Working Capital Management and Profitability: The examination of the interrelationship between profitability and working capital, with

the assistance of ratio analysis

Submitted By: Course:

Constantinos Constantinou (U104N0905)

MBA-726 WORKING CAPITAL MANAGEMENT

Name of Instructor: Dr. Petros Lois

Table of contents

Page

1. 2. 3. 4. 5. 6.

Introduction ............................................................................................ Literature review .................................................................................. Research Methodology ......................................................................... Analysis of findings ................................................................................ Conclusion .............................................................................................. References ...............................................................................................

1 4 7 9 13 14

ABSTRACT The current study investigated the interrelationship between profitability and working capital and more specific with the components of cash conversion cycle. Researchers had discovered the significance of the subject and a number of studies have been carried out all over the world. Field of study was USA listed manufacturing companies. The data were collected from 38 companies for the period 2001-2010. The data were analyzed using descriptive statistics, Pearson correlation coefficients and ordinary regressions analysis. The results indicated a negative connection between profitability, expressed as return on Assets, and the receivable collection period, average inventory period and average payment period, and also the cash conversion cycle which expresses the efficiency of working capital. Furthermore, financial leverage linked inversely with profitability and positive with sales growth. The above results are an indicator that managers should adopt an efficient management of working capital in order to achieved maximum profitability. 1. INTRODUCTION Working capital management is an aspect of firms finance, which is related to the companys current assets, accounts receivables, inventory and current liabilities through current payables. Investors worldwide are investing in a company to get some return on their investment. After all, companies should operate to contribute to the shareholder wealth. Big multinational companies management are operating by the directors and managers that appointed from the shareholders. Owners of the company are expecting from their representatives to act in a way, in order the value of the company will increase and therefore, their investment in the company will have a return. In the past years most of the researches were concentrate in the aspects of long term investment and capital structure in order to examine the performance of the companies and to give an indicator what influence their profitability. However, through of series of studies, it was proven that the management of working capital (receivables, inventory, payables) have significant influence in firms profitability. Nazir & Afza (2008) stated that decisions concerning working capital are vital, because they are proving the financial stability of a business and market growing perception about the firm accordingly. Management o f working capital is important for every company. All over the world researches study the issue in the framework of many countries. In developing countries, researchers came to the conclusion that working capital is probably the most important factor for a company to succeed. The same is for the companies in the developed countries, such as in USA where the field of my study is.

For a manager to effectively create value through the management of the working capital should not concentrate only in the management of current assets (inventory management and account management requirements) ,but also cover the management of current liabilities as Lazaridis & Tryfonidis (2006) point out. A good policy in the direction of working capital can create value for the shareholders. In contrast, an inefficiency policy might affect the company in a dreadful direction and could cause financial hardship. As Nazir & Afza (2008) indicated, this failure in the management of working capital will lead to the failure of the long term planning of the company and therefore to the lost shareholder wealth. Most vital aspect of working capital is current assets. The strategy that the company adapt against working capital is mostly depended from the level of current assets. Low level of current assets can be contribute more effectively to the profitability of a company, however this is a risky option, as the possibility of the company to not meet its financial obligations are greater. A different approach can be followed by increasing the amount of current assets against current liabilities. This will reduce the danger of the previous strategy of a company to fail to meet its financial obligation, however it will contribute to the reduction of companys profitability (Afza & Nazir, 2008). Working capital policy aim is to ensure that current assets liquidity meet the needs of current liabilities. Liquidity is the guideline of how efficient a company can meet its current liabilities. A company must have a sufficient level of liquidity, due to excessive liquidity results in inactive funds that do not create any value. On the other hand, as Shah & Vishnani (2007) indicated, low liquidity could lead to lack of resources and in result to default, therefore, creates financial hardship. Brian (2009) defines working capital policy, as a policy which creates a balance of cash flows, i.e. the same level of cash inflows and outflows. This cash flow will help to manage the affairs of the company in an efficient manner. However, in order to establish such a policy, managers should first proper understanding the driving forces of working capital. Lamberson (1995) referred that a good understanding of these drivers and their role assist managers to reduce the risk of default and to enhance performance. The efficient management of receivables, payables and inventory contributes to the increase of the profitability of a company. All these are elements of working capital and poor management of these elements may lead to failure of the companys targets. As the increase of profitability is directly connected with the increase of the company turnover, in the same time an amount is need to be invested in working capital. Deloof (2003) stated that the result of this increased profitability may disappear if the cost of higher investment in working capital overcomes its benefits.

Therefore, the main goal of the working capital management is to maintain this level of cash inflow and cash outflow that would create balance between each element of working capital. Without such a balance is impossible to move or bring businesses function in a proper way. In addition, a reliable and incessant monitoring of components of working capital is required in order to achieve such balance. However as Filbeck & Krueger (2005) and Lamberson (1995) stated, failed of managers to manage effectiveness this cash inflow and outflow will lead to used lot of their time to balance the level of short term assets with that of short term liabilities. Working capital management has an effect on the profitability of the business and there is a relationship between the working capital management and the profitability of a company. Cash Conversion Cycle is a useful measure to examine this relationship. Cash Conversion Cycle is calculated as number of days accounts receivable + number of days inventory number of days accounts payable. The goal of the current study is to examine the relationship between cash conversion cycle and its components, receivables, inventory and payables days, with the profitability of the companies as expressed by Return on Assets. Data collected for this study from US listed manufacturing companies for a period of ten years, 2001-2010. This paper is structured as follows: firstly the literature about the relationship between working capital management and profitability, then the research methodology, analysis of findings and conclusion on the findings.

2. LITERATURE REVIEW The current study investigates the interrelationship between profitability and working capital. Below are referred some studies and their results were investigated the same subject. Shin and Sonen (1998) examined the connection between net trade cycle (working capital) and the profitability. Their sample was consisted from 58,985 firms for the period 1975 to 1994. Their result indicated that firms net trade cycle and its profitability have a strong negative correlation. The result of this relationship, is that financial managers should take in to consideration to reduce in an efficient way net trade cycle in order to increase profitability and contribute to shareholder wealth. Athens stock exchange was the field of study for Lazaridis and Tryfonidis (2006). They examined 131 listed companies for the period of 2001-2004. Their centre of their research was to investigate the impact of efficient working capital management on profitability. Gross operating profit was used to determine profitability. For their research they used Cash Conversion Cycle, size of the company, fixed financial assets and financial debt ratio as independent variable. The result shows that a negative connection is existing between Cash Conversion Cycle and profitability. Cash Conversion Cycle was also used as a measure of working capital management by Deloof (2003) to study the link between working capital management and companies profitability. His result point out a important inverse relation between gross operating income and the number of days accounts receivable, inventories and accounts payable. He used as a sample 1009 large Belgian non-financial firms, examined the period between 1992-1996. In his conclusion mentioned that managers can create value for their shareholders by decreasing the number of days accounts receivable and inventories to an acceptable minimum. In Christopher and Kamalavalli (2009) study, they examined a sample of 14 corporate hospitals in India using panel data analysis for the period from 1996 up to 2006. They used as independent variables current ratio, quick ratio, inventory turnover ratio, working capital turnover ratio, receivables turnover ratio, ratio of current asset to total asset, ratio of current asset to operating income, comprehensive liquidity index, net liquid balance size, leverage and growth. The dependent variable to measured profitability was Return on Investment. By using multiple regression analysis, they found a negative correlation between Return on Investment and current ratio, cash turnover ratio, current asset to operating income and leverage. Positive connection with Return on Investment were had quick ratio, receivables turnover ratio, current asset to total asset and growth rate. Conclusion is that hospitals should focus more on competent use of working capital for growing the profitability which would enlarge the worth of hospitals. Ganesan (2007) investigated 349 firms from Telecommunication & Equipment industry over the period of 2001-2007. In his conclusion mentioned that despite an inverse

correlation exists between firms working capital efficiency and their profitability, this relationship was not significant in the Telecommunication & Equipment industry. Uyar (2009) analyzed 166 Turkish corporation registered with Istanbul Stock Exchange to investigate the connection of Cash Conversion Cycle with profitability and size for the year 2007. As indicated by the result, Cash Conversion Cycle has strong negative relationship with size and profitability of the companies. Azhar & Noriza (2010) have selected 172 Malaysian firms in a random way in order to assess the consequence of Working Capital Management on the firm profitability and market value. Results demonstrate a strong negative relationship between working capital variables and firms performance. Shah and Sana (2006) investigated the oil and gas sector of Pakistan. In their conclusions are referring that a negative correlation between Gross Profit and working capital ratios exists, except for the average payment period which is positively related to gross profit. A sample of 94 Pakistani firms listed on Karachi Stock Exchange for a period of 6 years from 1999-2004 was selected from Raheman and Nasr (2007) to conduct their research. They study the influence of average receivables days, average inventory days, average payables days and cash conversion cycle on the net operating profitability. Their result indicated that there was a negative relations between the components of working capital management (average receivables days, average inventory days, average payables days and cash conversion cycle) and profitability. The result show in addition that size of the firm, expressed by natural logarithm of sales, and profitability had a positive correlation. Indian cement industry was the field of study for Ghosh (2003). He examined working capital management efficiency and his result showed that that there is a connection between efficient employment of current assets and profitability of the companies that he reviewed. However the result indicated also that this connection varies from company to company. Mathuva (2009) examined also the impact of working capital management components on companies profitability. His sample was 30 firms listed on the Nairobi Stock Exchange (NSE) for the periods 1993 to 2008. Mathuva (2009) results indicated that there exists a greatly important negative correlation between the time it takes for firms to collect cash from their receivables and profitability. In addition his result showed that there is a greatly important positive correlation between the period taken to convert inventories into sales (the inventory conversion period) and profitability. Lastly, Mathuva (2009) results indicated that there is a greatly important positive correlation between the time it takes the company to pay its payables and profitability. Charitou, Elfani and Lois (2010) contacted a survey with a sample of 43 listed Cyprus, excluding financial institution and financial firms, for a period of 10 years, from 19982007 to examine the relationship between working capital management and profitability. They used as independent variables average receivables days, average conversion inventory days, average payables days and cash conversion cycle. Return on assets was

the dependent variable used to express profitability. Debt ratio, sales growth and natural logarithm of sales have been selected as control variables. Charitou, Elfani and Lois (2010) through their research indicated that there is an inverse correlation between the components of the working capital and profitability. Afza and Nazir (2009) examined the connection between working capital management and companies profitability through a sample of 204 non-financial firms listed on Karachi Stock Exchange (KSE) for the period 1998-2005.Results revealed great different between working capital requirements and financing policies across the various industries. Furthermore, an inverse connection between the profitability of companies and degree of aggressiveness of working capital investment and financing policies was found. A conservative approach in the direction of working capital investment and working capital financing policies was suggested by the authors in order for the companies increase their value. Vishanani and Shah (2007) examined the influence of working capital management on the performance of Indian consumer electronic industry. Their result indicated that no recognized correlation between liquidity and profitability is been present for the industry as a whole; but various companies of the industry revealed different types of relationship between liquidity and profitability. However, most of the firms showed positive correlation between liquidity and profitability. Eljelly (2004) through his research concluded that efficient liquidity management involves planning and controlling current assets and current liabilities in such a way that eliminates the risk of failure to meet due short-term liabilities and avoids extreme investment in these assets. Joint stock companies in Saudi Arabia were the field of study for Eljelly (2004). The correlation between profitability and liquidity was examined, as measured by current ratio and cash conversion cycle. The results revealed that the cash conversion cycle was of more importance as a measure of liquidity than the current ratio that affects profitability. Trends in working capital management and its influence on firms performance was the subject under research by Padachi (2006). The results showed that high investments in inventories and receivables are connected with less profitability. In addition, he disclosure that inventory days and cash conversion cycle had positive correlation with profitability. In contrast, account receivables days and account payables days connected negatively with profitability. From the above studies we have a guideline regarding working capital management and its components and its correlation with profitability. Those researches tool place on the same subject for different countries and environment from different aspects and they revealed us their results and conclusions. Past studies had concluded to the same results roughly, which had proved there is the negative link between the working capital (cash conversion cycle, average receivables days, average payables days, average inventory days) and profitability and the positive relationship between size of the firm with profitability. This study attempted, based on previous studies to contribute to the research of how working capital can affect profitability.

3. RESEARCH METHODOLOGY 3.1 Data set and measurement of variables The sample of the current study was selected from USA listed manufacturing companies. The period of study covers 10 years, 2001 to 2010. Total 38 manufacturing firms were examined and data contains of total of 380 observations. All date were collected from financial statements of the annual reports of sample companies found in the World Wide Web. Below are the dependent and independent variables of the current study: Dependent variables include profitability which is express as following: Return on Assets (ROA) = Total Assets/Operating Profit Independent variables are into two groups. First group contains working capital variables which are the following: Average receivable collections period (DED) are used to express the credit policy. It can be found by the following calculation: Average receivable collections period (DED) = Account Receivables /Sales*365 Average conversion inventory period (SHD), which is expressed the inventory policy. It is identified by the following calculation: Average conversion inventory period (SHD) = Inventory /Cost of Sales*365 Average payables payment period (CPD) is used to reflect the payment policy which is identified by the following calculation: Average payables payment period (CPD) = Accounts Payables /Cost of Sales*365 Cash Conversion Cycle (CCY) is used to express the general working capital efficiency, which is identified by the following calculation. Cash Conversion Cycle (CCY) = Average receivable collections period + Average conversion inventory period - Average payables payment period Second group are the control variables, which are the following: Size of the company = Natural of logarithm of sales (NALOGS). Sales Growth (SAGRR) = (Sales t-Salest-1)/Sales Debt Ratio or Financial leverage ratio (DER) = Total Liabilities / Total Assets.

3.2 Hypotheses of the Study The following hypotheses are examined in the current study that depends on the variables of study:

1. There is an inverse correlation between the components of working capital efficiency and the profitability. 2. There is positive link between sales growth and the profitability. 3. There is negative relationship between financial leverage and the profitability.

3.3 Empirical Models Deloof, (2003), Charitou, Elfani & Lois (2010) and Lazaridis and Tryfonidis (2006) used regression analysis in order to tested their hypotheses. Based on the above studies I regressed the cash conversion cycle and the components of the cash conversion cycle. I tested the below models: ROAit = 0 + 1 SHDit + 2 NALOGS it + 3 SAGRR it + 4 DERit + eit ROAit = 0 + 1 DEDit + 2 NALOGS it + 3 SAGRR it + 4 DERit + eit ROAit = 0 + 1 CPDit + 2 NALOGS it + 3 SAGRR it + 4 DERit + eit ROAit = 0 + 1 CCYit + 2 NALOGS it + 3 SAGRR it + 4 DERit + eit where: ROAit = Return on Asset counted yearly of each firm ; SHDit = Average conversion inventory period counted yearly of each firm; DEDit = Average receivable collections period counted yearly of each firm; CPDit = Average payables payment period counted yearly of each firm; CCYit = Cash Conversion Cycle counted yearly of each firm; NALOGS it = Natural Logarithm of Sales counted yearly of each firm; SAGRR it = Sales Growth counted yearly of each firm; DERit = Debt Ratio counted yearly of each firm. i=1,.n, where n is the total number of firms; n=38 eit = estimate of yearly residual for each firm (1) (2) (3) (4)

4. ANALYSIS OF FINDINGS Table 1 presents the descriptive statistics of the study variables for 38 manufacturing US listed companies (2001-2010) and for a total 380 observations. The minimum value of Return on Asset (ROA) -1% and the maximum is 24%, whereas the mean of ROA is 10%. The average inventory holding period has 15 days as minimum, maximum inventory holding period is 509 days and mean of inventory holding period days are 82. In addition, the average receivables collection period has 3 days as minimum, maximum receivables collection period is 107 days and mean of average receivables collection days are 50. Furthermore, the average payables payment period has 35 days as minimum, maximum payables payment period is 346 days and mean of payables payment period days are 115. The cash conversion cycle has -72 days as minimum and a maximum of 437 days. Mean of cash conversion cycle is 18 days. The natural logarithm of size shows a minimum of 4 whilst the maximum is 5.66 in the year. The mean of natural logarithm of sales is 5.6 . In table 1 is also indicated the minimum of debt ratio (leverage) which is 42%, whilst the maximum is 89% and the mean is 60%. Sales (in million) have minimum of $10,018. Maximum of $459,579 and an average of $ 146,757.

Next I used Pearson correlation analysis examine the connection between all variables of the study. In Table 2 is present the Pearson correlation matrix among the variables. The table indicated a negative correlation between Return on Assets and average Inventory Holding period which is compatible with our hypothesis.

In the other hand, Pearson correlation analysis shows positive relation between average Receivables Collection Period and average Payables Payment Period. These result are opposite of my hypothesis, however the Cash Conversion Cycle has a negative relationship with Return on Assets which is agree with the hypothesis of the current study. This means that if firms want to increase their profitability, they should decrease the duration of the Cash Conversion Cycle and as result and the components of the cycle. Sales Growth indicates a positive correlation with return on Assets, which is agreed with my hypothesis. In addition debt ratio (leverage) has negative correlation with Return on Assets which again is agree with my hypothesis.

where: ROAit = Return on Asset counted yearly of each firm ; SHDit = Average conversion inventory period counted yearly of each firm; DEDit = Average receivable collections period counted yearly of each firm; CPDit = Average payables payment period counted yearly of each firm; CCYit = Cash Conversion Cycle counted yearly of each firm; NALOGS it = Natural Logarithm of Sales counted yearly of each firm; SAGRR it = Sales Growth counted yearly of each firm; DERit = Debt Ratio counted yearly of each firm.

I also tested my hypothesis by using regression analysis. This analysis will find the relationship between working capital components and the profitability as expressed by Return on Assets. The results of the regression analysis for the correlation average inventory holding period and the three control variables with profitability are show below in Table 3. As indicated below, inventory holding period is negative related with profitability (ROA), which is agree with my hypothesis. In addition, Table 3 revealed a positive connection between sales growth and profitability (ROA), which result that an increase in sale leads to increase of profitability. Also debt ratio (leverage) has negative relationship with profitability, which means that companies with high debt have problem to meet their financial obligation. Both the relationship of sales growth and debt ratio with profitability agree with my hypothesis. The results are statistically important as indicated from the Ftest.

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where: ROAit = Return on Asset counted yearly of each firm ; SHDit = Average conversion inventory period counted yearly of each firm; DEDit = Average receivable collections period counted yearly of each firm; CPDit = Average payables payment period counted yearly of each firm; CCYit = Cash Conversion Cycle counted yearly of each firm; NALOGS it = Natural Logarithm of Sales counted yearly of each firm; SAGRR it = Sales Growth counted yearly of each firm; DERit = Debt Ratio counted yearly of each firm.

Next are the results of the regression analysis for the correlation average receivables collection period and the three control variables with profitability are show below in Table 4. As indicated below, receivables collection period is negative related with profitability (ROA), which is agree with my hypothesis. In addition, Table 4 revealed a positive connection between sales growth and profitability (ROA), which result that an increase in sale leads to increase of profitability. Also debt ratio (leverage) has negative relationship with profitability, which means that companies with high debt have problem to meet their financial obligation. Both the relationship of sales growth and debt ratio with profitability agree with my hypothesis. The results are statistically important as indicated from the F-test.

where: ROAit = Return on Asset counted yearly of each firm ; SHDit = Average conversion inventory period counted yearly of each firm; DEDit = Average receivable collections period counted yearly of each firm; CPDit = Average payables payment period counted yearly of each firm; CCYit = Cash Conversion Cycle counted yearly of each firm; NALOGS it = Natural Logarithm of Sales counted yearly of each firm; SAGRR it = Sales Growth counted yearly of each firm; DERit = Debt Ratio counted yearly of each firm.

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Following the results of the regression analysis for the correlation average payables period and the three control variables with profitability are show below in Table 5. As indicated below, payables payment period is negative related with profitability (ROA), which is agree with my hypothesis. In addition, Table 5 revealed a positive connection between sales growth and profitability (ROA), which result that an increase in sale leads to increase of profitability. Also debt ratio (leverage) has negative relationship with profitability, which means that companies with high debt have problem to meet their financial obligation. Both the relationship of sales growth and debt ratio with profitability agree with my hypothesis. The results are statistically important as indicated from the Ftest.

where: ROAit = Return on Asset counted yearly of each firm ; SHDit = Average conversion inventory period counted yearly of each firm; DEDit = Average receivable collections period counted yearly of each firm; CPDit = Average payables payment period counted yearly of each firm; CCYit = Cash Conversion Cycle counted yearly of each firm; NALOGS it = Natural Logarithm of Sales counted yearly of each firm; SAGRR it = Sales Growth counted yearly of each firm; DERit = Debt Ratio counted yearly of each firm.

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Finally are the results of the regression analysis for the correlation cash conversion cycle and the three control variables with profitability are show below in Table 6. As indicated below, cash conversion cycle is negative related with profitability (ROA), which is agreeing with my hypothesis. In addition, Table 6 revealed a positive connection between sales growth and profitability (ROA), which result that an increase in sale leads to increase of profitability. Also debt ratio (leverage) has negative relationship with profitability, which means that companies with high debt have problem to meet their financial obligation. Both the relationship of sales growth and debt ratio with profitability agree with my hypothesis. The results are statistically important as indicated from the Ftest.

where: ROAit = Return on Asset counted yearly of each firm ; SHDit = Average conversion inventory period counted yearly of each firm; DEDit = Average receivable collections period counted yearly of each firm; CPDit = Average payables payment period counted yearly of each firm; CCYit = Cash Conversion Cycle counted yearly of each firm; NALOGS it = Natural Logarithm of Sales counted yearly of each firm; SAGRR it = Sales Growth counted yearly of each firm; DERit = Debt Ratio counted yearly of each firm.

The above results are in line with my hypothesis and also are in line with the result of the previous studies, that profitability can be increase by an efficient working capital management. 5. CONCLUSION Through the current study, I had investigated the interrelationship between the profitability and working capital management. My field of study was 38 US listed manufacturing companies. The results of the current project revealed that there is an inverse correlation between average receivables collection period, average inventory holding period, average payables payment period and the profitability. It is also indicated negative relationship between the cash conversion cycle and profitability. In addition this study reveals a positive correlation between sales growth and profitability and an inverse relationship between debt ratio (leverage) and profitability. According the results of this study and the results of the previous it is concluded that companies should to manage their working capital effectively in order to increase their profitability.

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