The corporate finance literature has customarily focused on the impact of long-term financial decisions. Researchers have mostly offered studies and work for analyzing investments, capital structure, dividends, earnings or company valuation, among other topics. The investment made by the company in the short term, and the resources used with maturities of less than one year, represent the more than 50% share of items on a firm's balance sheet. Actually, in the sample used in the present study, current assets of small and medium-sized Spanish firms represent 69 percent of their assets, and at the same time their current liabilities represent more than 52 percent of their liabilities.
Working capital management is vital because of its impact on the firm's profitability and risk, and at the same time, its impact on value (Smith, 1980). Specifically, working capital investment involves a tradeoff between profitability and risk. Decisions that tend to increase profitability tend to increase risk, and, conversely, decisions that focus on risk reduction will tend to reduce potential profitability. Gitman (1974) argued that the cash conversion cycle was a key factor in working capital management. Actually, decisions about how much to invest in the customer and inventory accounts, and how much credit to accept from suppliers, are reflected in the firm's cash conversion cycle,which represents the average number of days between the date when the firm must start paying its suppliers and the date when it begins to collect payments from its customers. Previous studies have used measures based on the cash conversion cycle to analyze whether shortening this cycle has positive or negative effects on the firm'sprofitability. Empirical evidence relating working capital management and profitability in general supports the fact that aggressive working capital policies enhance profitability (Jose et al., 1996; Shin and Soenen, 1998; for US companies; Deloof, 2003; for Belgian firms; Wang (2002) for Japanese and Taiwanese firms). This suggests that reducing working capital investment is likely to lead to higher profits.
These previous studies have focused their analysis on larger firms. However, the supervision of current assets and current liabilities is particularly important in the case of small and medium-sized companies. Most of these companies' assets are in the form of current assets. Also, current liabilities are one of their main sources of external finance because they encounter difficulties in obtaining funding in the long-term capital markets (Petersen and Rajan, 1997) and the financing constraints that they face (Whited, 1992; Fazzari and Petersen, 1993). In this respect, Elliehausen and Wolken (1993), Petersen and Rajan (1997) and Danielson and Scott (2000) show that small and medium-sized US firms use vendor financing when they have run out of debt. Thus, efficient working capital management is particularly important for smaller companies (Peel and Wilson, 1996).
In this context, the objective of the current work is to provide practical example about the consequences of working capital management on profitability for a panel comprises 10 cement manufacturing companies during the period 2006 to 2010. This work supports to the literature review in two ways. First, no such evidence exists for the case of cement sector in earlier studies. A sample of Spanish SMEs was studied that operate within the so-called continental model, which is characterized by its less developed capital markets (La Porta et al., 1997), and by the fact that most resources are channeled through financial intermediaries
(Pampillo´n, 2000). All this suggests that Spanish SMEs have limited alternative sources of external finance available, which restrict them more on short-term finance and in general, on short term trade credit specially. As Demigurc-Kunt and Maksimovic (2002) suggest, firms operating in countries with more developed banking systems grant more trade credit to their customers, and at the same time they receive more finance from their own suppliers.
The second contribution is that, unlike the previous studies (Jose et al., 1996; Shin and Soenen, 1998; Deloof, 2003; Wang, 2002) in the current work robust tests for the possible presence of endogeneity problems have been applied. The aim is to ensure that the associations found in the analysis done are due to the belongings of the cash conversion cycle on firm's profitability and not vice versa. Our findings suggest that manager's can outperformed by reducing their inventories as well as the number of days their accounts are outstanding. Similarly, reducing the cash conversion cycle also advances the firm's profitability.
Data and Variables:
Top performing companies of Karachi Stock Exchange are selected for this analysis. All these companies are the volume leaders in the cement sector as well as well reputed and investor's preferred in the cement sector. Filtering process of eradication of abnormal values like negative values in their assets, current assets, fixed assets, liabilities, current liabilities, capital, depreciation, or interest paid further more entry items from the balance sheet and income statement exhibiting signs that were contrary to reasonable expectations were also removed.
Variables:
Return On Assets (ROA): Working capital managements' effect on the company profitability cannot be measured without the application of return on assets (ROA), as it is the dependent and core variable. ROA means "ratio of earnings, before interest and tax, to assets". ROA tells you what income was generated from invested capital (assets). ROA for public companies can vary significantly and will be extremely dependent on the industry. This is why when using ROA as a comparative gauge, it is best to compare it against a company's historic ROA numbers or the ROA of relevant companies.
According to investopedia, the assets of the company are consisting of of both debt and equity. Both are used to fund the operations of the company. The ROA figure provides investors an idea of how efficiently the company is converting the funds it has to invest into net income. The higher the ROA number, the better, in the sense that company is earning more income on less investment. For example, if Xyz Company has a net income of $100 million and total assets of $500 million, its ROA is 20%; however, if another company makes the same amount but has total assets of $100 million, it has an ROA of 10%. Based on this example, the Xyz Company is better at converting its investment into profit. When you really consider about it, management's salient job is to make shrewd choices in allocating its resources. Anybody can make a profit by investing ton of money at a problem, but very few managers are able of making large profits with little investment.
Accounts Receivable Turnover: The working capital management is measured using the three basic components namely accounts receivable turnover, inventory turnover and accounts payable turnover. Accounts receivable turnover is calculated as 365 x [accounts receivable/sales]. This variable indicates the average number of days that the company takes to receive payments from its customers. The higher the value of this ratio, the higher its investment or cash blockage in accounts receivable. By maintaining accounts receivable, firms are providing loans to their clients at zero interest rate. A high ratio implies either that a company run on a cash basis or that the firm is extremely good in collecting accounts receivable. A low ratio implies vice versa situation and need to be work on re assessment of its credit policies and collection process.
Inventory Turnover: Inventory turnover ratio was calculated as 365 x [inventories/purchases]. This variable means the average number of days of stock held by the firm. Longer storage time means a greater investment in inventory for a particular level of operations. This ratio should be evaluated against industry averages. A low turnover implies low sales and, therefore, above required inventory. A high ratio implies either strong volume of sales or ineffective purchases. High inventory levels are damaging because they represent an investment with zero rate of return.
Accounts Payable Turnover: The accounts payable turnover reflects the average time it takes to pay their suppliers. This was calculated as 365 x [accounts payable/sales]. The higher the value, more time firms take to payoff their payment commitments to their suppliers. According to investopedia, this measure shows that how many times per period the company pays its average payable amount. For example, if the company makes $1000 million in purchases from vender in a year and at year end holds an average accounts payable of $200 million, the accounts payable turnover ratio for this period is 5 ($1000 million/$200 million). If the turnover ratio is declining from one period to another, this is a sign that the company is taking more time to pay off its suppliers than it was before. The opposite is true when the payable turnover ratio is increasing; it means that the company is paying off its liabilities at a faster rate.
Cash Conversion Cycle (CCC): Considering above mention three periods jointly, the cash conversion cycle (CCC) was anticipated. CCC is calculated as "the number of days accounts receivable plus the number of days of inventory minus the number of days accounts payable". Higher the cash conversion cycle specify more time between outlay of cash and cash recovery. Summing up these variables, control variables were launched, such as the size of the firm, the growth in its sales, and its leverage. Cash Conversion Cycle can also be explained as: "A metric that indicate the length of time, in days, that it takes for a business to convert its resource inputs into cash flows. According to investopedia, the cash conversion cycle tries to measure the amount of time each net input dollar is attached with the production and sales process before it is transform into cash through sales to customers. This metric looks at the sum of time needed to sell inventory, the sum of time needed to collect receivables and the span of time the company is afforded to pay off its bills without incurring penalties.
Calculated as:
Where:
DIO represents days inventory outstanding
DSO represents days sales outstanding
DPO represents days payable outstanding
Usually a company purchased inventory on leverage, which results in accounts payable. A company can also sell products on leverage, which results in accounts receivable. Cash, therefore, is not concerned until the company pays the accounts payable and receives accounts receivable. So the cash conversion cycle actually measures the time between outlay of cash and cash recovery.
This cycle is enormously important for retailers and similar traders. This measure exhibits that how quickly a business can convert its assets into cash through sales. The shorter the cycle, the less time capital is attached up in the business process, and thus the better for the company's profitability.
Karachi Stock Exchange: The KSE-100 index was launched in November 1991 with a base of only 1,000 points. Over the next ten years, the index witnessed a record high of 2,661 points (March 1994) - up by a staggering 161%; and ended the decade with a respectable growth of +35.81% (10-yr CAGR: +3.11%). Over 2001-2004, the index registered a sizeable growth of +388.46%, however, its first feat was achieved in 2005, when it reached its then all time high of 10,294 points - significant due to its penetration of the much awaited 10,000 barrier. The peak, despite being a healthy 250+ points above the critical 10,000 level, could not sustain itself and the index collapsed under its own weight. At the end of the persistent bearish run, the index had reached a level of 6,467 points - down by 37.18% from its peak. The March 2005 crash, which caused a loss of approximately PKR12-15bn to investors, was attributed to insider trading, wash trades, unfair broker-investor business practices, broker maneuverings, nature of leverage deals ('Badla' financing), future contracts and lack of regulatory policy implementation by the SECP.
On January 16, 2006, the index finally breached the 10,000 barrier again, on its way to reach a new height of 12,274 points in April 2006. During 2007, the index reached a new high of 14,814 points on December 26, 2007. Surprisingly, this new record for the index coincided with the assassination of the PPP Chairperson and former Prime Minister of Pakistan, late Benazir Bhutto. The index, it was perceived, would record a significant slide after the assassination on December 26, 2007; however, it was quick to recover and reach its historical high of 15,676 points on April 18, 2008.
The international crisis coupled with domestic issues played havoc with the KSE-100 index after its all time high of 15,676, causing the index to plunge to 9,144 points till August 27, 2008. At this point the index was frozen to protect investments and prevent further leverage-related losses to investors and intermediaries. Major domestic factors responsible for the disintegration of the index at the time were (a) Worsening political climate (b) Massive foreign investment outflows (c) Draining FDI (d) High borrowing costs (e) Low corporate profitability (f) Commodity price spikes (g) Falling foreign exchange reserves and (h) Rising militancy in northern areas. Before being frozen on August 27, 2009, the KSE management attempted to artificially resuscitate the equity market by shifting circuit breakers from the usual +5%/-5% to +10%/-1%. Upon the unfruitful attempt, the management finally had to resort to floor imposition. To provide additional support to a cascading index, prohibition was placed on short selling on September 19, 2008. The final major support move came in the form of a decision to launch a PKR20bn (USD251.4mn) market stabilization fund. It was due to the possibility and potential of this very emergency fund that market participants finally woke from their investment slumber. Eventually, the index recommenced on December 15, 2008 from a level of 8,817, and started a bearish momentum that led to a level of 4,815 points - a fall of 69.3% from its all time high of 15,676. The PKR20bn fund was given final approval by the Securities Exchange Commission of Pakistan (SECP) on January 09, 2009, and became operational on January 14, 2009.
After touching a low of 4,815 points in January 2009, the KSE-100 index witnessed a remarkable rally that saw the index rise and touch the 10,000 level during intraday sessions ten times over a span of three months (i.e. January 2010 to March 2010). This intraday penetration did not materialize into a close above the psychological barrier till March 25, 2010. On March 25, 2010, the barrier was finally broken with a closing beyond the 10,000 mark. On March 31, 2010, the KSE-100 index benchmark stood at a level of 10,073 points, having successfully gained 109.20% from its recent low of 4,815 points on January 27, 2009.
The rally that the index witnessed from January 27, 2009 onwards saw the index beat pertinent Morgan Stanley Capital International (MSCI) Barra benchmark indices. KSE-100 had been de-listed from the MSCI Emerging Market Index during December 2008 due to index inactivity that ensued as a result of floor imposition on August 27, 2008. Nonetheless, upon resumption of the index, the KSE-100 was reconsidered and eventually included in the MSCI Frontier Market Index in May 2009.
Methodology:
The methodology adopted in this research work is simple and practical. The reason of applying simplicity is that the researcher wants this research a role model for other students of business studies and encourages them to follow. The methodology followed is explained below:
Selection of top ten performing cement companies from the cement sector of KSE.
Historic data of these companies are extracted from the annual reports.
Removal of extreme data that may influence the outcome derived from the historic data.
Formula used are:
Return on Asset= EBIT/ Total Assets
Inventory Turnover= 360*(Inventory/ Sales)
Accounts Receivable Turnover= 360(Receivables/ Sales)
Accounts Payable Turnover= 360(Payables/ Sales)
Cash Conversion Cycle= Accounts Receivables turnover+ Inventory turnover- Accounts Payable turnover.
Development of spread sheet using the above mention formulas
Importing of spread sheet analysis into SPSS for further detailed and extensive analysis.
