Literature on Working Capital Management and Profitability

Literature on Working Capital Management and Profitability Regarding the research of working capital management and profitability. This chapter consists of literature review of different researchers and their studies findings in accordance to the region their studies are based on. I will start with the region of United States of American and followed by the European countries. Studies from other countries not included in the aforementioned regions will be described in the following topic. This chapter ends with a table summarizing the findings of different authors from this literature review. Variables Description Average Collection Period on Profitability In an article wrote by Milling (1991, p. 48), he mentioned that: Average collection period measures the time that a firms average sales dollar remains outstanding as an account receivable. Average collection period is formulated by dividing accounts receivable by sales and multiplying by the number of days in a year (365). It is the average number of days which a firm manages to collect its outstanding debts from customers (Garcia-Teruel Martinez-Solano, 2007). According to Lazaridis and Tryfonidis (2006), acerage collection period is one of the components to measure the cash conversion cycle which is manageable to maximize the profitability and improve firms growth. In Raheman and Nasr (2007) research adaptation, the correlation analysis between average collection period and net operating profitability shows a negative coefficient. This means that if the average collection period increases, it will lower the profits in return. However, the Pearsons correlation proved there is a strong positive relationship between average collection period and cash conversion cycle. Most profitable firms are observed to have a shorter period of collection period (Deloof, 2003). These same firms a re also larger in size, have higher sales growth and lower debt fin ancing. Further research done by Garcia-Teruel and Martinez-Solano (2007) had its result consistent with Deloof (2003) finding. They had agreed that elongate the deadlines for customers to repay their payments may project greater payment facilities, but would negatively affect the profitability of a firm. Sales may also be increased due to the leniency of firms collection policy. To increase corporate value, a high quality accounts receivable portfolio could be created, safeguarded and realized through effective credit management. This is due to heavy investments in accounts receivable by larger corporations. Hence, Pike and Cheng (2001) felt it is important to control the credit management policy and practices choices in order to maximize value. The lower the investments placed on accounts receivable, the more reduction in interest costs, hence, a respectable increase in earnings (Milling, 1991). Besides that, there is a close relationship between sales growth and the level of current assets (Kim, Rowland Kim, 1992). The example given was that the increment in credit sales will lead to higher inventories and accounts receivable. It is unavoidable to invest in current assets in that matter. According to Deloof (2003, p.584): An alternative explanation for the negative relation between accounts receivable and profitability could be that customers want more time to assess the quality of products they buy from firms with declining profitability. Schwartz (1974) debated that firms that are able to obtain funds at lower cost would offer trade credit to firms facing higher financing cost through finance-based models. Emery (1984) was able to conclude that investments in trade credit are a much better option for short-term investment than market securities. The advantage of trade credit can be spontaneous and exist without formalities, but the limitation is that it is available for goods and services only (Hossain Akon, 1997). Inventory Turnover on Profitability Zero inventory and Just-in-time manufacturing had been a popular inventory management practices (Reynolds, 1999). In much simpler terminology, inventory turnover means the cycle of using and replenishing goods. According to Reynolds (1999), inventory turnover analysis has major importance because inventory management directly impact operations profitability. This analysis serves as a measure of firms efficiency and profitability. Inventory turnover analysis can assist financial managers in recognizing problems and can help reduce associated costs. Average Payment Period on Profitability Companies of different sizes (small, medium and large) are now taking longer time period to repay their debts (Anonymous, 2005). The same author also mentioned that was affected due to larger companies imposing longer payment terms on their suppliers, who are usually not in a position to choose. Companies in a lower part of the chain would face cash flow problems as companies on the upper chain wait for payment before they pay their suppliers. Cash Conversion Cycle on Profitability The cash conversion cycle is able to capture the impact of an effective working capital management policy, which are due to the effects from turnover of receivables, inventories and payables. The function of cash conversion cycle is defined by Jose, Lancaster and Stevens (1996, p.34): The CCC measures the time between cash outlays for resources and cash receipts from product sales. The CCC is dynamic in the sense it combines both balance sheet and income statement data to create a measure with a time dimension. Richards and Laughlin (1980) consequently operated this concept by measuring the number of days funds are committed to receivables and inventories and less the number of days payments are deferred to suppliers. Shin and Soenan (1998) are able to prove a strong correlation between cash conversion cycle and profitability. Even so, they used a substitute of cash conversion cycle called the net trading cycle. Using this cash conversion cycle, also known as cash-to-cash (C2C), companies could establish a point of reference for inter-firm comparisons. Besides improving profits earned, companies could obtain overall efficiencies and balance supply chain operations (Hutchison, Farris II Anders, 2007). Regional United States of America According to a research done by Kim, Rowland and Kim (1992), it was about the implications of working capital management practices by Japanese manufacturers in the US. This study is to determine the objectives of working capital management by Japanese manufacturers in US and to identify options for funding. As Japans foreign direct investment in the business expansion of US has increased rapidly, therefore, it is important to manage the firms working capital well. International working capital management has significant importance as total assets and liabilities of multinational corporations consist of current assets and short-term liabilities. There are few differences in financial structure between the US companies and Japanese manufacturers: Japanese firms rely more on banks short-term debt. Japanese firms project a lower level of net working capital. Japanese firms operate with about half as much equity as US firms. Japanese firms hold twice as much in long-term investments as US firms. Japanese firms reported lower inventory level; more accounts receivables and twice as much cash as US firms. Questionnaires were sent out to Japanese manufacturing companies operating in US. Executives from these Japanese-owned firms perform this survey to determine the companys working capital policies and practices. The data reverted back to researchers show that Japanese firms rated the most important objective of working capital management is to be providing current assets and liabilities in support of anticipated sales, while minimizing investments in current assets being the least important. Moreover, most of their short-term financing were sources from Japanese banks. In 1996, Jose, Lancaster and Stevens performed a research on the relationship of corporate returns and cash conversion cycle. This study examined the long-run equilibrium relationship between a measure of ongoing liquidity needs (cash conversion cycle) and measures of profitability. Data collected were from the annual Compustat tapes, which covers the twenty-year period starting from year 1974 to 1993. There are altogether 2,718 firms which have complete data required. The variables were tested using nonparametric and multiple regression analysis, with the industry and size variable controlled. Richards and Laughlin (1980) and Emery (1984) had noted the constraints of using traditional financial ratios and believed in the liquidity management measures to reflect the ability of firms meeting their short-term financial obligations. Return on assets (ROA) and return on equity (ROE) measures are also included in this study to separate asset management and financing influence. Jose, Lancaster and Stevens concluded that there are key findings for ROA and ROE. These ass et management returns and levered returns revealed an increase in performance and benefits. Shin and Soenan (1998) did a study to test the efficiency of working capital management to create profitability. They used a Compustat sample of 58,985 firms covering the period 1975 1994. The relationship between the length of net trading cycle, corporate profitability and risk-adjusted stock return was examined. Net trading cycle could be computed as below: Net Trading Cycle = (Inventory Turnover + Average Collection Period Average Payment Period) x (365 / Sales) The outcome of the study shows strong negative relation between the length of firms net trade cycle and profitability. They also considered that working capital efficiency increases profitability; there will be a negative relationship between net trading cycle and stock return. The examination of this relationship is done using the correlation and regression analysis, by industry and working capital intensity. In their study, it is mentioned that working capital is a result of the cash conversion cycle. Gentry, Vaidyanathan and Lee (1990) developed the weighted cash conversion cycle, which scales the timing by the amount of funds in each step of the cycle. On the other hand, Deloof (2003) said that this method could not be used due to incompleteness of information available for calculation. Liquidity ratios, such as current ratio and acid-test ratio, could not measure the working capital management efficiently due to reasons that these ratios include calculation of assets which are n ot readily available to be converted into cash and the ratios ignored the timing of cash conversion (Shin Soenan, 1998). In all, maximum working capital efficiency is an essential factor of total corporate strategy to create shareholders value. A research was done on the international working capital of multinational corporations by Dr. Hadley Leavell from Sam Houston State University. His journal was published in 2006. To enhance profitability of multinational corporations, Ricci and Di Vito (2000) suggested reducing the floating costs of time value, losses on outstanding accounts receivables, transaction costs and foreign exchange conversion costs when moving cash between countries. However, the difficulty to overcome regulatory and geographical barriers may lead to a loss of control and payment regulations placed on cross-border cash concentration to maximize profitability. Regional Europe In year 2003, Deloof investigated the relation between working capital management and profitability of a sample 1,009 large Belgian non-financial firms between years 1992 1996. The cash conversion cycle was considered as the comprehensive measure for working capital, whereas gross operating income is the measurement for profits. There is the weighted cash conversion cycle modified by Gentry, Vaidyanathan and Lee in 1990, but was not applied by Deloof because of the limited information availability. Deloof related the correlation and regression analysis to his research to prove that there is a relationship between working capital management and profitability. Another research done in Europe is by Lazaridis and Tryfonidis in year 2006. They investigated the relationship between working capital management and corporate profitability of a sample of 131 companies listed in the Athens Stock Exchange. Data was collected from year 2001 2004. In this research, profitability was measured through gross operating profit and cash conversion cycle. Lazaridis and Tryfonidiss research also established that larger companies are cash-management-focused with more credit sales, which led to cash flow problems. Smaller scale firms are more focused on stock management and credit management. Similar to Deloofs (2003) research, the cash conversion cycle is used to describe the effectiveness of working capital management in this study. Regression analysis used in this research showed a negative relationship between cash conversion cycle and profitability. Garcia-Teruel and Martinez-Solano (2007) were involved in a research to provide evidence about the effects of working capital management towards to profitability of Spanish small and medium-sized (SME) enterprises. Many previous researches are focused on larger form of firms. They collected a sample of over 8, 800 SMEs which covers the year 1996 2002 from the AMADEUS database. The selection was done in accordance to the requirements by Europeans Commissions recommendation on the definition of SMEs. In fact, the current assets and current liabilities of their sample of SMEs proportion is the majority of total assets and liabilities available to the firms. They used the cash conversion cycle to measure the profitability of the firms on their research sample. Their study was supported by Deloof (2003), confirmed that firms can improve profitability by lowering outstanding accounts receivables and payables and inventories. A univariate analysis was conducted to determine differences in variables, followed by a multivariate analysis to determine working capi tal management on corporate profitability. Return on Assets ratio was set as the dependent variable to establish profitability. In the correlation matrix used, they found a negative relationship between their dependent variable (return on assets) with the number of days accounts receivables, days of inventory and days accounts payable. They confirmed that by shortening the cash conversion cycle, firms could improve profitability. Regional Others Hossain and Akon (1997) did a case study on financing working capital of Bangladesh textile mills corporations. This case study covers 40 public sector textile units under the ownership and administration of Bangladesh Textile Mills Corporations. The study covered a period of twelve years from 1982 1993. According to Hossain and Akon, well-known economists believed that current assets should be considered as working capital as the whole of it helps to generate profits. In their study, it shows that a vast amount of short-term finance was used in financing fixed and current assets to the extent of 100 percent. This caused a lower capability to earn profits, but increases the risk of insolvency. The aggressive working capital financing (using short-term funds to finance fixed assets) should be tamed in Bangladesh textile mills corporations to maximize profits, by resorting to long-term funds which are less costly. Methods used to test their hypothesis are through regression analysis and comparing the calculation of financial ratios. Raheman and Nasr (2007) had done a research to prove the relationship between working capital management and profitability of Pakistani firms. A sample of 94 firms listed on Karachi Stock Exchange was selected. Firms are listed for a period of 6 years from 1999 2004. It was mentioned that an excess of current assets could lead to a firm realizing its return on investment. However, it was proven otherwise if firms have a shortage of current assets (Horne Wachowicz, 2000). The measurement of profitability used by Raheman and Nasr is the Net Operating Profitability. They used the regression analysis to assess their hypothesis. Their study includes data of regression analysis of cross-sectional and time-series data. The pooled-regression (constant coefficient models) type of panel data analysis was applied. They believe that increase in the cash conversion cycle would lead to lower profit generation (Shin Soenan, 1998; Deloof, 2003; Lazaridis Tryfonidis, 2006; Garcia-Teruel Martinez-Solano, 2007). Summary of Literature Review Author (Year) Market (Region) Evidence of Findings Kim, Rowland and Kim (1992) Japanese Manufacturers in US (USA) Objective of working capital management is to be providing current assets and liabilities in support of anticipated sales. Jose, Lancaster and Stevens (1996) Compustat (USA) Key findings in asset management returns and levered returns. Shin and Soenan (1998) Compustat (USA) Relationship between the length of net trading cycle, corporate profitability and risk-adjusted stock return. Leavell (2006) Multinational corporations (USA) International working capital and multinational corporations. Deloof (2003) Belgian non-financial firms (Europe) Application of cash conversion cycle. Lazaridis and Tryfonidis (2006) Companies listed on Athens Stock Exchange (Europe) Larger companies are cash-management-focused, Smaller firms are more focused on stock management and credit management. Garcia-Teruel and Martinez-Solano (2007) Spanish SMEs (Europe) Effects of SMEs working capital management towards its profitability. Hossain and Akon (1997) Bangladesh (Asia) Financing Bangladesh textile mills corporations. Raheman and Nasr (2007) Karachi Stock Exchange (Asia) Working capital management of Pakistani firms and its profitability. Table 2.1 Summary of Literature Review Conclusion Working capital is about establishing optimum liquidity position by effectively managing resources invested in day-to-day operations of the business. After studying the journals and researches done, it can be concluded that liquidity and profitability of firms was affected by the components and working capital management measures (accounts receivable, inventory and accounts payable).