November; THE EFFECT OF WORKING CAPITAL MANAGEMENT ON FIRMS PROFITABILITY IN STABLE AND UNSTABLE FINANCIAL CONDITIONS:

Transcription

1 THE EFFECT OF WORKING CAPITAL MANAGEMENT ON FIRMS PROFITABILITY IN STABLE AND UNSTABLE FINANCIAL CONDITIONS: EVIDENCE FROM LISTED FIRMS IN THE NETHERLANDS November;

2 Abstract This study examines the effect of working capital management on the profitability of Dutch companies. Working capital management (WCM) involves the relationship between a company s short-term assets and its short-term liabilities. I use a sample of 80 companies listed on the Dutch stock market. The research will be conducted in the light of the economic crisis of , and the period prior to the crisis ( ). The purpose of this paper is to determine whether the relationship between WCM and profitability of Dutch companies will change during the crisis ( ). When ROI is used as a measure of profitability, the findings reveal that during the pre-crisis there is (1) a statistically insignificant negative association between number of days inventories and profitability, (2) a statistically insignificant positive association between number of days accounts receivable and profitability, and (3) a statistically significant negative association between number of days accounts payable and profitability. When profitability is measured by GPM the findings show that during the pre-crisis there is (1) a statistically significant positive association between number of days inventories, (2) a statistically insignificant negative association between number of days accounts receivable and profitability, and (3) a statistically significant positive association between number of days accounts payable and profitability. Furthermore the findings show that during the period of the crisis, when ROI is used as a measure of profitability, there is (1) a statistically insignificant positive association between the number of days inventories and profitability, (2) a statistically significant positive association between the number of days accounts receivable and profitability, and (3) a statistically significant negative association between the number of days accounts payable and profitability. When GPM is used as a measure of profitability, the findings reveal that there is (1) a statistically significant positive association between profitability and both number of days inventories and accounts payable, and (2) a statistically significant negative association between number of days accounts receivable and profitability. The results indicate that before and during the crisis, the working capital management policies of companies differed from each other, and therefore the effect of working capital management on profitability was different for both periods. Keywords: Working capital management, profitability, liquidity. November;

3 1. INTRODUCTION 4 2. THEORETICAL FRAMEWORK WORKING CAPITAL MANAGEMENT DETERMINANTS FOR MEASURING WORKING CAPITAL MANAGEMENT WORKING CAPITAL FINANCING APPROACHES LIQUIDITY VS. PROFITABILITY UNLOCKING CASH FROM WORKING CAPITAL REVIEW OF EMPIRICAL STUDIES THEORETICAL UNDERPINNINGS EMPIRICAL RESULTS HYPOTHESIS DEVELOPMENT RESEARCH DESIGN DATA AND SAMPLE SELECTION MODEL DEVELOPMENT EMPIRICAL RESULTS CORRELATION ANALYSIS REGRESSION ANALYSIS RESULTS OF THE FIRST REGRESSION MODEL RESULTS OF THE SECOND REGRESSION MODEL 39 DISCUSSION AND CONCLUSIONS 43 REFERENCES 46 APPENDIX A: ILLUSTRATIVE EXAMPLE OF A COMPANY S NET WORKING CAPITAL 48 APPENDIX B: COMPARING THE NET WORKING CAPITAL OF TWO COMPANIES 49 APPENDIX C: CALCULATION OF THE DETERMINANTS OF WCM 51 APPENDIX D: WORKING CAPITAL FINANCING APPROACH 55 November;

4 1. Introduction Working capital management is used to ensure that organizations are able to fund the difference between short-term assets and short-term liabilities. Many CFO s have a problem to recognize the core working capital drivers and they also have difficulty measuring the proper level of working capital. The outcome of this is that companies are limited in their ability to minimize risk, effectively prepare for uncertainty and improve overall performance. To accomplish these perspectives, companies need to understand the role and the drivers of working capital, but they also need to take steps to reach the right levels of working capital (Harris, 2005). The purpose of working capital management is to keep an optimum level of both working capital components (current assets and current liabilities). An optimum level refers to a balance between risk and efficiency (Filbeck and Krueger, 2005). According to others (Shin and Soenen, 1998) efficient and effective working capital management refers to keeping a balance between liquidity and profitability, because decisions that tend to maximize profitability tend not to maximize the challenges of adequate liquidity. On the other hand, focusing almost entirely on liquidity will tend to reduce the potential profitability of a company. When companies focus on liquidity, they increase the level of investment in current assets, meaning that there will also be an increase in total assets. If return on investment (net profit/total assets) is used as a measure of profitability, than it becomes clear that when total assets increase as a result of the investment in current assets, the profitability of a company will decrease. In times of financial uncertainty it is most likely that companies will shift their focus from maximizing profit to entirely focusing on liquidity to continue their day-to-day operations. This could have consequences for the profitability of companies. It is important that companies give WCM proper consideration, because it can make the difference in times of financial uncertainty. In the Netherlands companies were also under enormous pressure to maintain daily operations running, and maybe companies even went bankrupt. The financial report of the Dutch Bank of 2009 reveals that as a result of the economic recession the Dutch economy diminished with 4%, the largest annual decline ever recorded. In an interview between Prime Minister Jan Peter Balkenende and top executives of the steel company Corus and the truck company DAF is pointed out that the economic recession caused the liquidity position of companies to November;

5 deteriorate. I presume that the first priority of Dutch companies was to improve their liquidity position by keeping an optimal level of working capital. Deloof (2002) and Soenen (1998), reveal that there is a negative relationship between WCM and profitability. Their result motivated me to examine the effect of WCM on the profitability of Dutch companies in the light of the economic recession. I presume that during the economic recession Dutch companies increased their sales level by providing supple credit to their customers and speeded up payment to suppliers in order to get discounts for fast payment. Prior to the crises I expect a reverse situation, where companies tighten up there credit policy and postpone payment to suppliers for as long as possible. In both cases I expect working capital management to have effect on corporate profitability. What the magnitude of that effect is I do not know. So the question remains whether during the financial crises WCM had a significant effect on the profitability of Dutch companies, and if there is a difference between the effect before and during the crises. In order to answer this question properly I will examine whether WCM has effect on the profitability of Dutch companies. Therefore the focus of this research is on WCM and its effect on profitability for a sample of 80 Dutch listed companies on the Amsterdam Stock Exchange (Euronext Amsterdam) over a period of six years. The six years will be separated in a pre-crises period and the period of the crises itself. The first test that I will do will examine the effect of WCM on firms profitability in the pre-crises period and will determine what the magnitude of that effect is. The second test is similar to the first test, but the only difference is that the second test is conducted by using data from the period of the crisis itself. The aim of the second test is to recognize whether Dutch companies improved their WCM policy during the crisis and what the effect was on firms profitability in comparison to the pre-crises period. The findings show that during the crisis, when ROI is used as a measure of profitability, there is (1) a statistically insignificant positive association between the number of days inventories and profitability, (2) a statistically significant positive association between the number of days accounts receivable and profitability, and (3) a statistically significant negative association between the number of days accounts payable and profitability. When GPM is used as a measure of profitability, the findings reveal that there is (1) a statistically significant positive association between profitability and both the number of days inventories and accounts November;

6 payable, and (2) a statistically significant negative association between the number of days accounts receivable and profitability. The paper is organized as follows: Section two and three focus on relevant theoretical and empirical work of WCM and its effect on profitability. Section four consists of the methodology and the framework which includes the sample and the variables used in the empirical analysis. Section five analyzes the results and the last chapter will conclude and discuss the findings. November;

7 2. Theoretical framework 2.1 Working capital management Throughout the years working capital management has been approached from different stand points. The most common used approach argues that the purpose of working capital management is to keep an optimal level of both working capital components, which are current assets and current liabilities (Payne S.M., 2002). Working capital here means the current assets of a company. Current assets refer to those assets that can be converted into cash within a year. Cash, inventory (generates cash when sold) and accounts receivables (produces cash when clients pay off their credit account) are examples of current assets. Current liabilities on the other hand are obligations of a company that have to be paid within a year. Examples of current liabilities are accounts payables and short term loans (loans that have to be paid off within a year). The difference between current assets and current liabilities is the net working capital of a company (Gallagher and Andrew, 1997). The net working capital represents the cash that a company must obtain from non-free sources (bank loans) to carry its current assets (Brigham and Houston, 2009). For an illustrative example see appendix A. Brigham and Houston (2009) define working capital management as a company s policy on its working capital level and how its working capital should be financed. This indicates that a company needs to make decisions about how high its cash level must be, what level of inventory to maintain, and how much to allow accounts receivables to build up. Working capital management is more than a numbers game, because it focuses almost on every business process of the revenue cycle (customer to cash; C2C), the expenditure cycle (procure to pay; P2P) and the supply chain management cycle (forecast to fulfill; F2F). These components the REL Consultancy Group describes as total working capital management. Each of them implies the following (Payne, 2002). The revenue cycle touches all aspects of customer relationship and strategy through credit management. This cycle includes sales processing, order fulfillment, billing, cash collection, dispute management and cash management. The expenditure cycle focuses on the aspects of expenditure management. This cycle contains procedures that reflect on development of purchasing, budgeting, forecasting, ordering of goods and services, receiving those goods and services, processing invoices and issuing payments. November;

8 The supply chain management concentrates on the development of a supply chain strategy to forecast demand, scheduling, production, warehousing and distribution. By managing these cycles effectively and efficiently a company can increase its liquidity position. Companies can do that by (Van der Wielen, 2006): Slow down payment to suppliers, which will result in higher values of accounts payable (expenditure cycle). Persuade customers to pay more quickly, which will result in lower values of accounts receivable (revenue cycle) Lower stocks, which will speed up the turnover of inventory. The result of these actions is that cash will flow faster into the company and slower out of the company. The liquidity of a company can be measured by the size of a company s working capital, and the composition of working capital determines a company s actual liquidity position (Van der Wielen, 2006). It can happen that two companies have the same level of working capital, but still one is more liquid then the other. For an illustrative example see appendix B. 2.2 Determinants for measuring working capital management In the financial literature there are different ways of how working capital management is measured. The most common used determinants for measuring working capital management are discussed in this section of the paper. The cash conversion cycle, the merchandising ratio, the current ratio, the quick ratio, the inventory turnover ratio, the accounts receivable turnover ratio, the accounts payable turnover ratio, sales to net working capital ratio, the comprehensive liquidity index, the net liquid balance and the working capital requirements are a few of the determinants that are used to measure working capital management. The cash conversion cycle The cash conversion cycle (CCC) or the net trade cycle is often used in the financial literature as a measure of working capital management. Berk, Demarzo and Harford (2009), argue that the CCC is also used as a measure of the cash cycle, which is calculated as the sum of a company s inventory days and accounts receivables days minus its accounts payable days. The cash cycle refers to the length of time between the period a company pays in cash to purchase its initial inventory and the period it receives cash from the sales of the output produced from that inventory. The cash conversion cycle is the result of the turnover rates of November;

9 inventory, accounts receivable and accounts payable (Van der Wielen, 2006). According to Jose, Lancaster and Stevens (1996) the CCC measures the time between cash outlays for resources and cash receipts from product sales. Deloof (2003) argues that the CCC is the time lag between the expenditure for the purchases of raw materials and the collection of sales of finished goods, and that it is calculated by the sum of the number of days accounts receivable (or days sales outstanding) and the number of days inventories (or inventory days outstanding) minus the number of days accounts payable. If these ratios are observed, it becomes clear that the CCC is dynamic in the sense that it combines both balance sheet and income statement data to create a measure with a time dimension. In figure 2.1 the CCC is illustrated. The number of days accounts receivable is defined as the average time that passes between invoice and collection of receivables from customers. This ratio is calculated as: The number of days accounts payable reveals a company s ability of how quickly its suppliers are paid. This ratio is calculated as: The number of days inventories shows how long the inventory stays within the company. This ratio is calculated as: November;

10 Figure 2.1 (Cote and Kamm Latham, 1999) accounts payable payment of credit purchases purchases on credit purchases for cash cash inventory sales for cash collection of cash sales on credit accounts receivable Sales for cash and purchases for cash are not included in the CCC, because these two actions result in direct cash in- and outflow, whereas sales on credit and trade credit do not exist. Purchases on credit, sales on credit, the collection of cash and the payment of credit purchases are used to calculate the number of days accounts receivable, the number of days accounts payable and the number of days inventories, which ultimately are used to calculate the CCC. In case a company cannot denounce the CCC to produce positive cash flows, it will be inclined to borrow money to continue its operations. See appendix C for an example of the CCC. The merchandising ratio The merchandising ratio is defined as the aggregation of accounts receivable, inventory and accounts payable turnover ratio, which can be used to examine the CCC in total. This ratio was developed because it becomes complex when an attempt is made to interpret the total impact of accounts receivable, accounts payable and inventory turnover ratio to measure WCM. The difficult part lies in the fact that it is hard to determine whether improvement in one ratio causes the decline of another ratio while assessing the impact on the total CCC. For instance, when the sales on credit policy are tightened, sales of inventory should be affected, November;

11 and when taken together a sound management policy should be able to demonstrate that the loss in sales is minor in relationship to the gain of collections. The merchandising ratio can determine the net effect of such a policy (Cote and Latham, 1999). The merchandising ratio is calculated as follows: ( ) Accounts receivable are reduced by (1-gross margin %) so that it is stated in a consistent dollar with each of the other variables. In order to give a good interpretation of the ratio, the ratio is transposed in terms of the number of days a dollar stays in the cash conversion cycle. This is done with the merchandising ratio-days. The calculation of this ratio is as follows: The current ratio The current ratio is defined as the current assets divided by the current liabilities of a company (Van Horne and Wachowicz, 2001). This ratio indicates whether a company is capable to pay its current liabilities (liabilities that need to be paid within one year) with its current assets. It shows whether a company s cash on hand plus the cash to be collected from accounts receivable and from selling inventory will be enough to pay off the liabilities that will come due in the next period (Tracy, 2008). The level of the current ratio is hard to determine. The important thing is that companies are able to convert current assets into cash on a timely manner, to meet their short-term obligations. However this depends on the customers paying on time and on the marketability of the inventory etc. In most cases companies use a norm of 1.5 up till 2 for the current ratio (ots, 2004). For an example of the current ratio see appendix C. November;

12 The Quick ratio The quick ratio is a more severe test of a company s liquidity position than the current ratio. The quick ratio excludes inventory and includes only cash and items a company can quickly convert to cash. This limited category of assets is known quick or liquid assets. This ratio is calculated as: For an example see appendix C Inventory turnover ratio, accounts receivable turnover ratio and accounts payable turnover ratio The inventory turnover ratio measures how adequate a company is in using its inventory. The ratio measures a company s annual cost of goods sold against its average inventory balance (Hunt, 2009). This view in consistent with the view of Nelson (2008), who argues that the inventory turnover ratio is used to measure how many times in an accounting period the inventory balance sells out. As illustrated earlier the inventory turnover ratio is used to determine the number of days inventory, which tells us how many days of inventory a company had in its position for a given period. The inventory turnover ratio is calculated as: See appendix C for an example of the inventory turnover ratio. The accounts receivable turnover ratio focuses on the efficiency of management in managing its account receivables. Just like the inventory turnover ratio is used to determine the number of days inventory, similarly the accounts receivable turnover ratio is used to determine the number of days accounts receivable. As mentioned earlier the number of days accounts receivable indicates how many days it takes to convert receivables to cash (Hunt, 2009). Feldman and Libman (2007) argue that the accounts receivable turnover ratio measures a company s efficiency in managing and collecting its accounts receivables. The accounts receivable turnover ratio is calculated as (Feldman and Libam, 2007): November;

13 See appendix C for an example of the accounts receivable turnover ratio. The accounts payable turnover ratio companies use to measure how many times they generate and pay accounts payable during the year. The accounts payable turnover ratio is used to calculate the number of days accounts payable, which indicates how long on average a company takes to pay its accounts payable (Baker and Powell, 2005). The calculation of the accounts payable turnover ratio is as follows: See appendix C for an example of the accounts payable turnover ratio. Sales to net working capital ratio The sales to net working capital ratio also known as the working capital turnover ratio is estimated by dividing sales at year s end by net working capital at year s end. This ratio can be useful in comparing a company s own history with those of other companies in the same industry (Pratt and Niculita, 2008). The ratio is calculated as follows: The sales to net working capital ratio is calculated in appendix C. Pratt and Niculita (2008), argue that a more acceptable way to calculate the ratio would be to use average net working capital rather than net working capital at year s end. The ratio is then calculated as: ( ) The comprehensive liquidity index The comprehensive liquidity index (CLI) is weighted version of the current ratio. The problem with the current ratio is that it treats all assets and liabilities as being of equal degree of liquidity (Gangadhar, 2003). The comprehensive liquidity index deals with this problem by weighting each current asset or liability based on its turnover (nearness to cash). The weighting is done by multiplying the monetary value of each current asset of liability by one November;

14 minus the inverse of the asset or liability s turnover ratio. Where more than two turnovers are required to generate cash from the asset, the inverse of each of these ratios is deducted, and the results are added for all the current assets and liabilities. In the case of inventory two turnovers are required to generate cash, first from turnover of inventory to accounts receivable and then turnover of accounts receivable to cash (Beaumont and Begemann, 1996). The calculation of the comprehensive liquidity index is as follows: * ( + * (,( ) ( )-)+ * ( )+ See appendix C for an example of the calculation of the CLI The net liquid balance The net liquid balance (NLB) excludes a company s investment in accounts receivable and inventory as contributions to aggregate liquidity, but it includes other assets to be financed. The argument is that this balance represents a company s true reserve against unforeseen expenditure, since other remedies for cash shortages can be very costly (Gangadhar, 2003). Beaumont and Begemann (1996), argue that the NLB differentiates operational assets from liquid assets in order to measure the true liquid balance of financial assets after operational needs have been met. The net liquid balance is calculated as follows (Beaumont and Begemann, 1996): ( ) Gangadhar s, (2003) calculation of the NLB is similar to Beaumont s and Begemann s calculation, but the only difference is that he divides it by the total assets. The calculation of the NLB according to Gangadhar is as follows: November;

15 Figure 2.2 (illustration of the NLB) Current liabilities Liquid Financial Asset (including notes payable) (cash + marketable securities) Net liquid balance Working capital requirements Total working capital requirement (WCR) is determined by a diversity of factors, such as the general nature of the business, product cycle, production policy, credit policy, growth and expansion. The working capital requirements of a company are basically related to the conduct of business (Khan and Jain, 2008). The working capital requirements are calculated as follows: ( ) ( ) The calculation shows that the accounts are related to the operation cycle and therefore called working capital requirements. 2.3 Working capital financing approaches There are three primary working capital financing approaches, the aggressive approach, the conservative approach and the moderate approach. The aggressive approach This approach implies that companies use more short-term financing to finance current assets. The risk of this approach is fluctuating interest rates and the benefit is a potential for higher increases of returns because of low-cost financing (short-term interest rates are lower than long-term interest rates). Furthermore this approach indicates that short-term debt is used to finance at least the firm s temporary current assets, most of its permanent current assets, and possibly some of its long-term fixed assets (Gallagher and Andrew, 1996). Permanent current assets are current assets that remain, no matter the seasonal or economic conditions and no matter what the type of business cycle (Besley, Eugene and Brigham, 2008). Temporary current assets are current assets that fluctuate with seasonal or cyclical variations in sales (Brigham and Houston, 2009). The aggressive approach is shown in appendix D. The figure in appendix D shows that the company s temporary current assets and most of its permanent November;

16 current assets are financed by short-term debt (the current liabilities). The result is that the company has a relatively small net working capital. The conservative approach Companies that choose for the conservative approach avoid short-term financing to reduce risk, but this approach decreases the potential of maximizing its value because of high cost of long-term debt and equity financing. It involves the use of long-term debt and equity to finance all long-term fixed assets and permanent current assets. Some parts of the temporary current assets are also financed by the long-term debt and equity. The current assets exceed the current liabilities by a wide margin, which results in a large amount of net working capital, as illustrated in figure 2 in appendix D (Gallagher and Andrew, 1996). The conservative approach is shown in appendix D. The moderate approach The moderate approach focuses on keeping a balance between risks and returns. This approach implies that the temporary current assets, that will be on the balance sheet for a short time, must be financed with short-term debt (current liabilities). The permanent current assets and long-term fixed assets that will be on the balance sheet for a long time (longer than a year), must be financed with long-term debt and equity. In this case the company will match its temporary current assets to its current liabilities, and match both permanent current assets and long-term fixed assets to its long-term liabilities and equity (Gallagher and Andrew, 1996). The moderate approach is shown in appendix D. 2.4 Liquidity vs. profitability The survival of a company depends on the capital funds it generates and not so much on the profit it makes. A company that does not make profit can be designated as an unhealthy company, but if a company does not possess working capital, it might result in the company s bankruptcy and closure over a period of time. I am not implying that profit is not important for a company, of course it is. For one, it can be important to attract investors or to maximize shareholders value. That is why management of working capital is of great importance for both profitability and liquidity, because it consumes a lot of time to increase profitability and at the same time maintains liquidity at a minimum risk (Kumar, 2001). Mittal (2009), argues that if working capital increases, liquidity will increase as well, but that a decrease will be spotted in profitability and risk. On the other hand, if working capital decreases, liquidity will November;

17 also decrease, while profitability and risk will increase. Mittal s argument draws forward that an increase in profit is associated with high risk, and that an increase in liquidity is associated with low risk. 2.5 Unlocking cash from working capital When companies are faced with financial problems there is an urgent need for cash in order to keep day to day operations running. To have access to cash is not an easy task to accomplish, but it is possible. It is even possible without attracting cash from outside the company. The challenge is how to unlock cash from working capital. Fundamentally the most important process of unlocking cash from working capital include three important segments of working capital, which are the following (Colina, 2002): revenue management this focuses on receivables, order processing, billing and collections, supply chain management this focuses on inventory and logistics, expenditure management this focuses on purchasing and payables. Companies can unlock cash from working capital by reducing days sales outstanding (DSO), delaying payment to suppliers for as long as possible by stretching days payables outstanding (DPO) and improving days sales of inventory (DSI). So improvements to receivables, payables and inventory processes can result in lower operating cost and improved cash flows (Ellis, 2006). November;

18 3. Review of empirical studies 3.1 Theoretical underpinnings Deloof (2003) discusses that a long cash conversion cycle (measure of working capital management) may lead to an increase in profitability, because it leads to higher sales. Nevertheless it must not slip management s attention that a long cash conversion cycle can also lead to a decrease in profitability, when costs of higher investments in working capital rise faster than the benefits of holding more inventories and/or granting more trade credit to customers. Shin and Soenen (1998), argue that large sales and a generous credit policy lead to a long net trade cycle, which may result in higher corporate profitability. On the contrary they argue that a long net trade cycle hurts the profitability of a company, which is consistent with the argument of Deloof (2003). In essence they explain that a short net trade cycle is associated with a higher present value of the net cash flow generated by current assets. It is furthermore explained that with a short net trade cycle a company will manage its working capital efficiently and will lower its need for external financing, which will increase its financial performance. The rationale of both arguments, Deloof (2003) expounds by implicating that a company s sales may increase with large inventory and/or a generous trade credit policy, because large inventory reduces the risk of a stock out, and trade credit can spur on sales because customers are able to assess the quality of the product before paying, which in the end maximizes the company s value. The turning point of keeping large inventory and granting trade credit is that money is locked up in working capital, and an inefficient investment in working capital can reduce profitability. Deloof also explains that delaying payment to suppliers makes it possible for companies to assess the quality of the products bought, which is an inexpensive financing procedure. On the contrary he illustrates that late payment can be very costly for a company if a discount is offered for early payment, and that this can cause a decrease in a company s profitability. Jose and Lancaster (1996), argue that an aggressive (conservative) approach to liquidity management results in a lower (higher) CCC, by reducing (increasing) the inventory and the accounts receivable period, and by increasing (reducing) the accounts payable period. Their argument is clarified by explaining that if the inventory period and the accounts receivable period are reduced too far, the firm risks lost sales as a result of respectively stock outs and November;

19 customers requiring credit, and a to high increase in the accounts payable period will result in the loss of both discounts for early payments and flexibility for future debt. The essence of the arguments of Deloof (2003), Shin et al. (1998), and Jose et al. (1996) reveal that strict WCM refers to keeping a low level of accounts receivable, inventory and cash, but a high level of accounts payable. These current assets are concentrated into one measure, namely the cash conversion cycle (or net trade cycle). Their argument forms a theory which suggests two possible relationships between WCM and profitability. The first relationship indicates that strict WCM leads to higher profitability, because less cash is locked up in operating activities which leads to lower financing needs and more efficient use of assets. The second relationship shows that lenient WCM leads to higher profitability, meaning that when companies offer customers generous trade credit terms, sales will increase. Furthermore lenient WCM can also mean that fast payment to suppliers can acquire payment discounts and create a devoted business relationship between a company and its suppliers (good for the quality of the supplies). Chiou and Cheng (2006), investigate the determinants of WCM, rather than the relationship between WCM and profitability. They argue that the business indicator (fluctuations of general economic performance in the long-term development of an economy) is negatively related to the net liquid balance (measure of WCM), because they claim that in times of economic recession it is hard for companies to raise money and that in order to retain capital for daily operations the net liquid balance is kept at a high level. They also expect a negative relationship between business indicator and working capital requirements (measure of WCM), because in an economic recession, the authors argue, a company s growth might slow down due to a longer period for collecting accounts receivable or holding large inventories as a result of a decline in sales. Furthermore Chiou and Cheng expect the debt ratio to be negatively related to the net liquid balance and working capital requirements, meaning that more debt leads to less internal capital available for operations. Growth rate of a company and operating cash flows were expected to be positively related to the net liquid balance and negatively related to working capital requirements. The positive relationship reveals that fast generating cash flows from operating activities lead to better working capital management. This the authors clarify by implying that if the payment of operation-related liabilities is lengthened and if the operation-related receivables November;

20 are accelerated in collection, it will cause less demand on working capital. The negative relationship indicates that companies have more efficient working capital management when operating cash flows increase. In terms of growth the negative relationship indicates that in the early ages of a company its growth rate will be high and that it will slow down when time passes, which means that working capital management will become less efficient when the company gets older. 3.2 Empirical results Deloof (2003) investigates the relationship between working capital management and corporate profitability for a sample of 1009 Belgium non-financial firms from 1992 to Mainly he examines the effect of WCM on profitability, using the number of days accounts receivable, the number of days accounts payable and inventory as a measures of trade credit and inventory policy. He uses the cash conversion cycle as a measure of WCM and the gross operating income as a measure of profitability. The results reveal that the number of days accounts receivable, the number of days accounts payable, inventory and the cash conversion cycle are negatively related to the gross operating income, which is consistent with the view that a long CCC decreases corporate profitability and that a decrease of the CCC will increases corporate profitability. These results do not correspond with the theory that lenient WCM leads to higher profitability, but on the contrary the results show that lenient WCM leads to a decrease in profitability. However part of the theory does show consistency with the results, indicating that speeding up payments to suppliers will cause corporate profitability to increase, because according to Deloof, Belgium companies often receive a substantial discount for prompt payment. Based on his findings he purposes that by reducing the number of days accounts receivable and inventory to a reasonable minimum, shareholder value can be created. Shin and Soenen (1998), examine the relationship between a firms net trade cycle (also known as the cash conversion cycle) and its profitability using a sample of 58,985 firm years from the Compustat Annual Industrial and full coverage files, covering the period They use the net trade cycle as a measure for working capital management and profitability is measured by operating income plus depreciation related to total assets (IA: operating income + depreciation/total assets) and to net sales (IS: operating income + depreciation/net sales). November;

21 The results reveal that there is a strong negative relationship between the length of the company s net trade cycle and its profitability. The results also reveal that a company with a relatively short net trade cycle has higher risk adjusted stock returns. So reducing the net trade cycle to amplify the efficiency of a company s working capital management will lead to an increase in operating income and high risk-adjusted returns for shareholders. The results are coherent with the theory that strict WCM leads to higher profitability, because it indicates an efficient use of current assets (low cash, low receivables and low inventory) and current liabilities (high level of accounts payable). Jose and Lancaster (1996), examine the relationship between the CCC and profitability to ascertain whether aggressive liquidity management (increase of investments in current assets) is affiliated with higher returns. Operating return on assets (income before taxes divided by stockholder equity) and pre-tax return on assets (income before taxes divided by stockholders equity) are used to determine whether financial structure differences affect the CCCprofitability relationship. Their sample consists of a large cross section of 2718 companies from the annual Compustat tapes over a twenty year period ( ). The research was conducted using data from several industries, such as: natural resources construction, manufacturing, retail, financial services and professional services. The findings show that aggressive liquidity management (lower CCC) is associated with higher profitability, which is consistent with the theory that strict WCM will cause an increase in corporate profitability. In summary the results show that besides the strict and lenient WCM concepts there can be other WCM concepts as well, and that each concept can have a different effect on the profitability of a company. The determinants of WCM can be the reason for the different concepts of WCM. Therefore it is important to reflect on the fact that there are factors which affect working capital management, and that this effect can shape the relationship between working capital management and profitability. 3.3 Hypotheses development The hypotheses to be tested in this thesis are derived from the theoretical underpinnings and results of previous studies discussed in the first and second section of this chapter. The hypotheses are formulated with the underlying idea to test the prognostic impact of WCM on profitability in times of financial distress. The measures of WCM used in this paper are namely; the number of days inventory, the number of days accounts receivable and the November;

22 number of days accounts payable. Prior studies (Deloof, 2003) found a negative relationship between profitability and the number of days accounts receivable, the number of days inventory and the number of days accounts payable. However, none of these studies were conducted in the light of an economic recession. In that respect this paper differs from other academic research done on this subject. It is hard to make any predictions of how the number of days inventory developed before and during the crisis. Based on requirements of customers, companies could have bought more or less inventory during these two periods. Therefore it is difficult to determine whether an increase or a decrease was seen in the number of days inventory during the crisis, which makes it hard to hypothesize what the effect of the number of days inventory is on profitability during the crisis. I presume that during the crisis the level of accounts receivable was significantly higher than before the crisis, indicating that during the crisis companies offered their customers a longer period to meet their payment obligations. The purpose of this policy choice was probably to promote sales. Deloof (2003) found that a high level of accounts receivable has a negative effect on profitability. Despite his results, I still assume that the effect of the number of days accounts receivable on profitability is less negative during the crisis. Figure 3.1 illustrates the predicted relationship between the number of days accounts receivable and profitability before and during the crisis. Figure 3.1: Relationship betw een Receivable days and profitability during and /RECDAYS-PROFITABILITY /RECDAYS-PROFITABILITY Note: Figure 3.1 illustrates the predicted relationship between profitability and the number of days accounts receivable before and during the crisis. Profitability is laid out on the Y axis and the number of days accounts receivable is laid out on the X axis. Figure 3.1 shows that during the period the number of days accounts receivable is expected to be negatively related to profitability. The period indicates a positive association between the number of days accounts receivable and profitability. Based on these predictions hypothesis 1 is developed. November;

23 Hypothesis 1: The relationship between the number of days accounts receivable and profitability is more positive (less negative) during the crisis. The development of accounts payable before and during the crisis was probably different from the development of accounts receivable. I am assuming that before the crisis companies probably postponed the payment to suppliers and that during the crisis payment to suppliers was accelerated (probably to create a devoted business relationship). I think that delaying payment to suppliers will have a positive effect on profitability, and that faster payment will have a less positive effect on profitability. Figure 3.2 illustrates the predicted relationship between the number of days accounts payable and profitability before and during the crisis. Figure 3.2: Relationship between Payable days and profitability during and / PAYDAYS-PROFITABILITY /PAYDAYS-PROFITABILITY Note: Figure 3.2 illustrates the predicted relationship between profitability and the number of days accounts payable before and during the crisis. Profitability is laid out on the Y axis and the number of days accounts receivable is laid out on the X axis. Figure 3.2 shows that during the period the number of days accounts payable is expected to be positively related to profitability. The period indicates a less positive association between the number of days accounts payable and profitability. These assumptions lead to the development of hypothesis 2. Hypothesis 2: The relationship between the number of days accounts payable and profitability is more negative (less positive) during the crisis. November;

24 4. Research design 4.1 Data and sample selection The empirical investigation of this paper is conducted by using a sample of Dutch publicly traded companies in the period from 2004 to The data of these companies were obtained from the Dutch stock market (Euronext Amsterdam), and were collected from the Datastream Database. Companies in the financial sector (banks, insurance agencies and real estate agencies) were excluded from the sample, mainly because these companies do not produce ratios that measure WCM. The initial sample consisted of 110 companies, but with the exclusion of the financial companies and companies with incomplete data, the final sample consists 80 companies. The data are divided in two periods of three years, whereas the first period contains data of the pre-crises and the second period contains data of the crises itself. I used a part of the data to calculate the cash conversion cycle, the leverage, the sales growth, the number of days inventories, the number of days accounts receivable and the number of days accounts payable. The other variables (sales, net cash flows) were collected from Datastream. Table 1 presents the descriptive statistics of the sample for the pre-crisis period and table 2 for the period during the crisis. The differences between large and small companies in these periods are shown with minimum and maximum. ROI and GPM vary from negative to positive in both periods. Table 1 shows that ROI and GPM are on average and 23.58, while table 2 shows an average of 7.56 for ROI and for GPM. During the pre-crisis companies received payment on sales after an average of days, and during the crisis this is an average of days. Table 1 also reveals that it takes on average days to sell inventory, and that companies wait on average days to pay for their purchases. In table 2 it is an average of respectively and In the period prior to the crisis companies had an average sales growth of 22.45%, but during the crisis the sales growth of companies had an average of 7% (a decrease of 15.45%). Although the results indicate that there is a small difference between WCM before and during the crisis, the fact remains that during the crisis companies offered their customers generous trade credit terms, and payment to suppliers was accelerated. The results indicate that the expectations regarding the development of the number of days accounts receivable and the number of days accounts payable were correct. If the median is used to establish the results of the descriptive statistics, it seems that before the November;

25 crisis it took companies on average days to collect money from credit sales, and during the crisis payment on sales was received after an average of days. The median number of days accounts payable and inventories are on average days and days before the crisis. During the crisis the median number of days accounts payable and inventories showed an average of days and days. The median number of days accounts receivable, accounts payable and inventories are illustrated in figure 4.1. The figure shows that: - during the crisis ( ) it took companies longer to sell inventory. - after 2006 the number of days accounts receivable was decreasing, indicating that companies collected their receivables faster during the crisis. This result does not match the predictions concerning the development of accounts receivable during the crisis. - in 2007 and 2008 companies accelerated payment to suppliers, compared to the years before. Although payment to suppliers was slowed down in 2009, my predictions are in line with the development of accounts payable in 2007 and November;

26 Table 1; Descriptive Statistics of the pre-crises period ( ) N Minimum Maximum Mean Median Std. Deviation ROI ,54 122,10 10,34 11,91 20,36 GPM ,95 75,42 23,58 20,78 15,84 Sales 240, , , , ,17 SG 239-1,00 6,85,2245,08,77 LEV 240 -,15 2,43,5342,54,23 OCF , , , , ,22 Invdays , ,41 81,73 60,80 105,18 Recdays 239 3, ,20 99,74 69,00 304,31 Paydays 238 3,35 765,25 59,56 46,63 79,95 Valid N (listwise) 175 Note: Sales indicate the yearly sales of Dutch companies in Euro's. Sales growth (SG) is (this year's sales - previous year's sales)/previous year's sales. Leverage (LEV) is total liabilities divided by total assets. Operating cash flow indicates the net operating cash flows from operating activities. The calculation of the number of days inventory (Invdays),the number of days accounts receivable (Recdays) and the number of days accounts payable (Paydays)are described in paragraph 2.2. November;

27 Table 2. Descriptive Statistics of the period of the crises ( ) N Minimum Maximum Mean Median Std. Deviation ROI ,71 152,16 7,56 10,23 22,40 GPM ,36 73,08 23,45 21,15 18,99 Sales , , , , ,08 SG 238-1,00 3,69,07,03,43 LEV 238 -,08,98,55,55,18 OCF , , , , ,13 Invdays 192,74 501,00 78,36 68,30 78,51 Recdays 238 5, ,25 111,53 67,91 412,46 Paydays 231 3,49 159,36 50,66 44,67 30,38 Valid N (listwise) 175 Note: Sales indicate the yearly sales of Dutch companies in Euro's. Sales growth (SG) is (this year's sales - previous year's sales)/previous year's sales. Leverage (LEV) is total liabilities divided by total assets. Operating cash flow indicates the net operating cash flows from operating activities. The calculation of the number of days inventory (Invdays),the number of days accounts receivable (Recdays) and the number of days accounts payable (Paydays)are described in paragraph 2.2. November;