Since the beginning of the economic crisis, a large number of companies have set up special policies to improve their liquidity and their working capital management processes. These strategies are often linked with the increasing difficulty and cost of external financing in these periods. It is a mean to improve firm's efficiency and find new ways to generate cash. However, although both liquidity strategies and working capital management are crucial for a company, they are just tools to achieve firm's main objective, profitability meaning the creation of wealth for shareholders. As this objective remains unchanged in all economic periods, it is interesting to assess whether policies put in place by large companies to improve their liquidity are effectively linked with their profitability.
Is there a statistical relationship between liquidity strategies and profitability?
What are the main variables to focus on in order to impact significantly firm's profitability?
We will discuss about the background of the study in the first part, then we will analyze in details the different theoretical concepts involved in liquidity strategies and working capital management. Last but not least, we will try to answer the key questions of this paper by using a statistical study of the relationship between profitability and some specific variables.
Background
Financial Crisis
For a clear understanding of this research paper, it is important to focus a little bit on the economic environment on which this study takes place. Since the beginning of 2010, Europe is facing a new severe economic crisis, consequence of huge public debt ratio in a large number of European countries. This crisis started with the realization of the debt level in Greece leading to a widespread distrust in state debt of several major countries such as Italy, Spain and France. As a consequence of this financial market distrust, cost of debt has increased in a lot of countries leading to critical situations in Greece and Ireland where European Union has been obliged to set up huge emergency plan to avoid these countries to bankrupt. Based on these important troubles, a lot of countries have decided to take several austerity measures in order to reduce their levels of debt: increase of taxes, cuts in public expenditures, decrease of civil servants' salaries in the worst cases. This debt crisis must also be seen against the 2008 financial crisis that drove the world into recession and has weakened the entire world economy. In total, Europe and France in particular have been facing economic trouble since the beginning of subprime crisis in 2006.
The compilation of these two crises has impacted strongly European companies. The first on the list were banks that suffered a lot from sub primes crisis with massive credit losses and are still in trouble as they are very exposed on South European countries debts. For example, Societe Generale has announced at the end of 2011, a 31% decrease of it net profit due to a depreciation of Greek state bonds (http://www.france24.com).
Unfortunately, the crisis has not impacted banks only. French companies are also strongly impacted by the tightening of credit and the economic slowdown. The effects of the crisis for French companies are tighter credit terms as banks reinforced debt covenants with a consequence of making investments more complicated. Moreover, investor's attention is not only focus on sovereign debt crisis. Financial markets have started to look closely at companies' level of debt and companies have to implement efficient measure to improve their financial situations. However, in a credit crunch context, it is not an easy thing. That's why, firms put the stress on new ways to manage their balance sheets and improve liquidity. In order to do that, companies are implementing working capital management and cash management strategies that are usually ignored during positive economic conditions. We observe a comeback of liquidity strategies in several firms today and we will dedicate this paper to analyze in which extent these efforts are useful to improve profitability.
Working Capital
During my research, gathering a large amount of studies related to working capital management, cash management and liquidity strategies in general, I noticed that a lot of these studies were published in economic downturn period (especially during the recovery period just following the 1973 Oil crisis). In fact, economic crises are period, where it is more difficult for companies to find external sources of financing and so, they have to study organic ways of savings and generating cash. However, firms' main objective is to be profitable so we can ask the following question: is it proven that improving liquidity has a positive impact on liquidity (H7). We will analyze this question during our research. Thus, we can point out that economic turbulences are a favorable ground to reflect on the link between liquidity and profitability, as people tends to oppose these two concepts. As example, Pass and Pike studied the relationship between working capital and profitability in 1984 and showed a significant link between the two concepts.
The working capital issue is particularly interesting because it involves a large number of components and is linked with many areas of a company. Thus, receivables are impacted by sales policy, invoicing, financial term and, in same time, another component such as inventories is driven by production and logistics. Many authors has been focusing on one of these particular components but I think that this issue has to be tackle globally by implementing an overall strategy aiming at improving working capital level and enhance liquidity. In fact, as it is an area with multiple stakeholders, the best way to succeed in improving liquidity is to set up a "liquidity culture" in the company.
In this context, some authors have discussed the best way to manage working capital and thus, create more values. Kolay (1991) underlined the necessity of a pro active management of the different components as WC is evolving regarding the situation (economic environment, firm's financial structure) and the strategy in place has to be continuously adapted and revisited. Kolay pointed out the need to implement both long-term and short term strategies. Maynard E. Raffuse (1996) put the stress on stock reduction in order to achieve WC reduction by supporting strategies based on "lean supply-chain" techniques. He argued that strategies aiming at delaying payment to creditors are not efficient and can even be harmful for the economy. In fact, it is a negative sign sent to creditors and economy as a whole and will lead to worse credit terms in the future.
More recent studies focused more on the link between WC management and cash. Thus, Chiou & Cheng (2006) underlined the more systematic use of financial ratios such as quick and current ration, by companies' management. In 2009, Russell P. Boisjoly studied several companies' ratio linked to WC components in order to assess if their management practices had an impact on their ratios. He concluded that an aggressive management of working capital together with a productivity improvement had a strong impact on companies' cash flows.
Lazaridis & Tryfonidis (2006) focused on the relationship between working capital management and profitability. They showed on a sample of Greek companies that there was a statistical significance between profitability and firm's cash conversion cycle. Thus, managers can create value by looking carefully at cash conversion cycle components such as receivables, payables and inventories.
Our idea is to look carefully at the impact of key variables related to liquidity strategies on firms' profitability and thus, identify ones for which it is important to put resources firstly.
Research questions
Aim of the study
Our study aims at assessing the validity of the relationship between liquidity and profitability in economic downturn and at least, identifying the key variables to focus on in order to create value.
Limitations
The scope of the study is quiet limited since the analyses is focused on the 40 largest French companies, part of the CAC 40 indices. Thus, it does not take into account the smaller companies that represent the most important part of the economy. It would be interested to extend the study to other location and type of businesses. However, the objective of the study is not to generalize the results for the whole economy but to provide useful information regarding the largest French companies.
Another big issue with this kind of analyses is endogeneity. In fact, it is one thing to establish that there is a strong link between working capital management variables and profitability but it is different from demonstrating causality. It will be very important to be cautious in interpreting the results of the regression in order to draw the rights conclusions.
Last but not least, it is crucial to point out that the period of study is very anomalous considering the strong financial crisis that the world has to face. As a consequence, all the results will have to be interpreted with this in mind.
Motivations
My choice of this specific subject is mainly motivated by two things. Firstly, I am really interested in the issues tackled in this paper. As I am working in strategy in a big industrial group, I would like, in this research paper, to deal with both financial and strategic issues. I am convinced that finance knowledge is a very powerful tool to improve companies' performance, not only in the financial department but also on more operational issues, and I want to use this paper to deliver relevant results which can be used by both financial and strategic managers.
Liquidity strategies and working capital management sound very common in the business environment but their links with profitability are often neglected. I think that it neglected, especially in good economic situation, because it is quite difficult to assess the impact of an action on the firm's profitability. That is why I want to highlight this link in order to encourage financial managers to focus on these issues. It is exactly my second motivation for this research paper. I am convinced that this study can be useful in business environment especially for French financial managers as the analysis has been made on CAC 40 companies, a sample never explored for this kind of study. I have noticed during my research a growing number of researches in this area especially from auditing companies. It shows a real come back of working capital management topic and largely liquidity strategies in firms' top priorities. This feeling has been confirmed by the new management policy in my current company: Schneider Electric. In fact, management put working capital management at the top of the agenda as it is a key factor to improve cash position and thus ensure the independence of the company. Liquidity strategies have even more importance in downturn period as they become key differentiators to seize opportunities such as M&A opportunities.
Given that, it is easier to understand the interest of this study for the corporate finance community which is facing one of the largest crises of the history.
Theoretical Methodology
Potential biases
In this part, I would like to underline the biases inherent in any studies. In most of cases, there are linked to a specific vision of the reality due to educational background and experiences. For my part, as I am specialized in finance, I am tempted to see working capital management's issue through a financial angle.
In fact, as we have described before, working capital management and liquidity strategies are dependent of many variables, some of them related to finance area others more related to logistics or production for example. Given my background, my knowledge and the context of this research paper, I decided to focus on the study of the financial variables even if I am aware that they are not the only things to take into account in order to pretend to make an exhaustive study.
One of the main preconceived ideas I had regarding working capital management and liquidity was that the predominance of this subject for companies was growing with crisis and bad economic conditions. It is this feeling that motivated me to study this field more in details, all the more that is was a recurring subject in the company where I am working: Schneider Electric. Before my readings and deeper companies' analysis I was not very familiar with the different levers that can be used to manage liquidity and it allowed me to exceed my preconceptions.
Research Approach
I started this research paper with the intuition that working capital management and liquidity strategies were closely correlated to profitability or at least that an action on certain key levers could have an impact on the value creation within a company. The objective of this paper is to validate or reject this intuition and identify these key levers that can impact profitability.
Quantitative Research
In order to do that, I chose a quantitative approach consisting of gathering key financial data of several companies and test these data to assess the potential relationship with profitability. Thus, I will use regression analysis to test the relationship between profitability and key variables linked to working capital such as receivables, payables or inventories. I thought that the quantitative approach was the best method for my subject as it deals with a lot of number and requires a statistical analysis.
Targeted audience
One of the particularities of a research paper is that it supposed to complement or bring something new to the existing literature. In this context the problem raised has to be useful in a business perspective. However, if you want to be accurate and offer an efficient answer to a particular problem it is important to think about who is the target of my research.
As mentioned above, I chose to tackle the working management issue under the financial angle. As a consequence, my main audience will be financial managers and business managers that are interested to know in what extent WCM is linked with profitability and which are the most important factors that need to be studied in order to improve the value creation. In fact, my objective is to select the key variables for which the management has to focus its resources in order to improve efficiency and gain value.
Theoretical Framework
Working Capital
The working capital represents the amount needed by a company to ensure its operational exploitation. According to Shin and Soenen, working capital is a "time lag between the expenditure for the purchase of materials and the collection for the sale of the finished products" (Hyun-Han Shin& Luc Soenen, 1998). As a result, it is closely linked to liquidity as the time gap generates a cash flow gap that must be taken into account and forecasted. The most common form of WC is given by a difference between the current assets and the current liabilities. Thus we have the following standard formula:
Net WC = Current Assets - Current Liabilities
All the components of this formula are in the balance sheet of the company. The current assets are the assets that "can either be easily converted into cash or used to pay current liabilities within 12 months" (Wikipedia). The most known components of this category are: Receivables, Cash and cash equivalents, short-term investments, prepaid expenses and inventories. The current liabilities represent the debts that the company must pay within one year. They include components such as: Short term loans, account payables, dividend and interest payable.
There are no standard levels of working capital but we can observe big trends related to sectors. For example, automobile firms have traditionally a high level of working capital due to the substantial amount of stock needed in this industry. At the contrary, some sectors such as retail have negative working capital due to the fact that firms collect the sales from customers before paying their suppliers. That is why, in the retail industry, a large amount of benefits are made thanks to short term investment during the time gap between the collection and the payment of suppliers. This idea is very clear when it is presented on a graph.
Working capital cycle illustration
http://finntrack.co.uk/images/working_capital_cycle.gif
Source: Fundamental of Financial Management - Van Horne & Wachowicz
The figure above is an illustration of the working capital cycle in industrial companies. The cycle begins with raw materials stocks that go through the production process in order to be transformed in finished goods. These goods are held in inventories until the sale. The sale can be done either directly or through trade debtors meaning that the cash collection is delayed. After that, the cash is used to pay supplier usually this payment is also delayed thanks to trade creditors. At each stage of the cycle there are costs attached and it is the arbitrage between these costs and the optimum level of cash, inventories that is called working capital management. In the grey part, we have a clear view of the different use of cash. This figure gives a big picture of all the different components of the working capital and highlights the different steps that have to be taken into consideration in a firm's working capital policy.
Objectives of WCM
Working capital management is key for financial managers. It is about aligning assets and liabilities flows over time in order to ensure the sustainability of the business. In fact, a large part of bankruptcies, especially for new companies, are due to a bad management of working capital. At the end of the day, working capital management has a dual objective: Liquidity and profitability.
It is usual in the literature to oppose these two concepts or at least to identify the potential conflict that can exist between them. As liquidity is aiming at being able to face its financial obligations, profitability is about maximizing the shareholder's wealth and these two goals can be in conflict sometimes. Let's take the example of a long term investment with a positive net present value meaning that it will increase the value of the company in the long term: this investment is a good operation concerning the profitability but as it requires a significant initial investment, it can affect the liquidity of the company for reimbursing short term loan for example. Working capital management is always a trade-off between this two essential goals of a company. Pass & Pike pointed out that a way to prevent these conflicts is to define a clear global strategy as working capital management is often divided into different department that can have different interests.
WC policies
We observe today in this domain an evolution of financial managers' mind. During a long period, a substantial amount of working capital has been considered positive especially if this level was driven by stocks. In fact, it was a sign of strength to face demand. It was reassuring to have in hand a large amount of cash available in order to face a potential unpredictable event. Now, companies are more and more focused on the ideal "zero working capital" meaning that the current assets just cover current liabilities. Financial managers want to optimize resources and it is not positively perceived to have sleeping cash on its balance sheet.
In realty, these different working capital policies should be looked through sectors perspective. Indeed, sectors have a strong impact on firms' working capital policies. In this context, Glen Arnold has distinguished 3 main working capital policies. The relaxed WC policy is defined by the presence of a high level of cash. We mainly see this policy in uncertain industries where liquidity protections are needed and cash flow not secured. In most cases, companies have large inventories and generous credit term. At the opposite, he defined an aggressive working capital policy essentially present in sure cash flow businesses. Inventories and the amount of cash are usually small. At the middle of these two policies, he defined a moderate WC policy in use in a large part of businesses.
Cash Management
Cash management is an important part of working capital management. Its main goal is to ensure firm's liquidity and its ability to seize opportunities such as acquisition especially in period where the access to credit is more difficult. Another benefit of a good cash management is an increase of profitability through better profit margin and higher turnover ratio.
Larsson & Hammarlund, in 2005, highlighted the different elements that are part of this topic:
Payables process, receivables process, management of liquid funds, currency risk, accounts payable and receivables.
Cash Flow Timeline:
http://www.qfinance.com/contentFiles/40/iyr/46_-3381_50.png
Source: QFinance.com - Juergen Bernd Weiss
Inventory Management
An efficient management of stocks is crucial in order to improve its cash flows. In fact, too much stock can damage company's liquidity as stocks correspond to frozen cash, not directly convertible into cash. The importance of inventory management is particularly important in the industry sector where the levels of inventory are usually high.
The traditional way to improve its inventory management is to align production with the level of sales by forecasting the demand. This method is quiet difficult to set up especially in an economic crisis. Indeed, the downturn in the economy often obliges companies to reduce their production and decrease their level of stocks but they have also to get ready for a potential revival of the economy.
Some famous companies, like Dell or Toyota have put in place innovative production and delivery systems to decrease their levels of inventories and thus improve their cash conversion cycles. Thus, Toyota in the 60's developed a new production system based on a new way to manage stocks: the "just in time". This system aims at synchronizing and aligning exactly the inventory flow (parts for example) with the production cycle in order to keep stocks at the minimum level and as a consequence improve the average time of cash conversion.
The most common way to assess the efficiency of inventory management is to measure the average period that a product is held in stocks before being converted into cash. This ratio is called Days of Inventory Held (DIH) and is given by the following formula:
Days of Inventory Held (DIH) = Inventory/Cost of Sales * 365
As stocks represent a cost for the companies, we can formulate the following hypothesis that we will study in the regression.
H1: The Days of Inventory Held ratio is negatively correlated to profitability.
Account Receivable
In the balance sheet, receivables are the value of the goods delivered to the clients but not turned into cash yet. In other words, it is the amount due by the clients of the company. This amount is the result of credit time granted by companies to clients. The longer this credit time is, the more company is facing risks. In this context, companies should always work on reducing this period in order to collect cash as soon as possible. In fact, not working on credit terms can lead to longer credit time and thus potential liquidity issues. On other reason of managing continuously credit period is that the risk is evolving over time. A client can be very safe in year 1 and faces serious trouble the next year leading to a much higher risk taken by the company. In this situation, the company has to adapt its strategy by selling goods at a higher price for example.
One objective of our study will be to assess if there is a statistical link between the credit time period granted to clients and company's profitability. Based on the comments above, we can make the following hypothesis:
H2: Lower credit time (measured in our case by a decrease of DSO ratio) leads to higher profitability.
In our study, we will work on the Days of Sales Outstanding to validate or reject the hypothesis. This ratio measure the average period it takes for company's clients to pay for its delivered products. An increase of this ratio is usually negative for the company. The ratio is given by the following formula:
Days of Sales Outstanding (DSO) = Receivables / Sales * 365
Account Payable
Accounts payable are very similar to receivables. They measure the value of goods or services delivered to the company and not paid yet. It is a debt of the company towards its suppliers. One way to benefit from this delay is to deposit the amount on an account and gain interest on it. Accounts payable management is usually tracked using the Days of Payables Outstanding ratio defined as:
Days of Payables Outstanding (DPO) = Payables/Cost of goods sold * 365
This ratio represents the average period that the company has to pay its suppliers. Thus, we would like to formulate the following hypothesis:
H3: The DPO ratio is positively related to company's profitability.
The Cash Conversion Cycle
Improve its cash conversion cycle (CCC) is one of the main objectives of working capital management. In fact, it measures the time it takes for a company to convert goods or services into cash. An increase of this ratio will damage company's liquidity. As a consequence, financial managers are always looking for reducing this cycle as much as possible.
If it is obvious that, CCC is linked with liquidity, I also make the hypothesis that the Cash Conversion Cycle is negatively related to profitability, i.e, a decrease of this ratio will lead to higher profitability on average (H4).
The cash conversion cycle ratio is computed from the three precedent ratio:
CCC = DSO+DIH-DPO
Liquidity
Liquidity can be defined as the ability for a company to face its short term obligations (short term debts, payment of suppliers, bank overdrafts…) without costs. It is one of the most important objectives of Working Capital Management as we defined in the last paragraph. When we talk about liquidity, the cash issue is coming soon. In fact, financial managers have always the dilemma to hold cash in hand to ensure liquidity and prevent the company from bad situations and on the other hand, invest this cash with higher return. In difficult economic situations, holding cash is also a way to ensure its independence regarding external source of financing that can be very costly in these periods. We can see easily that it is very difficult to establish an optimum level of liquidity as it is strongly dependent of the economic situation, the sector of the company, its strategy…
Instruments for liquidity management
In this context, there is a need to put in place efficient liquidity strategies in order to define the level of debt and resources available. In order to do that, managers can use two well known ratios. The first one is the current ratio, also known as "Liquidity ratio", it measures company's ability to face its short term obligations. If the ratio is smaller than 1, it means that the company will have some trouble to face its obligations. The ratio is computed by the following formula:
Current Ratio = Current Assets/Current Liabilities
Looking at this ratio, it is important to notice that current liabilities incorporate inventories in their amount. As already mentioned, inventories are kind of frozen asset that cannot be easily converted in cash. As a consequence, some financial managers prefer to assess liquidity with the quick ratio which cancels the impact of inventories.
Quick ratio = (Current Assets - Inventories)/Current Liabilities
Short term Financing
- Link with budget implementation.
- A lot of different option available.
Short-Term Loans
Def,
- Unsecured debt, 90 days of maturity
- Other forms: bankers' acceptance, letter of credit and reverse purchase agreement
Practical Method & Data Collection
Research Design
Rationale
As already mentioned above, I want to use this paper to challenge the potential relationship between WCM management, liquidity in a more general extent and profitability. I chose to study a sample of French companies over the period 2006-2011. In fact, I did not find any studies on this subject referring to French companies and to this difficult economic period. According to me, it is very interesting to challenge the relationship during this period of crisis as a lot of companies put the stress on the ways to improve working capital and liquidity management. In this context, I think it is really important to understand which variables impact the most profitability in order to provide statistical elements that could be useful in the strategy planning of a firm. In fact, several studies realized before the crisis (Deloof in 2003, Lazaridis and Tryfonidis in 2006) established a statistical link between profitability and Working Capital Management. These studies influenced certainly firms on their strategy to improve profitability. My willingness is to assess if this relationship is still in place for largest French companies in a downturn period.
Hypothesis and expected findings
In this paper we will try to validate or reject the different hypothesis mentioned in the part 3, Theoretical framework, and see if the expected outcomes are confirmed or not. The hypothesis and expected outcome can be summarized by the following table:
Variables
The objective of this study is to express company's profitability in function of several independent variables linked to working capital management and liquidity.
The dependant variable
Firm's profitability can be measured in several ways depending on what aspect you want to highlight. For our study, I decided to use Return on Capital Employed (ROCE) as the measure of company's profitability. This ratio is given by the following formula:
ROCE = EBIT (1-Tax rate)/ Capital Employed
This ratio measures the operational earnings compared to assets invested by the company. As it is link to the operational activity of the company it was a good ratio to study in order to explore the potential relationship between profitability and liquidity strategies.
The independent variables
I selected 9 independent variables to use in the regression analysis. The four first variables, the explanatory ones, are directly linked to WCM and are described in the part 3 of this research. We have:
The Cash Conversion Cycle (CCC) which is the pillar of WCM
The Days of Inventory Held (DIH)
The Days of Sales Outstanding (DSO)
The Days of Payables Outstanding (DPO)
We will focus on these key variables to assess which of them are the more strongly related to profitability and, as a consequence, identify the key area where the management has to put resources.
The other variables chosen (control variables) are also link to profitability and can explain a part of the difference of the performance of the sample. I have selected:
The Logarithm of Sales (LnSales)
This variable measures the size of the company
Financial Debt ratio
This ratio is given by the following formula: Debt ratio = (Long Term + Short term borrowings)/Total Assets. It represents the proportion of debts a company has compared to its assets and gives an idea of its leverage.
Current Liabilities/Total Liabilities (CL/TL)
This ratio is a good indicator of debt's structure of the company. It measures the proportion of short term obligations among company's total liabilities.
Sales / Current Assets (Sales/CA)
This ratio measures how well a company is using its assets to generate sales. We can notice that a way to improve the efficiency of the company is to reduce its current assets ie its inventories or its accounts receivables.
Current Ratio
Cf: definition in Part 3
Last but not least, I used 4 dummy variables related to the sector break down of the sample.
D1 = Industry
D2 = Building
D3= Services
D4 = Consumer goods
It is important to notice that we have 5 categories of sector but only 4 dummy variables as we need to remove one variable to avoid perfect co linearity situations.
Empirical Data Collection
Financial Data Collection
All the financial data used in my research paper come from Bloomberg. This choice has been motivated by two main reasons. First, it ensures consistency in the data collection since all the data is coming from one single source. This consistency is crucial in my analysis since we want to demonstrate a correlation between several variables related to different firms and period. The second reason is simplicity. In fact, given the large amount of data required for the analysis, it would have been too fastidious and also less consistent to collect data from the financial statements directly.
Last but not least, I paid also a particular attention to the quality of the data and Bloomberg met my expectations. It is a well known tool widely used in the financial area especially for data collection of listed company for which information is easily available.
Description of the sample
The sample I have studied is extracted from the 40 French companies listed in the CAC 40 index. This index is "an index weighted by free-float market capitalization that measures the performance of 40 equities listed on Euronext's regulated markets in Paris" according to Euronext website. It is composed by the 40 largest French companies in term of market capitalization and number of exchange.
Among these 40 companies, I removed companies from Bank & Insurance sector which have a very specific business model not very relevant for my analysis and 6 other companies for which data were no reliable enough. As a result, my sample is composed of 30 companies. It is quite well diversified in term of sectors even if Industry sectors represents 40% of the sample (cf. graph below). For simplifying the lecture, I have broken down the 30 companies into 5 main sectors: Industry, Services, Consumer Goods, Energy and Building.
Source: Boursorama.com and author's classification
Processing the data
Description of the statistical process
In this part, we will test the different hypothesis thanks to multi linear regression analysis. In order to do that we will try to express, Return on Capital Employed, in a polynomial format:
ROCE = a1*X1+a2*X2+a3*X3+…+ a0 where a0 … a1 are the coefficients multiplying each independent variable X1…Xn. It is important to notice here, that the size of the regression sample is big enough to have significant results and make relevant conclusions. In the following part we will study the correlation of the different variables and make conclusions on the best way to proceed to the regression. We will then validate or reject the different hypothesis and elaborate on the results found.
Study of correlation of the variables
The results presented in Table 1 gives two interesting indications. The first one is that the reality is quite different from the expected outcome. In fact, we can notice as example that the correlation between the Cash Conversion Cycle, DSO and DIH and ROCE is positive and very small. These results are not consistent with my expectations and the idea that reducing the time gap between production and sales is benefit for the company. We will study in depth all these relationships in the regressions in order to extract the interesting results and identified the significant relationship from the one for which it is difficult to conclude something.
The second indication comes from the strong correlation between the 4 explanatory variables, in particular the correlations between Cash Conversion Cycle and both Days of Inventory Held (0.82) and DPO (-0.44). My first idea was to put all the variables in a single regression but due to these results and in order to avoid multicollinearity biases, I will make a regression for each explanatory variable.
Table 1: Variables Correlation
Regression Analysis & Findings
Before going into the details of the regressions, it is important to spend some time on the logic I used to reject or validate hypothesis. I mainly focused on the p-value, which is the probability that under the hypothesis tested, data as extreme as what has been observed would occur just by chance. The choice of the significance level is conventional and usually set to 0.05, meaning that if the p value is under 0.05 we can reject the null hypothesis and supports the alternative hypothesis (the one we have formulated). At this stage it is important to mention the two errors that can be made:
Type I error: False rejection of the null hypothesis
Type II error: false acceptance of the null hypothesis
The set up of the level of significance is a tradeoff between these two errors. In our case I kept the conventional value of 0.05 in order to validate or reject the hypothesis formulated. If the p-value is under 0.05 the hypothesis will be validated and it can be concluded that the result is statistically significant.
As mentioned, I will study 4 regressions each one focusing of one of the explanatory variables in order to assess if there is a significant relationship between the variable and profitability. Based on my findings in the 4 regressions I will also elaborate on the control variable and see if we can extract some common relationship.
The Regression 1 (Table 2) is focusing on the relationship between ROCE and Cash Conversion Cycle. The model shows that the coefficient attributed to CCC is very close to zero meaning that this variable has very little impact on the dependent variable, the ROCE. It is completely not in line with my expectations. However, looking at the p-value, we realize that this result is not statistically significant as the probability of having this result only by chance is close to 80%. In
this context, we cannot conclude anything on the relationship between Cash Conversion Cycle and ROCE. In fact, in this case there are two possibilities impossible to distinguish:
- We are not able to conclude to a relationship because there is no relation
- There is a relation but we are not able to find it because the data we have are not representative enough to discover the relation.
As in regression 1, the regression 2 (Table 3) shows that the relation between Days of Sales Outstanding and ROCE is not statistically significant as the p-value exceeds 0.05 (0.473). Again, for this variable, we cannot validate the hypothesis in order to avoid a type II error. The sign of the correlation is also surprising in this case as it is usually the case that a decrease of the number days granted to the clients for the payment is a positive sign and should be linked with an higher profitability.
In the regression 3 (Table 4), we observe a positive correlation between Days of Payables Outstanding and ROCE meaning that negotiation of better payment term is linked with the increase of the ROCE. This result is statistically significant as the p value is below our cut off value of 0.05. For the DPO variable we can thus validate our hypothesis and conclude that our expected outcome is in line with the statistical outputs.
The regression 4 (Table 5) shows a significant relationship between Days of Inventory Held and ROCE. In fact, the p-value is equal to 0.028 meaning that there is more than 97% of probability that this result is not due to chance. Thus, we can validate the formulated hypothesis saying that there is a significant relation between DIH and profitability. Looking at the expected outcome, the conclusion is different. In fact, we observe a positive correlation between DIH and ROCE meaning that an increase of stocks relatively to cost of goods sold lead to an higher ROCE. This result is very surprising as stocks represent a cost for the company and do not contribute to liquidity as it is frozen assets. The explanation of these results could be found in the time period studied. In fact, the period studied in very specific as it corresponds to a severe economic recession and can help to explain surprising results. Inventory management is
Table 2: Regression Analysis 1 - CCC
Table 3: Regression Analysis 2 - DSO
Table 4: Regression Analysis 3 - DPO
Table 5: Regression 4 - DIH
particularly difficult during a long period of economic downturn as companies have to decrease inventories to improve their working capital and generate cash as well as keeping inventories at a sufficient level to get ready for a potential recovery. These opposite strategies could be an explanation of the positive correlation given the fact that the period of study includes severe recession period and recovery ones.
From the 4 regressions we can also draw conclusions regarding some control variables chosen.
Size of the companies
The 4 regressions show the same negative relationship between size and profitability with a statistical significance. At a first sight it is surprising as usually larger firms have larger profitability as shown for example in Lazaridis and Tryfonidis' study. But this result is more common when sample are more diversified in term of size. In our case, all companies are very large and we can make the hypothesis that largest companies of the sample have been the most impacted by economic crisis.
Financial debt ratio
We can observe a significant relationship between debt ratio and ROCE in 3 regressions but surprisingly this relationship is negative meaning that a decrease of debt leads to a higher ROCE. This can be due to a too large part of short term debt that do not generate value or it can express the fact that the investment financed by debt are not generating enough operating profit.
CL/TL
The study of this variable shows that it exists a significant positive relationship between the part of current liabilities in the total liabilities of a company. These results can be explained with two approaches. The first one is to notice that trade payables are part of current liabilities and as better payment term can allow companies to improve their performance. The second one is to notice that ROCE is calculated with EBIT as numerator meaning that it does not take into account the interest paid regarding the short term debt.
Sales/CA
The 4 regressions come out with the same result, i.e. a significant positive relationship between Sales/Current Asset ratio and ROCE. This result is consistent with the fact that a decrease of this ratio is usually a bad signal for a company indicating that the firm may have reduced its production, decreased its stocks and so the amount of total current assets. This positive effect of stocks as a synonym of a good production has to be linked with our findings in the relationship between DIH and ROCE.
Current ratio
Given the aim of the research paper, the relationship between liquidity ratio and ROCE was very important to study. The regression outputs show in all cases a positive and significant relation between liquidity status and profitability. The positive coefficient points out that an increase of the ability for a company to face its obligations is related to the increase of profitability. This result is crucial as it shows that profitability and liquidity are not necessarily in conflict.
