A significant portion of financial research is concerned with the management of working capital. This issue has been investigated at both theoretical and empirical levels. Many researchers have worked on working capital from different perspectives and in different socio-economic environment. To me the following environments and perspectives are discussed in detail.
This research is conducted for the relationship between working capital management and value creation for shareholders. The standard measure for working capital management is the cash conversion cycle (CCC). Cash conversion period reflects the time span between disbursement and collection of cash. It is calculated by subtracting the payable conversion period from the sum of inventory conversion period and receivable conversion period. In their study, Shin and Soenen used net-trade cycle (NTC) as a measure of working capital management. NTC is basically equal to the cash conversion cycle (CCC) where all three components are expressed as a percentage of sales. Net-trade cycle (NTC) may be a proxy for additional working capital needs as a function of the projected sales growth. They examined this relationship by using correlation and regression analysis, by industry, and working capital intensity. Based on the findings, they suggest that one possible way to create shareholder value is to reduce firm's NTC (soenen, 1998).
In Marc's view most firms invest ample amount of cash in working capital and it can be expected that the management of working capital will leave a good impression on the profitability of firms. Similarly, to many firms working capital management (WCM) is a major component of their financial management. This help the firm maximize the worth. On the one hand, large inventory and trade credit policy may lead to higher sales. Larger inventory reduces the risk of a stock-out. Trade credit may stimulate sales because it allows customers to assess product quality before paying. Because suppliers may have significant cost advantages over financial institutions in providing credit to their customers, but it can also become fusible source of credit or loan for customers. On the other hand, late payment of invoices can be very costly if the firm is offered a discount for early payment (Deloof, 2002).
There is a research conducted from the Belgian non- financial firms in 1992-1996 periods. In this study researcher uses correlation and regression model on the non-financial firms and concludes that there is a significant negative relation between operating income and account receivable. He suggests that managers can increase the corporate profitability by reducing the day of account receivable outstanding. Because operating cost was too high from current assets value and firms can't pay the obligations on the due date. The negative relation between accounts payable and profitability causes that less profitable firms wait longer to pay their bills.
Efficient liquidity management includes planning and controlling of current assets and current liabilities. The relationship between profitability and liquidity can be measured by current ratio and cash gap (cash conversion cycle). In the Saudi Arabia, different firms have conducted the study on the relationship of profitability and liquidity. As a result, there is a negative relationship between profitability and liquidity and great variation among the industries regarding significant measure of liquidity (abdual raheman, March 2007).
There is another study conducted by Kesseven Padachi, in his views a firm needs to maintain a balance between liquidity and profitability in day to day operations. Firms short terms liabilities are directly related to the former while the continuity of liabilities is concerned with the latter. In the result, high investment in stock and receivable is associated with lower profitability and strong relationship between working capital management and profitability of the firm (Padachi, October 2006).
The Lazaridis and Tryfonidis researched on the relationship between working capital management and corporate profitability of listed company in the Athens Stock Exchange (ASE). The result indicated that there was a statistical significance between profitability, measured through gross operating profit, and the cash conversion cycle. Based on the results analysis by using correlation and regression tests, they suggested that managers can create profits for their companies by correctly handling the cash conversion cycle and by keeping each component of the conversion cycle (accounts receivables, accounts payables, and inventory) at an optimal level (Nazir & Afza, 2009).
Raheman and Nasr's work on liquidity and profitability shows that most of the Pakistani firms have large amounts of cash invested in working capital and they found a strong negative relationship between variables of working capital management and profitability of the firm and they also found that as the cash conversion cycle increases, it leads to decreasing profitability of the firm and managers can create a positive value for the shareholders by reducing the cash conversion cycle to a possible minimum level. These results suggested that managers can create value for their shareholders by reducing the number of day's accounts receivable and inventories to minimum number. The negative relationship between accounts payable and profitability is consistent with the view that less profitable firms wait longer to pay their bills (Abdul Raheman, March 2007,). Statistical evidences have also shown that day's working capital of the sample firms is higher than day's working capital of the industry average and the working capital management components day's sales outstanding and day's payable outstanding are in line with their industry averages. This indicates the inventory management among the sample firms may not be efficient. It also affects the return on assets and profit margin. It shows poor management of accounts receivable and accounts payable, too. In the light of above discussion it can be said that working capital management efficiency can be improved by concentrating on reducing inventory and improving day's payable outstanding by getting more credits from suppliers.
Garcia and Martiniz salano have worked on to test the effects of working capital management on small to medium-sized enterprises (SME) profitability using the panel data methodology. Their research results recommended that managers could create value by reducing their inventories and the number of days for which their accounts are outstanding. Moreover, shortening the cash conversion cycle also improves the firm's profitability. They found a significant negative relation between an SME's profitability and the number of days accounts receivable and days of inventory. Finally, they concluded that SMEs have to be concerned with working capital management because they can also create value by reducing their cash conversion cycle to a minimum, as far as that is reasonable (Garcia-Teruel, 2007).
Afza and Nazir have also put their effort to investigate the traditional relationship between working capital management policies and a firm's profitability. The impact of aggressive/conservative working capital investment and the financing policies has been examined using panel data regression models between working capital policies and profitability. The result of this study also reached a negative relationship between the profitability measures of firms and degree of aggressiveness of working capital investment and financing policies. They suggested that managers could create value if they adopt a conservative approach towards working capital investment and working capital financing policies but negative returns in aggressive working capital policy (Nazir & Afza, 2009).
Uyar (2009) research shows relationship between cash conversion cycle with firm size and profitability of the corporations listed on the Instambul Stock Exchange (ISE). For this purpose, he (1) set industry benchmarks for cash conversion cycle (CCC) of merchandising and manufacturing companies, and to examine the relationship between (2) the length of the CCC and the size of the firms, and (3) the length of the CCC and profitability. He utilized ANOVA and Pearson correlation analyses for empirical investigation. A significant negative correlation between the CCC and the variables; the firm size and the profitability can be found.
Zariyawati, Annuar, Taufiq, and Rahim examined the relationship between working capital management and firm profitability. Cash conversion cycle is used to measure working capital management. Their study consists of six different economic sectors in Bursa Malaysia using panel data method. The coefficient results of Pooled OLS regression analysis provide a strong negative significant relationship between cash conversion cycle and firm profitability. This reveals that reducing cash conversion period results to profitability increase. Thus, in purpose to create shareholder value, firm manager should concern on shorten of cash conversion cycle till optimal level is achieved (M. A. Zariyawati, 2009).
Raheman, Afza, Qayyum, and Bodla analyzed the impact of working capital management on performance of manufacturing firms of Pakistan listed on Karachi Stock Exchange (KSE) using balanced panel data method (Abdul Raheman T. A., 2010).
From the analysis, the results indicated that the cash conversion cycle, net trade cycle and inventory turnover in days are significantly affecting the performance of the firms. Moreover, the financial leverage, sales growth and firm size also have significant effect on the firm's profitability. They concluded that firms in Pakistan are following conservative working capital management policy and the firms are needed to concentrate and improve their collection and payment policy. Furthermore, efficient management and financing of working capital (current assets and current liabilities) can increase their operating profitability.
Theoretically, it is found that there exist a negative relationship between liquidity and profitability of the firms; therefore, the measures of liquidity, Current Ratio should have negative association with the profitability. However, empirical researches have found both positive and negative association between current ratio and profitability. Several policy implications can be drawn from the above findings of the study which include that working capital management should be the concern of all the manufacturing sectors firms and need to be given due importance. The collection and payment policies of the firms in manufacturing sectors, in general, need to be thoroughly reviewed.
In Dong and Su's view working capital management determines the success or failure of firm in business because of its effect on firm's profitability as well on liquidity. Their study consisted of non financial firms to investigate the relationship between liquidity and profitability. Their findings show that there is a strong negative relationship between profitability, measured through gross operating profit, and the cash conversion cycle. It shows that as the cash conversion cycle increases, it will lead to declining of profitability of firm. Therefore, the managers can create a positive value for the shareholders by handling the adequate cash conversion cycle and keeping each different component to an optimum level (Huynh Phuong Dong, 2010).
By supporting the existing literatures such as Shin and Soenen, Deloof, Raheman and Nars, they found a strong negative relationship between the measures of working capital management including the number of days accounts receivable, number of days inventories and cash conversion cycle with corporate profitability. The negative between corporate profitability that measured by gross operating profitability and cash conversion cycle that used as measuring efficiency of working capital management shows that cash conversion cycle is longer, profitability is smaller. This study suggests that managers can create value for their shareholders by reducing the cash conversion cycle to a reasonable range.
Result from analysis of relationship between working capital management and profitability on stock market also indicates that there is a negative relation between number of day's accounts receivable, number of day's inventories and profitability. Besides, their research also shows that less profitability firms wait longer to pay their bills. From the statistical results, they suggest that managers can create value for their shareholders by reducing the number of days for accounts receivables. In addition, the negative relationship between accounts receivables and firm's profitability suggest that less profitable firms will pursue a decrease of their accounts receivables in an attempt to reduce their cash gap in the cash conversion cycle. They also concluded that profitability can be enhanced if firms manage their working capital in a more efficient way.
After studying the all above articles, I have come to know that the results of all researchers are the same that there is significant relationship between working capital management and profitability regardless of different companies, environments and situations by different researchers. On the basis of all these researches, I have selected my own methodology for research.
Problem Statement
Working capital management has its impact on profitability as well as liquidity of the company and the primary goal of any company is to maximize the annual profit. But, keeping the company liquid is an extremely important task, too. Increase in company profitabiliy by reducing the liquidity of the company can bring some serious problems for it. Hence, there should be a balance between these two aims of the firms. First goal should not be ignored at the cost of the other because each individual goal has its own importance. If goal of maximizing the profit is ignored, survival is not possible for a longer time. Similarly, if liquidity objective is ignored, insolvency or bankruptcy could be faced. Because of these bases, proper attention should be given to working capital management which will affect the firms` profits and through this, it can be found out the impact of working capital on the profitability of companies.
