Chapter 1
Working capital refers to current assets minus current liabilities of a company. It measures company's short-term financial health. A positive working capital means a company has enough current assets to pay off its short-term liabilities. On the other hand, a negative working capital shows the inability of a company to meets its short-term liabilities.
Generally, company with higher working capital will be more successful since it has more resources to expand and improve its operation. However, high working capital ratio may also show that a company is not operating in the most efficient manner. Company may have high level of current assets but unable to payoff its short term debt because money is tied up in inventory or customers still owe the company. Therefore, an appropriate working capital management should be implemented.
Working capital management refers to decision relating to working capital and company's short term financing. The goal of working capital management is to ensure that company is able to continue its operation and that it has sufficient cash flow to support future operational expenses and maturing short-term liabilities.
There are different measures of working capital management efficiency. The conventional ones are current ratio and quick ratio. However, those numbers may not reflect the true working capital management efficiency. According to Shin and Soenen (1998) liquidity of on-going firm does not really depend on the liquidation value of its assets but rather on the operating cash flow generated by those assets. Therefore, cash conversion efficiency, cash conversion cycle, weighted cash conversion cycle and net trade cycle have been used as crucial measures of working capital management efficiency. All these measures show the management of inventory, account receivable and payable of a firm.
Cash conversion cycle (CCC) measures the number of days between the purchase of inventory until the sale to the customers, the collection of receivable and payment receipt. CCC indicates how quickly a company can convert its product into cash through sales. Increases in number of days of inventory, increases in number of days of account receivable and decreases in number of days of account payable will contribute to increase the firm's CCC. High CCC means that capital is tied up in the business process for longer period. Thus, it may not be good for the company. CCC is said to be a good measure of working capital efficiency as it is dynamic in the sense that it combines the data from balance sheet and income statement and considers the time dimension.
The way in which the company manages its working capital may have a significant impact in company's profitability. It is because the more efficient the management of working capital is, the lesser money tied in assets and therefore can be used in raising profit from investment elsewhere.
The project is structured as followed. In the next section, I provide the objectives of the project and also the scopes and limitations that it has. Hence, literature review, which is used as the foundation of this paper, is provided. The next section gives the list of explanation about the data and methodology of this project. This is followed by finding and analysis parts, which explain the results of this project. It ends with conclusion, which is made related to the relationship between working capital management and profitability of company and some recommendation to improve the projects.
1.1 Objective
The objective of this project is to identify the relationship between working capital efficiency, which is measured by CCC and the profitability of a company, measured by Return on Assets (ROA). In addition, relationship between each element of CCC, which are days of inventory, account receivable and account payable with ROA are also identified. The data used in this project cover 120 companies listed in Singapore Stock Exchange over the period 2004 to 2008.
The study of the relationship between working capital management and profitability is important for the company especially in Singapore to advance the knowledge of management on how likely certain working capital management would have impact on company's profitability.
This project will address the questions mentioned below:
Is there any significant relationship between CCC and ROA?
Is there any significant relationship between number of days account receivable and ROA?
Is there any significant relationship between number of days account payable and ROA?
Is there any significant relationship between number of days inventory and ROA?
1.2 Scopes and Limitations
The scopes of this project are:
Only includes 120 companies that are listed in Singapore Stock Exchange.
Only cover the period from 2004 to 2008.
Use only ROA as the measurement of profitability.
Use only CCC as the measurement of working capital efficiency.
Only measures the degree of association between ROA and CCC and also each elements of CCC through coefficient of correlation
Since the scope is limited, limitations of the project are highlighted as follows:
Findings are sample specific since they are based on observation in 120 listed companies in Singapore Stock Exchange.
Only includes listed companies.
Does not classify the company according to the type of industry.
Due to the different type of activity, certain industries such as banking and financial institution, insurance, electricity and water, and other services companies are not included in the sample. These industries provides services other than goods so they might have no cost of goods sold that is needed to calculate cash conversion cycle.
Chapter 2
Literature Review
Working capital management involves the management of inventory, account receivable and payable. Deloof (2003) found out through statistics from National Bank of Belgium that in 1997 account receivable, inventory and account payable were respectively 17%, 10% and 13% of total assets of all Belgian non-financial firms. It can be expected that there is a certain level of working capital management, which can potentially maximize return. Lazaridis and Tryfonidis (2006) believed that by handling correctly the cash conversion cycle, managers could create profits for their companies. This means that they should keep each component of the cycle (account receivable, account payable and inventory) to an optimum level.
Most firms tied a large amount of cash in its working capital. According to Deloof (2003), there is a negative relationship between CCC and profitability in Belgian firms. However, the coefficient of CCC is not significantly different from zero. He believed that gross operating income declines with number of day account receivable and inventory, and the number of day account payable. Decreases in number of days account payable will be canceled out by decreases in number of days account receivable and inventory as they are subtracted when CCC is calculated. He found out that gross operating income, which is one of the measures of profitability, is positively affected by firm size, sales growth and fixed financial assets. On the other hand, it is negatively affected by financial debt.
Based on study conducted by Deloof (2003) on 5,045 Belgian firm-year observations, significant negative relationship is found between gross operating income and number of days of inventory. Firms experience lower profitability due to lower sales, which lead to increase in inventory level. He also found out that the number of days of account receivable has inverse relationship with company's profitability. It can be explained as when customers buy products from company with declining profitability, they will need more time to assess the quality of products. He believed that managers could improve the profitability of a company by minimizing number of days account receivable and inventory. Moreover, a very significant negative relationship between gross operating income and number of days of account payable is found. This means that less profitable firms wait longer to pay their bills taking advantage of credit period granted by their suppliers. Deloof (2003) found out that low-income companies have longer days account payable.
Research conducted by García-Teruel and Martínez-Solano (2007) on 8,872 SMEs in Spain covering the period 1996-2002 shows that there is a significant negative correlation between the return on assets and the number of days of account receivable, days of inventory and days of account payable. They found out that more restrictive credit policy would improve the performance of the company as days account payable will be reduced. Although lengthening number of days account receivable may improve sales, it will hurt the profitability of the firm since the firm's cash position is affected. Moreover, keeping inventory for shorter period of time helps the company to cut cost and therefore improve its profit. Unlike Deloof (2003), they cannot confirm that number of days account payables negatively affected SME's profitability. They found out that short CCC is associated with higher profitability. It means that the more efficient working capital management will lead to better return. The correlation analysis shows that the most significant value of coefficient of correlation is found only in cash conversion cycle and account receivable.
According to García-Teruel and Martínez-Solano (2007), shorter number of days of account receivable, days of inventory and days of account payable, and shorter cash conversion cycle are found in the most profitable firms. These firms are large in size and have higher sales growth and lower leverage. Therefore, they believed that profitability is positively affected by size of the company and the sales growth. It is consistent with the view that bigger company will have more opportunity to grow, thus increase business opportunities to enhance profitability.
A study conducted by Singh and Pandey (2008) on Hindalco Industry Limited covering the period 1989 to 2007 found out that management of working capital has direct impact on company's profitability and liquidity. There is a low degree of positive correlation between profitability ratio and current ratio, liquid ratio, inventory turnover ratio. Moreover, there is moderate degree of positive correlation between profitability ratio and receivable turnover ratio, turnover of cash in sales ratio and working capital to total assets. On the other hand, the correlation between profitability ratio and working capital turnover ratio shows low degree of negative correlation.
Observations by Lazaridis and Tryfonidis (2006) on 131 companies in Athens Stock Exchange during the period 2001-2004 show that inventory, account receivable, account payable and gross profit are negatively related. Managers can improve profitability by reducing credit period granted to customers since there is a negative relationship between gross operating profit and account receivable. They found out that less profitable firms would reduce their account receivable in attempt to reduce cash gap in the CCC. Negative relationship between inventory and gross operating profit can be explained as the longer the inventory is tied up, the less working capital is available. However, the negative relationship found between days of inventory and gross operating profit is not statistically significant. Moreover, the negative relationship between days account payable and profitability implies that less profitable firms wait longer to pay their bills.
Lazaridis and Tryfonidis (2006) also found negative relationship between profitability, which is measured by gross operating profit, and CCC, which is a measure of working capital management efficiency. This means that decrease in CCC will lead to higher profit of a company. According to their study, profitability of a firm is positively related with the size of a company. Profitability increases as fixed financial assets increase. In addition, negative relationship is found between gross operating profit and financial debt. Listed companies in Greece used financial debt to shorten its conversion cycle and thus increase the profitability. Financial debt enables the company to have more cash in hands that can be used to make early payment to suppliers to enjoy discount or cash rebates.
Filbeck and Krueger (2005) found out that significant differences exist between industries in working capital measures across time. The working capital measures used in this study are Cash Conversion Efficiency (CCE) and Days of Working Capital (DWC). Across nearly 1,000 firm surveys during 1996-2000 periods, they discovered that DWC in both food services and food stores industries is relatively low (DWC = 1 day) compare to those in textiles industries (DWC = 26 days). The reason for the low DWC is that food services have quicker inventory turnover and tend to get payment upon purchase of merchandise. Moreover, it also needs to make payments rapidly. However, food services industry's CCE is not that good. It is due to poor cash flow from operation per dollar of sales. For most industries, day inventory and account receivable are longer than day account payable.
In addition, Working capital measures change significantly within industry across time. Industries with the greatest variation of working capital measures are telecommunication and beverage industry. According to Filbeck and Krueger (2005) these changes are caused by changes in macroeconomic factors such as changes in interest rates, rate of innovation and competition. As interest rate increases, customers will be more unlikely to make payments early. This would stretch account payable, account receivable and cash account.
A study conducted by Jose et al (1996) shows that aggressive working capital policies enhance the profitability of a company. Aggressive liquidity management will result in lower CCC through reducing inventory and account receivable period and increasing account payable period. Inventory is an important element of working capital. If there's too much inventory, company's money is tied up and therefore cannot be invested elsewhere. However, if inventory period is short, company may lose its sales. It may experience shortage, hence unable to support sales opportunity. If account receivable period is reduced too far, a company may lose its opportunity to capture more customers.
Delaying payment to suppliers allows a firm to assess the quality of the products bought, and can be an inexpensive and flexible source of financing for the firm. However, if the firm increases the days-in-payable too much, discount for early payments and flexibility for future debt are both lost (Jose et al, 1996).
Jose at al (1996) found out that lower CCC reduces the need for credit and therefore enhance company's debt capacity. He also discovered that different industries have different working capital measures. This is due to difference in products and markets. The lowest mean value of CCC is found in the service industry and the highest in construction industry.
According to Jose et al (1996), the more aggressive liquidity management (lower CCC) is associated with higher profitability (ROA/ROE) for several industries such as Natural Resources, Manufacturing, Service, Retail and Professional Services. There is a statistically significant inverse relationship between CCC and profitability and this relationship is not driven by size. In addition, the relationship between CCC and ROA is sensitive to industry factors such as capital intensity, product durability, production process, channels of marketing and competitive forces.
Shin and Soenen (1998) who conducted a study covering the sample of 58,985 firm years for the period 1975-1994 concluded that strong negative association exists between firm's net trade cycle and its profitability. Reducing firm's net trade cycle to a reasonable minimum is one way to create shareholder value and should be a major concern for financial executives. However, the length of net trade cycle is affected by market power or market share. Different industries will have different level of bargaining power of suppliers and/or customers. Agricultural industries have the lowest trade credit period and communication industries have the shortest average net trade cycle. They believed that the relation between net trade cycle and risk adjusted return may vary by different types of industries.
Shin and Soenen (1998) also found negative relationship between profitability and current ratio. This means liquidity and profitability of a company is inversely related. In addition, there is significant positive correlation between sales growth and profitability. They also discovered that firm's leverage and profitability have negative relationship. According to their study, increase in both net trade cycle and current ratio will result in lower level of profitability.
According to Richards and Laughlin (1980), operating cycle concept which include account receivable, inventory and account payable turnover are more appropriate to reflect liquidity management than current ratio or acid test ratio. Thus, it is better to use cash conversion cycle as the measurement of working capital management efficiency. According to their study, the use of cash conversion cycle is better than current ratio or acid-test ratio because cash conversion cycle enables the manager to know exactly the amount and timing of funds available to pay firm's obligation. They found out that an increase in operating cycle without increase in day account payable will create additional liquidity problems. These problems are caused by the need to get more financing over longer or less certain cash conversion period.
Richards and Laughlin (1980) discovered that longer cash conversion cycle might create higher current ratio and acid-test ratio of a firm. In contrast with the traditional view, this result shows that higher current ratio and acid-test ratio means company assets are less liquid. By having longer cash conversion cycle, money is tied up in assets and company may not be able to pay its obligation using cash flows it has.
Based on a study conducted by Sathyamoorthi and Wally-Dima (2008) on retail domestic companies listed on Botswana Stock Exchange, the way in which working capital is managed is not static overtime. Changes in working capital management are caused by the state of the economy. There are 3 different approaches to working capital management; they are moderate approach, conservatives approach and aggressive approach. These three approaches are different in the level of short-term credit used to finance fixed and current assets. During the period where business volatility is high, companies tend to adopt conservative approach, which uses the least short-term credit. In contrast, when business volatility is low, companies adopt aggressive approach that uses more short-term credit.
According to Sathyamoorthi and Wally-Dima (2008), in the year 2004 companies in Botswana were using moderate approach and later on, as the economy was going down, they used conservatives approach of working capital management. However, in 2006, they switched to more aggressive approach. This is shown by increase in stock and cash balances. The liquidity level of listed companies in Botswana was decreasing in 2006 due to increase in creditors associated with decline in trade debtors' balance. They also found out that amount invested in current assets differed substantially from year to year.
According to Singh (2008), there is significant relation between actual working capital and expected working capital. Similarly, there is significant relation between actual inventory and expected inventory. These results were found based on his observation on IFFCO and NFL, 2 largest manufacturers and distributors of fertilizer products in India.
Singh (2008) has also discovered that there was positive correlation between inventory and working capital in both companies during the period 1994-2006. The liquidity positions of the companies are affected by the portion of inventory compared to gross working capital. This means that the lower inventory contribution to gross working capital is, the better the liquidity of a company is. Singh (2008) justifies that the liquidity position of a company is mainly affected by the level of inventory. However, other component such as debtors, loan, account receivable, cash and bank balances may also affect the liquidity position.
Chapter 3
Data and Methodology
3.1 Data collection
The data used in this paper was collected from Bloomberg databases. It includes 120 companies listed in Singapore Stock Exchange. The data cover the period from 2004 to 2008. The total observations are 3,000 which include 600 data each on days of account receivable, days of inventory, days account payable, cash conversion cycle, and return on assets of the companies.
Only listed companies in Singapore Stock Exchange are used since the information of those companies are readily available and easy to get. Listed companies might want to attract investors to invest in their businesses, therefore, it will give them incentive to present their annual report for public use. As all the information in the reports had gone through the auditing process, the information is reliable.
3.2 Variables
ROA =
Earning before interest and tax
Total assets3.2.1 Return on Assets
The objective of this project is to test the relationship between working capital management and profitability of a firm. Profitability of the firm is measured by return on assets (ROA). ROA, not other profitability measures, is used to avoid difference in company's capital structure. Moreover, ROA figures are readily available. ROA is calculated as earning before interest and tax divided by total assets.
3.2.2 Cash Conversion Cycle
Cash conversion cycle (CCC) is used as the measure of working capital management efficiency. CCC measures the length of period whereby cash is converted into inventory until the sale through customers, collection of receivable and payment received. CCC can be calculated as number of days account receivable plus number of days inventory minus number of days account payable.
Cash Conversion Cycle = No of days A/R + No of days inventory - No of days A/P
3.2.3 Number of Days Account Receivable
No of days A/R =
Account Receivable
X 365 days
Sales
Number of days account receivable is one component of cash conversion cycle. It measures how long it takes for a company to collect payments from customers or debtors. It can be calculated as the ratio of account receivable divided by sales times 365 days.
3.2.4 Number of Days Inventory
No of days inventory =
Inventory
x 365 days
Cost of Goods Sold
Number of days inventory indicates how long it takes for a company to turn its stocks into sales. It can be calculated as the ratio of inventory over cost of goods sold times 365 days.
3.2.5 Number of Days Account Payable
No of days A/P =
Account Payable
x 365 days
Cost of Goods Sold
Company can choose whether to pay its supplier on cash or credit terms. Number of days account payable shows the period taken by a company to pay its liability to the suppliers or creditors. It is calculated as the ratio of account payable divided by credit purchases times 365 days.
3.3 Correlation Test and Student t-test
In order to test whether there is significant relationship between working capital management and profitability, correlation test is used. Correlation test is used to identify the degree of interdependence between CCC and ROA, number of days account receivable and ROA, number of days inventory and ROA, number of days account payable and ROA.
Coefficient of correlation is calculated to know the degree and direction of linear relationship between the 2 variables. Coefficient of correlation shows whether the two variables are either positively or negatively correlated, and it also shows how high or low it is associated. In addition, the student t-test is used to calculate the p-value. P-value is hence used to ensure that the result is unlikely to have occurred by chance.
Chapter 4
Finding and Analysis
4.1 Descriptive Statistics
All of the data collected are presented in Appendix A. Table 4.1 shows a summary of all data. More detailed descriptive statistics of the data can be seen in Appendix B.
All data
Variable
N
Mean
Standard Deviation
Minimum
Median
Maximum
A/R
600
103.22
387.18
1.76
67.65
6,469.79
INV
600
262.90
1,209.66
0.48
76.41
21,810.72
A/P
600
71.36
265.98
(3,730.82)
56.05
4,350.15
CCC
600
295.16
1,361.15
(3,882.62)
88.17
21,908.57
ROA
600
6.41
15.65
(111.06)
6.07
104.34
3000
Table 4.1 Descriptive statistics of all data
As shown in Table 4.1, total observations for each variable are 600 that are sum up to 3,000 total observations. The companies included in the sample have an average ROA of 6.41%. ROA of the sample ranges from minimum -111.06% to maximum 104.34% with median of 6.07%. The variation of ROA is small (standard deviation = 15.65) compared to those of A/R, INV, A/P and CCC. Figure 4.1 shows the distribution of ROA.
On average, most of listed companies in Singapore take 103 days to collect payment from its debtors. The shortest time taken to collect payment is 1 day and the longest is 6,469 days. The standard deviation of data is 387.18, which shows that the data are spread out over a medium range of values. The distribution of data is shown in the Figure 4.2.
Figure 4.1 Return on assets distribution curve
Figure 4.2 Account Receivable distribution curve
Inventory takes on average 262.9 days to be sold. The minimum, median and maximum days of inventory are 0, 76, and 21,810 days respectively. These numbers show high standard deviation as the data is spread out over large range of value (standard deviation = 1,209.66). The inventory distribution curve can be seen in Figure 4.3.
Figure 4.3 Inventory distribution curve
Number of days account payable range from -3,730 days to 4,350 days with median of 56 days. The distribution curve is presented in Figure 4.4. On average, companies in the sample pay their creditors in 71 days. Negative number of days account payable may come from negative amount of account payable itself [] . Negative account payable means that company pays the supplier in advance. There might be incentives such as discount or cash rebate that is given so that company are willing to do so.
Figure 4.4 Account payable distribution curve
The average cash conversion cycle of companies used in the sample is 295 days with median of 88 days. The standard deviation of data is considered high at 1,361.15; therefore the data contain wide range of number from -3,882 days to 21,908 days. Figure 4.5 shows the distribution of cash conversion cycle of 120 companies listed in Singapore Stock Exchange.
Figure 4.5 Cash conversion cycle distribution curve
4.2 Correlation Analysis
As can be seen in Table 4.2, number of days account receivable, inventory and account payable are all correlated negatively with ROA. Number of days account receivable has the highest coefficient of correlation of -0.14418, while number of days account payable has the lowest coefficient of -0.03616. All tests are statistically significance with the p-value of 0.00000.
A/R-ROA
INV-ROA
A/P-ROA
CCC-ROA
Coefficient of correlation
-0.14418
-0.04564
-0.03616
-0.07431
p-value
0.00000
0.00000
0.00000
0.00000Table 4.2 Correlation Analysis
4.2.1 Return on Assets and Cash Conversion Cycle
Cash conversion cycle reflects the number of days it takes from the time money is paid out for purchasing raw materials, converting material into finished goods, selling the finished products to customers and receiving payment for the sales. It tells the number of days cash is tied up. The longer the cash conversion cycle is, the more working capital needed by the company.
Table 4.2 shows that there is a significant negative relationship between ROA and cash conversion cycle. This means that an increase in the length of cash conversion cycle will negatively affect the profitability of a firm. Having shorter cash conversion cycle enables the company to have an increase in cash flow. This cash flow can be used to support company's growth and therefore increases company's profitability. Cash in hand can be used for investment and it can also be used to make early payment to supplier that gives discount, this will contribute higher profit for the company.
Having longer period of cash conversion cycle reduces the ability of the company to pay on its current obligation. Although company can overcome this shortfall of cash by short term financing, this is not suggested as this will increase company's liquidity risk. Therefore, company should improve their cash position rather than rely on external source of finance. Conservatives approach of working capital management tends to give better performance results (Jose et al, 2006). However, at the time when business volatility is low, company may use short term financing to overcome cash shortage and use them to improve company's profitability. The way company should manage its working capital also depends on the macroeconomic environment. Benefit and cost should be considered before deciding the optimum level of working capital.
Table 4.3 shows that in the year 2004, companies included in the sample had an average cash conversion cycle of 240 days and ROA of 6.72%. The coefficient of correlation shows that there is low degree of negative correlation between the two variables. The test is statistically significance as the p-value equal to 0.02328. The next year, the average cash conversion cycle period increased to 334 days and ROA was 5.66%. Coefficient of correlation equals to -0.01609, which is considered low. However, the correlation between the two variables in 2005 is not statistically significant.
Mean
2008
2007
2006
2005
2004
CCC (days)
341.91
375.05
184.26
334.29
240.27
ROA (%)
5.60
6.84
7.23
5.66
6.72
coefficient of correlation
-0.13013
-0.14789
-0.00722
-0.01609
-0.02339
p-value
0.00618
0.00680
0.00000
0.07618
0.02328
Table 4.3 Cash conversion cycle and return on assets analysis
In 2006, cash conversion cycle went down to 184 days and ROA increased to 7.23%. Correlation test shows that there is significant negative correlation between the two variables during the year. However, the degree of correlation is very low. In 2007, significant negative relationship is found between ROA and CCC. The average cash conversion cycle and ROA of companies included in the sample was 375 days and 6.84%. The degree of correlation in 2007 was the highest among all.
In 2008, average cash conversion cycle decreased to 341 days from 375 days in the previous year. Average ROA during the year was 5.6% which is lower than the one in 2007.
Annual analysis shown in Table 4.3 shows that there is significant negative association between ROA and cash conversion cycle, except in the year 2005. This confirms that shorter cash conversion cycle will improve the profit of the company. The average cash conversion cycle of companies that is included in sample change overtime. This supports the findings by Filbeck and Krueger (2005) who commented that working capital measures will change overtime due to changes in macroeconomic environment. In addition, the degree of dependency between ROA and cash conversion cycle also differ from one year to another.
Cash conversion cycle is calculated by adding days of account receivable and inventory days, then subtracting days of account payable.
CCC-A/R
CCC-INV
CCC-A/P
Coefficient of correlation
0.45379
0.95022
-0.12671
p-value
0.00015
0.06814
0.00012
Table 4.4 The relationship of cash conversion cycle and its components
Table 4.4 shows that days account receivable and inventory are positively correlated, while days of account payable are negatively correlated with cash conversion cycle. This means that if the company wants to reduce the length of cash conversion cycle, it would need to collect payment earlier from customers, keep the inventory low and extend payment to suppliers.
Since ROA and cash conversion cycle are negatively correlated, this project will investigate further on the relationship between each elements of cash conversion cycle, which are days account receivable, inventory and account payable with ROA.
4.2.2 Return on Assets and Days Account Receivable
Customers may prefer to buy from company that provides longer collection period, thus, applying tight credit control may negatively affect the profitability of the company. However, based on data presented in Table 4.2, ROA and number of days account receivable is negatively correlated. The negative correlation between number of days account receivable and ROA is consistent with the view that by shortening the time taken to collect payment, profitability of the company will increase. This is because by shortening the deadline of payment, company will have more cash in hand that can be invested somewhere else. Investment will bring return for the company and it helps company to improve the profit. Table 4.2 shows that ROA and days account receivable have the highest degree of correlation.
Mean
2008
2007
2006
2005
2004
A/R (days)
132.26
153.27
85.03
73.40
72.13
ROA (%)
5.60
6.84
7.23
5.66
6.72
coefficient of correlation
-0.16706
-0.19337
-0.12385
-0.10626
-0.20262
p-value
0.01878
0.01161
0.00000
0.00000
0.00000Table 4.5 The relationship of return on assets and days account receivable
Table 4.5 shows the average days account receivable and ROA, coefficient of correlation and p-value of two variables during the period 2004 to 2008. During the period 2004 to 2008, coefficient of correlation shows high degree of negative correlation which explained inverse relationship between ROA and days account receivable. Moreover, the p-value shows that all the results are statistically significant.
There was an upward trend in account receivable except in 2008 whereby days account receivable declined to 132 days. Average days of account receivable change overtime due to changes in external factors such as interest rate. When interest rates increase, customers would be more likely to delay their payment (Filbeck and Krueger, 2005).
As can be seen in Table 4.5, the highest coefficient of correlation was found in 2004, while the lowest in 2005. Both results are statistically significant. In 2004, the average days account receivable was 72 days and average ROA was 6.72%. In the following year, the average days account receivable increased to 73 days and ROA decreased to 5.66%. Both years show negative coefficient of correlation.
In 2006, significant negative relationship was found between the two variables. Average days account receivable of sample was 85 days with ROA 7.23%. Days account receivable went up in 2007 and declined in 2008. Average ROA for these two years are 6.84% and 5.60%. Comparing the results in 2007 and 2008, decline in days account payable results in decline in ROA. This is inconsistent with what has previously said that ROA and days account receivable is negatively correlated. The reason for this is because both years have different external factors that affect the profitability position and account receivable turnover.
As mentioned before, increase in days account receivable will lead to increase in CCC. Hence, increase in CCC results in ROA. Through correlation test between ROA and days account receivable, it is confirmed that the two variables have inverse relationship during the year 2004 to 2008. This shows that ROA and days account receivable are interdependent with each other. Less profitable company will need to give longer account receivable period for customers to assess their products. Moreover, shortening the days account receivable will reduce the gap in cash conversion cycle and thus, improve company's profit.
4.2.3 Return on Assets and Days Inventory
Inventory is one element of cash conversion cycle. Days of inventory and cash conversion cycle are correlated positively. Therefore, increase in inventory period will increase cash conversion cycle. Given that increase in cash conversion cycle will lead to decline in ROA, there should be negative correlation between ROA and days of inventory. The results in Table 4.2 confirm that there is a significant negative correlation between ROA and number of days inventory. It means that decline in number of days inventory will lead to increase in company's ROA. This can be explained as the lesser time period taken to keep inventory, the lesser money is tied up on the assets. Moreover, the negative association can also be interpreted that less profitable firm will have longer inventory period since sales declines due to drops in demand, hence, level of inventory goes up.
Having higher inventory turnover is good for a company, as it can reduce handling and carrying cost. Moreover, lower days of inventory can reduce amount of defective product that will bring loss to the company.
One way to reduce number of days inventory is by applying Just-in-time (JIT) systems. JIT approach enables the firm to have higher inventory turnover as product is produced only when it is needed. Problems with this approach are related to changes in market demand. The market demand is fluctuated at every time and firm needs to be responsive of those changes. Sometimes, the demand can be so high that company may not have enough inventories to fulfill those and therefore unable to support sales opportunities.
Mean
2008
2007
2006
2005
2004
INV (days)
277.67
306.34
173.49
325.59
231.43
ROA (%)
5.60
6.84
7.23
5.66
6.72
coefficient of correlation
-0.06578
-0.08552
-0.03425
-0.02428
-0.03381
p-value
0.00269
0.00518
0.00000
0.08288
0.01248
Table 4.6 The relationship of return on assets and days of inventory
As can be seen in Table 4.6, there is negative correlation between ROA and days inventory. However, the degree of dependency between these two variables is lower than those of account receivable (Table 5). In 2005, age of inventory went up from 231 days to 325 days. Average ROA for the year 2004 and 2005 are 6.72% and 5.66% respectively. The degree of negative correlation was found in both years. However, the result from year 2005 is not statistically significant.
In 2006, age of inventory went down to 173 days and ROA went up to 7.23%. The year 2007 shows the highest negative coefficient of correlation of -0.08552 with average days of inventory 306 days and ROA 6.84%. In 2008, ROA went down by 1.24% while days of inventory decreased to 277 days. Moderate negative degree of correlation is found in this year and this result is statistically significant.
Just like account receivable, average days of inventory of companies in the sample differ across time. It may be due to the macroeconomic factors such as changes in the demand of products. Managers must decide the most optimum level of inventory in order to avoid overstock that will hurt the profitability. Products that have not been sold didn't make money for the company.
4.2.4 Return on Assets and Days Account Payable
Unlike days of account receivable and inventory, number of days account payable is negatively correlated with cash conversion cycle. It is because when company pays the supplier earlier, the cash conversion cycle would be longer. As mentioned earlier, ROA and cash conversion cycle are correlated negatively. Therefore one way to increase ROA is by reducing CCC, thus, number of days account payable should be increased. This argument is not true since data in Table 4.2 shows that ROA and days of account payable are negatively correlated. The result is statistically significance with p-value equal to 0.00000. This is supported by García-Teruel and Martínez-Solano (2007) who believed that delaying payment to supplier would hurt the profitability of the firm since company might not be able to enjoy discounts for early payments. However, with coefficient of correlation of -0.03616, the degree of interdependence between ROA and days of account payable is considered low.
The negative coefficient of correlation can also be interpreted as the less profitable companies wait longer to pay its bills so that they can enjoy credit period granted by suppliers. Delaying payment to supplier enables company to use the money for other purposes such as investment. It also enables the company to assess the quality of product before it is paid. However, this will affect company's liquidity position and the relationship with suppliers. On the other hand, paying the supplier earlier enables company to enjoy cash discount or rebates that will give benefits and increase the profitability as well.
Table 4.7 shows average days account payable, average ROA, coefficient of correlation and p-value of companies included in the sample. In the year 2004, there was a low degree of negative correlation between ROA and days account payable. However, this result is not significant since the p-value is 0.24207.
Mean
2008
2007
2006
2005
2004
A/P (days)
67.59
84.87
76.28
64.72
63.30
ROA (%)
5.60
6.84
7.23
5.66
6.72
coefficient of correlation
0.11866
-0.00925
-0.20506
-0.38743
-0.02949
p-value
0.00000
0.00013
0.00000
0.00000
0.24207
Table 4.7 The relationship of return on assets and days account payable
Negative coefficient of correlation in 2005 and 2007 was, respectively, the highest and the lowest compared with other years. Average days account payable in 2005 was 64 days and ROA 5.66%. In 2007, days account payable increased to 84 days on average and ROA declined to 6.84%. Coefficient of correlation equals to -0.00925, which is the lowest among all. Significant negative relationship was found in both years which ensure that decrease (increase) in days account payable will lead to increase (decrease) in company's ROA.
In 2006, average days account payable and ROA were 76 days and 7.23%. During this year, high degree of negative correlation was found and the results were statistically significant with p-value equal to 0.00000.
Unlike any other years, in 2008, correlation test showed that there was significant positive relationship between days account payable and ROA. As mentioned earlier, there are pros and cons in delaying payment to supplier. It may be due to changes in macroeconomic environment that the benefits of delaying payment were more than the drawbacks. In 2008, conservative approach of working capital management was implemented, as business volatility was probably high. Company prefers not to use short-term credit to finance its account payable.
Chapter 5
Conclusions and Recommendations
5.1 Conclusions
Based on observations on 120 listed company in Singapore Stock Exchange during the period 2004 to 2008, significant negative relationship is found between company's profitability (measured by ROA) and working capital management efficiency (measured by CCC, days account receivable, inventory and account payable).
The negative relationship between ROA and CCC implies that decrease in cash conversion period will lead to increase in company's ROA. This is because shorter cash conversion cycle will contribute to higher cash flow of the firm. This cash can be used to raise money by investing it somewhere. For example, firm can use its cash to make early payment to supplier, thus, enjoy discount or cash rebates, which drive the cost down and profit up. The coefficient of correlation of these two variables is -0.07431, which is considered as moderate degree of association.
Days account receivable, which is one of the three elements of cash conversion cycle, is also found to have negative correlation with company's ROA. The coefficient of correlation between ROA and days account receivable is the highest compared to days of inventory and account receivable. This inverse relationship shows that shorter payment collection period will help firm to increase its profit. The correlation might also mean that less profitable firm will give more lenient credit period for its customers so that they have more time to assess the products. However, Figure 5.1 doesn't clearly show the dependency of account receivable with ROA. Longer period of cash collection is found in 1st and 7th deciles. On the other hand, shorter period is found in 4th and 5th deciles.
Figure 5.1
Median of days account receivable, inventory and account payable relative to ROA deciles
Another element of cash conversion cycle is days of inventory. There is significant negative correlation between days of inventory and ROA. This can be explained as the shorter the days of inventory, the lesser cost associated with holding and carrying cost, thus, profit goes up. Moreover, this can also be explained as less profitable company will have more inventories since the supply is more than demand. However, there is no clear trend in median days of inventory and average ROA deciles presented in Figure 6. Higher median days of inventory come from companies that classified in 3rd, 4th and 6th deciles. The lowest is found in 5th deciles.
The coefficient of correlation between ROA and days account payable is the lowest compared to CCC, days of account receivable and inventory. The coefficient shows that there is negative relationship between ROA and days account payable. Figure 6 shows that the median number of days account payable is higher for lower average ROA deciles than for higher deciles. The first 4th deciles have days account payables of more than 60 days, while the rest have number of days of account payable from 44 to 61 days.
The way in which manager can manage account payable in order to achieve optimum return is affected by external environment. It means that manager should decide when company should implement aggressive approach of working capital management or more conservatives approach. Unlike period 2004 to 2007, correlation test in 2008 shows that ROA and days account payable are positively correlated. The result is statistically significant. This can happen because the year 2008 probably had different environment that urge company to use conservatives approach, as business volatility is high.
5.2 Recommendations
This project only provides the coefficient of correlation between profitability and working capital efficiency, which shows the degree and direction of interdependency between two variables. In order to get more accurate results on the dependency of one variable with another, regression analysis can be used.
Profitability of a company is affected not only by the way working capital is managed but also size, sales growth and financial debt. Further analysis can be done in order to test on the relationship between profitability and those variables.
Return on assets is used as a variable that represents profitability of the firm. Other measures of profitability can be used to replace return on assets such as gross profit margin, operating profit margin and return on equity.
Since the project only includes samples from listed companies in Singapore Stock Exchange, it can be improved further by including unlisted companies and/or small and medium enterprises. Moreover, the companies should be classified according to the industry so that impact of working capital management among different industries can be identified.
