Working Capital Management and Firms Performance: An Analysis of Sri Lankan Manufacturing Companies

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1 Working Capital Management and Firms Performance: An Analysis of Sri Lankan Manufacturing Companies Lingesiya Y. Department of Financial Management, University of Jaffna, Sri Lanka Nalini S. Northern Provincial Office, Central Bank of Sri Lanka, Sri Lanka Abstract Management of working capital refers to management of current assets and of current liabilities. Firms may have an optimal level of working capital that maximizes their value. Prior evidence has determined the relationship between working capital and performance. This study extends the literature. The working capital was determined by the cash conversion cycle and position of working capital, indicated by the current ratio, quick ratio, and stock to current assets. The performance was measured in terms of profitability by return on total assets, and relationship between working capital management and profitability was investigated by using panel data analysis for a sample of 30 listed manufacturing companies for the period of Estimated equation by the panel data method to obtain the estimates of the parameters of pooled model was applied for explanatory variables to measure their effect on firm performance. Results indicate that high investment in inventories and receivables lead to lower profitability and current assets to total assets lead to higher profitability. The results conclude that a strong relationship between working capital management and performance. Key words: Performance, Working Capital Management 1.0 introduction Capital structure and working capital management are two areas widely revisited by academia in order to postulate firms profitability. The working capital meets the short-term

2 financial requirements of a business enterprise. It is the investment required for running dayto-day business. It is the result of the time lag between the expenditure for the purchase of raw materials and the collection for the sales of finished products. The main components of working capital are inventories, accounts to be paid to suppliers, and payments to be received from customers after sales. Financing is needed for receivables and inventories net of payables. The proportions of these components in the working capital change from time to time during the trade cycle. The working capital requirements decide the liquidity and profitability of a firm and hence affect the financing and investing decisions. Lesser requirement of working capital leads to less need for financing and less cost of capital and hence availability of more cash for shareholders. However the lesser working capital may lead to lost sales and thus may affect the profitability. The management of working capital by managing the proportions of the working capital components is important to the financial health of businesses from all industries. Working capital management has been approached in numerous ways. Working capital is known as life giving force for any economic unit and its management is considered among the most important function of corporate management. Every organization whether, profit oriented or not, irrespective of size and nature of business, requires necessary amount of working capital. Working capital is the most crucial factor for maintaining liquidity, survival, solvency and profitability of business (Mukhopadhyay, 2004). Working capital management is one of the most important areas while making the liquidity and profitability comparisons among firms (Eljelly, 2004), involving the decision of the amount and composition of current assets and the financing of these assets. The greater the relative proportion of liquid assets, the lesser the risk of running out of cash, all other things being equal. All individual components of working capital including cash, marketable securities, account receivables and inventory management play a vital role in the performance of any firm. Shin and Soenen, (1998) argued that efficient working capital management is very important to create value for the shareholders while Smith et. al., (1997) emphasized that profitability and liquidity are the salient goals of working capital management. Therefore, many organizations that are profitable on which are forced to cease their operations due to an inability to meet their shortterm debt obligations. In order to sustain the business, it is essential for any organization to successfully manage its working capital. Keeping in view the realistic importance of working capital management as a youthful area of corporate finance function, an attempt has been made to examine working capital management in manufacturing companies of Sri Lanka.

3 The level of working capital in a business has a direct effect on the amount of growth of the company which can sustain organically from its own internal resources. Growth of sales requires that the business takes on additional stocks and incurs additional debtors. These currents assets of manufacturing firms accounts for over half of its total assets. Excessive levels of current assets can easily result in a firm s realizing a substandard return on investment. However, firms with too few current assets may incur shortage and difficulties in maintaining smooth operations (Horne and Wachowicz, 2000). Companies inventory management policy, debtors management policy and creditors management policy have an important role in its profitability performance (Vishanani and Shah, 2007). In this paper researchers investigate the relationship between working capital management and firms performance for 30 listed manufacturing companies in the Colombo Stock Exchange (CSE) for the period The purpose of this paper is to establish a relationship that is statistical significant between profitability, the cash conversion cycle and its components for listed firms in the CSE. The outlook for Sri Lanka s economy has improved with the ending of the conflict in May 2009, there re-integration of the Northern and Eastern Provinces with the rest of provinces, and renewed investor confidence following the favorable post conflict developments. The manufacturers have taken timely measures to safeguard and promote the industry in the current global economic condition. Manufacturing, the largest sub-sector of the industry sector recorded a significant growth to economy (Central Bank Report, 2009). Therefore, in this study, specially manufacturing companies were taken into consideration since those are playing very important role in the Sri Lankan economy in order to enhance the economic growth. This study has following objectives: To identify the influences of liquidity management on profitability over a period of 5 years. To measure the relationship between working capital cycle and performance. To find out the effect of current assets component of stock on profitability. The paper is structured as follows. In the next section researchers present the variables used as well as the chosen sample of firms. Results of the descriptive statistics accompanied with regression modeling relating profitability (the dependent variable) against other independent variables including components of the cash conversion cycle, in order to test statistical significance. Finally the last section discusses the findings of this paper and comes up with conclusions related with working capital management policies and profitability.

4 2.0 Literature Review Many researchers have studied working capital from different views and in different environments. Vijaykumar and Venkatachalam (1995) in their study on Tamilnadu sugar industry with regard to relationship between working management and profitability concluded that liquidity was negatively associated with profitability. Smith and Begemann (1997) emphasized that profitability and liquidity comprised the salient goals of working capital management. The problem arose because maximization of the firm s return could seriously threaten its liquidity. Pursuit of liquidity had a tendency to dilute returns. They evaluate traditional and alternatives working capital measures and the return on investment (ROI). The problem under investigation was to establish whether the more recently developed alternative working capital concepts show improve association with the return on investment to that of traditional working capital ratio or not. The result shows that a traditional working capital leverage ratio, current liability divided by funds flow, displayed the greatest association with return on investment. Current assets quick ratios registered insignificant association whilst one of the never working capital concepts, the comprehensive liquidity index, indicated significant association with return on investment. Shin and Soeven (1998) measured the relationship between the lengths of net trading cycle; corporative profitability and risk adjusted stock return was examined using correlation and regression by industry and capital intensity. The results showed that strong negative relationship between the length of the firm s net trading cycle and its profitability. In addition, shorter net trading cycles were associated with high-risk adjusted stock returns. Govind Rao and Rao (1999) studied the impact of working capital on profitability in Indian cement industry and found both positive as well as negative correlations between working capital related ratios and profitability. Sur, Biswas and Ganguly (2001) revealed in their study of Indian aluminium producing industry, a very significant positive association between liquidity and profitability. Mukhopadhyay (2004) conducted a case study on working capital management in heavy engineering firms and indicated that loans and advances, and other current assets hardly had only role to contribute in sales / business generation of the firm during the period of, to Bardia (2004) in his study on steel giant SAIL for the period from to concluded that there is a positive relationship between liquidity and profitability. Ghosh and Maji (2004) concluded a study on working capital management efficiency from the view point of Indian cement industries and indicated that there is a relationship between

5 effective utilization of current assets and profitability of the companies under study, although there seemed to be a wide range in the degrees of such relationship between company to company Amit, Sur and Rakshit (2005) studied the relationship between working capital and profitability in the context of Indian pharmaceutical industries and concluded that no definite relationship can be established between liquidity and profitability. Further, Narware (2004) conducted a study of working capital management and profitability by using Fertilizer Company, which disclosed both negative and positive association. Additionally Padachi (2006) analyzed working capital management and performance and trend of the working capital management in different sectors in small manufacturing firms by using key variables of inventory days, account receivable days, account payable days and cash conversion cycle. He concluded that different industries operational efficiency shows significant changes and the paper and printing industry has been able to achieve high scores on the various components of working capital and this has positively influenced its profitability. Vishmani at el., (2007) explained that the company s inventory management policy, debtors management policy and creditors management policy play an important role in its profitability performance. In the study of Uyar (2009) he examined industry benchmarks for cash conversion cycle (CCC) of merchandising and manufacturing companies and found that merchandising industry has shorter CCC than manufacturing industries. He further examined the relationship between the length of the CCC and the size of the firms and the findings indicated a significant negative correlation between the length of CCC and the firm size, in terms of both net sales and total assets. The study further showed significant negative correlation between the length of CCC and the profitability. Koperunthevi (2010) studied Working Capital Management and Firms Performance: An Analysis of Sri Lankan Manufacturing Companies by panel data analysis. Her study concluded that the working capital management very much influences on profitability of manufacturing companies and increase of the cash conversion cycle leads to less profitability. Current ratio and Quick ratio are positively related to the profitability. All the above studies provide us a solid base and give us idea regarding working capital management and its components. They also give us the results and conclusions of those researches already conducted on the same area for different countries and environment from

6 different aspects. On basis of these researches done in different countries, we have developed our own methodology for research. 3.0 Methodology This paper analyses the impact of working capital management on firms performance with special reference to Sri Lankan manufacturing companies with the period of 2006 to Population and Sample The data collected were from listed firms in the Colombo Stock Exchange Market. The reason we chose this market is primarily due to the reliability of the financial statements.the population consisted of 242 listed companies those are including manufacturing companies. 30 sample companies were selected from manufacturing companies according to the data availability. From each sample firm the working capital data and other information is gathered Variables Working capital managements effect on performance is calculated by using explanatory variables and control variables. Explanatory variables are liquidity ratios, working capital cycle and components of current assets. Profitability is measured by Return on Total Assets (ROTA), which is defined as profit before interest and tax divided by total assets. 3.3 Explanatory Variables Liquidity ratio of current ratio (cr) is defined as current assets divided by current liabilities and quick ratio (qr) defined as current assets other than inventories divided by current liabilities. Working capital cycle is the cash conversion cycle (CCC), which is used as a comprehensive measure of working capital as it shows the time lag between expenditure for the purchase of raw materials and the collection of sales of finished goods. CCC = INP_days + AR_daya AP_days Where: IN_days = Number of inventory days is (Stock *365)/cost of sales AR_days = Number of days account receivables is (Account receivable *365)/ Sales AP_days = Number of days account payable is (Account payable *365)/ cost of sales Working capital component of inventory is defined as inventory to total current assets (skca).

7 3.4 Control Variables Control variables include assets management system and financial policies. In order to include the firm size as a control variable sales, a proxy for size (The natural logarithm of sales (lnsales)), the gearing ratio (financial debt to total assets (gear)), the gross working capital turnover (sales to current assets (ca_turn)), current assets to total assets (ca_ta) and current liability to total assets (cl_ta) are included as control variables. 3.5 Hypotheses The working capital management have great importance in financial management system. To maximize the profit and smooth run of the business, working capital management is a vital factor. Increasing profits need more liquidity and it can bring liquidity cost to the firms. Therefore, there must be a trade- off between these two objectives of the firms. For this reason working capital management should be given proper consideration and will ultimately affect the profitability of the firm. In this concept the hypotheses are: H 1 : There is no relation between cash conversion cycle (CCC) and profitability of manufacturing companies. H 2 : There is no relation between liquidity (current ratio and quick ratio) and profitability of manufacturing companies. H 3 : There is no relation between current assets component of stock and profitability of manufacturing companies. 3.6 Model Specification and Data Analysis The analyses include panel data analysis and the models estimate using the regression based framework (pooled ordinary least square). The relationship between working capital management and performance is examined by regressing by Return on Total Assets against Cash Conversion Cycle (Model 1), current ratio (Model 2), quick ratio (Model 3), and stock to current assets (Model 4).The coefficient on the Return on Total Assets reflects the relationship between working capital management and performance. Model (1): ROTA=β 0 +β 1 lnsales it +β 2 gear it +β 3 cata it +β 4 clta it +β 5 ca_turn it +β 6 ccc it Model (2): ROTA=β 0 +β 1 lnsales it +β 2 gear it +β 3 cata it +β 4 clta it +β 5 ca_turn it +β 6 cr it Model (3): ROTA=β 0 +β 1 lnsales it +β 2 gear it +β 3 cata it +β 4 clta it +β 5 ca_turn it +β 6 qr it Model (4): ROTA=β 0 +β 1 lnsales it +β 2 gear it +β 3 cata it +β 4 clta it +β 5 ca_turn it +β 6 skca it

8 4.0 Results and Discussion 4.1 Descriptive Statistics The following table gives the descriptive statistics of the collected variables. The firms included in our sample had an average of 13.1 % return on total assets. On average % of total assets were current liabilities. Mean value of explanatory variables of cash conversion cycle was days, current ratio was , quick ratio was and stock to current assets was 42.51%. This means 42.51% of currents assets were stocks. This could be the reason for difference between current ratio and quick ratio. Table 1: Descriptive statistics of variables Variables Statistics N = 150 ROTA Mean SD Lnsales Mean SD Gearing Mean SD CATA Mean SD CLTA Mean SD CA_TURN Mean SD CCC Mean SD CR Mean SD QAR Mean

9 SD SKCA Mean SD Source: Survey data 4.2 Regression Analysis This analysis was done to estimate the casual relationship between profitability variable (ROTA), other working capital variables (ccc, cr, qr, and skca). The Pooled ordinary least square is used for the regression analysis. Table 2: Results of Model (1): ROTA=β 0 +β 1 lnsales it +β 2 gear it +β 3 cata it +β 4 clta it +β 5 ca_turn it +β 6 ccc it Variable Coefficient Std. Error t-statistic Prob. C LNSALES GEARING CATA CLTA CA_TURN CCC R-squared F-statistic Adjusted R-squared Prob(Fstatistic) S.E. of regression Source: Survey data Table 2 presents the regression results of model 1. The result of the Model 1 is expressed by regression analysis. The results of the regression indicated that coefficient of cash conversion cycle was negatively related and significant at 5% level. It implied that the increase of cash conversion cycle will significantly affect the ROTA of the firms. The size of the firm had positive effect on dependent variable. The gearing of the firm had negative effect on dependent variable. It showed that size of the firm had positive influence on ROTA and financial debt had negative influence on ROTA. The current assets to total assets showed positive relations with ROTA at 5 % significant level. The current liability to total assets showed positive relation with ROTA in the pooled regression method.

10 The adjusted R 2 also called as the coefficient of multiple determinations, is the percent of the variance in the dependent. It explained uniquely or jointly by the independent variables was The F statistics was used to test the significance of R. Overall; the model represented by regression F value and significant (F = , p = ). The results indicated that null hypothesis was rejected and there was a negative relationship between cash conversion cycle and Return on Total Assets. This findings consisted with the study of Koperunthevi (2010),Uyar (2009), and Shin and Soeven (1998). Table 3: Results of Model (2): ROTA=β 0 +β 1 lnsales it +β 2 gear it +β 3 cata it +β 4 clta it +β 5 ca_turn it +β 6 cr it Variable Coefficient Std. Error t-statistic Prob. C SIZE GEARING CATA CLTA CA_TURN CR R-squared F-statistic Adjusted R-squared Prob(F-statistic) S.E. of regression Source: Survey data Based on the table 3 of the model 2, the regression result of the current ratio was positively related with ROTA and size of the firm had positive relations with ROTA but it was not a statistically significant level and gear negatively related with ROTA but it was also not a statistically significant level. Current assets to total assets positively related and significant at 5% level. Current liability to total assets and gross working capital turnover also positively impact the ROTA. The adjusted R 2 of the regression was and the F value of regression was with significance level (p=0.000). This finding is consisted with the study of Koperunthevi (2010) and Bardia (2004) and Padachi (2006).

11 Table 4: Results of Model (3): ROTA=β 0 +β 1 lnsales it +β 2 gear it +β 3 cata it +β 4 clta it +β 5 ca_turn it +β 6 qar it Variable Coefficient Std. Error t-statistic Prob. C SIZE GEARING CATA CLTA CA_TURN QAR R-squared F-statistic Adjusted R-squared Prob(Fstatistic) S.E. of regression Source: Survey data Based on table 4, Model (3) identified the relation with quick ratio to ROTA and control variables. Size of the firm had positive relations with ROTA but it was not a statistically significant and gear negatively related with ROTA but it was also not a statistically significant. Current liability to total assets, gross working capital turnover and quick ratios also positively determined the ROTA. Adjusted R 2 of regression is , and the F value was The results of this regression also confirm that there is a well-built relation between ROTA and quick ratio. This finding is consisted with the study of Koperunthevi (2010) and Bardia (2004) and Padachi (2006). Table 5: Results of Model (4): ROTA=β 0 +β 1 lnsales it +β 2 gear it +β 3 cata it +β 4 clta it +β 5 ca_turn it +β 6 skca it Variable Coefficient Std. Error t-statistic Prob. C SIZE GEARING CATA CLTA CA_TURN SKCA

12 R-squared F-statistic Adjusted R- squared Prob(F-statistic) S.E. of regression Source: Survey data The Model 4 stated by regression of above table 5. This regression was not recognized the relation with ROTA and stock to current assets. The size of the firm was also not significant this result provide the evidence that there was no significant relation with these two variables and ROTA. Current assets to total assets, current liabilities to total assets and gross working capital turnover as well prove the strong positive relation with depended variable and are significant at 5% level. But there was no significant relationship between stock of current assets and ROTA. The adjusted R 2 of the regression was The F values of the model was (p = 0.000), this F value supported to prove this model was suitable to this analysis. And these result accept the null hypothesis of H 03 and that there was no relation between ROTA and stocks to current assets. 5.0 Conclusion The study set out to provide empirical evidence about the effects of working capital management on profitability for a panel made up of a sample of 30 listed manufacturing companies for the period This paper adds to existing literature such as Shin and Soenen (1998) and Koperunthevi (2010) who found a strong negative relationship between the cash conversion cycle and corporate profitability for listed Sri Lankan manufacturing firms for the period. So far researchers observed a negative relationship between profitability (measured through ROTA) and the cash conversion cycle which was used as a measure of working capital management efficacy. Therefore it seems that operational profitability dictates how managers or owners will act in terms of managing the working capital of the firm. The study concluded that the working capital management very much influences on profitability of manufacturing companies and increase of the cash conversion cycle leads to less profitability. Current ratio and Quick ratio were positively related to the profitability. Having the more current assets to total assets was the good decision to get the more profit.

13 On basis of the above analysis researchers may further conclude that these results can be further strengthened if the firms manage their working capital in more efficient ways. Management of working capital means management of current assets, current liabilities and financing these current assets. If these firms properly manage their cash conversion period and inventories in a proper way this will ultimately increase profitability of these companies. References Amit, K. Mallik, Debashish Sur and Debdas Rakshit (2005). Working Capital and Profitability: A Study on their Relationship with Reference to Selected Companies in Indian Pharmaceutical Industry, GITAM Journal of Management, 3: Bardia, S.C (2004), Liquidity Management: A Case Study of Steel Authority of India Ltd, The Management Accountant, ICWAI Kolkata, June: Eljelly, A (2004), Liquidity Profitability Tradeoff: An Empirical Investigation in an Emergent Market, International Journal of Commerce & Management, Vol 14(2): Ghosh, S.K and Maji,S.G (2004), Working Capital Management Efficiency: A Study of Indian Cement Industry, The Management Accountant, May: Govind Rao, D. and Rao,P.M (1999), Impact of Working Capital on Profitability in Cement Industry A Correlation Analysis, Working Capital Management (Deep & Deep Publications Pvt. Ltd., New Delhi) Koperunthevi, K (2010), Working Capital Management and Firms Performance: An Analysis of Sri Lankan Manufacturing Companies, Wayampa journal of management, 1(2): Mukhopadhyay, D (2004), Working Capital Management in Heavy Engineering Firms A Case Study, myicwai.com.knowledgebank/fm48. Padachi, K (2006), Trends in Working Capital Management and its Impact on Firms Performance: An Analysis of Mauritian Small Manufacturing Firms, International Review of Business Research Papers, 2(2): Shin, H.H and Soenen, L (1998).Efficiency of Working Capital Management and Corporate Profitability, Financial Practice and Education, 8(2): Smith, M. Meaumont, and Begmemann, E (1997). Measuring Association between Working Capital and Return on Investment, South African Journal of Business Management, 28(1). Sur, D., Biswas and Ganguly, P (2001), Liquidity Management in Indian Private Sector Enterprises: A Case Study of Indian Primary Aluminium Producing Industry, Indian Journal of Accounting, June: 8-14.

14 Uyar, Ali, (2009) The Relationship of Cash Conversion Cycle with Firm Size and Profitability: An Empirical Investigation in Turkey, International Research Journal of Finance and Economics, 24, Vijaykumar, A and Venkatachalam,A (1995), Working Capital and Profitability An Empirical Analysis, The Management Accountant, ICWAI, Kolkata, June: Visnani, S and Bhupesh Kr. Shah (2007), Impact of Working Capital Management Policies on Corporate performance Empirical Study, Global Business Review, 8(2):