitability of the firm.

A negative working capital implies that current liabilities exceed current assets due to investments in fixed assets- property, plant and equipment. It indicates the inability of the firm to meet its short term liabilities. Long-term liabilities are usually more expensive than current liabilities. Hence, current liabilities are a desirable source of financing. This may create value, but the default risk of the firm increases. The illiquidity of a firm adversely affects the goodwill of the firm and deteriorates the credit standings. This may further lead to unwanted but necessary liquidation of the assets of the firm.

Working capital management aims at maximizing profits, while simultaneously minimizing risk of incapability of satisfying maturing short-term debt. The efficacy of working capital management depends on the balance that the firm manages to achieve between liquidity and profitability (Faulkender & Wang, 2006; Filbeck, Krueger, & Preece, 2007).

The Cash Conversion Cycle (hereafter CCC) is a standard measure of the firm’s operations, as defined by Richards and Laughlin (1980). It is a measure of efficiency of cash conversion of a firm. CCC is defined as the amount of time taken to convert cash spent by a firm into cash inflows obtained from the operations of the firm. It has 3 components: the first one being Number of days Accounts Receivable (AR), also referred to as receivable’s Collection Period (hereafter RCP). This denotes the number of days it takes for customers who have bought goods on credit to pay-back the amount due, after the sale of the products. Comparing RCP of various firms gives an idea of how much control the firm has over its credit collections. The second component is the number of day’s inventory, also known as Inventory Conversion Period (hereafter ICP). This refers to the number of days the firm takes to convert raw materials into finished goods, which are then sold. The third component is the number of days Accounts Payable (AP), also referred to as Payment Deferral Period (hereafter PDP). This represents the number of days it takes the firm to pay back those suppliers who have sold raw material on credit to the firm.

The larger the value of RCP and ICP, the greater the CCC. On the other hand, the smaller the value of PDP, the larger the value of CCC.

Mathematically, CCC can be given by the expression:

CCC = RCP + ICP – PDP (2)

The efficiency of working capital management of a firm is best represented by CCC and its 3 components.

The purpose of this study is to investigate the effect of working capital management on the profitability of Indian manufacturing firms, subject to global economic conditions. This research enriches the existing literature in the field of working capital management by studying its impact on profitability. It further elucidates how managers can employ various working capital strategies to maximize their firms’ market value.

For better exposition, we have divided this paper into four sections. Section II contains a brief literature review pertaining to working capital management and its bearing on profitability. Section III outlines the scope and methodology employed in the study. Sections IV presents the empirical results from the analytical tools utilized in the study. Concluding observations are highlighted in section V.

II. LITERATURE REVIEW

There have been various studies to analyze the relationship of working capital management and the profitability of a firm. These include firms of varied nature across the world and have used various variables like sales growth, net income growth, return on investment invested, capital intensity etc. Different methodologies such as linear regression, panel data regression, ratio analysis etc. have been adopted to carry out this analysis. Though the results are mixed, a majority of these studies conclude a strong relationship between working capital management and the firm’s profitability and indicate that effective management of working capital is an important indicator of financial health of an organization.

Hofer (1983) chose sales growth as the measure of financial performance. Venkatraman and Ramanujam (1987) however, noted that besides sales growth, net income growth and return on investment are also important to measure the business economic performance. McGuire et al. (1988) observed correlations amongst return on assets, sales growth and assets growth to be positive and significant parameters, while Paquette (2005) noticed growth in sales to be the most important parameter to judge a company’s financial performance. Penmen (2003) argues that investors buy earnings and that they pay more for earnings growth. Huseli (1995) found sales growth, net sales, industry concentration and capital intensity as important variables to measure financial performance of a company.

Panel Data Analysis (Teruel and Solano, 2007), multiple regression analysis (Samiloglo and Demirgunes, 2008), pooled OLS regression analysis (Zariyawati et al., 2009), ratio analysis (Palepu et al.., 1999; Houghton and Woodiff, 1987; Whittengton, 1980) are some of the important tools used in the past to analyze the company’s financial performance. Lawder (1989) observed that the ability to measure the relationship between two numbers in the financial statement is one of the main advantages of financial ratio analysis. According to Beaver (1967), ratios can be used for forecasting/predictive purposes. Coyne (1986) and Cleverly (1990) evaluated a single overall performance measure as a by-product of combination of ratios. Ratios have also been used by Houghton and Woodlif (1987) to predict corporate success and failure. Mramor and Valentincic (2003) have also advocated the use of financial ratios to forecast the cash shortage of the company.

Working capital management is very vital in determining the profitability of a firm as well as its value (Smith, 1980). There is a strong relation between the cash conversion cycle of a firm and its profitability. Huchison et al. (2007) found a direct relationship between smaller cash conversion cycle and high profitability. Kamath (1989) studied retailing firms and concluded that there was an inverse association between cash conversion cycle and profitability. Wang (2002) also observed that lesser the investment in working capital, higher is the profitability of the firm. Eljelly (2004) also found a negative relationship between profitability and liquidity for the Saudi Arabian companies. Like conclusions have been drawn by Long et al. (1993).

Analysis of 1009 Belgian non-financial firms for the period 1992-96 led Deloof (2003) to the conclusion that the way working capital is managed has a significant impact on the profitability of the firms. He found a significant negative relation between gross operating income and the number of days accounts receivable, inventories and accounts payable. The findings were consistent to those of Shin and Soenen (1998) who noticed a strong negative relationship between the cash conversion cycle and corporate profitability for listed American firms for 1975-1994 period. Based on their analysis of working capital management policies of 32 non-financial USA institutions, Filbeck and Krueger (2005) also concluded that business success is greatly dependent on the effective management of receivables, inventory and payables.

Lazaridis and Tryfonidis (2006) carried out a cross sectional study of 131 listed firms of the Athens Stock Exchange for the period 2001-2004 and observed statistically significant relationship between gross operating profit (profitability) and the cash conversion cycle and its components (accounts receivable, accounts payable and inventory). They observed that lower gross operating profit is associated with an increase in the number of days accounts payable

Analysis of 94 Pakistani Karachi Stock Exchange listed firms over the period 1999-2004 revealed a negative relationship between variables of working capital management (average conversion period, inventory turnover in days, cash conversion cycle) and profitability (Raheman and Nasr, 2007). Regression analysis conducted over a large number of non-financial firms listed on Karachi Stock Exchange over the period 1998-2005 also indicated a negative relationship between the profitability of the firm and degree of assertiveness of the working capital investment. (Afza and Nazir, 2009). Raheman and Afza (2010) analysed the working capital management practices and their impact on corporate performance of a sample of 204 manufacturing firms of Karachi Stock Exchange for the period 1998-2007 and found cash conversion cycle, net trade cycle and inventory turnover affecting the performance of the firms significantly.

Teruel and Solano (2007) conducted panel data analysis of 8872 small and medium size Spanish companies for the period 1996-2002 with both random effect and fix effect models. They observed a negative relationship between returning assets and cash conversion cycle. They proved that even small and medium size firms can also increase their profitability by shortening cash conversion cycle. Likewise, applying multiple regression analysis over a sample of Istanbul Stock Exchange listed manufacturing firms for the period 1998-2007, Samilogol and Demirgunes (2008) observed that shorter is the accounts receivable cycle and inventory conversion period, higher is the profitability.

Singh and Pandey (2008) studied the relationship of working capital management with profitability for Hindalco Industries Ltd. for the period 1990-2007 and found that current ratio, liquid ratio, receivables turnover ratio and working capital to total assets ratio and had statistically significant impact on the profitability of the firm.

Results of Zariyawati et al. (2009) using pooled OLS regression of a panel of Malaysian firm over the period 1997-2006 also indicated a negative relationship between working capital proxy and profitability leading to an inference that profitability can be increased by decreasing the length of cash conversion period. Findings of Azhar and Noriza (2010) for a sample of 172 Malaysian Stock Exchange listed firms also indicate that managers can increase their firms’ market value and performance by managing working capital effectively. Saad and Mohammad (2010) applied correlation and multiple regression analysis over some Malaysian firms and concluded that there were significant negative associations between working capital variables and firms performance. Similar observations were substantiated by Nobanee et al. (2011) for a large cross section of 2123 Japanese corporations listed in Tokyo Stock Exchange for the period 1990-2004. Like observations have been made by Vijaykumar (2011) based on his studies of 20 automobile industries for the period 1996-2009.

Van Horne and Wachowicz (2004) inferred that excessive level of current assets may have a negative effect on a firm’s profitability. Lazaridis and Lyroudi (2000) also observed a positive relationship between cash conversion cycle and return on assets in a sample of 82 Greek Stock Exchange listed companies.

Mathuva (2009) found that a highly significant negative association exists between the time taken by the firms to collect cash from is receivables and the profitability. His study was based on a sample of 30 companies on the Narobi Stock Exchange for the period 1993-2008. Sen and Oruc (2009) investigated the efficiency of working capital management and its relationship with profitability of 49 corporations listed on Istanbul stock market exchange for the period 1993-2007. Their results showed that shorter cash conversion cycle and less current ratio i.e. aggressive work capital management, leads to increase in profitability. A study conducted by Ali Uyar (2009) also concluded identically for a sample of firms listed on the Turkey Stock Exchange. Findings of Dong and Su (2010) also revealed a strong negative relationship between profitability and the cash conversion cycle for firms listed on Vietnam Stock Exchange for the period 2006-2008. His results confirm that firms can improve their profitability by reducing the number of days accounts receivables remain outstanding and by reducing inventories.

Closer examination of the available literature leads to a comprehensive view that aggressive working capital policies leads to enhanced profitability of a firm. However, available literature on Indian firms exhibits contrary findings. Sharma and Kumar (2011) investigated the relationship between the working capital management and profitability of 263 Indian firms for the period 2000-2008 and found a negative relationship between profitability and number of days accounts payables, but a positive relationship between profitability and number of days accounts receivables. These findings were contrary to many studies conducted in different countries in the past. Hence, it makes it relevant and interesting to explore the nature of relationship between working capital management and profitability of Indian manufacturing firms.

III. SCOPE AND METHODOLOGY

The scope of this research study is limited to the Indian manufacturing firms comprising the BSE-500 index of the Bombay Stock Exchange, as on 31st March, 2012. These firms are studied over an 8-year period (2005-2012). The sources for the data were the consolidated financial statements of the firms. The relevant secondary data was taken from the Capitaline database from 2005-2012. Our final sample consisted of a total of 656 firm-year observations, which comprised of data from 82 firms over the 8 year period. [1] 

For the purpose of investigating the impact of varied global economic conditions on the relationship between working capital management and profitability, we study 3 specific time periods of 2 years each, namely: Phase 1(2005-06), Phase 2(2007-08) and Phase 3(2009-10). The basis of this division is to understand the trend in the relationship between working capital management and profitability over the 8 year period of the study. Phase 1 is defined to analyse the relationship under consideration for the period prior to the global recession which manifested in the second quarter of 2008-09. Phase 2 distribution is utilized to investigate the impact of the global recession on the working capital strategies of the analysed firms. Phase 3 depicts the post-recession period.

Data analysis has been performed using Microsoft Excel spreadsheets, the software EViews 6 and Statistical Package for Social Sciences.

Variables: Various financial ratios have been used comprehensively in this study. They are listed out below in Table 1.

Table 1: Variables and their Notations

S. No.

Ratio/Variable

Explanation

Formula

1

ROA

Return on Assets

Net Profit / Total Assets

2

NOP

Net Operating Profit

EBIT/Net Sales

3

GOP

Gross Operating Profit

Net Profit / Net Sales

4

RCP

Receivables Collection Period

Average Receivables * 365 / Sales Turnover

5

ICP

Inventory Conversion Period

Average Inventories * 365/COGS

6

PDP

Payment Deferral Period

Average Payables * 365/COGS

7

CCC

Cash Conversion Cycle

RCP + ICP - PDP

8

SGt

Sales Growth

(Salest / Salest-1 ) - 1

9

Firm size

Size of the firm, represented by sales

ln(Sales Turnover)

10

CR

Current ratio

Total current assets/ Total current liabilities

11

DR

Debt Ratio

(short term loans + long term loans) / Total Assets

12

QR

Quick Ratio

(Total Current Assets – Inventories)/Total Current Liabilities

The above mentioned ratios for each firm have been calculated from the financial statements of the respective firm. The ratios ROA, NOP and GOP are indicative of a firm’s profitability. Hence, we hereafter term these as profitability ratios. Firm size, SG, CR, DR and QR are defined as control variables. Furthermore, RCP, ICP, PDP and CCC are indicative of the working capital decisions of the firms.

Descriptive Statistics: Table A.1 included in the appendix highlights the descriptive statistics for the variables under consideration. It includes calculation of the mean, median and standard error of the respective variables. We also compute the standard error, minimum and maximum values of the sample for the particular variables. The profitability ratio ROA took a mean value of 8.68%, a maximum value of 57.49% and a standard deviation of 9.85%. The mean value of the variable NOP was 16.21% and it had a median value of 14.16%. Maximum GOP was 110.98%, with it having a mean value of 19.99%. The mean values of NOP and GOP for the data sample were almost comparable with values of -60.76% and -57.16% respectively. The mean value of CCC for the sample was 4.424 days, and it had a maximum value of 252.14 days. The average of RCP for the firms was 49.115 days, with the median values being 43.354 and the minimum value in the sample being 1.798 days. The conversion of inventory into goods that are sold took an average of 90.515 days and the minimum value for the same was 4.366 days. The mean value of the PDP was 135.206 days and the minimum PDP value of 15.975 days. The sample had a median PDP value of 100.027 days. Firm size, which has been defined as the natural logarithm of sales turnover, had a mean value of 8.116 and a maximum value of 13, with a standard deviation of 1.712. The control value sales growth took a mean value of 24.80%. The sample had a median value of 19.94% and a standard deviation of 31.29%. The average CR value for the sample was 2.312 and a minimum value of 0.336. DR for the sample had a maximum value of 4.365 and a mean value of 0.527. The minimum DR value was 0.027.The variable QR had a mean value of 1.526; a median of 1.215 and the sample had a minimum value of 0.188.

Model Specification: GOP is considered to be a good barometer of the efficacy with which a firm utilises its assets for the purpose of generating earnings. The more the value of the ratio, the more efficient is the firm in using its assets. Therefore, GOP is used as the measure of profitability and is the dependent variable in the study. Various recent studies use CCC as a measure of working capital management (Wang, 2002; Deloof, 2003; Lazaridis & Tryfonidis, 2006; Śamiloġlo & Demirgũneş, 2008; Vijayakumar, 2011). Therefore, CCC is used as a broad indicator of the Working capital management.

We intend to explore the relationship between the firm’s profitability and working capital management. To do so, we implement four regression models. These models are based on the structures of the models previously analysed by Deloof (2003), Lazaridis and Tryfonidis (2006) and Ŝen and Oruč (2009).

In the first regression model, we explore the relationship between GOP and CCC. The second model investigates the relationship between GOP and RCP. The third model studies the relationship between GOP and ICP. The fourth model is used to analyse the relationship between GOP and PDP.

Model 1: GOP= β0 + β1 CCC + β2 FIRM_SIZE + β3 SG + β4 DR + β5 CR + β6 QR + β7 (D1*CCC) + β8 (D2* CCC) + β9 (D3*CCC) + €

Model 2: GOP= β0 + β1 RCP + β2 FIRM_SIZE + β3 SG + β4 DR + β5 CR+ β6 QR + β7 (D1*RCP) + β8 (D2* RCP) + β9 (D3*RCP) + €

Model 3: GOP= β0 + β1 ICP + β2 FIRM_SIZE + β3 SG + β4 DR + β5 CR + β6 QR + β7 (D1*ICP) + β8 (D2* ICP) + β9 (D3*ICP) + €

Model 4: GOP= β0 + β1 PDP + β2 FIRM_SIZE + β3 SG + β4 DR + β5 CR + β6 QR + β7 (D1*PDP) + β8 (D2* PDP) + β9 (D3*PDP) + €

where, € stands for regression residuals; D1, D2 and D3 are the dummy variables for Phase 1, Phase 2 and Phase 3 respectively.

We also analyse the of Pearson correlation to determine the existence of a significant linear relationship in a bivariate relationship.

IV. Results

Correlation Analysis: The results for the Pearson Correlation performed among the profitability ratios and the working capital management ratios are depicted in Table A.2 in the appendix. The results indicate that the profitability ratios have statistically significant values and are positively correlated with each other. It is also observed that CCC has statistically significant values with the profitability ratios NOP and GOP. CCC, in fact, has a negative correlation with these ratios. This means that firms, to increase their profitability, would attempt to reduce their CCC. Moreover, CCC has a positive correlation with RCP and ICP, and a negative correlation with PDP; in accordance with equation (2). PDP has a statistically significant relationship with NOP and GOP, and the above table also depicts a positive correlation between these variables and PDP. This implies that firms that have a greater value of number of days payables are more profitable. Furthermore, RCP has a statistically significant positive relationship with profitability ratio ROA. ICP has a statistically significant, negative relationship with each of GOP and NOP.

Further to determine the degree of association between the profitability ratios and control variables, we employ the usage of Pearson Correlation. The results are as shown in Table A.3 in the appendix.

The results obtained are indicative of a statistically significant negative correlation between DR and each of the profitability ratios. Further, we observe that the control variable SG has a statically significant, positive relationship with each of the profitability ratios. The relationship of firm size with GOP and NOP is negative, and statistically significant. Also, a negative correlation is observed between firm size and the other profitability ratio ROA, though this relationship is not statistically significant.

Regression Analysis: We apply regression analysis to find the relationship between profitability and working capital decisions. We make use of panel data analysis, in particular Fixed Effect estimation, on our data sample. We employ the 4 regression models that have been earlier defined. CCC and its individual constituents are regressed, one after the other, against our measure of profitability, GOP. The effect of the global recession is also taken into account by including dummy variables for the particular global economic states.

First, we define the restricted and unrestricted models; where the unrestricted model contains dummy variables. We applied the F-test, and the results of the F-test [2] reveal evidence in support of the unrestricted model.

The choice between Random Effects Estimation and Fixed Effects Estimation is made based on the results of the Hausman test [3] . The results of the test signify that Fixed Effects estimation is to be utilised.

Model 1 explores the relationship between the profitability ratio GOP and CCC.

As mentioned above:

Model 1: GOP= β0 + β1 CCC + β2 FIRM_SIZE + β3 SG + β4 DR + β5 CR + β6 QR + β7 (D1*CCC) + β8 (D2* CCC) + β9 (D3*CCC) + €

Table 2 given below displays the regression results for fixed effects estimation performed on Model 1.

Table 2: Results from fixed effects estimation applied on Model 1

Variable

Coefficient

T-Statistic

P Value

 

 

 

 

C

0.5868

6.1323

0.0000

CCC

-0.0004

-5.7361

0.0000

FIRM_SIZE

-0.0322

-2.8394

0.0047

SG

0.0267

2.5624

0.0107

DR

-0.2383

-11.8640

0.0000

CR

-0.0201

-2.3314

0.0201

QR

0.0276

2.7122

0.0069

D1*CCC

0.0003

4.8787

0.0000

D2*CCC

0.0001

1.9794

0.0483

D3*CCC

0.0001

1.2871

0.1986

 

 

R-squared

 

0.8324

 

Adjusted R-squared

0.8033

 

F-statistic

28.5691

 

Prob. (F-statistic)

0.0000

 

Durbin-Watson stat

 

1.7228

 

It can be observed from the above results that CCC has a statistically significant, negative relationship with profitability. This result is in agreement with previous studies (Deloof 2003; Lazaridis and Tryfonidis 2006; Garcia-Teruel & Matrinez-Solano 2007; and Gill et al.. 2010). Thus it is consistent with the view that a reduction in the cash conversion cycle leads to an improvement in the performance of the firm. Moreover, Firm size, DR and CR also have highly significant negative relationships with GOP. The negative relationship observed between firm size and GOP differs from the findings of previous studies (Raheman, A., and M. Nasr 2007). The relationship of GOP with SG and QR is positive and statistically significant. Moreover, the interactive dummy variable D1*CCC, which stands for the performance of CCC in Phase 1, displays a statistically significant, positive relationship with GOP. This observation, in conjunction with the observations obtained from the results of D2*CCC, imply that the CCC-GOP relationship is more significant in Phase 1 and Phase 2, i.e. this relationship is more significant in the pre-recession phase and in the phase when the recession set in. Also, contrary to the negative GOP-CCC relationship over the entire 8 year period, there exists a positive relationship during these 2 phases. Furthermore, there is no statistically significant evidence to imply that the GOP-CCC relationship is actually positive during Phase 3.

Model 2 investigates the relationship between GOP and RCP, along with other control variables. As mentioned above:

Model 2: GOP= β0 + β1 RCP + β2 FIRM_SIZE + β3 SG + β4 DR + β5 CR+ β6 QR + β7 (D1*RCP) + β8 (D2* RCP) + β9 (D3*RCP) + €

Table 3 given below depicts the results obtained for fixed effects estimation implemented on Model 2.

Table 3: Results from fixed effects estimation applied on Model 2

Variable

Coefficient

T-Statistic

P Value

 

 

 

 

C

0.4998

5.0891

0.0000

RCP

-0.0007

-2.0930

0.0368

FIRM_SIZE

-0.0178

-1.5528

0.1210

SG

0.0127

1.1599

0.2466

DR

-0.1983

-10.4345

0.0000

CR

-0.0271

-3.0145

0.0027

QR

0.0342

3.1960

0.0015

D1*RCP

0.0000

0.0981

0.9219

D2*RCP

-0.0004

-1.8200

0.0693

D3*RCP

-0.0003

-1.2470

0.2129

 

 

R-squared

 

0.8206

 

Adjusted R-squared

0.7894

 

F-statistic

26.3071

 

Prob. (F-statistic)

0.0000

 

Durbin-Watson stat

 

1.7118

 

It is evident from the above observations that RCP has a statistically significant, negative relationship with the profitability ratio GOP. This implies that the firms can increase their profitability by shortening the number of days accounts receivables. Furthermore, DR, CR and QR have a negative relationship with GOP. Moreover, this relationship is statistically significant. The negative GOP-DR relationship is indicative of the fact that as the debt of a firm increases, its profitability decreases. This clearly depicts the trade-off between profitability and liquidity. Also, by analysing the interactive dummy variables, we can conclude that the GOP-RCP relationship is comparatively most significant in Phase 2, i.e. during the global economic recession period. It can be observed from the above results that RCP has a negative relationship with GOP during the economic downturn. Interactive dummies for Phase 1 and Phase 3 do not have statistically significant values.

Model 3 studies the relationship between GOP and ICP and other control variables. As mentioned above:

Model 3: GOP= β0 + β1 ICP + β2 FIRM_SIZE + β3 SG + β4 DR + β5 CR + β6 QR + β7 (D1*ICP) + β8 (D2* ICP) + β9 (D3*ICP) + €

The results obtained for this model are not statistically significant and hence are not reported here. [4] 

Model 4 examines the relationship between GOP and PDP, along with the other control variables. As mentioned before:

Model 4: GOP= β0 + β1 PDP + β2 FIRM_SIZE + β3 SG + β4 DR + β5 CR + β6 QR + β7 (D1*PDP) + β8 (D2* PDP) + β9 (D3*PDP) + €

Table 4 presents the results of the fixed effects estimation of Model 4.

Table 4: Results from fixed effects estimation applied on Model 4

Variable

Coefficient

T-Statistic

P Value

C

0.5158

5.4024

0.0000

PDP

0.0004

4.9837

0.0000

FIRM_SIZE

-0.0282

-2.4685

0.0139

SG

0.0338

3.1628

0.0016

DR

-0.2327

-11.3273

0.0000

CR

-0.0234

-2.6828

0.0075

QR

0.0306

2.9562

0.0032

D1*PDP

-0.0003

-4.2996

0.0000

D2*PDP

-0.0002

-2.9137

0.0037

D3*PDP

-0.0001

-1.3869

0.1660

 

 

R-squared

 

0.8277

 

Adjusted R-squared

0.7977

 

F-statistic

25.4536

 

Prob. (F-statistic)

0.0000

 

Durbin-Watson stat

 

1.6448

 

From these results, we observe that there exists a statistically significant, positive relationship between GOP and PDP. This demonstrates that the performance of a firm can be increased with an increase in its number of days payables. This result, though expected mathematically from equation (2), is in contrast to the findings of Deloof (2003). DR, CR and Firm size all have a negative statistically significant relationship GOP. The other control variables SG and QR have a positive relationship with profitability GOP. Moreover, these relationships are statistically significant. The positive SG-GOP relationship implies that an increase in the sales growth of a firm results in an increase in its profitability. This result is in accordance with previous studies (Macguire et al.. 1988).The negative GOP-CR relationship indicates that an increase in the current assets, under the constraint of constant current liabilities, would lead to a reduction in firm’s profits. Through the analysis of the interactive dummy variables, we can infer that the PDP-GOP relationship, which was positive during the entire time period, is negative and statistically significant during Phases 1 and 2. This means that an increase in the number of days payables, during these time periods in particular, would have led to a reduction in the profitability of the firm. Furthermore, there is no statistical evidence that suggests any change in the dependence of GOP on PDP during the post-recession period.

V. Concluding Observations

This study has inspected the working capital management strategies employed by the managers of the Indian manufacturing firms from BSE 500 index. Secondary data was utilized to analyse the firms over the 8 year period (2005-2012). We summarize the key observations of the research in this section.

We have utilized cash conversion cycle as a broad measure of working capital management in this study. Based on the results obtained from both the Pearson correlation matrix and the regression model employed, it can be safely concluded that a reduction in the cash conversion cycle of a firm leads to an increase in its profitability. Furthermore the regression analysis performed, indicates that an increase in a firm’s number of days receivables leads to a decrease in its profitability. This study also highlights the relationship between profitability and the number of days payables. The observations propound that an increase in a firm’s number of days payables will result in the improvement of the performance of the firm.

These findings overall are in accordance with the existing literature (Sonen 1983; Kamath 1989; Long et al. 1993; Maxwel et al.. 1998; Wang 2002; Taruel and Solano 2005; Samilogol and Demirgunes 2008; Mathuva 2009; Dong and Su 2010).

Observations drawn from the Pearson correlation matrix and the regression analysis also indicate that profitability is negatively dependent on firm size, whereas sales growth and profitability are positively related. Relationship between the liquidity ratios (debt ratio, current ratio and quick ratio) and profitability of a firm have also been studied. Two of the ratios utilized in the study, debt ratio and current ratio, exhibit a negative relationship with profitability, i.e. an increase in the values of these ratios will worsen the performance of the firm in question. The results also suggest that an increase in a firm’s quick ratio will lead to an increase in the profitability of the firm.

These conclusions overall are in agreement with existing literature (McGuire et al.. 1988; Lairodi and et al.. 1999; Sen and Oruc 2009; Mansoori and Muhammad 2012).

We venture further into analysing the impact of the global economic recession on the relationship between working capital management decisions and profitability. We conclude that an increase in the cash conversion cycle during periods of recession will lead to an increase in the profitability of the firm. Furthermore, an increase in the number of days receivables of a firm will have a negative impact on the profitability of the firm during an economic slump. Contrary to the positive relationship observed between profitability and the number of days payables during the entire time period of study, the results indicate that, during an economic slump, it is negatively related to profitability. Hence, during economic downturns, an increase in the firm’s number of days payables will result in a decrease in the profitability of the firm. In addition to these observations, we can also conclude that there is no significant relationship observed during the post-recession time period between profitability with the cash conversion cycle, and individually each of its components.

Thus, it can be safely concluded that working capital decisions have an impact on corporate profitability. The basis for working capital management is hence attaining optimal profitability, while concurrently ensuring that the firm is capable of paying off its short-term debt. Working capital management is essential in ensuring that the balance between liquidity and profitability is maintained. Working capital decisions taken by the managers’ of firms impact the firm’s value. Hence, the performance of the firm can be improved by adopting suitable working capital strategies.

The research study undertaken has limitations associated with it. Though the initial sample consisted of 172 firms, non-availability of relevant data in the financial statements during the period of study restricted the analysis to 82 firms. A comparative analysis between various sectors of the economy could have also been performed.

Future research in this area should not just address these limitations, but can also analyse a more comprehensive data sample. This study can also be carried out in the financial markets of different countries to compare the working capital strategies historically employed by firms’, with those of Indian firms, as carried out in this study. Also, an investigation could be carried out to represent profitability and working capital management by other variables and financial ratios.

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