The interrelationship between working capital and profitability: a pre-crisis examination of the Cyprus Stock Exchange.

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1 The interrelationship between working capital and profitability: a pre-crisis examination of the Cyprus Stock Exchange. ABSTRACT The purpose of the current study was to investigate the interrelationship between working capital and profitability of companies listed in the Cyprus Stock Exchange. A repeated measures cross-sectional design was used. A sample of sixty companies was collected, where a balanced panel data-set of 300 observations was analysed, obtaining annual data for the pre-crisis period of 2004 to The effect of days accounts receivables, days accounts payables, stock holding period and cash conversion cycle on gross operating profit was examined, where a number of control variables were additionally included in a pooled regression framework. The results showed that there was a significant negative relation between gross operating profit and days accounts receivables, as well as a marginally significant positive relation between profitability and stock holding. In addition, industry was significantly negatively related to gross operating profit, where the most profitable firms in Cyprus were the ones belonging to the consumer goods industry, followed by those in the industrials industry, consumer services, technology and finally basic materials industry. The conclusion of the present study is that profitability of companies in Cyprus will increase if the period debtors take to pay the company is kept short, and the amount of stock held in warehouses is reasonably high. Keywords: working capital management, gross operating profit, firm size, cash conversion cycle, industry, Cyprus Stock Exchange 1

2 1. Introduction Working capital management policy choices have important implications on corporate value and profitability. The importance of balancing a company s liquidity and profitability has been widely examined (Lazaridis and Tryfonidis, 2006; Padachi, 2006; Raheman and Nasr, 2007; Mathuva, 2010 and Zariyawati et al., 2010). Working capital management has been shown to directly impact that balance (Lazaridis and Tryfonidis, 2006; Narware, 2008; Ramachandran and Janakiraman, 2009 and Sen and Oruc, 2009). Attempts to maximise profitability (overtrading) can result to liquidity decreases, making it difficult for the company to meet its everyday obligations and additionally increase its risk of bankruptcy (Raheman and Nasr, 2007; Sen and Oruc, 2009 and Mathuva, 2010; Dong and Su, 2010 and Lois, 2010). On the other hand, a working capital management policy that favors liquidity and over-invests in current assets (over-capitalization) might consequently inversely influence a company s profitability (Dong and Su, 2010 and Lois, 2010). It is therefore expected, that bad management of working capital may result in the declining performance of a company, have a negative impact on profitability, which consequently negatively impacts shareholders wealth (Garcia-Teruel and Martinez- Solano, 2007; Dong and Su, 2010 and Gill et al., 2010). Although many studies have attempted to evaluate the relationship between working capital and profitability, not enough evidence exists in related literature about companies in Cyprus. The present study aims to investigate which working capital components affected profitability in companies listed in the Cyprus Stock Exchange in the pre-crisis period, namely during the years ending 2004 to Thus, the study can serve as a reference for managers in Cyprus firms on how to manage their working capital components to improve their company s performance during the current, difficult years when Cyprus is facing the consequences of the financial crisis and is struggling to survive economically. 2. Background on the factors that affect the profitability of a company Working capital management has been identified as a critical component in the success or failure of a business (Padachi, 2006 and Ramachandran and Janakiraman, 2009) and 2

3 several authors have shown that ways of managing different working capital components have a significant impact on a company s profitability (Deloof, 2003; Lazaridis and Tryfonidis, 2006; Padachi, 2006; Sayaduzzaman, 2006; Ramachandran and Janakiraman, 2009; Sen and Oruc, 2009; Gill et al., 2010 and Mathuva, 2010). Thus, managers spend a considerable amount of time on planning and controlling working capital, a process that can be very time-consuming (Raheman and Nasr, 2007 and Mathuva, 2010). The need to assist in this process has resulted in a more extensive study of the interrelationship between working capital and profitability. Working capital management has been shown to be best described by the cash conversion cycle, which indicates the time gap between purchase of goods and collection of sales or how long a firm can carry on if it was to stop its operation (Deloof, 2003; Lazaridis and Tryfonidis, 2006; Garcia-Teruel and Martinez-Solano, 2007; Raheman and Nasr, 2007; Dong and Su, 2010; Gill et al., 2010 and Zariyawati et al., 2010). Thus, numerous studies have used the different components of the cash conversion cycle, namely days accounts payable, days accounts receivables and stock holding period, as the explanatory variables for the variation of profitability in different companies. Many studies have shown a negative relation between cash conversion cycle and profitability (Deloof, 2003; Lazaridis and Tryfonidis, 2006; Garcia-Teruel and Martinez- Solano, 2007; Raheman and Nasr, 2007; Dong and Su, 2010; Ramachandran and Janakiraman, 2009; Sen and Oruc, 2009; Zariyawati et al., 2010). On the other hand, Padachi (2006) and Gill et al. (2010) found contradicting results. Padachi (2006) used fifty-eight small manufacturing firms in Mauritius for the years He found a positive, but not significant relation between cash conversion cycle and profitability, with a fixed effects model, but he also found a negative relation when he used a pooled OLS. Gill et al. (2010) in their study with US companies resulted in a positive relationship between gross operating profitability and the cash conversion cycle. Many authors mention that extension of the cash conversion cycle can lead to increased sales and higher profits (Deloof, 2003; Raheman and Nasr, 2007; Sen and Oruc, 2009 and Mathuva, 2010). 3

4 The components of the cash conversion cycle will be considered separately. The results of several studies show an inverse relationship between days accounts payable and profitability (Deloof, 2003; Padachi, 2006; Garcia-Teruel and Martinez-Solano, 2007 and Raheman and Nasr, 2007). A possible reason for this would be that by delaying payment to creditors, a company could lose any discount given for early payment of purchases, thus increasing its costs (Deloof, 2003; Padachi, 2006; Sayaduzzaman, 2006, Garcia- Teruel and Martinez-Solano, 2007; Raheman and Nasr, 2007 and Gill et al., 2010). Conversely, there have been several studies that resulted in a positive relationship between creditor s payment period and profitability, indicating that by extending payment to creditors profitability will rise (Lazaridis and Tryfonidis, 2006; Narware, 2008; Ramachandran and Janakiraman, 2009; Sen and Oruc, 2009; Dong and Su, 2010; Gill et al., 2010 and Mathuva, 2010). Contradicting results are also noted throughout the literature relative to the relationship between the stock holding period and profitability. Many studies have shown that the shorter the inventory is kept unsold, the more working capital is available for reinvestment within the firm, and thus the higher the profitability (Deloof, 2003; Lazaridis and Tryfonidis, 2006; Padachi, 2006; Raheman and Nasr, 2007; Falope and Ajilore, 2009; Sen and Oruc, 2009; Ramachandran and Janakiraman, 2009 and Zariyawati et al., 2010). The results of Narware (2008) and Mathuva (2010) contradicted these findings and found a positive relationship between inventory holding period and profitability. Narware (2008), however, used a different measure of profitability compared to aforementioned studies (return on investment), which might make a difference in the results. The result of Mathuva (2010), who measured profitability according to Deloof (2003) (net operating profit) for 30 Nairobian companies, could be explained by the fact that holding extra inventory can reduce any possible loss of sales caused by interruptions in the availability of stock, as well as by the fact that it can reduce supply costs and price fluctuations caused by adverse macroeconomic movements (Raheman and Nasr, 2007; Gill et al., 2010; Mathuva, 2010). The literature is more consistent in the findings of the relationship between days accounts receivables and profitability. Most studies agree that the shorter the period the 4

5 firm allows credit to its customers, the more its profitability (Deloof, 2003; Lazaridis and Tryfonidis, 2006; Padachi, 2006; Sayaduzzaman, 2006; Raheman and Nasr, 2007; Sen and Oruc, 2009; Mathuva, 2010 and Zariyawati et al., 2010). Some exceptions can by found, such as Narware (2008) and Ramachandran and Janakiraman (2009), who, however, used different measures for profitability (return on investment and EBIT respectively). Allowing trade credit to customers is a very important factor in the relations between the company and its customers. A generous trade policy can lead to higher sales (Deloof, 2003; Lazaridis and Tryfonidis, 2006; Garcia-Teruel and Martinez-Solano, 2007; Raheman and Nasr, 2007; Gill et al., 2010), since it offers customers incentive to buy at periods of lower demand, while it additionally offers the buyer a period to check the order s quantity and quality. Furthermore, it can serve as a module to strengthen the long term relationships with existing customers, as well as help attract new customers, since it is an inexpensive and flexible source of financing (Garcia-Teruel and Martinez- Solano, 2007 and Gill et al., 2010). On the other hand, uncollected accounts receivables lead to cash inflow problems if not planned and handled correctly. Lacking payment from their customers, managers would have to pay their own suppliers from reserves, and from other sources of external finance, which, in turn, would cause the financing costs to increase (Dong and Su, 2010). 3. Methodology 3.1 Data collection The data collected for the present study served the purpose of investigating whether there is an interrelationship between profitability and working capital management of companies listed in the Cyprus Stock Exchange. For this reason, the study used a repeated measures cross-sectional design, where balanced panel data were collected, excluding companies with missing data on any of the years under examination. Panel data analysis was also chosen in previous studies (e.g, Garcia-Teruel and Martinez-Solano, 2007; Falope and Ajilore, 2009; Mathuva, 2010), because it has many advantages. For example, panel data modelling assumes that individuals, firms, states or countries are 5

6 heterogeneous, and therefore better controls for bias. Moreover, it offers more variability to the study, less collinearity and more degrees of freedom, resulting in the estimates to be more efficient and providing information on the time-ordering of events, thus allowing to control for individual unobserved heterogeneity (Garcia-Teruel and Martinez-Solano, 2007 and Mathuva, 2010). For the purpose of the study, annual data were collected from the financial statements of all the firms listed in the Cyprus Stock Exchange, for the period (Cyprus Stock Exchange, 2011). Listed companies were chosen since they have an incentive on presenting reliable and truthful financial statements and show profits, where present, in order to attract more investors to buy their shares (Lazarides and Tryfonides, 2006). Furthermore, they undergo mandatory audit, making their financial statements more reliable (Mathuva, 2010). Industries such as electricity and water, banking and financial institutions and insurances were excluded from the study, because, due to their type of activity, the calculation of their working capital management is very different (Deloof, 2003; Lazaridis and Tryfonidis, 2006; Raheman and Nasr, 2007 and Mathuva, 2010). Using the Sample Size Calculator 9/1 (Venture Data, 2011), the population size (123 companies, reduced to 88 after excluding the aforementioned companies), the confidence level (95%) and the confidence interval were entered, providing a rough estimation of the target sample size for the study to be 72. However, some companies were excluded due to lack of information for the certain period of study, and others because they were purely service companies that held no inventory and therefore could not be used for the purpose of the study. Therefore, the final sample included sixty firms, resulting in a total of 300 (panel) observations for the five years of examination. As already mentioned, the chosen period for data collection was selected to be the years ending 2004 to The reason why more recent financial reports were not chosen was mainly because at the end of 2008 the global financial crisis started to affect the Cypriot market. Data collected during that crisis, which lasts until today and is currently very severe for Cyprus, would not be representative for the examination of the topic of 6

7 interest and would include an exogenous macroeconomic effect in the analysis of the data. 3.2 Variables The dependent variable chosen as a measure of corporate profitability for the regression analysis was the Gross Operating Profit (GOP), and was calculated as: The same variable was used in many such previous studies to measure profitability (e.g., Deloof, 2003; Gill et al., 2010), and was preferred instead of Return on Assets (ROA) or Earnings Before Interest or Tax (EBIT). According to Gill et al. (2010), using Gross Operating Profit instead of ROA or EBIT allows to assess operating performance with an operating ratio, and relate this variable with other operating variables like the cash conversion cycle, days accounts payables/receivables and stock holding period. In addition, using Gross Operating Profit as a measure of profitability, distinguishes participation of any financial activity from operating activity that may affect overall profitability (Gill et al., 2010). According to Deloof (2003), when a company has a large number of financial assets on its balance sheet, its operating activities will contribute little to the overall return on assets, thus making it an inappropriate variable in this case. For this reason financial assets are deducted from total assets when calculating gross operating profit. A large percentage of the chosen companies indeed have a large number of financial assets, mainly shares in other firms or subsidiaries, thus showing that the choice of Gross Operating Profit was appropriate for the study. The independent variables chosen in the study were as follows: Days accounts payables (AP)= (Average trade creditors / Purchases )* 365 Days accounts receivables (AR)= (Accounts receivables / Sales ) * 365 Stock Holding period (days) (INV)= (Average Stock / Cost of Sales) * 365 7

8 Cash conversion cycle (days) (CCC) = Days accounts receivables + Stock Holding period Days accounts payables In addition, Financial debt ratio (FD), Fixed Financial Asset Ratio (FFA), Firm Size (LnS) and Gross Domestic Product (GDP) growth were used as control variables, consistent with Gill et al. (2010). Financial debt ratio was calculated by adding short term loans to long term loans, divided by total assets. Fixed financial asset ratio was taken as fixed financial assets divided by total assets, whereas firm size was taken as the natural logarithm of sales in agreement with Deloof (2003), Lazaridis and Tryfonidis (2006), Padachi (2006), Raheman and Nasr (2007), Ramachandran and Janakiraman (2009), Gill et al. (2010) and Mathuva (2010). According to Mathuva (2010), inclusion of GDP growth controls for the evolution of the economic cycle, since adverse or favorable economic conditions are reflected in the firm s performance, controls inflationary pressures and also reflects economic changes in the macroeconomic environment. GDP was retrieved from CYSTAT (Republic of Cyprus, Ministry of Finance, Statistical Service, ) for the period , and used as a control of the external environment. Constant market prices were used, instead of current market GDP, because the latter measures value-added production in current prices whereas constant price GDP measures value-added production expressed in a particular year, the base period, in this case 2005 and thus it is corrected for inflation and deflation and is not driven only from price changes. Finally, Industry was also added as a variable. This variable was added after it was observed in the data that some balance sheet representations slightly differed according to the industry the firm belongs to. In the construction industry for example, land available for construction was not in the fixed assets part of the balance sheet, but in the current assets part and was therefore regarded as inventory. Furthermore, some authors suggested that the relationship between working capital and profitability may also be affected by industry and sectors (Mathuva, 2010). Therefore, the sixty companies used in the study were divided according to five industries: consumer goods, industrials, consumer services, technology and basic materials, coded as 1-5 respectively. All the variables were calculated using balance sheet and income statement values. 8

9 3.3 Statistical Analysis All the statistical analyses were carried out using the Statistical Package for Social Sciences (SPSS, version 19). The statistical methods used included descriptive statistics, correlation analysis and regression analysis for panel data, namely pooled OLS regression. 4. Results 4.1 Descriptive Statistics Descriptive statistics for the variables of interest appear in Table 1. Table 1: Descriptive Statistics for the variables of interest, for (N=300) Variable Minimum Maximum Mean Std. Deviation Gross Operating Profitability Days Accounts Receivables Days Accounts Payables Stock Holding Period Cash Conversion Cycle Debt Ratio Fixed Financial Asset Ratio GDP growth (% Annual change) Firm Size As can be seen from Table 1, the mean gross operating profitability for all companies during the five-year period was 18.0%, with the lowest value being a loss of 13% for the specific company at one year and the maximum reaching as high as 86%. There exists a big difference between the minimum and maximum values for operating profitability in our results. This may be due to the existence of some outliers in our data or to the fact that the data were taken from companies from different industries. The mean creditors payment period (days accounts payables) for the companies in Cyprus was 189 days, while these companies receive payment for their sales (days accounts receivables) within 126 days on average. This result is quite encouraging for the overall image of Cypriot companies, since it appears that they make payments to their 9

10 creditors after they have collected from their customers, showing cash inflow prior to outflow. In addition, it appears that companies in Cyprus take on average 154 days to sell their inventory (stock holding period). How extra inventory can benefit or harm profitability will become more evident in the regression analysis. The cash conversion cycle for Cyprus companies is on average 91 days, illustrating that the time lag between the purchase of goods and actual collection from sales is approximately 91 days. This number is quite small and can be considered as very satisfactory, since the smaller the cash conversion cycle, the better for the company and can be deduced that companies complete approximately four cycles during a year. However, this statistic is accompanied by a large standard deviation of 412 days. The mean firm size as measured by the natural logarithm of sales was 16.2m with a low standard deviation of 1.4m, illustrating that the companies were approximately of the same size and are therefore comparable. The mean debt ratio of the sample was 26.6% which represents a good proportion of total liabilities to total assets, while the fixed financial asset ratio had a mean of 8.5% illustrating that in the companies of our sample only 8.5% of total assets are represented by fixed financial assets (i.e. investments in subsidiaries and other long-term cash equivalents). The mean GDP growth for the period was 4.2% with a standard deviation of 0.5%, illustrating a quite stable growth in the economy during that period. 4.2 Pearson Correlations The Pearson Correlation Coefficient was calculated to examine the strength of the bivariate relation between all the variables of interest. The correlations are provided in Table 2. The only working capital component which is significantly correlated with profitability is Days Accounts Receivables, with a correlation coefficient of (p<0.001), thus showing that as days accounts receivables decrease, the profitability of Cyprus companies increases. No significant correlation was found between gross operating profitability and other components of working capital, although the results illustrated a negative relationship between profitability and days accounts payables and 10

11 the cash conversion cycle and a positive relationship between gross operating profit and stock holding period, which, however, had p-values larger than Table 2. Pearson Correlation Coefficients Variable GOP AR AP INV CCC FFA GDP LnS AR ** 1 p<0.001 AP p=0.546 INV * 1 p=0.714 CCC ** ** 0.342** 1 p=0.235 FFA ** 0.121* 0.245** p=0.007 GDP p=0.880 LnS 0.148* ** ** ** p=0.010 Debt * ** 0.232** ** p=0.028 **Correlation is significant at the 0.01 level; * Correlation is significant at the 0.05 level Profitability was also found to be significantly correlated with firm size, debt ratio and fixed financial asset ratio, with correlation coefficients of 0.148, and respectively. It appears that the larger the firm the highest its profitability, while the company is more profitable when total liabilities represent a small proportion of the total assets. Fixed financial assets appear to be very important for a company s profitability as well, since the lower the fixed financial asset ratio is, the higher the profitability. Moreover and more importantly, the fact that profitability is significantly related with these three variables, shows that it makes sense to include them in the regression models as control variables and examine whether there is an effect of the working capital variables beyond the effect of firm size, liabilities over assets and fixed financial assets. Looking at other correlations, firm size was found to have a significant negative relationship with days accounts receivables, stock holding period and the cash conversion cycle. The cash conversion cycle also had a significant positive correlation with days accounts receivables and stock holding period and a negative correlation with days accounts payables. Moreover, debt ratio had a significant positive correlation with days 11

12 accounts payables, stock holding period and the fixed financial asset ratio, while the economic variables GDP growth did not have a significant relation with any of these financial variables. Pearson correlations examine only pairwise relations and, therefore, cannot provide a reliable indicator of the association between the variables of interest in a manner which controls for explanatory variables (Padachi, 2006; Deloof, 2003; Padachi, 2006; Mathuva, 2010). For this reason, following the correlation analysis, regression analysis was also conducted to better describe the interrelationship between profitability and working capital. 4.3 Regression Analysis To assess the effects of working capital management on the companies profitability, gross operating profit was modelled as a function of the three cash conversion cycle s components, as well as cash conversion cycle itself. As a result, four models were formed. An additional fifth model was formed including all three working capital components simultaneously, in accordance to Mathuva (2010). The control variables and the variable industry were also included in the regressions. Consistent with previous studies the pooled OLS regression equation used to examine the relationship of working capital components with profitability was:, where GOP= Gross Operating Profit, AR= days accounts receivables, AP=days accounts payable, INV= stock holding period, DR= debt ratio, FFA= fixed financial asset ratio, GDPGrow=growth of Gross Domestic Product, LnS= firm size and Ind=Industry Model 1: Relationship between Profitability and Days Accounts Receivables The first hypothesis that was set to be examined by model 1 was that, ceteris paribus, profitability and days accounts receivables are significantly related. Table 3 shows the regression results of Model 1. 12

13 Table 3. Model 1: Regression results for the effect of Days Accounts Receivables on Gross Operating Profit Variable Beta t p-value Firm Size Debt Ratio Fixed Financial Asset Ratio GDP Growth (% ) Industry Days Accounts Receivables Rsquare= <0.001 The results show that among all the variables of interest, days accounts receivables and the industry variable, were significantly related to profitability, when controlling for firm size, debt ratio, fixed financial asset ratio and GDP growth. Days accounts receivables were negatively related to profitability, which shows that Gross Operating Profit increase as the customers take fewer days to pay for their purchases. More specifically, the coefficient of shows that when AR increases by 1 day then GOP decreases by 0.235%. The negative sign for industry means that companies with lower coding number have higher profitability. Based on the coding used, as there is movement across each industry category, i.e. from basic materials, to technology, to consumer services, to industrials, to consumer goods, there is an increase in the company s profitability, which shows that the most profitable companies in Cyprus belong to the consumer goods industry Model 2: Relationship between Profitability and Days Accounts Payables The second hypothesis that was set to be examined by model 2 was that, ceteris paribus, profitability and days accounts payables are significantly related. Table 4 shows the regression results of Model 2. It appears that there is no significant relationship between profitability and days accounts payables (p=0.629). Industry is once more negatively related to profitability. 13

14 Table 4. Model 2: Regression results for the effect of Days Accounts Payables on Gross Operating Profit Variable Beta t p-value Firm Size Debt Ratio Fixed Financial Asset Ratio GDP Growth (% ) Industry Days Accounts Payables Rsquare= Regarding the control variables, firm size appears to be significantly positively related to gross operating profit, indicating that the larger a company is within Cyprus, the higher its profitability will be and that days accounts payables do not have a significant effect on profitability beyond the effect of this control variable Model 3: Relationship between Profitability and Stock Holding Period The third hypothesis that was set to be examined by model 3 was that, ceteris paribus, profitability and stock holding period are significantly related. Table 5 shows the regression results of Model 3. Table 5. Model 3: Regression results for the effect of Stock Holding Period on Gross Operating Profit Variable Beta t p-value Firm Size Debt Ratio Fixed Financial Asset Ratio GDP Growth (% ) Industry Stock Holding Period Rsquare= As shown in Table 5, stock holding period is marginally positively related to profitability (at the 10% level of significance), with a p-value of 0.056, suggesting that by increasing stock holding period by 1 day, profitability of Cyprus companies can be increased by 0.118%. Industry and firm size still remain significantly related to gross operating profit with p=0.017 and p=0.001 respectively. 14

15 4.3.4 Model 4: Relationship between Profitability and the Cash Conversion Cycle After examining the individual components of the cash conversion cycle, the fourth hypothesis that was set to be examined by model 4 was that, ceteris paribus, profitability and cash conversion cycle are significantly related. Table 6 shows the regression results of Model 4. Table 6. Model 4: Regression results for the effect of Cash Conversion Cycle on Gross Operating Profit Variable Beta t p-value Firm Size Debt Ratio Fixed Financial Asset Ratio GDP Growth (% ) Industry Cash Conversion Cycle Rsquare=0.071 Although the regression beta coefficient illustrates that there is a negative relationship between the cash conversion cycle and gross operating profit, the relationship is not significant (p=0.173). Debt ratio, financial fixed asset ratio and industry still illustrate a negative relationship with profitability, however only industry is significantly related with p=0.012 and can be the only relationship recognised to exist in this model. Firm size still remains a significant variable for the explanation in variability of gross operating profit Model 5: Relationship between Profitability and the components of the Cash Conversion Cycle. The final model regressed all the components of the cash conversion cycle, namely days accounts receivables, days accounts payable and the stock holding period, with gross operating profit, in order to examine their simultaneous effect on profitability. Cash conversion cycle was not included in this regression since this would create multicollinearity problems. This model was included according to Mathuva (2010). Table 7 shows the results of the regression. 15

16 Table 7. Model 5: Regression results for the effect of all the components of the Cash Conversion Cycle on Gross Operating Profit Variable Beta t p-value Firm Size Debt Ratio Fixed Financial Asset Ratio GDP Growth (% ) Industry Days Accounts Receivables Days Accounts Payables Stock Holding Period < Rsquare=0.123 It is evident that the only variables with a significant relationship with profitability are days accounts receivables (with a highly significant relation, p<0.001), firm size and industry. For profitability to increase, days accounts receivables should be kept at a minimum, while profitability increases with larger firm size. In addition, as indicated by the inverse relationship of industry to profitability, the most profitable firms are those in the consumer goods industry, followed by the industrials, consumer services, technology and basic materials industries. Days accounts payables and stock holding period still illustrate a positive relationship with profitability, suggesting that for a company in Cyprus to increase its profits, managers should increase the period when they pay their suppliers and have more stock in their warehouses available for sale, however these relationships are not significant at the 5% level of significance. Stock holding period, which was found to have a marginally significant effect on profitability (Model 3), now does not appear to have an effect, when all the variables are considered simultaneously, perhaps due to possible interactions between the independent variables or a much stronger effect of the other variables on profitability. It should be noted that all the models were tested for multicollinearity and all the VIF were found lower than 10, showing that there was no problem of multicollinearity between the variables. 16

17 5. Discussion This study examined the interrelationship between working capital management and profitability in 60 companies belonging to the Cyprus Stock Exchange for the period When the variables were examined individually in terms of their relation with profitability, using Pearson correlation, only days accounts receivables, firm size, debt ratio and fixed financial asset ratio were found to have a significant relation with gross operating profit. The other two components of working capital management, namely days accounts payables and stock holding period, as well as the cash conversion cycle itself, were found not to have a significant correlation with profitability, a result that contradicts the findings of previous studies. Deloof (2003), Padachi (2006), Garcia-Teruel and Martinez-Solano (2007) and Raheman and Nasr (2007) found a negative relation, while Lazaridis and Tryfonidis (2006), Dong and Su (2010) and Mathuva (2010) resulted in a positive correlation between days accounts payables and profitability. The non-significant correlation between stock holding period and profitability is similarly in contrast with previous studies. Sen and Opuc (2009), Deloof (2003), Lazaridis and Tryfonidis (2006), Raheman and Nasr (2007) and Dong and Su (2010) found a negative correlation between these two variables, while various studies have found a positive correlation between stock holding period and profitability, (eg., Mathuva, 2010; Gill et al., 2010). Looking at other correlations, firm size was found to have a significant negative relationship with days accounts receivables, stock holding period and the cash conversion cycle. These relationships suggest that larger firms receive cash for their sales earlier, keep stock in their warehouses for a shorter period, and consequently have a shorter cash conversion cycle. The analysis shows a significant positive correlation between debt ratio and days accounts payables, stock holding period and the fixed financial asset ratio, illustrating that they are proportionately related. As days accounts payables, stock holding period and the fixed financial asset ratio increase, the companies borrowings increase as well. This is a logical consequence since credit period from creditors is a form of a shortterm financing, with the company using the money that should have been used to pay the suppliers, to finance its operations. Furthermore, the longer inventory is tied up and not 17

18 converted to sales, the longer the companies would use external finance to continue operating. Finally, with capital tied up in long-term investments in subsidiaries, less capital is available for reinvesting within the company, hence the larger debt, which will eventually lead to fewer profits. Pooled OLS regression was then implemented, in order to investigate which components of the cash conversion cycle affect gross operating profit. The results showed that only the component Days Accounts Receivables (debtor collection period) was found to be significantly negatively related to profitability. Debtor collection period has been similarly shown in a number of previous studies to have a significant negative relationship with profitability (Deloof, 2003; Lazaridis and Tryfonidis, 2006; Padachi, 2006; Garcia-Teruel and Martinez-Solano, 2007; Raheman and Nasr, 2007; Falope and Ajilore, 2009; Sen and Oruc, 2009; Dong and Su, 2010; Gill et al., 2010 and Mathuva, 2010). In general, when a company offers a generous trade credit to its customers, it can be very beneficial to its profitability since it provides them with many advantages. First, trade credit is a form of external financing. Most firms operating within Cyprus are smallmedium enterprises (SMEs) and encounter problems on borrowing in the long term capital markets and greatly use vendor financing as a means to finance their working capital. Second, trade credit allows customers to verify their order and check the quality of their products prior to payment, a factor that greatly enhances the trust between customer and supplier (Deloof, 2003; Lazaridis and Tryfonidis, 2006; Garcia-Teruel and Martinez-Solano, 2007; Raheman and Nasr, 2007). In addition, in an industry like Cyprus where product differentiation is very difficult due to its low population and large number of companies operating within it, trade credit policies are an important criterion to customers when it is time to select between various suppliers. Finally, trade credit also encourages sales in periods of low demand and reduces transaction costs (Garcia-Teruel and Martinez-Solano, 2007). Regarding stock holding period, the descriptives showed that companies in Cyprus take on average 154 days to sell their inventory. The regression results showed that stock holding period marginally positively affected profitability, when it was included as the only working capital component in the model. Therefore, the results suggested that companies in Cyprus will be more profitable by extending their stock 18

19 holding period. This result is in agreement with Narware (2008) and Mathuva (2010) who also found a positive relationship. A positive relation shows that by holding extra inventory a company can reduce its supply costs, be protected from price fluctuations brought by extrinsic factors or adverse macroeconomic movements, reduce the risk of stock-outs and of subsequent loss of customers, and eventually increase sales (Garcia- Teruel and Martinez-Solano, 2007; Mathuva, 2010; Gill et al., 2010). Holding extra inventory can reduce any possible loss of sales caused by interruptions in the availability of stock (Raheman and Nasr, 2007; Gill et al., 2010 and Mathuva, 2010). On the other hand, several studies resulted in a negative effect of stock holding period to profitability, showing that a long period of stock holding could increase operational costs due to tied-in capital and increased warehousing and security expenses (Deloof, 2003; Lazaridis and Tryfonidis, 2006; Padachi, 2006; Raheman and Nasr, 2007; Falope and Ajilore, 2009 and Sen and Oruc, 2009). Therefore, the contradictory results suggest that managers should be careful when deciding the amount of stock to keep tied in, since keeping too large or too little can cause adverse effects on the profitability of the business. It should additionally be noted that in the present study, stock holding period was not found to be significant when it was included together with the other components of working capital, which could be due to its significant correlation with other variables in the model, such as days accounts payables, firm size or debt ratio. The results of the study showed that days accounts payables were not related with profitability in companies operating within the Cypriot industry, in other words it does not make any difference for the profitability of a business whether suppliers are paid earlier. Related literature has found contradictory results regarding the effect of days accounts payable, either with a positive relationship, which shows that delaying payment to creditors can increase profitability (e.g, Lazaridis and Tryfonidis, 2006; Narware, 2008; Ramachandran and Janakiraman, 2009; Sen and Oruc, 2009; Dong and Su, 2010; Mathuva, 2010) or with an inverse relationship, which could indicate that by delaying payment to creditors, a company could lose any discount given for early payment of purchases, thus increasing its costs (e.g, Deloof, 2003; Padachi, 2006; Garcia-Teruel and Martinez-Solano, 2007 and Raheman and Nasr, 2007). Deloof (2003) actually states that, even if the results show a relationship between the two variables, it is not possible to 19

20 determine whether manipulation of the working capital causes a change in profitability or whether variation in profitability causes the different working capital components to vary. The cash conversion cycle for Cyprus companies is on average 91 days, which is small and satisfactory. However, the standard deviation was large, 412 days, indicating a large variation in the length of the cycle between the various companies. Those companies with a large cycle should reconsider their credit policies with both customers and suppliers, and renegotiate better terms, as to decrease their cash conversion cycle. The result of the present study that the cash conversion cycle is not related to profitability is in contrast to the findings of past studies. Many studies have identified a negative relation between cash conversion cycle and profitability, showing that the shorter the period between production and sale, the larger a firm s profit (e.g., Lazaridis and Tryfonidis, 2006; Padachi, 2006; Garcia-Teruel and Martinez-Solano, 2007; Ramachandran and Janakiraman, 2009; Zariyawati et al., 2010). In this way the company may use the inflow of cash to pay its liabilities on time, avoiding possible penalties from delays, as well as invest in other projects that would result in further profits and additional cash inflows. Although the sign of the coefficient was similarly negative in our study, the relation was not significant. On the other hand, various studies have found a positive relation between cash conversion cycle and profitability or suggest that an extension of the cash conversion cycle can lead to increased sales and higher profits (e.g., Deloof, 2003; Dong and Su, 2010; Mathuva, 2010; Gill et al., 2010). As highlighted by Dong and Su (2010) and Gill et al. (2010), if the costs of having a high investment in working capital are higher than the benefits of holding more inventories and granting more trade credit, profitability will eventually fall. It is for this reason that managers should be very careful to outweigh costs and benefits prior to any decision regarding working capital investment. The average of days accounts payables was found to be 189 days, while these companies receive payment for their sales (days accounts receivables) within 126 days on average. The benefit for the companies is that they can pay their creditors in time, have low financing costs since they do not have to use external finance for their operational obligations, and have enough capital to reinvest for the improvement of corporate value. 20

21 However, the standard deviation for both these variables was quite large, indicating a differentiation in the operations and credit policies of companies in different industries. In fact, Industry was found to significantly affect Gross Operating Profitability, with a negative sign. The industry variable was entered as a categorical variable, where category 1 represented the consumer goods industry, 2 the industrials industry, 3 consumer services, 4 technology and 5 the basic materials industry, therefore companies with lower coding have higher profitability; in other words, from consumer goods, to industrials, to consumer services, to technology, to basic materials, there is a decrease in the company s profitability, illustrating that the more profitable industry is the consumer goods industry, while the least profitable industry is the basic materials industry. This finding is of particular importance to new companies looking to enter the Cypriot market, showing that the consumer goods industry is the most appealing. The study of Zariyawati et al. (2010) similarly investigated the industry effect for the relationship between working capital management and profitability, and found a significant effect on the profitability of firms. According to Sen and Oruc (2009), working capital management policies vary according to the industry sector, however when they investigated whether there was a difference within industry sectors for the relationships that they had found they concluded that their results were very similar to their first step s results and that different industry sectors were not a significant variable. It should be stressed that not many studies have included industry in their models, especially studies that have used panel data methodologies; therefore the present study provides additional insight to the topic, by using this variable in the modelling approach. Some interesting results were obtained also for the control variables used in the study. In the correlation analysis, debt ratio and fixed financial asset ratio were found to be significantly correlated with gross operating profitability showing that it makes sense to include them in the regression analysis and that keeping total liabilities at low levels relative to total assets, as well as low fixed financial assets will lead to increased profits in companies belonging to the Cyprus market. When these variables were examined with the rest of the variables simultaneously in the multiple regression analysis, this relationship disappeared. This could be a result of the interactions between the variables when examined all together. In addition, the control variable Gross Domestic Product 21

22 growth, used for the purpose of controlling for the macroeconomic changes in the Cyprus economic environment during the period of study, was not found to be significantly related to profitability, either when examined by itself or simultaneously with the other variables. It would be expected that with beneficial economic circumstances the profitability of companies in Cyprus would increase as well. This result is in contrast to the results of some previous studies, such as Mathuva (2010), who found a positive correlation between GDP and profit. The control variable firm size was found to be significantly positively related to profitability, showing that profitability is increased in large Cyprus firms. This finding also agrees with the existing literature, where larger firms have been shown to enjoy the benefits of economies of scale. As an organisation increases in size and gains power over the market within which it operates in, it can take advantage of lower costs, since suppliers may offer better prices with larger orders, have fewer transactions and therefore lower transaction costs, and gain more customers due to higher order capacity (Johnson et al., 2008). In fact, it is interesting that some of the key variables in the study (e.g. cash conversion cycle, days accounts payables) did not have a significant effect beyond the controlling effect of the firm size. A limitation of the study is the low value of Rsquare that was found in all the models, which implies that additional variables are needed in order to fully explain the profitability of companies. Although the corresponding value of Rsquare has been similarly found to at rather low levels in related studies (e.g., Gill et al., 2010; Dong and Su, 2010; Lazaridis and Tryfonidis, 2006), the results of the current study indicate that future work should include more explanatory variables to ensure a more complete picture of the effects on profitability. The results of the present study suggest that managers should design a good credit policy and maintain a good and up to date Debtors analysis, to more efficiently control their receivables (Sayaduzzaman, 2006; Mathuva, 2010), a variable shown to be significant for the profitability of the business. More specifically, managers of companies operating in Cyprus should concentrate on finding ways to decrease debtor collection period and controllably increase the stock holding period, in order to maximise profits. In 22

23 addition, the study has provided evidence that the most profitable industry sector in Cyprus is the consumers goods industry, whereas the least profitable industry is basic materials industry. It is imperative for managers to be very cautious when deciding on trade credit, since credit management policy choices have important implications for corporate value (Lazaridis and Tryfonidis, 2006; Padachi, 2006; Narware, 2008; Mathuva, 2010; Zariyawati et al., 2010). Offering extensive credit to customers includes the danger of causing cash flow problems within the company and liquidity problems. In a company where days accounts receivables exceed days accounts payables, these problems will start taking effect. From the descriptive statistics in the study, it seems that overall companies receive payments for their sales prior to having to pay for their raw material purchases. When companies do not receive payment for their sales, they will seek external sources of financing, which usually involve short-term loans from banks and overdrafts which consequently raise the financing costs of the companies and are very difficult to obtain these days in Cyprus, when the economy is going through a severe depression. The present study can have practical implications and serve as a reference for managers in Cypriot firms. The results have provided insight on the profitability in Cypriot companies, a topic that lacks empirical evidence in related literature. It has offered insight on the relationship between profitability and working capital management components, and guidelines on how firms can manipulate variables such as their inventory levels, the period they allow their customers to pay for their products and the period the company itself takes to pay its suppliers, in a way that would increase profitability, improve their performance and offer a competitive advantage against competitors. References Cyprus Stock Exchange. (2011, January 9). Information and List: Cyprus Stock Exchange. Retrieved January 9, 2013, from Cyprus Stock Exchange Web site: Deloof, M. (2003). Does Working Capital Management Affect Profitability of Belgian Firms? Journal of Business Finance & Accounting, 30 (3-4),

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