Study on the Working Capital Management Efficiency in Indian Leather Industry- An Empirical Analysis

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1 Study on the Working Capital Management Efficiency in Indian Leather Industry- An Empirical Analysis Mr. N.Suresh Babu 1 Prof. G.V.Chalam 2 Research scholar Professor in Finance Dept. of Commerce and Business Administration, Acharya Nagarjuna University, Nagarjuna Nagar, A.P., India. babu40806@gmail.com and chalam.goriparthi@gmail.com Abstract- This paper empirically investigates the relationship between the components of working capital and firms profitability of firms in Indian leather industry. We undertake profitability (ROA) as a dependent variable and the inventory conversion period (ICP), the average collection period (ACP), the average payment period (APP), and the cash conversion Cycle (CCC) are used as independent variables, and are considered for measuring working capital management. The data was taken from secondary data source named as Industry; financial aggregates and ratios (PROWS) of center for monitoring Indian economy (CMIE) covering the period from to (14 years). The regression result shows that profitability has insignificant positive relationship of inventory conversion period and significant positive relationship of average collection period. Even though, average payment period and cash conversion cycle were significant negatively related to profitability. The results show that for overall leather industry, working capital management has significant impact on profitability of the firms. Key Words: Profitability, Leather Industry, Working Capital. 1. Introduction In the fast moving business world, firms are highly competing among them. Generally, we believe that finance covers three main topics that are capital budgeting, capital structure and working capital management. Capital budgeting and capital structures are associated with investment decisions while working capital management is the functional area of finance. It involves the relationship between a firm s short term assets and its short term liabilities like managing inventories, accounts receivable and payable, and cash (Gitman, 2005). The main purpose of any firm is to maximize profit. But, maintaining liquidity of the firm also is an important objective. So, liquidity and profitability are both the two different sides of same coin. The problem is that increasing profits at the cost of liquidity can bring serious problems the firm. Thus, strategy of firm must maintain a balance between these two objectives of the firm. Dilemma in working capital management is to achieve desired trade-off between liquidity and profitability. Referring to theory of risk and return, investment with more risk will result to more return. Thus, firms with high liquidity of working capital may have low risk and low profitability. Conversely, a firm that has low liquidity of working capital faces high risk this result leads to high profitability. Although this might increase profitability (due to increase sales), if may also adversely affect the profitability if the costs tied up working capital exceed the benefits of holding more inventory and / or granting more trade credit to customers. About the Indian Leather Industry Leather industry is a traditional industry and occupies prominence in the Indian economy in term of its massive potential for generating employment, income and export earnings. Indian leather industry is found in cottage and small scale, medium scale and large scale level. This industry is largely decentralized. Indian leather industry is both in the organized as well as unorganized sectors. Indian leather industry is organized as tanning and finishing footwear and footwear components, leather components, and saddler and harness articles. Our country has nearly 2.5 percent of the global leather trade, at present 196

2 around 80 percent of total export to the other countries. This industry gives employment to more than 2.5 million persons. Leather industry has become the fourth largest foreign exchange earner and among the top eight revenue earners for the country. Due to all these dynamics Indian leather industry has been facing loads of challenges to manage proper working capital. The industry was also committed to reduce the overall cost of production. Efficient management of working capital plays an important role of overall corporate strategy in order to create shareholders value as result of the time lag between the expenditure for the purchase of raw material and the collection for the sale of the finished goods. In the light of the above statement of problem, an attempt is made to study the working capital trend of Indian leather industry. This paper organized as follows: section 2 deals brief review of important literature, the 3 d section provides the objectives of the study. The research methodological part and the explanatory variables used for the analysis part are dealt in section 4. The 5 th section describes the empirical analysis and findings of the study and finally 6 th section discusses the conclusion of the study. 2. Reviews of Literature Many researchers have studied working capital from different views and in different environments. The following study was very interesting and useful for our research: Barot Haresh (2012) observed that a negative relationship between account receivables and corporate profitability and a positive relationship between accounts payable and profitability. The researcher concludes that the firms properly manage their cash, accounts receivables, accounts payables, and inventories in proper way, will ultimately increase profitability of these firms. Biswajit Bose (2013) found that out of seven ratios (such as working capital turnover ratio, net current assets to total assets ratio, inventory turnover ratio, cash position ratio, current ratio), only cash position ratio has positive influence on return on total assets and the remaining has negative correlation with return on total assets and also found that return total assets is negatively associated with days of working capital. Daniel Mogaka and Ambrose Jagongo (2013) found that the negative correlation between return on assets and the firms average collection period and cash conversion cycle while positive correlation with inventory holding period, accounts payment period. The authors conclude that working capital management has a significant impact on profitability of the firms and play a key role in value creation for shareholders as large cash conversion cycle have negative impact on profitability of firms. Hina Agha (2014) found that creditors turnover ratio, debtors turnover ratio and inventory turnover ratio have a positive significant impact on return on assets and there is no significant impact of current ratio on return on assets. Mahum Bukhari and Mohammad Shaukat Malik (2014) found that positive and insignificant relationship of average collection period and profitability while negative and insignificant relationship between profitability and average age of inventory and also found that the relationship between the average payment period and profitability is negative and significant. Moreover, operating cycle has positively insignificant while cash conversion cycle is positively significant relationship with profitability. The authors suggest that managers of these companies should spend more time to manage cash conversion cycle of their firms and make strategies of efficient management of working capital. Above studies provide base and idea regarding working capital management and its components. But, these studies do not provide clear-cut direction of the relationship between working capital and firms profitability. However, there are a few studies with reference to India on working capital management and firm profitability. Therefore, the present study is an attempt to fill this gap and estimates the relationship between working capital management variables (inventory conversion period, average collection period, average payment period and cash conversion cycle) and profitability of firms in Indian Leather Industry. 3. Objectives of the Study The major objective of the study is to examine the relationship between working capital management components and profitability of firms in Indian Leather Industry listed on the Bombay Stock Exchange (BSE). To achieve the main objective, the following specific objectives were used: To determine whether there is a significant relationship between Inventory Conversion Period (ICP) and Profitability of the firm. 197

3 To examine whether there is a significant relationship between Average Collection Period (ACP) and Profitability of the firm. To establish if there is a significant relationship between Average Payment Period (APP) and Profitability of the firm. To ascertain if there is a significant relationship between Cash Conversion Cycle (CCC) and Profitability of the firm. 4. Research Methodology The present study is based on secondary data collected from secondary source named as Industry; Financial Aggregates and Ratios the corporate database (PROWS) of the Centre for monitoring Indian economy (CMIE) and then various issues of magazines and journals, working papers and newspapers were also accessed for the relevant and covering the period from to (14 years) as a part of study designed to an evaluation of profitability and working capital management of Leather Industry based on the following statistical tools were used: Summary Statistics, Correlation Analysis, multiple regressions Analysis, t test, f test and Analysis of variance (ANOVA) and SSPS-20 software is used for the analysis. 4.1 Variables Explanation In this study, we undertake profitability (ROA) as a dependent variable and the inventory conversion period (ICP), the average collection period (ACP), the average payment period (APP), and the cash conversion Cycle (CCC) are used as independent variables, and are considered for measuring working capital management. All the dependent and independent variables stated below have been used to test the hypotheses of study Return on Assets (ROA): Profitability is measured by return on assets, which is defined as the ratio of earning after tax to total assets. ROA is used as a dependent variable. The return on assets determines the management efficiency to use assets generates earnings. It is a better measure since it relates the profitability of the company to the asset base Inventory Conversion Period (ICP): ICP calculates how quickly the inventory is converted into sales. It s an excellent measure of the efficiency of the company in managing the inventory. The important decision regarding inventory is that how much amount of cash should tied up in inventory while meeting the other operations and functions of the business and demands of customers. It is calculated as 365/ (Cost of goods sold/average inventory) Average Collection Period (ACP): It is used as proxy for the working capital collection policy is an independent variable. ACP is calculated by dividing trade debtors by sales and multiplying the result by 365. It indicates the time taken to collect cash from customers. The higher the value, the more will be the investment in account receivables Average Payment Period (APP): APP used as proxy for the payment policy is also an independent variable. It is the time taken to pay the firms suppliers. The longer the time period the more advantageous for the firm so that funds can be put to other uses. It can be calculated as trade creditors / (purchases/365) Cash Conversion Cycle (CCC): Taking together inventory conversion period, average collection period, and average payment period, cash conversion cycle is calculated. It is used as a comprehensive measure of working capital management is another independent variable. It considers the amount of time to sell the inventory, collect the receivables and to pay bills. It is expected to have a negative relationship with profitability as a lower value of cash conversion cycle shows less investments in current assets and also signifies higher liquidity, which easily converts its short term investments in current assets to cash while higher value of cash conversion cycle signifies greater investment in current assets and therefore shows the greater need of financing of current assets. It is calculated as adding inventory conversion period with average collection period and deducting average payment period. 5. Empirical Analysis In this section, the empirical results are presented from quantitative data analysis using SPSS 20 version. Descriptive analysis is presented first followed by the Pearson s correlation and regression analysis. 5.1 Descriptive Statistics: Descriptive analysis presented the mean and standard deviation of the different variables of interest in this study and also presents the minimum and maximum values of the variables which help in getting a picture about the 198

4 maximum and minimum values a variable has achieved. Table I: Summary Statistics of the Research Variables of Leather Industry in India Variable Mean Std. deviation Minimum Maximum ROA ICP ACP APP CCC Source: Compiled from the CMIE Prowess Database Table I presents the summary statistics of the research variables used in the presented study for 14 years observations were used. The mean value of return on assets is 9 percent with a standard deviation of 23.3 percent. The mean of inventory conversion period is days (approximately four and half months) with a standard deviation of 7.55 days. The mean accounts collection period is days (approximately one and half month) with a standard deviation of 9.96 days and also shows that on average the firms take days (approximately three months) to pay its creditors with standard deviation of days. The mean cash conversion cycle is days. The firms have seen their profitability by almost 47 percent. 5.2 Pearson Correlation Analysis: Correlation analysis is attempts to determine the degree and direction of between two variables under study. In bivariate distribution, if the variables have the cause and effect relationship, they have high degree of correlation between them. The coefficient of correlation is denoted by r. Table II: Correlation Matrix for all the Dependent and Independent Variables of Leather Industry in India Variable ROA ICP ACP APP CCC ROA 1 ICP ACP APP CCC ** 1 *. Correlation is significant at the 0.05 level (2-tailed). **. Correlation is significant at the 0.01 level (2-tailed). Source: Compiled from the CMIE Prowess Database Table II shows both the Pearson correlations among the observed variables. The ROA is negatively related with inventory conversion period (-0.290) while positively correlated with average collection period (0.034), average payment period (0.053) and cash conversion cycle (0.244). The negative relation between ROA and ICP can explained by the facts that firms which maintain low inventory levels because of the cost of possible interruptions in the production process. The positive relation between ROA and ACP is consistent with the view that more the time taken by customers to pay their bills, the low cash is available to replenish the inventory hence not leading 5.3 Regression Analysis: In order to test which element of working capital contributes most in predicting profitability, a linear regression was to more sales which result to decrease in profitability. The positive relation between ROA and APP can be explained by the fact that lagging payments to suppliers ensures that the firms have some cash purchase more inventories for sale thus increasing its sales levels hence boosting its profits. Further, cash conversion cycle is positively related to ROA which means that the time lag between expenditure for the purchase of raw materials and the collection of sales of finished products can be too short that the increasing this time lag decreases profitability. The correlation coefficients of CCC is significant while the ICP, ACP, APP are insignificant. performed. Moreover, the impact of these different components on profitability was evaluated through multiple regressions. In multiple regressions, various 199

5 dimensions of working capital were entered as independent variables and profitability was entered as dependent variable. Enter method was used where in researchers specifies the set of predictor variables and relative contribution of each predictor in dependent variable. Table III: Model Summary of Regression Analysis over Different Measures of Leather Industry Model Un-standardized Coefficients Standardized t Sig. Coefficients B Std. Error Beta (Constant) ICP ACP APP CCP R 2 (0.609), Adjusted R 2 (0.435), F (3.499*), Sig (0.055) Data Source: Compiled from the Centre for Monitoring India Economy (January2005 and June 2012) Results in Table III provide model summary and ANOVA of regression analysis. It indicates number of observation as 14 relating to the Lather industry. The overall statistical fitness of the regression model is indicated by Prob > F = which means that the model is fit. The R 2 indicates that 60.9 percent variation in profitability is explained by inventory conversion period, average collection period, average payment period, and cash conversion cycle while the remaining 39.1 percent is explained by unobserved factors. The adjusted-r 2 is 17.4 percent lower than the R 2 and is indicated as 43.5 percent. The overall regression model is statistically significant at 5 percent level. Table III also presents the results obtained after regression analysis. The regression result shows that inventory conversion period is not significant and has a positive relationship with profitability (p-value is 0.104). This show that increasing inventory conversion period will decrease profitability while decreasing inventory conversion period will positively affect profitability which means that firms must have to increase number of days of inventory to decrease profitability. Moreover firms with lower inventory turnover in days earn more profits as compared to firms having higher inventory turnover. This result is not consistent with the theory of corporate finance. This theory explains that lower number of days of holding inventory will result in higher profitability of firms. The positive relationship of inventory conversion period and profitability was also supported by some other studies; Daniel Mogaka and Ambrose Jagongo (2013) and Hina Agha (2014). we can observe from the regression results that the average collection period is positive correlation with profitability with coefficient value as 1.562, but it is 5 percent significant (p=0.044). This positive relationship indicates that as the average collection period increases, the profitability of the firm also increase which means that greater the average collection period, higher will be the profitability. According to the corporate finance theory, less number of days of accounts receivable will add more profits to the firm but the results of this study contradict with the theory of corporate finance. It is due to the reason that customers of this leather industry do not require more time assess the quality of products they buy from these firms. Also firms with higher profits have more finance to lend to customers. So they charge high margins on credit granted to customers for greater time period. The result is also consistent with the following researchers; Mahum Bukhri and Mohammad Shaukat Malik (2014) and Hina Agha (2014). From the regression analysis, we can find that the average payment period shows a negative relationship with profitability and it is statistically significant at 5 percent level i.e This result shows that, increase of the average payment period will decrease in profitability. This result contradicts with the corporate finance theory. It shows that higher the payment period of firm, lower will be its profitability because of this negative relationship indicates that less profitable firms take more time to pay their bills to creditors. Even though, low profitable firms don t have more cash available to them so delay their payables. This finding is also consistent with most previous studies; Mahum Bukhri and Mohammad Shaukat Malik (2014). If we observe the cash conversion cycle is estimated to have negative impact on profitability with coefficient value was but it is 5 percent significant (P > 0.040). This result indicates that decrease in cash conversion cycle negatively impacts 200

6 on the profitability while increase in cash conversion cycle will positively affect on the profitability and it also shows that firms have low profits are highly motivated to manage their cash conversion cycle. In the process of supply chain, the operating cycle is very high due to the reason that the resources got stuck at different level and the cost of blocked capital is less as compared to holding stock and advancing credits. This result is consistent with that of Daniel Mogaka and Ambrose Jagongo (2013). 6. Conclusion By observing the relationship between return on assets and all other research variables that affect the firm s profitability in the leather industry through the regression test, we can find that a positive and insignificant relationship of inventory conversion period and profitability and also average collection period is positive relationship with leverage but statistically significant. Even though, average References [1] Barot Haresh, Working Capital Management and Profitability: Evidence from India- An Empirical Study, GFJMR, 2012, Vol. 5, pp.1-9. [2] Biswajit Bose, The Impact of Working Capital Management Practices on Firms Profitability, International Journal of Applied Research Studies, 2013, Vol. 2 (6), pp [3] Daniel Mogaka and Ambrose Jagongo, Working Capital Management and Firm Profitability: Empirical Evidence from Manufacturing and Construction firms listed on Nairobi Securities Exchange, Kenya, International of Accounting and Taxation, 2013, Vol. 1(1), pp payment period and cash conversion cycle were significant negatively related to profitability. The results show that for overall leather industry, working capital management has significant impact on profitability of the firms. These results suggest that managers can create value for their shareholders by reducing the number of day s accounts receivable and increasing the account payment period and inventories to a reasonable maximum and also suggests that managers of these firms should spend more time to manage cash conversion cycle of their firms and make strategies of efficient management of working capital. We may further conclude that these firms properly manage components of working capital like cash, marketable securities, receivables and inventory management should be explored and their relationship with more proxies of profitability should be examined. [4] Gitman, L.J. Principles of Managerial Finance (11 th ed.). Pearson Education. USA [5] Hina Agha, Impact of Working Capital Management on Profitability, European Scientific Journal, 2014, Vol. 10 (1), pp [6] Mahum Bukhari and Mohammad Shaukat Malik, The Working Capital Management on Corporate Performance: A Study of Firms in Cement, Chemical and Engineering Sectors of Pakistan, Pakistan Journal of Commerce and Social Sciences, 2014, Vol.8 (1), pp