In this paper we investigate the relation between the firm's cash conversion cycle and its profitability. This relationship is examined using dynamic panel data analysis for the full sample, by industry and by size. Using a sample of 34771 firm years covering the period 1990-2004, we find a strong negative relation between the length of the firm's cash conversion cycle and its profitability in all our study samples except for consumer goods companies and services companies.
Keywords: Working Capital Management; Cash Conversion Cycle; Return on Investment
JEL classification: G30
1. Introduction
The traditional focus in corporate finance was on the long term financial decisions such as capital budgeting, capital structure, and dividends. However, the interest on working capital management has increased during the last two decades (Lyroudi and Lazaridis, 2000), and both academics and financial officers show more interest in working capital management. For example, Dell and Wal-Mart declare that their working capital management practices are an important source of their competitive advantage (Ruback and Sesia 2000). One good example about the importance of the efficiency of a corporation's working capital management is given by Shin and Soenen (1998). They point out that Wal-Mart and Kmart had similar capital structures in 1994, but Kmart had a cash conversion cycle of roughly 61 days while Wal-Mart had a cash conversion cycle of 40 days. Probably for that reason, Kmart faced an additional $198.3 million per year in financing expenses. Such evidence demonstrates that Kmart's poor management of its working capital contributed to its bankruptcy (Moussawi et al, 2006). Efficiency of working capital management is based on the principle of speeding up collections as much as possible and slowing down disbursements as much as possible. This working management principal based on the traditional concepts of the cash conversion cycle introduced by Richards and Laughlin (1980), is a powerful performance measure for assisting how well a company is managing its working capital. Gentry et al. (1990) argue that a short cash conversion cycle is indirectly related to firm's value. Short cash conversion cycle indicates that the firm is collecting the receivables as quickly as possible and delaying the payments to suppliers as much as possible. This leads to relatively high net present value of cash flow and relatively high firm value.
Cash conversion cycle definitions are not constant. For example, Stewart (1995) define cash conversion cycle as " a composite metric describing the average days required to turn a dollar invested in raw materials into a dollar collected from a customer". Besley and Brigham (2005) describes cash conversion cycle as " the length of time from the payment for the purchase of raw materials to manufacture a product until the collection of account receivable associated with the sale of the product.
A shorter cash conversion cycle could be associated with high profitability because it improves the efficiency of using the working capital. A short cash conversion cycle indicates that the company manages and processes inventory more quickly, collects cash from receivables more quickly and slows down cash payments to suppliers. This increases the efficiency of internal operations of a firm and results in higher profitability, higher net present value of cash flows, and higher market value of a firm (Gentry et al, 1990). The cash conversion cycle can be shortened by reducing the time that cash is tied up in working capital. This could happen by shortening the inventory conversion period via quicker processing and selling goods to customers, or by shortening the receivable collection period via speeding up collections, or by lengthening the payable deferral period via slowing down payments to suppliers. On the other hand, shortening the cash conversion cycle could harm the firm's operations and lead to poor performanc. Reducing the inventory conversion period could increase the shortage cost and make the company's lose it's good credit customers, and lengthening the payable period could damage the firm's credit reputation.
The cash conversion cycle is a useful way of assessing the liquidity of a firm especially for small companies that are usually operated with fewer financial resources, compared with larger companies that have better access to both money and capital markets. Shortening the cash conversion cycle could be one important source of financing for small firms.
The purpose of this paper, therefore, is to investigate the relation between the length of cash conversion cycle and firm profitability for a sample of 34771 firm years covering the period 1990-2004 for Japanese non-financial firms listed on the Tokyo Stock Exchange. In addition, to examine the relation between the length of the cash conversion cycle and the firm's profitability for different firm sizes and for firms from different industries.
The rest of the paper is organized along the following lines. The next section describes data and methodology. Section three contains the results. And finally, section four concludes the paper.
2. Data and Methodology
The data set in this study was obtained from the DataStream &World Scope. It includes yearly data of sales, cost of good sold, receivables, payables, inventory and return on investment. These data are used to calculate the receivable collection period, the inventory conversion period, the payable deferral period and the cash conversion cycle. The data includes all non-financial firms listed in the Tokyo Stock Exchange. Some firms with missing data are excluded from the sample. The final sample contains 34771 firm years covering the period 1990-2004.
To investigate the relationships between our variables we use a Generalized Method of Moment System Estimation (GMM) applied to dynamic panel data. We used this estimation for the following reasons: first, our dependent variables are likely to be measured using annual data, and it seemed desirable to use a dynamic specification to allow for it, and second, there is a possibility of unobserved province specific effects correlated with the regressors, and it seemed desirable to control for such effects. De Granwe and Skdenly (2000) mention that the lagged dependent variable in the dynamic panel data estimation catches up some of the effects of omitted variables varying over time, so it helps to correct for autocorrelation. The Generalized Method of Moment System Estimation applied in this study is proposed by Arellano and Bover (1995) and Blundell and Bond (1998), who have shown in Monte Carlo estimations that the estimators behave better than the GMM difference estimators proposed by Arellano and Bond (1991) for the short sample period and for variables persistent over time. Roodman (2005) mentioned that the Arellano-Bond estimators have one and two-steps variants. He argued that the two-steps estimate of the standard errors tends to be severely downward biased. Therefore, the researchers apply the finite sample correction for the asymptotic variance of the two-step GMM estimator (see Windmeijer, 2005). This estimation approach leads to the following estimation equation:
(1)
Where () is the first deference the return on investment. The exploratory variables in our model include the differenced lagged dependent variable () and the first difference of cash conversion cycle (). The cash conversion cycle is simply calculated as [Receivable collection period + Inventory conversion period - Payable deferral period]. The receivable collection period measures the average number of days from the sale of goods to collection of resulting receivables. It is calculated as [(accounts receivable/sales) *365]. The inventory conversion period is the length of time on average needed for converting raw materials into finished goods and selling these goods. It is calculated as [(inventory/cost of good sold)*365]. The payable deferral period is the average length of time needed to purchase goods and pay for them. It is computed as [(accounts payable/cost of goods sold)* 365]. In this study we hypothesize that shortening the length of the cash conversion cycle improves the company's performance. This means that the coefficient of the cash conversion cycle should be significant and negative especially for small firms.
3. Empirical Results
In this section we present our estimation results concerning the effect of the length of the cash conversion cycle on corporate performance. The estimated coefficients based on equation (1) are reported on table (1). The results show that the length of the cash conversion cycle () had a significant and negative impact on the companies' performance measured by return on investments () for the full sample and for all the sub samples, except for consumer goods and services companies, where the coefficients of the cash conversion cycle are negative and insignificant. This indicates that shortening the cash conversion cycle () by reducing the time that cash are tied up in working capital and by speeding up collections results on high return on investments (). These results are consistent with the results of the existing working capital management literatures such as (Deloof, 2003) and (Shin and Soenen, 1998).
Results of the lagged return on investments () indicate that the company's performance in the previous period has a strong positive effect on the company's performance in the current period for the full sample and for all the sub samples of the study except small companies, where the coefficient is positive and insignificant, and for basic industries and information companies where the coefficients are significant and negative.
Table 1
Tow-Steps Results of GMM System Estimation for the Relationship between the Cash Conversion Cycle and Firm's Performance
Study Samples
Exploratory Variables
LROI
CCC
Constant
Full Sample
0.1082179**
-0.0082981**
-0.3242791**
Small Size
0.0253326
-0.0038462*
-0.4712807**
Medium Size
0.099843**
-0.0116027**
-0.3606753**
Large Size
0.2328998**
-0.0108979**
-0.1846034**
Basic Industries(1)
-0.0234192**
-0.0078771**
-0.5024529**
General Industries(2)
0.2412124**
-0.0214374**
-0.2476479**
Consumer Goods(3)
0.4129598**
-0.0047878
-0.0785687**
Services(4)
0.1024312**
-0.0010285
-0.2882625**
Information Technology(5)
-0.0782775**
-0.0216819**
-0.4640247**
Table 1 reports the results of Arellano-Bond dynamic panel-data two- steps GMM system estimation for the relationship between the cash conversion cycle and firm's performance for an unbalanced sample of 2318 Japanese non-financial firms listed in the Tokyo Stock Exchange, for the period 1990-2004 (34770 firm-year observation). The dependent variable and the independent variables are in the form of first difference. (ROI) is the dependent variable of return on investment. The exploratory variables are: (LROI) is the lagged return on investment, and (CCC) is the cash conversion cycle. The analysis includes the results for the full sample and all the sub samples that includes three size levels and five industries
(1) Basic Industries includes; Mining', 'Oil & Gas', 'Chemicals', 'Construction & Building Materials', 'Forestry & Papers' and 'Steel & Other Metals'.
(2)General Industries includes; 'Aerospace & Defense', 'Diversified Industries', 'Electronic & Electrical Equipment' and 'Engineering Machinery'.
(3)Consumer Goods Consists of 'Automobiles & Parts', 'Household Goods & Textiles'. 'Beverages', Food Producers & Processors', 'Health', 'Personal Care & Household Products', 'Pharmaceuticals & Biotechnology' and 'Tobacco'.
(4) Services Includes; 'General Retailers', 'Leisure', 'Entertainment & Hotels', 'Media & Photography', 'Support Services', 'Transport', 'Food & Drug Retailers' , 'Telecommunication Services', 'Electricity', 'Gas Distribution' and 'Water'.
(5) Information Technology Includes; 'Information Technology Hardware' and 'Software & Computer Services'
Note: * significant at 95% confidence level, * *significant at 99% confidence level
4. Conclusion
The cash conversion cycle is a powerful performance measure for assisting how well a company is managing its working capital. Shin and Soenen (1998) show a strong negative relation between the length of the cash conversion cycle and corporate profitability of listed American firms covering the period 1975-1994. In this study, a significant negative relationship is found between the cash conversion cycle and return on investment for the Japanese firms for the full sample, small companies, medium companies, and large companies, and for all industries except of consumer goods and services.
The results also show that the company's performance in the previous period has a strong positive effect on the company's performance in the current period all the study samples except for small companies where the coefficient is positive and insignificant, and for basic industries and information companies where the coefficients are significant and negative.
These results suggest that working capital managers of the Japanese firms can improve the profitability of their firms by shortening the cash conversion cycle. Cash conversion cycle can be shortened by reducing the inventory conversion period via processing and selling goods more quickly, or by reducing the receivable collection period via speeding up collections, or by lengthening the payable deferral period through slowing down payments to suppliers. Shortening the cash conversion cycle improves profitability of a firm because the longer the cash conversion cycle the greater the need for expensive external financing. Therefore, by reducing the time that cash are tied up in working capital, a firm can operate more efficiently (Moss and Stine 1993).
