WORKING CAPITAL MANAGEMENT AND PROFITABILITY IN SUGAR INDUSTRY OF PAKISTAN

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1 WORKING CAPITAL MANAGEMENT AND PROFITABILITY IN SUGAR INDUSTRY OF PAKISTAN Muhammad Ehsan Javaid Leghari PhD Management Sciences COMSATS Institute of Information Technology Islamabad, Pakistan ABSTRACT Working capital management is necessary for profitability. In this study working capital management of sugar industry and its impact on profitability is checked from 2002 to Total observations are 308 while 28 companies listed at Karachi Stock Exchange are in sample. Correlation and pooled panel data regression analysis is performed. Results show that day s inventory, cash conversion cycle, cash ratio, account receivable to sale ratio, short term investment ratio, secured short term obligation and fixed asset ratio are negatively affecting profitability of firm. Whereas quick ratio, days account receivable and working capital are positively affecting profitability. Key words: Return on Asset, Cash Conversion Cycle, Secured Short Term Obligations, Cash Ratio, Account Receivable to Sale INTRODUCTION In finance field two extensively examined areas are capital structure and working capital management. It is matter of great importance both for researchers and corporate individuals to figure out firm s value and profitability. Working capital management has a direct impact on the firm profitability along with reducing the liquidity risk. Liquidity is one face of coin and profitability is other. It clarify that working capital management is directly proportional of firm profitability. US financial crises highlighted problems in already identified factors for working capital management. Introduction of Basel 3 accord also directed us toward working capital management to hold liquidity in financial sector. Current business world is highly dependent on financial sector and business organizations also need to adjust their balance sheet compositions to maintain optimal working capital balance. Not only in service sector but manufacturing sector as well (Iqbal & Zhuquan, 2015). Optimal working capital management is always desirable to efficiently meet liquidity requirements and reduce liquidity risk. Increase liquidity risk ultimately leads to default risk (Della Seta, Morellec, & Zucchi, 2015). Traditionally cash, money market instruments, inventory, account receivables, account payables, debtors are main components of working capital. Optimal proportion is to hold different mix of these components to efficiently meet organizational liquidity requirements. New component got prominence after US financial crisis is secured short term liabilities. Sugar sector of Pakistan listed on Karachi stock exchange is studied on working capital management perspective with special focus on secured short term liabilities. LITERATURE Accounting simple formula to deduct profit from business operations is very simple. Profit is reminder when expenses are deducted from revenue. Through working capital management expenses are reduced which increases profit. Numerous ways to managed working capital that leads to maximize return (Besley & Meyer, 1987). Deloof (2003) concluded that profitability dependent on working capital proper management. He considers it minimum necessary condition to maximize shareholder wealth. Different firms are operating in different business scenarios. Firms give preference to different factors in this way to manage working capital. Using one factor more than optimal level intensify problem. Firms in growth stage endorsed to focus more on inventory section and cautious on credit policy selection to protect relationship with suppliers and financial intermediaries. It reduces production and financial cost which increase sales, revenue and profits ultimately (Petersen & Rajan, 1997). Majority firms use 30

2 trade credit to meet working capital requirement although firms are aware about cost associated with its use e.g. normal interest rate charge on trade credit exceeds 18 percent. It put huge burden on liquidity (Wilner, 2000). Results show that large firms main emphasis on cash management usually ends with fewer sales which leads to more cash flow problems, while small firms mainly relay on stock management and firms with less profits uses credit management as a redemption from problem (Howorth & Westhead, 2003). Muhammad, Jan, and Ullah (2008) confirm positive relationship between working capital management and textile firm s profitability. Components of working capital i.e. cash, account receivable and inventory have positive association while account payable has negatively affecting profitability. Rahman (2011) confirm similar results along with pointing no efficient working capital management in textile firms of Pakistan. Ray (2012) confirm positive significant relationship in Indian manufacturing sector. Data analysis for time period of 14 years from 1996 to 2010 over 311 sample firms is done to approve this relationship. Pouraghajan and Emamgholipourarchi (2012) studied Tehran stock exchange listed companies from 2006 to Result confirms positive relationship between working capital and profitability. It is advised to reduce cash conversion cycle and proportion of debt to total asset. Firms listed on Thailand stock markets show inverse relationship between firm operating profit and inventory turnover in days. Account receivable turnover in days also show negative relationship (Napompech, 2012). Latest study confirmed that shareholder s wealth maximization cannot possible without working capital management. Firms listed on Karachi stock exchange are studied which show that average payment period, average collection time, inventory turnover in days, cash conversion cycle and debt show negative relationship with firm profitability. It means firms are not managing working capital in efficient and effective way which results decreasing firm profitability (Iqbal & Zhuquan, 2015). METHODOLOGY Variables: Following are definitions of variables used in study. Table #1 give summarized details of these variables. Independent Variables Account Receivable Turnover in Days It is defined as in how many days company converts its credit sales in to cash. Higher numbers increases liquidity issues. Inventory Turnover in Days It is defined as in how many days company converts its inventory into sales. Higher number shows that firm is bearing more inventory cost along with that emphasizing issue of over production and vice versa. Cash Conversion Cycle It is defined as number of day s company needs to convert resource inputs into cash flows. Higher the values increase liquidity problem for firm. Account Receivable to Sale ratio It is ratio of account receivable to sale. Higher value means that company has more sales on credit basis which in comparison with account receivable turn over in days means that if numbers of days are high then account receivable to sale ratio must be high. Short term Investment ratio It is ratio of short term investment to current ratio. Higher ratio means that more proportion of current assets are used for investment purposes which reduce liquidity. Due to short term nature, after small time period firms receive returns. Secured short term obligation It is ratio of short term secured loans to current liabilities. Higher value means firms pledge more of its loans with fixed assets in order to meet its current liquidity essentials. Remarkably interest charged on loan is less because secured loans are secured which make them less risk. That s make it more use full. 31

3 Fixed Asset Ratio It is ratio of fixed asset to total asset which show proportion of fixed assets in total asset structure. If value is high which means that firm has less current assets leads to working capital problem. However firms use these assets to get secured loans. Dependent Variable: Return on Asset It is ratio of net profit before tax to total assets. Higher value show more efficient use of assets to get return which increase firm asset base and act as an indicator of profitability. For this research listed sugar companies of Karachi Stock Market data is collected from 2002 to Main reason to select this sector for study is due to its growth and contribution in overall Pakistan economy. Products are not only to meet consumer necessity but it also used as an input in many other industrial products like candies and confectionaries. Data collected from State Bank Financial Statement Analysis of Non-Financial Sector of Karachi Stock Exchange. Main reason to select this source for data collection is its reliability. Total number of observations are 308 while there are 28 number of companies selected for study out of 31. Selection criteria for this study is firm must be operated during study time period. CORRELATION ANALYSIS Table #2 contains details of correlation analysis results. As literature indicate that profitability of firm is negatively related with slow account receivable conversion into cash, inventory conversion into cash. Due to high number to days required for conversions cash conversion cycle is also slow showing negative relationship with firm profitability. Higher proportion of account receivable in total sales reduces firm liquidity. Short term secured obligation which company normally acquired to meet its short term needs. Extensive use hinders firm profitability and limit firm ability to generate more debt at low interest for meeting short term requirements. If firm has more fixed assets in its balance sheet composition then it has liquidity problems but that fixed assets used to generate short term secured loans which indicate positive relationship between both. Companies invest on short term bases reduces liquid cash inflow but firm uses its secured assets to generate short term secured loans on low interest to meet cash flows. It indicates positive correlation between both confirmed from correlation analysis also. POOLED DATA REGRESSION Pooled regression analysis is performed. Model used to study impact of working capital management on profitability in sugar sector of Pakistan is only 27 percent efficient in explaining desired problem while 73 percent changes are unexplained. At industry level analysis all firms are homogenous due to meeting industry standards which remove firm s specific heterogeneity. This is rationale behind using pooled panel data regression in this study. Inventory turnover in days, cash conversion cycle, cash ratio, account receivable to sale ratio, short term investment ratio, secured short term obligation and fixed asset ratio are negatively affecting profitability of firm. Quick ratio and account receivable turnover in days are positively affecting profitability of sugar industry firms. Quick ratio has positive significant relationship at 5%, results are confirming with literature. It explains firms are in good position to meet its liquidity requirements. Main reason behind it is sales on account basis, which increases current assets. It means firms need to maintain liquid assets but shift liquid asset composition from account receivable centered to other. Account receivable to sale ratio has negative significant relationship means that firms used credit based sales to boast its revenue but it ultimately hurting firm profitability due to problem in credit recovery. Problem of credit recovery is solved by giving more time to return payments which again confirmed from results that account receivable turnover in days has positive significant relationship with profitability at 1%. It confirms firm has customers who defaulted on their payments. Firm under this condition wants profitability must have to provide customer relaxed payback time constraints. It is confirmed by negative relationship between cash conversion cycle and profitability but it is insignificant in nature because company focusing more on short term secured liabilities to meet liquidity problem raised by high account receivable turnover in days. Secured short term obligation has negative significant relationship at 1%. It is because firms relay extensively on short term secured obligation to reduce liquidity problems but lead to increase current liabilities. Extensive use of secured short term obligation reduces its efficiency and increases cost which decrease profitability. It also turn cash 32

4 conversion cycle and inventory turnover in days into insignificant because firm rely more on secured obligation for short period of time. Sugar producing firms asset composition indicates high fixed asset which not only reduces the proportion of current assets ultimately increase liquidity problems. No proper fixed asset handling increase maintenance expenses but stress on liquid asset management which reduce firm profitability. It is indicate in correlation analysis as well by having negative correlation with all working capital factors except short term secured obligations which are based on these assets. CONCLUSION In Pakistan sugar industry working capital management show results as day s inventory, cash conversion cycle, cash ratio, account receivable to sale ratio, short term investment ratio, secured short term obligation and fixed asset ratio are negatively affecting profitability of firm. Whereas quick ratio, days account receivable and working capital are positively affecting profitability. Company needs to restructure its strategy at customers end in such a way that reduces proportion of account receivables in sales which reduces days account receivables. It reduces extensive use of short term secured obligations all such leads to increase firm profitability. Along with that firm improve fixed asset handling to reduce maintenance expenses and in lined fixed asset investment with organizational productive use. REFERENCES 1. Besley, S., & Meyer, R. (1987). An empirical investigation of factors affecting the cash conversion cycle. Paper presented at the Annual Meeting of the Financial Management Association, Las Vegas, Nevada. 2. Della Seta, M., Morellec, E., & Zucchi, F. (2015). Debt Structure, Rollover Traps, and Default Risk. 3. Deloof, M. (2003). Does working capital management affect profitability of Belgian firms? Journal of Business Finance & Accounting, 30(3 4), Howorth, C., & Westhead, P. (2003). The focus of working capital management in UK small firms. Management Accounting Research, 14(2), Iqbal, A., & Zhuquan, W. (2015). Working Capital Management and Profitability Evidence from Firms Listed on Karachi Stock Exchange. International Journal of Business and Management, 10(2), p Muhammad, M., Jan, W. U., & Ullah, K. (2008). Working Capital Management and Profitability An Analysis of Firms of Textile Industry of Pakistan. Journal of Managerial Sciences Volume VI Number, 2, Napompech, K. (2012). Effects of working capital management on the profitability of Thai listed firms. International Journal of Trade, Economics and Finance, 3(3), Petersen, M. A., & Rajan, R. G. (1997). Trade credit: theories and evidence. Review of Financial Studies, 10(3), Pouraghajan, A., & Emamgholipourarchi, M. (2012). Impact of Working Capital Management on Profitability and Market Evaluation: Evidence from Tehran Stock Exchange. International Journal of Business and Social Science, 3(10), Rahman, M. M. (2011). Working Capital Management and Profitability: A Study on Textiles Industry. ASA University Review, 5(1), Ray, S. (2012). Evaluating the Impact of Working Capital Management Components on Corporate Profitability: Evidence from Indian Manufacturing Firms. International Journal of Economic Practices and Theories, 2(3), Wilner, B. S. (2000). The exploitation of relationships in financial distress: The case of trade credit. The Journal of Finance, 55(1),

5 Table#1 Variables Variable Symbol Formula Account Receivable Turnover in Days Inventory Turnover in Days Cash Conversion Cycle DAYAR DAYINV CCC (Account Receivable *365)/ Cost of goods Sold (Inventory *365)/ Cost of goods Sold Days Account Receivable + Days Inventory - Days Account Payable Cash Ratio CR Cash and Cash at bank/current Asset Quick Ratio QR (Current Asset-Inventory)/Current Liabilities Account Receivable to Sale ratio Short term Investment ratio Secured short term obligation AR/SALE INV OBLI Account Receivable /Sales Short Term Investment/Current Asset Secured Liabilities /Current Liabilities Fixed Asset Ratio FA Fixed Asset/Total Asset Return on Asset ROA Net Profit Before Tax/ Total Asset 34

6 Table # 2 Correlation Analysis ROA DAYA R DAYIN V CCC CR QR AR/SAL E INV OBLI FA ROA 1 DAYAR DAYINV CCC CR QR AR/SAL E INV OBLI FA

7 Table #3 Pooled Panel Regression Beta Coefficient Standard Error t statistics Significance (Constant) Days Account Receivable *** Days Inventory Cash Conversion Cycle -4.91E E Cash Ratio Quick Ratio ** Account Receivable to Sale ratio *** Short term Investment ratio Secured short term obligation * Fixed Asset Ratio ** Working Capital 1.77E E * R.521 a R Square Adjusted R Square Std. Error of the Estimate ***for 1%, ** for 5% and * for 10% 36