Working Capital Management’s Effect on Profitability

The first chapter of this dissertation introduces the readers to the area of study undertaken, provides a background for the complete study as a whole with its relevance. The research questions are presented along with the limitations of the study so as to incorporate all the factors influencing the results of this work. The final part of this chapter is the disposition which is illustrating the outline of the study conducted.

1.1 INTRODUCTION

In today’s challenging economic climate corporations are always looking for new methods to stimulate growth rate, improve financial performance and reduce the risks associated with running a business. Working capital is one such aspect of corporate finance which is perceived as useful reserve used for growth strategies such as capital expansion, diversification etc. Hence efficient Working Capital Management (WCM) can help a company eliminate the risk of deficit cash flow from operations thereby also obviating the risk of running a business into liquidity. According to Wilson (1996) companies should embrace formal Working Capital Management practices with the hope of minimising any probabilities of business failures, as well as to enhance the performance of the business.

Cash deterioration in any firm affects its potential to finance any kind of operating activities, any reinvestment requirements and also affects the profitability levels of that firm. Hence if the working capital falls below a certain required limit it may put the business at serious risk. Working capital management is therefore important because of its effects on the firm’s profitability and risk and consequently its value (Smith, 1980). An important aspect of working capital management is liquidity management which involves planning and controlling of current assets and current liabilities in such a manner that it helps in eliminating the risk of inability to meet due short –term obligations on one hand and also avoids excessive investment in these assets on the other (Eljelly, 2004). The ultimate result of liquidity planning, controlling and management is shown on the effect that it has on profits and shareholder’s value.

1.2 BACKGROUNG OF THE STUDY

Corporate finance primarily deals with three decision making processes: capital structure decisions, capital budgeting decisions and working capital management decisions. Several researches have been conducted analysing capital structure, investment decisions, budgeting, and valuation of company. Another important decision that involves management of investments in short term assets and the resources used with maturities less than one year is the Working Capital Management decision.

Working capital essentially is a measure of the liquid assets available with business i.e. a difference between the current assets and current liabilities. The term ‘Current’ here means that it is anticipated to change into cash or to be paid into cash within a period of twelve months. Shin and Soenen (1998) pointed out that a firm’s working capital is a result of a time lag between the expenditure for the purchase of raw materials and the collection from the sale of finished goods. Their submissions points out that this entails several areas of a company’s operational management which includes receivables, payables, management of inventories, management of trade credit etc. The aim of Working Capital Management is to actually maintain an optimum balance of all the components of working capital.

The most crucial part of managing the working capital is to maintain liquidity of a company in such a manner so as to ensure the smooth operation of business on daily basis and also meeting the obligations easily (Eljelly, 2004). During the working capital management process the decisions that tend to increase profitability also increase the risk factor involved and conversely decisions that focuses on risk reduction will tend to reduce profitability. Therefore Deloff in 2003 said that the way the working capital is managed has significant impact on the profitability of the firm.

The ultimate aim of every firm is to maximize the profits. But the problem in working capital management is to achieve a desired trade off between the liquidity and profitability (Smith, 1980; Raheman & Nasr, 2007). Referring to the theory of risk and return investments with high risk will yield more return. Hence firms with high liquidity of working capital may have low risk and therefore low profitability. Conversely firms with low liquidity of working capital, facing high risks would yield high profitability. This therefore highlights the fact to have efficient liquidity management practices since if the firm faces liquidity issues the payment to the creditors would be deferred, there might also be a serious risk of facing insolvency or bankruptcy etc.

Many researchers have attempted to understand the factors that determine the working capital of an organization. Liu (1985), Su (2001) and others in their findings have found that growth of firm; size, leverage etc. affect the working capital of a company a lot. They broadly define industry, firm-specific and financial environmental characteristics as determinants of working capital. The ways of maintaining efficient levels of WCM can vary from company to company since it is dependent on factors like kind of industry, nature of the business, strategies adopted, business policies etc.

Having an efficient WCM is also an essential in maintaining short term solvency of the company. It helps firm to react more quickly towards any unanticipated changes occurring in market variables such as any changes in raw material prices, interest rates etc. And also gives them a competitive edge over their other competitors in the market.

1.3 RESEARCH QUESTIONS

In today’s time of turbulent economic conditions for companies to survive such conditions and still being able to achieve its profit maximisation objectives is a major cause of concern. In such times it’s important for financial managers of organisations to understand that poor working capital management practices in a company can lead to severe consequences.

The research questions that are being addressed in this study are as follows-:

Studying and analysing the relationship between Working Capital Management and profitability.

What are the consequences of changes in working capital on the profitability of a firm?

Analysing how the changes in liquidity affects working capital and profitability.

For these objectives we have formulated the following hypotheses and will attempt to find statistical evidences to support and prove the assumed hypotheses.

Hypotheses H1: The Working Capital is negatively correlated with the profitability of the firm i.e. higher the working capital held by the companies lower will be the profitability and vice-versa.

Hypotheses H2: The liquidity and working capital holds a positive correlation with each other hence if liquidity management is poor it would affect WCM and therefore profitability as well (as mentioned in H1).

1.3.1 AIMS OF STUDY

The sudden failure of financial institutions in recent past has drawn a lot of attention to conduct a more detailed study into the management decisions and corporate governance of companies. The main aim of this study to analyze that does a better WCM from one period to another has any positive effect on the profitability of the organisation. Many researchers in past have pointed out the need to maintain efficient working capital and liquidity levels within a firm so as to reap favourable benefits and profits. The main focus of this research is to study small, medium and large scale businesses from various sectors, so as to establish factors that influence the working capital management and liquidity, variable that influence the profitability of these companies over a period of 5 years. Hence in this research we aim to take up data of 31 different companies classified into 8 different sectors namely – Oil & Gas, Food & Drug, Personal Goods, Household Goods, General Retailers, Pharmaceuticals, Tobacco and Mining.

1.3.2 LIMITATIONS OF THE STUDY

Since the data used in our study consists of 31 different companies and these companies vary in terms of their size, sales growth, type of industry and GDP growth, hence it sets certain limitations on the results we derived from this study.

The size effect is considered as a limitation since we have a mix of medium and large sized companies (which comprises of number of subsidiaries and associates). Therefore due to the different working capital requirements of each of these companies data used for analysis may deviate. Sales growth is another limiting factor in our research since these companies deal with different product lines which would result in varying demands of the products in the market place for e.g. some companies may have seasonal products which could lead to abnormal profitability in high demand season. All these companies survive in the same economic conditions and government regulations. At times some favourable or unfavourable changes in government policies relating to a specific industry might affect the profitability for e.g. companies involved in the export of produced goods are levied with an export duty it would result in companies restricting their international sales which in turn would disturb the BOP (Balance of Payment) and GDP of an economy and thereby finally influencing the profitability of the firms.

1.3.3 RESEARCH METHODOLOGY

1.4 DISPOSITION

As this chapter is introducing its readers to the current area of research we therefore continue with a short presentation of the structure of the research and of the following chapters.

Literature Review The second chapter deals with review and critical

Analysis of the literature that has been previously

written on this topic

Theoretical Framework The theoretical framework is presented next in

order to enable understanding of the research and

provide useful insights about the practice of

working capital and liquidity management in

relation to profitability.

Practical Method Before presenting the results of the study

& Data Collection conducted a description of the practical methods

used and the procedure of the data collection is

mentioned

Empirical Findings In this section we would write about the analysis

and findings of the results and thereafter discuss

the overall results obtained to fulfil aim of research

Conclusion In the final chapter of this dissertation the research

questions are answered along with the discussion

about the research purpose. We would also present

both theoretical and practical implications.

CHAPTER TWO: LITERATURE REVIEW

CHAPTER THREE: THEORETICAL FRAMEWORK

In the theoretical framework of this study a discussion about the tools, strategies and implications of cash management will be carried out in terms of working capital management, liquidity and profitability of an organisation. Emphasis will be laid on understanding the variables of working capital management and deciphering the relationship between working capital management and profitability and between liquidity and profitability.

3.1 WORKING CAPITAL

We start here with the presentation of a wider concept of working capital which plays an important role in the firm’s growth and profitability and it is also very closely interlinked with the context of liquidity. In its simplest and most common form working capital can be defined or expressed as a difference between the firm’s current assets and current liabilities. (Claes-Goran Larsson & Lars F. Hammarlund, 2005). Shin and Sonenen in 1998 have also defined working capital as a ‘’time lag between the expenditure for the purchase of raw material and the collections due from the sales of finished products”. The most common equation followed for working capital calculation is-:

Net Working Capital = Current Assets – Current Liabilities

In the above mentioned equation current assets can be defined as those which are expected to generate cash within one year and are classified in balance sheet as cash and cash equivalents, short-term investments, receivables, prepaid expenses and inventories. Similarly current liabilities are the obligations that will be due within one year and the components under this category on the balance sheet are trade payables, short-term debt, accrued liabilities (Stephen H. Penman, 2007). Working capital management decisions covers both inventory and work-in-progress and thereby it combines both the elements of operation, production and financial management.

Working capital essentially finances the cash conversion cycle (CCC) of a business, the time required to covert raw materials into finished goods, finished goods into sales and accounts receivables into cash. These factors vary with the type of the industry sector and scale of production which in turn gets affected with the seasonality of operation, size of business unit, production policy, and process technology used and also with sales expansion and sales contraction. Working Capital can also vary on the basis of the size of the industry. Small and medium sized industries tend to have relatively larger amount of capital tied up in current assets and liabilities than bigger firms (Pass and Pike, 1984). This is because small and medium firms operations actually depend on cash whereas in large companies due to the use of credit policies this requirement is significantly reduced.

Objectives of Working Capital Management

It is very elementary for our research the objectives of working capital management since without the clear understanding of the subject it will not be possible to decipher the relationship between WCM and profitability. WCM is a crucial part of the financial management and its primary task is to match the movement of assets and liabilities over time, which further takes us to two main purposes that it holds i.e. liquidity and profitability (Pass & Pike, 1984). The situation of these dual targets is often discussed in literature due to the conflicting and inverse relations they both have in between. Pass and Pike in 1984 have explained the conflicting relationship between liquidity and profitability by mentioning an instance that a profitable long-run investment opportunity might erode the company’s liquidity situation in short-run. WCM is very often about the trade –offs between the two main goals that it has i.e. liquidity and profitability, cause focussing on any of one particular variable may shake off the balance of between them which is very significant for the company’s financial status. Glen Arnold (2008) described three different working capital management policies determined by the working capital levels namely: Companies having so called relaxed working capital policy have larger levels of cash or near cash balances and also usually have larger inventories stock along with generous customer credit terms. Industries having aggressive policies in business have more certain and defined levels of cash flows with lower cash balance requirements and minimal inventory levels held as a safety measure. The moderate policy industries fall between the relaxed and aggressive policies. In recent years WCM has become a focus of attention because the issues of WCM can be easily associated with the economic downturn affecting the economies as a whole.

Working Capital Cycle is shown below:

WORK-IN-PROGRESS

FINISHED GOOD STOCK

RAW MATERIALS

OPERATING COSTS: LABOR< OVERHEADS, MARKETING, DISTRIBUTION etc.

SALES

TRADE CREDITORS

TRADE DEBTORS

CASH

TAXATION

SHAREHOLDERS

TAXATION; LONG TERM DEBTS

FIXED ASSETS

MEDIUM TERM FINANCE

The above figure is exemplifying the working capital cycle which is a typical aspect of the manufacturing firms but it can also be applied to other service sector companies by passing or stepping some of the steps. This cycle is explaining the start process from the purchase of raw materials inventories for the production process which are later turned into finished products. The finished products are then held as inventories until they are sold. The selling of these products can either be done in cash or by trade credit which causes the delay in the receiving of the payment. There are several costs involved at each of the step which could be named as the opportunity cost of the working capital. The main purpose of Working Capital Management is to effectively manage those costs and have an optimum balance of cash, raw materials and finished goods (Arnold, 2008). In 1987 Christopher and Richard Pass went on to mention that inadequate planning of working capital is one of the main causes of business failures. Also Kolay in 1991 mentioned that the importance of effective working capital management is often realised at the later stages of financial distress.

3.2 Cash Management

Cash management is an essential part of the working capital management and it usually is concerning with the different processes of handling, monitoring and planning of the liquidity of the company.

CHAPTER 4: ANALYSIS AND FINDINGS

Empirical findings conducted on 31 industries are represented in this chapter which includes statistical analysis and graphical analysis. This study explores the influence of change in working capital and liquidity management on return on assets. A SPSS (Statistical Package for Social Sciences) program was used to examine the statistical relationship and MS-Excel was used to calculate the value of variables.

DATA

We have obtained the data used in this study from the DATASTREAM database which focuses on global financial and macro-economic data. Our sample comprises of various sectors of 31 companies which includes medium and large sized firms.

We have applied filters to our sample which ignores the abnormalities such as occurrence of negative and null values for assets, current assets, fixed assets, liabilities, capital, depreciation etc. We removed observations of entry items from the balance sheet and profit and loss displaying sign that would be contrary to reasonable expectations. We have also eliminated extreme values presented by several variables and as a result in the end we had a sample of 137 observations.

In order to introduce and acknowledge the effect of economic cycle, we obtained information about the annual GDP growth in United Kingdom from the LSE (London Stock Exchange for period lying between 2005-2009.

VARIABLES

To study the effect of working capital management and liquidity management on the profitability we chose a number of variables. In our research the variables of working capital management and liquidity were considered to be independent variables since these variables individually and independently affect the profitability of the firm. The profitability variable was considered to be a dependent variable because its result depends on all the independent variables of WCM and Liquidity.

With regard to independent variable we measured working capital management by using Days Inventory Held, Days Receivable Outstanding, Days Payable Outstanding and Cash Conversion Cycle.

Here Days Receivable outstanding (no. of days A/R) is calculated as-:

No. of days A/R = Accounts Receivable/ Sales * 365

This variable basically represents the number of days a firm may take to collect payments from its customers. The higher the value of number of days A/R, higher would be the amount of accounts receivable.

Days payable outstanding (no. of days A/P) can be calculated as-:

No. of days A/P = Accounts Payable/ Purchases * 365

It reflects the average number of days a supplier takes to pay its suppliers. The higher the value of payable the more time it shall take to pay-off its commitments.

Days Inventory Held (no. of days inventory) can be formulated as-:

No. of days inventory held = Inventory/ Cost of Goods Sold * 365

All the above three components when jointly considered formulate up to make Cash Conversion Cycle (CCC). The calculation for this can be done as-:

Cash Conversion Cycle = No of days A/R + No of days Inv held – No of days A/P

The longer the time for the cash conversion cycle the greater is the investment in the net current assets of the company and hence there would be greater need to finance such current assets.

For considering the effect of liquidity on the profitability we have taken up three variables for the same which are Current Ratio, Quick Ratio and Debt to Equity Ratio.

Current Ratio is = Current Assets/ Current Liabilities

If a company has a current ratio near or equivalent to 2:1 then it would imply that company maintains a healthy amount of current assets to current liabilities and would also depict the company to be a profitable one.

Quick Ratio is = Current Assets- Inventory/ Current Liabilities

Quick Ratio almost defines similar aspects as Current Ratio does but since our sample of data comprises of some large companies having large diversified product line which takes time to be converted into sales so from that perspective such inventory should not be considered as a Current Asset. Hence quick ratio eliminates this factor since if it is not excluded from the data then it might depict a wrong result.

Debt to Equity Ratio is = Debt / Equity

Since it is elementary for a company to maintain an optimum level of debt to equity ratio hence if this ratio increases it might cause the company to dissolve and hence would directly affect profitability.

Other than the independent variables and dependent variables we also have control variables which tend to directly or indirectly influence independent variables. Although there are number of variables under the category of control variables but we have specifically chosen three major control variables which are size of the company, sales growth and GDP growth rate.

We measure size of a company as the logarithm of assets, the sales growth as (Sales1-Sales2)/Sales1. The reason for selecting size of company as a control variable is that bigger companies tends to keep more cash tied up in working capital that means it means it needs more efficient working capital management in order to keep the company running in terms of long term perspective and also to avoid any risk relating to liquidation of the firm. Large companies depicting profits in its accounts will not always mean that their business is running efficiently, it might happen that due to large amount of funds caught up in working capital cycle the firm may eventually have to face insolvency. Sales growth is another control variable since in some situations a company may have monopoly in the market place and therefore in such firms the value of efficient working capital management reduces since its sales would always be high. Such companies have no or very negligible amount of accounts receivables that means the significance of working capital management would be very low for that type of companies. Hence with such situations existing in an economy the sample of data may not remain consistent therefore we have considered Sales growth as a control variable. GDPGR (Gross Domestic Product Growth Rate) is another control variable in our research since we want to incorporate the effect of good and bad economic conditions prevailing in the evolution of the economic cycle in relation to profitability of the firms.

DESCRIPTION OF SAMPLE:

In this section we are presenting the description of sample in two sections. In the first sections we would be describing about the sample of data in tabular form and in the second section we have plotted the same data on to graphs and would furthermore have a detailed graphical analysis of them as well.

DESCRIPTION OF TABLES:

Table I: MEAN VALUE BY SECTORS

ROA measure return on assets; Inv. Days No. of Days inventory held; Rec. Days No. of days A/R; Pay. Days No. of days A/P; CCC Cash Conversion Cycle; D to E Ratio is Debt to Equity Ratio.

COMPANY

ROA %

INV. DAYS

REC. DAYS

PAY. DAYS

CCC

SALES GROWTH

SIZE OF CO.

Quick Ratio

Current Ratio

OIL & GAS

37%

240

106

668

-320

15%

7.62

1.341

1.46

FOOD & DRUG

5%

711

21

254

-54

7%

7.76

0.551

0.86

PERSONAL GOODS

18%

300

51

78

273

11%

6.65

0.938

1.44

HOUSE HOLD GOODS

19%

188

46

332

-98

16%

7.45

0.525

0.67

GENERAL RETAILERS

18%

140

24

105

69

5%

7.48

0.532

0.96

PHARMACEUITICALS

18%

146

87

124

108

12%

7.60

1.190

1.40

TOBACCO

13%

217

89

161

145

40%

7.74

0.570

0.92

MINING INDUSTRY

23%

232

61

158

135

26%

7.02

1.988

2.5

In Table I the dependent variable ROA is depicted as a percentage of profitability on Total Assets of company. Inventory days, Receivable Days and Payable Days are values shown in no of days which combine to build up Cash Conversion Cycle. The days of cash conversion cycle represents the time required for a company to turn purchases into cash receipts from customers.

We start by taking up the first sector i.e. Oil & Gas Sector, the ROA for this sectors holds the maximum value being 37% which could be the outcome of many possibilities. By studying the conceptual framework we understand that company’s credit policy with the suppliers is very favourable in respect of the company because it’s Payable days (payments made to creditors) stands at 668 days which is the maximum no of days of the total observations in this table. This might be one of the reasons that this sector fetches maximum profitability. The other reason for maximum profitability could be the negative cash conversion cycle i.e. -320 which is an improbable figure and is treated as zero but on the other hand it also implies that this sector’s cash conversion cycle is negligible or zero which automatically has a positive influence on the ROA percentage. When we look the profitability of this sector from liquidity perspective we decipher that the current and quick ratio’s are quite near to the ideal ratio (2:1) that should exist i.e. Current Ratio is 1.46:1 and quick ratio stands at 1.3:1. This means that this sector’s is dealing well with the liquidity management. Also the company’s Debt to Equity ratio is 34% which shows us that these industries aggregated debts stand at only 34% in comparison to its equity which is an indicator of the company’s efficient liquidity management.

While considering the Food & Drug sector we observe that the Return of Assets (ROA) of this sector hold the minimum value i.e. 5% in the complete table which could be a result of the highest inventory days (711 days) it has as compared to all other seven sectors. High inventory day’s means that the either this sector is keeping a lot of funds tied up in inventory or it could also mean that it is unable to sell its product in the market place. The other important observation to be considered is that the receivable days which is 21 days and holds the least values as compared to other observation. This can be a result due the fact that Food and Drugs sector has an immediate sales concept since it mostly deals with perishable or short terms shelf life products and hence they don’t accumulate too many debtors for the firm. The Food and Sector has a company size of 7.76 which falls within the average range of size of all the other companies but still the sales growth in its comparison is quite low at 7% this factor will also affect the profitability of the firms since lower the growth in sales lower will be the rate of increase in profitability. Whilst analysing the liquidity ratios we encounter that although the sector’s Debt to Equity Ratio is good at 24% but still the Current Ratio 0.86:1 and Quick Ratio 0.55:1 are not anywhere near the ideal requirement. This may be due to the fact that since this sector has limited amount of debts hence it might not have been an imperative requirement for firms to ideally balance the ratios. The second reason for such a result can be that firms may not have managed their liquidity well and that why it might have caused the profitability to go down.

In the Personal Goods Sector the ROA Ratio is 18% with the effect of inventory days 300, receivable days 51 and payable days 78 which has caused the companies in this sector to have a cash conversion cycle to go up to 273 days. This implies that a long cash conversion cycle will have funds tied up for longer duration thereby affecting the growth in the profitability levels. The profitability of the sector here is in accordance with the size of the company’s involved which is 6.65 (which is lowest in comparison to all the other sample of data in the table). This sector has also recorded near to ideal current and quick assets ratio which further justifies the lesser debt to equity percentage i.e. 21%. We can therefore infer that the good liquidity management in this sector caused the profitability to be at 18% despite having one of the largest cash conversion cycle of 273 days.

In the Household goods sector we are presented with second highest value in No. of payable days which means delayed payments to creditors and hence creates more funds available to the companies for activities useful in profit maximisation. The negative value of CCC at -98 (considered as zero) and lesser receivable days for such companies are due to the nature of the industry whose products are short-cycled (i.e. quick manufacturing and quick sales in market without having long-term debtors policy).

General Retailers has one of the highest Debts to Equity percentage at 56% which should generally be a cause of concern but when we compare this percentage with ROA which is 18% and with current ratio which is 0.96:1 we get an indication that since these two factors are showing a positive outcome the reasoning for Debt to Equity being so high can only be due to the fact that company has followed a long-term debt financing procedure. The control variable that is the Sales Growth at 5% is the least amongst all the data depicted and has acted as a deterrent for the profitability to grow because all other independent variable are showing a fairly good management results on the profitability percentage of this sector.

Analysing the Pharmaceuticals Sector we have seen the following scores for the variable -: Dependent variable ROA is at 18%, Independent variable of Working Capital Management are showing following results No of inventory days 146, No of receivable days 87, No of payable days 124, Cash conversion cycle at 108 days. Sales growth being 12% also presents an optimistic view of this sector. We also a clear understanding that the liquidity management has been effective because Current ratio is 1.4:1 and Quick ratio is 1.18:1 and the debt is equity is at optimal level of 34%. We derive that since overal