An Investigation into the relationship between working capital management and stock price. (Evidence of tehran stock exchange)

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1 An Investigation into the relationship between working capital management and stock price (Evidence of tehran stock exchange) Mohammad Ali Karchani* 1, Ibrahim Givaki 2 ISSN Research Article 1 Department of Accounting, Khomein Branch, Islamic Azad University, Khomein, Iran 2 Faculty Member, Department of Accounting, Khomein Branch, Islamic Azad University, Khomein, Iran ABSTRACT Financial strategy is a framework to guide the decisions which determine the nature and direction of the finances in a given organization. Therefore, financial strategy is a dynamic and interrelated set of reactions and responses adopted based on various environmental conditions and reactions of other organizations in the environment. In contrast, financial policies are made up of specific financial variables. For a profit-oriented business unit, the most important strategic objective is to optimize the wealth of the owners. The increasing importance of working capital in the continuation of the activity of profit unit led different strategies to be considered for the management of working capital. This study seeks to identify working capital policies affecting shareholder wealth. Accordingly, the relationship between the three aggressive, conservative, and moderate strategies of working capital and the stock price of companies listed in Tehran Stock Exchange during 2007 to 2011 was studied. To examine the relationships between the variables, data of 179 manufacturing companies were studied using Pearson's correlation coefficient. The evidence suggested that aggressive and moderate strategies had no correlation with stock price; however, if both current and quick ratios were at the moderate level of industry and debt ratio was at moderate or lower level of industry, the conservative working capital strategy would have a significant relationship with stock price. Keywords Stock Price; Working Capital Management; Aggressive strategy; Conservative Strategy; rate Strategy. INTRODUCTION One of the key issues for the managers of a business unit is working capital management which plays an important role in the growth and survival of that business unit. Equilibrium between current assets enjoys a high importance since decision making on each of the assets will impact others. Gross working capital is defined as the total amounts invested in current assets. If current debts are subtracted from current assets, the net working capital is obtained. Working capital management is one of the most important issues in management structure. Due to the inflationary situation and reduction of the purchasing power of money, most Iranian firms prefer to convert cash into other assets; meanwhile, this leads to the shortage of liquidity of companies' debt maturity and destructing the reputation of the organization. On the other hand, the lack of working capital is one of the main reasons for the importance of working capital in most firms that are faced with financial distress and the fate of some of them is finally bankruptcy. Investors are also looking for investments that have maximum stock return and * Corresponding Author Mohammad Ali Karchani in this case, investors must trust the available situation and this is obtained by consultation and planning to clarify the dark aspects of the investment path. In this case, an investor encounters two problems: first, how much and in what areas he invests and second, how he guides investment within a long-term horizon. For these cases, there is a need to formulate a strategy that recognizes today s market. Working capital management has various strategies which are obtained from the integration of the strategies of current assets and current debt. With regard to different circumstances, in working capital management, an appropriate strategy should be selected for the company in order to manage effectively current assets and of a business unit and properly meet its financial needs. In this way, the company's stock price increases and shareholders wealth maximizes as well. Through integrating the current assets and current debts, the general strategies of working capital management can be divided into three categories: conservative strategy, conservative strategy, and moderate strategy. Given the importance of working capital, this study helps managers to apply an optimal strategy of working capital based on the conditions of the business unit so that the strategy can maximize the inter- JK Welfare & Pharmascope Foundation International Journal of Review in Life Sciences 20

2 ests of business unit as well as those of the shareholders and thereby, it can attract investors. Therefore, in the present study, given the issues related to working capital management, investment, and increasing shareholders value, we seek to find the answer for the question that whether the policies adapted for working capital management are associated with the company's stock price or not. In other words, this study aims to identify the type of the relationship between strategies of working capital management and the stock price of companies listed in Tehran Stock Exchange. THEORETICAL FOUNDATIONS AND RESEARCH BACK- GROUND Long-term capital Management is related to capital budgeting and capital structure; however, asset management and current debt are in the field of working capital management. Working capital meets shortterm requirements of business enterprise and is a trading capital which does not remain in company more than a year. The payment invested in these items changes during business operations. The need to maintain sufficient working capital can hardly be questioned. As blood circulation in human body is a very important need to live, cash flow statement is very useful to sustain the business operations (Casey Van, 2006). Working capital management is one of the most important components of the finances of companies because it directly affects liquidity and profitability of the company. The literature in the finance of companies has traditionally focused on long-term study on financial decisions. In addition to the analysis of investment, researchers recommend for the detailed studies of capital structure, company valuation, and other related issues. In short-term investments, the issue that a company should use resources with short-term maturity (under one year) indicates that current assets are one of the most important items of balance sheet (Pedro and Pedro, 2007). The analysis of factors affecting working capital management shows how working capital management in a company is influenced by various variables including business indicators, industry effect, cash flows, company's performance, and the size of the company; however, variables such as business indicator, industry effect, company's performance, and the size of the company lead to the continuous result of balance liquidity and required working capital for the company. These studies indicate the consistence of the obtained results and operating cash flows and complete balance between them and required working capital (Chiu and Chang, 2006). Each profit unit with the current ratio of more than 1 has a positive working capital. For a certain level of current debts, the greater the working capital of profit unit, the higher the current ratio will be. Contracts to long-term debts often include cases Karchani et al., Int. J. Rev. Life. Sci., 4(10), 2014, such as the maintenance of certain amount of working capital. Considering these cases aims to provide a good safety margin for lenders because it is assumed that the current assets can provide more liquidity compared to other assets of profit unit (Shabahang, 2002). If working capital weakens, the company can hardly continue its activity. Lack of sufficient working capital is defined as a major cause of bankruptcy of small business units in many developing and advanced countries (Rafus, 1996). The success of a business unit depends on its ability to achieve more cash compared to its payment. Issues of cash flow have troubled many small business units due to poor financial management and particularly due to the lack of planning for cash needs (Jaroisital, 1996). For the company whose objective is to obtain profit, which policy is favorable in terms of working capital management? In general, the answer to this question is an easy task. For working capital a policy is desirable which maximizes shareholders wealth. But, in practice, implementing this policy and converting it into liquidity ratio, current ratio, and favorable working capital are not so simple and this is because several variables including operating environment of company should be simultaneously controlled and influenced over them. So, when managers adopt a policy on working capital and implement specific strategies on the structure of current assets and current debts of the company, they will have to act on their personal taste and subjective judgment. In their study, Shin and Soynin (1998) examined the efficiency of working capital management. In their study, the net of commercial activity period was considered as the efficiency criteria for working capital management. The results of the study performed based on the alpha of sex, Trainer index, and regression analysis indicated that there was a significant inverse relationship between cash conversion cycle and companies profitability. Managers could reasonably increase the period of company's profitability through reducing cash conversion cycle and its components, including collection of debts, deposits of creditors, and inventory turnover too. In a study in line with the study by Shin and Soynin (1998), Mark Dalaf (1998) investigated 1637 companies within 1991 and 1995 in Belgium. In his study, Dalaf used cash conversion cycle, collection of debts, inventory turnover, and deposits of creditors as a measure of working capital management, the ratio of gross profit to total assets as a measure of the profitability of the company, and growth of sale, size of company, ratio of financial assets to total assets and the ratio of financial debt to total debts as control variables. The results of the study based on the Pearson correlation and regression analysis revealed that there was a significant inverse relationship between cash conversion cycle whose components included the collection of debts inventory turnover, and deposits of creditors and company's profitability. JK Welfare & Pharmascope Foundation International Journal of Review in Life Sciences 21

3 In their study, Anand and Prakash Gupta examined the performance of working capital management of companies between 1991 and In this study, 427 companies were selected as the sample. In order to evaluate the performance of working capital management of companies, criteria of the efficiency of cash conversion cycle, operating cycle flow, and working capital flow were used. The results of the study showed that in addition to the usefulness for working capital management, criteria selected for evaluating the performance of working capital management helps to analyze the risk and return of companies too. Raheman (2006) studied the effect of various variables of working capital such as inventory turnover during the day, the average payment period, and cash conversion cycle on the operating net profit of company and came to the conclusion that there was a significant negative relationship between the ratio of working capital and company s profitability. Managers could also create positive value for shareholders by reducing the time of cash conversion. Tryfonidis and Lazaridis (2006) investigated the relationship between profitability and working capital management. The results revealed that there is a negative relationship between profitability (measured through gross operating profit) and cash conversion cycle used as a measure of the effectiveness of working capital management. PADACHI (2006) examined the process of required working capital and profitability of companies and found that the increase in the value of inventory and demands will be associated with lower profitability and showed that in short term, the growing trend should be done through short-term financing. Nasr (raheman, 2007) evaluated the impact of working capital management on liquidity and profitability of the company. The results indicated that there is a negative relationship between working capital management and company s profitability. It was also indicated that there is a negative relationship between liquidity and profitability, a positive relationship between the size of company and its profitability, and a negative relationship between its profitability and debts. Samilog and Dimyrns (2008) studied a sample of Turkish manufacturing companies over the period of 1998 to 2007 in order to examine the relationship between profitability and working capital management and concluded that accounts receivable period, inventory period, and leverage have a significant and negative effect on company's profitability while the growth of company has a significant and positive effect on company's profitability. However, cash conversion cycle, the size of company and fixed assets has statistically significant impact on the profitability of companies. Karchani et al., Int. J. Rev. Life. Sci., 4(10), 2014, companies could select the optimal amount of working capital by good management of working capital. After reviewing the status of working capital of companies studied during 1998 to 2002 in the form of 5 hypotheses, Enaiati (2004) concluded that ways of cash management impacts the liquidity of companies and that there is a significant relationship among them. Also, there is a significant relationship between the management methods of debts and liquidity of companies and the way of inventory management influences the inventory period while it has no effect on the comprehensive liquidity index. In addition, methods of financing have an impact on companies liquidity and the type of industry and size of companies are factors determining the management of cash and its effectiveness. Based on the separation of financial and operating policies of companies, Khurramnejad (2007) analyzed working capital management of companies in the pharmaceutical industry listed in Tehran Stock Exchange. In this study, the effect of various environmental and internal factors of company was studied on two components of working capital including net cash and required working capital. The results of the study showed that the separation of policies can to some extent be observed. The financial policies of pharmaceutical companies are generally aggressive; while their operational policies are conservative. The remaining net cash which indicates companies financial policies is at the minimal level, while the required working capital which reflects their operating policies is at its greatest extent. Heydariyan J. (2007) investigated the empirical evidences about the impact of working capital management on the profitability of companies in Iran. The results suggested that management can make volubility for company through decreasing the rate of inventories and the number of days of collection of receivables period. In addition, making the cash conversion cycle shorter can also improve the profitability of companies. Mohammadi M. (2009) examined the effect of working capital management on companies profitability in companies listed in Tehran Stock Exchange. In his study, the ratio of gross profit to total assets were used as a measure of companies profitability, collection of receivables, inventory turnover, deposit of creditors and cash conversion cycles a measure of working capital management, and the size of company, growth of sale, and the ratio of financial assets to total assets as control variables. The results of the study showed that there is a significant inverse relationship between companies profitability and the collection of receivables, inventory turnover; deposit of creditors, and cash conversion cycles, in other words, managers can reasonably increase In his study conducted via questionnaires, Pishkari (1996) found that 68% of companies which used the method for their working capital management influencing the total cost of goods or services and 71% of JK Welfare & Pharmascope Foundation International Journal of Review in Life Sciences 22

4 company s profitability by reducing the collection of receivables and cash conversion cycle. RESEARCH HYPOTHESES The studies conducted on working capital management show that researchers try to understand what variables affect working capital management and managers uses what kind of strategy of working capital for increasing shareholders wealth. Few studies limited in scope have so far been conducted on the effect of strategies of working capital management on the stock price. Therefore, in this study, we examine the impact of policies of working capital management on stock price of companies listed in Tehran Stock Exchange. In fact, this study seeks to find a convincing answer to this research question: are strategies of working capital management associated with stock price? In order to follow the above-mentioned research question, three hypotheses have been formulated as follows: Hypothesis 1: Aggressive working capital strategy has a significant relationship with stock price. Hypothesis 2: Conservative capital stock strategy has a significant relationship with stock price. Hypothesis 3: rate capital stock strategy has a significant relationship with stock price. METHODOLOGY In terms of the objective, this study is applied and with regard to the nature of the study, it is a correlational one. Correlational studies include all studies in which the relationship among various variables is tried to be explored and determined using correlation coefficient. In this study, using SPSS software, Pearson correlation test has been performed. The spatial domain of the study is Tehran Stock Exchange and its temporal domain is 2007 to 2011 year. The samples were selected based on the following conditions: 1- Samples belong to the manufacturing companies listed in Tehran Stock Exchange and their required information is available during the time period of the study. 2- The end of the fiscal year of companies is March 29 and they do not have trading interruption more than six months during the study period. According to the above criteria, the statistical sample of the study included179 companies. In the following, the way of measuring the variables of the study are addressed. MEASUREMENT OF THE VARIABLES Aggressive working capital strategy: Indexes Karchani et al., Int. J. Rev. Life. Sci., 4(10), 2014, In this study, aggressive working capital strategy has been measured in two modes: A) The current and quick ratios are less than the moderate level of industry and debt ratio is at the moderate or more level of industry. B) Either quick ratio or current ratio is at the moderate level of industry and the other ratio is lower than moderate level of industry and the debt ratio is also higher than the industry moderate level of industry. Conservative capital stock strategy: To calculate the conservative working capital strategy, the two following criteria were used: A) If both current and quick ratios are at the moderate level of industry, debt ratio will be at the moderate or lower than the industry. B) If one of the two current and quick ratios is at the moderate level of industry, the other ratio will be higher than the industry and the debt ratio will be lower than the industry. rate capital stock strategy: This strategy has also been measured using the f following our criteria: A) Both current and quick ratios are higher than the moderate level of industry and the debt ratio is higher B) Both current and quick ratios are lower than the moderate level of industry and the debt ratio is lower C) One of the current and quick ratios is at the moderate level of industry and the other ratio is higher than the moderate level of industry and the debt ratio is higher D) If one of the current or quick ratios is at the moderate level of industry, the other ratio will be lower than the moderate level of industry and the debt ratio will be lower than or at the moderate level of industry. Stock price: The price related to the end of fiscal period of company's stock i.e. 29 March has been used for the stock price. RESULTS Table (1): Descriptive statistics of the research data Aggressive working capital strategy Current ratio Quick ratio Debt ratio Stock price In this study, according to the hypothesis with two variables and type of its correlation, Pearson correlation coefficient has been used at the error level of 5% to examine the significance of the relationships between the variables. Descriptive statistics of the research data have been given in Table (1) In addition; the results of testing hypotheses have been displayed In Tables (2), (3), and (4). Working capi- JK Welfare & Pharmascope Foundation International Journal of Review in Life Sciences 23

5 Mean Middle SD Minimum Maximum Mean Middle SD Minimum Maximum Mean Middle SD Minimum Maximum Conservative working capital strategy a 1.222a 0.168a 808a E rate working capital strategy a tal strategy a a a TESTING THE FIRST HYPOTHESIS The first hypothesis indicates that aggressive working capital strategy has a significant relationship with stock price. This hypothesis has been investigated with stock price in two modes: A) The current and quick ratios are less than the moderate level of industry and debt ratio is at the moderate or more level of industry. B) One of the quick or current ratios is at the moderate level of industry and the other ratio is lower than moderate level of industry and debt ratio is also higher than the industry moderate level of industry. With regard to Table (2), it is observed that in both modes of A and B, the level of significance of the test is more than 5% (0.556 and 0.168). Therefore, no significant relationship has been established between the two variables of the hypothesis. As a result, aggressive working capital strategy has no significant relationship with stock price and the first hypothesis is not confirmed. Table (2): The results of testing the first hypothesis A B Number Pearson correlation coefficient TESTING THE SECOND HYPOTHESIS ɑ Level of significant The second hypothesis suggests that the conservative working capital strategy has a significant relationship with stock price. This hypothesis has been evaluated with the stock price in two modes: A) If both current and quick ratios are at the moderate level of industry, debt ratio will be at the moderate or lower than the industry B) If one of the two current and quick ratios is at the moderate level of industry, the other ratio will be higher than the industry. With regard to Table (3), it is observed that in the mode A the level of significance of the test is less than 1% (0.000). Thus, according to confidence level of 99%, it can be said that a significant relationship exists between the two variables of the hypothesis; in other words, if both current and quick ratios are at the moderate level of industry and debt ratio is also at the moderate or less than the level of industry, it can be claimed that conservative policy has a significant relationship with stock price. But in mode (B), the level of significance of testing is more than 5% (0.749). So if one of the two current and quick ratios is at the moderate level of industry and the other ratio is higher than the industry, the conservative working capital strategy will have no significant relationship with stock price. A B Table (3): Results of the second hypothesis Number Pearson correlation coefficient ɑ Level of significant JK Welfare & Pharmascope Foundation International Journal of Review in Life Sciences 24

6 TESTING THE THIRD HYPOTHESIS The third hypothesis suggests that moderate working capital strategy has a significant relationship with stock price. This hypothesis has been compared with the stock price in four modes: A) Both current and quick ratios are higher than the moderate level of industry and the debt ratio is higher B) Both current and quick ratios are lower than the moderate level of industry and the debt ratio is lower C) One of the two current and quick ratios is at the moderate level of industry and the other ratio is higher than the moderate level of industry and the debt ratio is higher D) If one of the current and quick ratios is at the moderate level of industry and the other ratio is lower than the moderate level of industry, the debt ratio will be lower than or at the moderate level of industry. With respect to Table (4), it can be observed that in the four modes (A), (B), (C), and (D), the level of significance is more than 5%. Therefore, the moderate working capital strategy has no significant relationship with the stock price; consequently, the third hypothesis is not confirmed. Table (4): The results of testing the third hypothesis A B C D Number Pearson correlation coefficient DISCUSSION AND CONCLUSION ɑ Level of significant In this study, the relationship between the three aggressive, conservative, and moderate strategies of working capital management with stock price of companies listed in Tehran Stock Exchange were studied. Results indicated that: 1. If both current and quick ratios are less than the moderate level of industry and the debt ratio is at the moderate or greater than the level of industry, aggressive working capital strategy has no relationship with the stock price. Also, if one of the two current and quick ratios is at the moderate level of industry, the other ratio is less than the moderate level of industry, and the debt ratio is more than the moderate level of industry, aggressive working capital strategy of has no relationship with the stock price. 2. We found that if both current and quick ratios are at the moderate level of industry and the debt ratio is at the moderate or greater than the level of industry, conservative working capital strategy has a significant relationship with the stock price while if one of the two current and quick ratios is at the moderate level of industry and the other is higher than the moderate level of industry and the debt ratio is lower than the moderate level of industry, conservative working capital strategy has no significant relationship with the stock price. 3. If both current and quick ratios are higher than the moderate level of industry and the debt ratio is more than the moderate level of industry, moderate working capital strategy has no relationship with the stock price. Furthermore, if both current and quick ratios are less than the moderate level of industry and the debt ratio is lower than the moderate level of industry; moderate working capital strategy has no relationship with the stock price. Also, we found if one of the two of current and quick ratios is at the moderate level of industry, the other ratio is higher than the moderate level of industry, and the debt ratio is at the moderate level of industry, moderate working capital strategy of has no relationship with the stock price. Finally, we concluded that if one of the two current and quick ratios is at the moderate level of industry, the other ratio is lower than the moderate level of industry, and the debt ratio is less than the moderate level of industry, moderate working capital strategy of has no relationship with the stock price too. According to the results of the study, the researchers are suggested to do the following studies in the future: 1 Investigation of the relationship between working capital strategies and stock return 2 - Investigation of the effect of strategies of working capital management on companies profitability 3 - Investigation of the role of working capital management in the continuation of companies activity. REFERENCES Amri Asrami M., (2001), Examination of Information Content of Earnings, Working Capital, and Cash Flow in Corporate Liquidity, MA. Thesis in Financial Management, Tehran University Jahankhani, A. and Parsaiian, A. (2001), Financial Management, Volume II, translated by and adapted from Raymond P.Neveus book; Tehran: SAMT Publication Hajizadeh Gharamaleki R., (2004), The Relationship between Accounting earring and Stock Return in the Optimal Portfolio, M.A Thesis in Financial Management, Shahid Beheshti University in Tehran Anayati, S., (2005), Examination and Explanation of Working Capital in Companies Listed in Tehran Stock Exchange, M.A Thesis in Financial Management, Shahid Beheshti University of Tehran JK Welfare & Pharmascope Foundation International Journal of Review in Life Sciences 25

7 Ezadinia N., (2003), The Evaluation of Commercial Units Using Economic Value-added and Free Cash Flow ls and Determination of the Gap between Price and Value of Stock, Doctoral Dissertation, Tabatabai University Erfanian D., (2005), The Relationship between Economic Added Value and Process of Stock Price in Companies listed in Tehran Stock Exchange, M.A Thesis, Islamic Azad University, Science and Research Branch, Tehran Tehrani R. and Norbakhsh A., (2007), Investment Management, Translated and adapted from Charles P. Jones, Tehran: Negah Danesh publication Mirab Astane P. (2009), Financial Strategies, M.A Thesis in Financial Management, Allameh Tabatabai University Mohammadi, M. (2009), The Effect of Management of Working Capital on Profitability of firms in Community and firms listed in Tehran Stock Exchange, M.S Thesis, Science and Research Branch, Tehran Scherr C. Fredrick, (1989) "rn Working Capital Management", prentice-hall, International editions Lazaridis I Try Fonidis D (2006) "Relationship Profitability of Listed Companies in the Athens Stock Exchange" Journal of financial management and analysis, V.19, no.1; p JK Welfare & Pharmascope Foundation International Journal of Review in Life Sciences 26

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