Working capital management and profitability: Evidence from Cement sector of Pakistan, listed on Karachi stock exchange

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1 Journal of Business Administration and Management Sciences Research Vol. 2(10), pp , October, 2013 Available online athttp:// ISSN Apex Journal International Full Length Research Paper Working capital management and profitability: Evidence from Cement sector of Pakistan, listed on Karachi stock exchange Hasnain Manzoor Department Of Management Sciences, Mohammad Ali Jinnah University Islamabad, Pakistan. Accepted 7 October, 2013 This study explores the relationship of profitability and working capital in the cement industry of the Pakistan. The sample of 20 listed companies in the Karachi stock exchange has been taken for the period of 10 years from 2001 to 2010 for the analysis. The correlation matrix and multiple regressions are used for testing the relationship. Negative significant relationship between the account receivable days, stock days and firm s size with profitability was found while the relationship of leverage with profitability is positive and significant. This study will help the managers to handle the working capital efficiently to increase its profitability. Key words: Working capital management, return on assets, panel data analysis. INTRODUCTION Working capital is a measure of company s efficiency and its short-term financial health. The working capital is calculated as Current Assets less Current Liabilities. It measures how much liquid assets a company has available to build its business, and is very important in corporate finance because it directly affects profitability and liquidity of the firm. Positive working capital means that the company is able to pay off its short-term liabilities. Negative working capital means that a company is currently unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory). Working capital also gives investors an idea of the company's original operational efficiency. Working capital management is a managerial accounting strategy focusing on maintaining efficient levels of both components of working capital, current assets and current liabilities, in respect to each other. Profitability and liquidity are two very important factors for any business in world. The term liquidity represents the strength of a firm to mature its obligations quite sufficiently if the firm have the better liquidity position. A firm cannot survive without significant liquidity position. The term Profitability indicates the return on firm s investment in fixed assets. An unnecessary investment in current assets which relates the liquidity would reduce the profitability or return on investment because the investment in fixed assets leads towards profitability. In order to maintain a good smooth business operation, working capital is one of the key measures for any business and due to this it should be maintained at an adequate level. Excessive liquidity position represents gathering of idle funds which fails to earn any profit for firm. The inadequate liquidity position not only badly affects the credit worthiness of any firm but also disrupts the process of production and ultimately reduces the earning capacity to an extensive level. In the business world the performance level have usually been based on some of the important managerial functions such as operations, manufacturing, working capital management, and marketing, these may have a

2 178 J. Edu. Res. Behav. Sci. consequential impact on business as ongoing concern existence and also the expansion as well. The working capital management is a major aspect to consider, which specifies the strength of any business. Usually the investment in working capital is more as compared to the fixed asset which leads towards profitability, so that s why it is more important that the amount which is invested in working capital is used in more effective and efficient terms. Another fact is that, most of the firms not effectively manage their working capital, which results in non-credit worthiness circumstances for any organization, which is a major hurdle in survival of business. The common predictors of liquidity are working capital, current ratio, quick ratio receivable turnover ratio etc, while the profitability predictor s are net profit margin, return on assets etc. High value of current ratio indicates the larger amount of investment in current assets and low in fixed which shows better liquidity position, the excess investment in the current assets will not leads towards profitability. Low value of current ratio shows a lesser investment in current assets which results a high rate of return on investment of fixed assets for any business. Though, a low value of current ratio interrupt production and sales, because of firm s incapability to pay to its liabilities in time due to severe polices. Therefore, it can be said that there is an inverse relationship between liquidity and profitability up to a certain level, beyond that level decline in liquidity will also decline in profitability as well. A poor liquidity position in any business would create troubles in smooth running of business operations; therefore hold back the growth of any business and reduction in profitability as well. Working capital management is related with the decision of amount invested in current assets. The excess amount of investment in working capital beyond its optimal level leads the tradeoff between the costs associated to have current assets. When we talk about working capital and profitability two questions arises. Does working capital management affect the firm performance? Does cash conversion cycle effect firm profitability? The objectives of the study are to determine the relationship between the liquidity and profitability. To identify the major factors of working capital that mainly predicts the extent to which they have influence on firm s profitability. To reveal the facts that whether the factors of working capital, which we have observed, are good predictors of profitability or not. The significance of study is that we conduct this study regarding objective to analyze that how working capital management effect profitability of a firm. When managers control cash conversion cycle and maintain optimal accounts receivable, accounts payable, firm size, financial debt ratio and fixed financial ratio, all these variables effect the profitability of a firm. For eliminating the risk and meeting the short term obligations with the avoidance of excessive investments in these assets, it is necessarily that working capital management should be efficient which occupied with the best planning and controlling of current assets and current liabilities. A theory described that poor management of working capital not just minimize the profitability of a firm but also lead to the financial crises, effect nature and size of the business, profit orientation, amount of working capital and value of the company. The efficient working capital management is the most important factor in maintaining survival, growth, liquidity, solvency and profitability of the business. Thus, we can say that approach in managing working capital has huge influence to the firm performance. LITERATURE REVIEW Working capital management is defined as investment in operations by long term funds. Working capital is calculated by current asset less current liabilities. Working capital management is management of current assets and current liabilities. The management of working capital is important in shareholder value creation. Khalid Zaman (2011) studied the working capital management relationship to the profitability of fourteen companies from cement industry in the Khyber Pakhtonkhuwa province of Pakistan. The data was collected from financial reports of the companies and from the KSE for the period of 6 years ( ). The testing techniques of correlation coefficient and multiple regression analysis were used to analyze the data. The findings showed that there was a moderate relationship between profitability and working capital management in this specific industry of Pakistan. Melita Stephanou Charitou (2010) conclude that the components of working capital, inventories, account receivable and account payable affects the profitability of firm and these variables which were required for cash conversion cycle. They collect the data of 43 industrial firms which were listed in Cyprus Stock Exchange for the period of 10 year 1998 to They used the multivariate regression analysis in their study and suggest that if a firm used conservative policy means maintain high level of inventories accounts receivable and accounts payable, the profitability of the firm will be less. Adina Elena Dănulețiu (2010) conducted a study to examine the working capital management efficiency of firms from Alba County. The relationship between working capital management and profitability was studied using the Pearson correlation analysis. The factors of working capital were accounts receivable, inventories and account payables, short term financial investments and current debt, Almost 20 financial statements of the period 2004 to 2008 of different companies were taken. A

3 Manzoor 179 negative linear correlation was found between the working capital management and profitability rates. Deloof (2003) took the sample of 2,000 most important Belgian firms under the National Bank of Belgium for the period 1991 to He found that a firm can be profitable, if it decrease its number of days accounts receivable, number of days accounts payables and number of days in inventory, in addition to his study he suggest that those firms that are not much profitable, delay in their payments and this effect their profitability. It has been also found that it was possible for a firm that it can minimize it investment in current assets. By Melita Charitou, Halim Budi Santoso (2012) conducted a study to find the relationship of working capital management and profitability in the firms of an emerging economy. The collected the data of all the Indonesian firms from the year 1998 to The concluded that cash conversion cycle and net trade cycle are related to the firms profitability positively. They also found that the risk associated with the firms is negatively related to the return on investment. The findings are useful for the stakeholders of the firms. Nor Edi and Noriza Binti (2010),for the evaluation of performance of the Malaysian Companies, they collect the data of 172 stock exchange listed companies for the period of 2003 to 2007.The purpose of the study was to find the relationship of working capital factors, cash conversion cycle, current asset divided by current liabilities, current liabilities divided by total asset, total debt dived by total asset and the factors of the profitability were return on asset and return on investment. They used correlation and multiple regression analysis in their study and found that the relationship between working capital and profitability is negative. Mona Al-Mwalla (2012) studied the impact of working capital management policies on the firm s profitability and value. They took the data of 57 listed companies on Amman Stock Exchange for the period of They concluded that a conservative policy regarding capital management shows a positive effect on the firm s profitability and value and vice versa. They also found that firm s size, growth and GDP shows a positive effect on the profitability and value keeping the leverage same. Mehmet SEN (2009) the purpose of this study was to examine the competency level of the firm, which were traded in Istanbul Stock Exchange (ISE). They selected the independent variables cash conversion cycle (inventories, accounts receivable and accounts payable),networking capital,current ratio and dependent variable return on assets. They collected the data of 49 production firms for the period of 1993 to 2007 and applied correlation and auto correlation for calculation of results. They found that there is significant negative relationship between working capital management and profitability of these firms. Puwanenthiren Pratheepkanth studied the effect of capital structure over companies performance. The data was collected for five years ( ) for business companies in Sri Lanka. The results reflected low level of negative relationship between the capital structure of companies and their financial performance. According to Tahmina Quayyum (2011) it examined that there is any relationship between working capital management and liquidity on profitability. For the period 2005 to 2009, this study has been conducted only in cement industry (4 companies) which was listed in Dhaka stock exchange. For calculation of results regression analysis has been used and founds that there was significant negative relationship between working capital and liquidity on profitability. Amarjit Gill Nahum Biger Neil Mathur (2010), analyze the relationship between working capital management and profitibility. They use the seven component of working capital, accounts receivables, accounts payables, inventory, cash conversion cycle, financial debt ratio, fixed financial assets ratio. They use firm size, financial debt ratio, and fixed financial assets ratio as control variables. They use the linier regression model and Pearson s correlation analysis to find the relationship between working capital management and gross operating profit. They found that gross operating profit is a negatively correlated with the accounts receivables and suggest that when average collection period increases it consequences on the profitability is negative. Raheman and Nasir (2007), study the relationship between Management of working capital and profitability of 94 Pakistani firms listed on Karachi stock exchange. For calculation of working capital, different component of working capital are taken including the Average collection period, inventory turnover in days, Average collection period cash conversion cycle and current ratio. They use debt ratio, size of firm and financial assets as a control variables. Two methods of data analyzing are used descriptive and quantitative.for analyzing quantitative data Linier Regression model and Pearson s correlation analysis is used to determine the relationship between variables. Bring into being that working capital is a strongly negative correlated with the profitability of the firm. Hussain, Hashmi and Saghir (2011), inspect the relationship between working capital management and profitability and study found that when firms maintain optimal level of working capital it leads to the higher level of profitability.cash conversion cycle number of account receivables in days number of account payables in days and number of inventory in days use as a working capital measurement tools. Profitability is measured through ROE. Liner equation model is used and results illustrate that there is there is negative significant relationship between profitability measured through ROE and working

4 180 J. Edu. Res. Behav. Sci. capital. Nadeem, Arif, and Jawaid (2012), carry out the study to determine the relationship between working capital management and profitability. They use the average annual cross sectional data of four Pakistani sectors including textile chemical sugar and engineering. For calculating working capital inventory turnover, average payment period current ratio, firm size, average collection period and debt ratio is used. Liner Regression Model is used and Results suggest that inventory turnover, current ratio and firm size has a significant relationship with the profitability in all sectors but average collection period has an insignificant relationship with the profitability in sugar and allied sector. Similarly debt ratio has a insignificant relationship with profitability in all sectors except engineering. On other hand average payment has a insignificant relationship in sugar and allied sector. Prabath suranga Morawakage (2010), examine the relationship between working capital cost structure and profitability of 65 Sri Lankan firms listed on Colombo stock exchange. Regression and correlation test is use to inspect the relationship between variables. Administrative finance and selling expense were used as variables for measuring cost structure. Working capital cycle debtors turn over in days; creditors payable in days and inventory were used for calculating working capital. The study found that the profitability of the companies increase when managers reduced the number of inventory turnover days and to reduce the length of working capital cycle increase the creditors payable in days. Results also suggest that more selling and distribution expenses did not increase the profitability and more finance cost become burden for the company s profits. Duggal and Budden (2012), conduct the study and found that when firm maintain the optimal level of working capital it create maximum value for the shareholder. They capture the 500 non financial firms listed on USA stock exchange. Financial firm were not included in sample because the net working capital and cash conversion concepts are not appropriate to the financial industry. Cash conversion cycle, inventory in days, account receivable turnover, account payable turnover, current assets, current liabilities cash and short term investment and net working capital use as variables. Bring into being that strict Economic condition exerts force on the firms to change their account payable account receivable polices inventory level that why firms maintain high or low level of working capital. Lazaridis and Tryfonidis (2006), observed a negative relationship between profitability (measured through gross operating profit) and the cash conversion cycle which was used as a measure of working capital management efficacy. It seems that operational profitability dictates how managers or owners will act in terms of managing the working capital of the firm. The data collected were from listed firms in the Athens Stock Exchange Market using a sample of about 300 firms which narrowed down to 131companies for a period of using regression analysis and Descriptive statics. Managers can create profits for their companies by handling correctly the cash conversion cycle and keeping each different component (accounts receivables, accounts payables, inventory) to an optimum level. Pedro Juan Garcia, Teruel and Solano (2007), argued that minimizing working capital investment (aggressive policies) would positively affect the profitability of the firm, by reducing the proportion of its total assets in the form of net current assets. He also found a negative relationship between ROA, Number of day s accounts receivable, number of days of inventory, number of day s accounts payable and Cash conversion cycle (CCC). David Mathuva (2010), found a positively significant relationship with the profitability and inventor conversion period, average payment period, while it shows a negative significant relationship with profitability and average collection period. The management of a firm can create value for their shareholders by reducing the number of days account receivable. The management can also create value for their shareholders by increasing inventory into a significant level. Ikram ul Haq (2011), found a moderate relationship between working capital management and profitability in the specific context of cement industry in Pakistan. Efficient management of working capital is essential for the profitability of the firm. Various studies have been conducted to test the relationship of working capital management with profitability. According to Smith (1980), working capital management affects the profitability and risk factor of the firms, and hence resulting increase in the value of firms. Soenen (1993) examined this relationship on US firms and finds that there is negative relationship of net trade cycle length with return on investment. Jose et al. (1996) studied relationship between cash conversion cycle and profitability which showed significant negative relationship exists between them. With expanded sample size and time period, Shin and Soenen (1998) investigated a large sample of 58,985 US firms for the period of 20 years i.e , they concluded that firm s net trade cycle has significant negative relationship with its profitability. Hypothesis H1: Account receivable days are significantly and negatively H2: Account payable days are significantly and negatively H3: Cash conversion cycle is significantly and negatively H4: Stock days are significantly and negatively

5 Manzoor 181 H5: Financial debt ratio is significantly and positively H6: Fixed financial assets are significantly and positively H7: Firm size is significantly and negatively associated with return on assets. METHODOLOGY The purpose of this study is the financial management of a very important feature; this is the so-called working capital management to contribute to Pakistan. Here we will see the relationship between working capital management practices and its effects on profitability of 20 Pakistani firms from cement sector and the companies are listed on Karachi stock Exchange, collect data for a period of ten years from This section of the article discusses the enterprise and the variables included in the study, data distribution patterns and application of statistical techniques in the relationship between the survey of working capital management and profitability. The correlation matrix and multiple regressions are use to check the relationship between the dependent and independent variables. The following is the equation of regression. ROA: β 0+β 1ACR β 2ACP+ β 3Stock+β 4CCC+ β 5FS+ β 6FFA+ β 7FDR+ε Where, ROA is the return on assets, β0 is the constant and other Betas are coefficients of relevant variables. ACR is account receivable days, ACP is account payable days, CCC is cash conversion cycle, stock is for the inventory days, FS is used for the firm size and it is log of sales, FFA is financial fixed assets and FDR is financial debt ratio and use as proxy of leverage. Data and sample We took the data from Karachi Stock Exchange (KSE), internet and web sites of different firms. The period covered by the study extends to ten years starting from 2001 to The reason for restricting to this period was that the latest data for investigation was available for this period. The sample is based on financial statements of the 20 manufacturing Pakistani firms, listed on KSE including firms from cement sectors of our economy. Because of the specific nature of their activities, firms in financial sector, banking and finance, insurance, leasing, modarabas, business services, renting and other services are excluded from the sample. Finally, the firms with data of the number of day s accounts receivable, number of days inventories, number of days accounts payable and operating income are included in sample. Variables The following variables in Figure 1 are used to find the relationship between Working Capital Management and Profitability RESULTS Descriptive statistics in Table 1 tells us about the mean value of a variable as well as the standard deviation. This also tells us about the minimum and maximum values. Skewness tells us that either the data is positively distributed or negatively distributed. Jarque-Bera tells about the normality of the data. Account payable mean values is which means that average payable period in the industry is 193 days and there may be deviation of 94 days in it. Maximum period is one year while minimum period is near by 9 days. The data is positively skewed and it is normally distributed as probability is less than The return on the assets in the industry is negative which shows the recession in the industry of the cement industry. Some firms are earning good profit and getting 396% return while negative return is more than it. All the other data is normally distributed. Cash conversion cycle is negative which shows that firms are paying late to its suppliers while collection from the customer is very quick. Table 2 represent the result of correlation matrix and indicate that cash conversion cycle has strong negative relationship with the account payable. The financial fixed assets also have relationship with the account payable as well as account receivable and this is also negative. Return on the assets has no significant relationship with any variable. This may be due to recession and negative return on the assets. The correlation matrix is weaker technique and does not indicate the better picture. So this can be checked through the regression analysis. Regression requires that data of the all variables should be stationary at the level. To meet this requirement, unit root tests designed by Dickey and Fuller (1979) and Phillips and Perron (1988) have been employed. Dickey-Fuller tests assume that the errors are statistically independent and have a constant variance. This may not be the case with some of the data used here so the less restrictive Phillips-Perron test is used to test the Stationary of a time series. Tables 3 present the results for the variables in levels with trend and trend and intercept. All the variables are stationary on the level as critical values at 5% are less than T-statistics of the variables with tend as well as trend and intercept under the ADF test. PP test also confirm the results of the ADF

6 182 J. Edu. Res. Behav. Sci. No. of Days A/R = (Accounts Receivables/Sales) x 365 No. of Days A/P = (Accounts Payables/Cost of Goods Sold) x 365 Independent Variables (Working Capital Management) No. of Days Inventory = (Inventory/Cost of Goods Sold) x 365 Cash Conversion Cycle = (No. of Days A/R + No. of Days Inventory) No. of Days A/P Firm Size = Natural Logarithm of Sales Financial Debt Ratio = (Short-Term Loans + Long-Term Loans)/Total Assets Fixed Financial Asset Ratio = Fixed Financial Assets/Total assets Dependent Variable Profit = (Sales - Cost of Goods Sold) / (Total Assets - Financial Assets) Figure 1. Independent and dependent variables. Table 1. Descriptive statistics. Mean Max Mini Std. Dev. Skewness Jarque-Bera Prob. ACP ACR CCC FDR FFA FS ROA STOCK Table 2. Correlation matrix. ACP ACR CCC FDR FFA FS ROA STOCK ACP ACR CCC FDR FFA FS ROA STOCK test. So we can apply the regression on this data. Table 3 represents the results of the unit root test. Table 4 represents the results of regression. Results show that Account receivable days, firm size and stock

7 Manzoor 183 Table 3. Unit root test. ADF Test PP Test Trend Trend& intercept Trend Trend& intercept ACR Stock ACP CCC FDR FFA FS FDR ROA Critical values 1% Level % Level % Level Table 4. Regression analysis. Variable Coefficient Std. Error t-statistic Prob. C ACR ACP FDR FFA FS CCC STOCK R-squared Mean dependent var Adjusted R-squared S.D. dependent var S.E. of regression Akaike info criterion Sum squared resid Schwarz criterion Log likelihood Hannan-Quinn criter F-statistic Durbin-Watson stat Prob(F-statistic) days has significant and negative relationship with the return on assets. While the relationship of financial debt ratio and return on assets is positive and significant. Fixed financial assets have positive but insignificant relationship while relationship between account payable days and cash conversion cycle is negative and insignificant. Adjusted R square of shows the value of which means that 51% impact on the dependent variable is due to our independent variables and remaining variation may be due to some other factors. F- statistics shows the value of which shows the fitness of the model and probability of F-statistics also confirm the fitness. The results are as follows. DISCUSSION AND CONCLUSION This paper explores the relationship between the return on assets and working capital. The numbers of Pakistani companies have to invest a lot of cash working capital.

8 184 J. Edu. Res. Behav. Sci. Therefore it is expected that working capital management can influence the profitability of the firm significantly. We found a significant negative relationship between the average collection period, inventory turnover days, firm size in the companies listed in Pakistan Karachi Stock Exchange. These results suggest that managers can create for their shareholders the value of the reduction in the number of day s accounts receivable and inventories to a reasonable minimum. To cope with the negative relationship between trade and profitability is consistent, low-profit enterprises to wait longer to pay their bills. We find statistically insignificant relationship between cash conversion cycle, fixed financial assets and account payable days. The reason of insignificant relation may be recession in the industry. The firms also delay in paying to their creditors in the cement industry. The relationship is according to literature in the positive or negative sense. The relationship of leverage with the profitability is significant and positive which is alien with the theories of capital structure because companies get the tax shield against the debt so it will increase the cost of capital. So the value of the firms will be increase. This article Add existing literature as Deloof, Lazaridis and Tryfonidis, Raheman and Nasr, Falope and Ajilore, Mathuva found that the relationship between the nonperforming receivables and profitability. Therefore, the results of this study show that managers can create value for their shareholders, to reduce the number of days of receivables. Furthermore, the negative correlation between Receivables and the company's profitability, lower corporate profits will continue to reduce their receivables in order to minimize their cash shortfall of cash conversion cycle. On this basis, the results of this paper, we believe earnings you can improve the company's working capital management, more efficient way. On the basis of the aforementioned analysis, we can conclude that these results can be further strengthened, if the corporate management of working capital in a more efficient manner. Working capital management is "the management of current assets and current Liabilities and financing current assets if these companies to properly manage their own cash. Receivables and inventories in an appropriate manner, which will ultimately increase the profitability of these companies. In the Pakistani capital, there is a lot of work to do in the future. Limitations This study was limited to a sample of 20 Pakistani manufacturing companies. The results of this study can be simply extended. Similarly, in this study they are involved in manufacturing businesses. In addition, the small sample size, there was the time constraint in conducting the research. Future research Further research on different companies could be carried out on the same subject with more samples such as working capital components management, including cash, securities, accounts receivable and inventory management. REFERENCES Al-Mwalla, M. (2012). The Impact of Working Capital Management Policies on Firm's Profitability and Value: The Case of Jordan. Int. Res. J. Finance Econ., 85: Charitou, M.S., Elfani, M., Lois, P. (2010). The Effect Of Working Capital Management On Firm s Profitability: Empirical Evidence From An Emerging Market. J. Bus. Econ. Res., 8(12): Charitou, M., Lois, P., Santoso, H.B. (2012). The Relationship Between Working Capital Management And Firm s Profitability: An Empirical Investigation For An Emerging Asian Country. Int. Bus. Econ. Res. J., 11(8), Dănulețiu, A.E. (2010). Working Capital Management And Profitability: A Case Of Alba County Companies. Annales Universitatis Apulensis Series Oecon., 12(1): Deloof, M. (2003). Does Working Capital Management Affect Profitability of Belgian Firms? J. Bus. Finance Accounting, 30(3) & (4): Duggal, R., Budden, M. C. (2012). The Effects Of The Great Recession On Corporate Working Capital Management Practices. Int. Bus. Econ. Res. J., 11(7): Gill, A., Biger, N., Mathur, N. (2010). The Relationship Between Working Capital Management And Profitability:Evidence From The United States. Bus. Econ. J., Beg-10, 1-9. Haq, I. u., Sohail, M., Zaman, K., Alam, Z. (2011). The Relationship between Working Capital Management and Profitability:A Case Study of Cement Industry in Pakistan. Mediterr. J. Social Sci., 2(2):, Morawakage, P.S., Lakshan, A.M. (2010). Determinants Of Profitability Underlining The Working Capital Management And Cost Structure Of Sri Lankan Companies. ICBI University of Kelaniya, Sri Lanka, Pratheepkanth, P. (2011). Capital Structure And Financial Performance:Evidence From Selected Business Companies In Colombo Stock Exchange Sri Lanka. J. Arts, Sci. Commer., ii(2):

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