IMPACT OF WORKING CAPITAL MANAGEMENT ON ...

Impact of Working Capital Management on Performance 1IMPACT OF WORKING CAPITAL MANAGEMENT ON PERFORMANCEImpact of Working Capital Management on Performance of Listed Non Financial Companies ofPakistan: Application of OLS and LOGIT ModelsIrfan AhmedUniversity of Sargodha, Sargodha, PakistanProceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 2AbstractPresent study investigates the impact of working capital management on the performance of thefirm using a sample of 253 non financial listed companies of Karachi Stock Exchange (KSE),Pakistan. The study used secondary data taken from Balance Sheet Analysis of Stock ListedCompanies on KSE published by State Bank of Pakistan. Results were analyzed by using theLogistic Regression, OLS Regression and Pearson Correlation techniques. The result suggeststhat out of the five selected components of working capital management only current asset overtotal sales showed significant negative relationship with both the proxies of performance i.e.return on equity and return on assets. While current asset over total asset (CATA), inventoryturnover, debtor’s turnover and current ratio showed significant positive relationship withperformance. Logistic regression results suggested that probability of firm being in profit ishighly determined by CATA, CATS and CR.KEYWORDS: Working capital management, Profitability, OLS regression, Logistic regression.1. IntroductionProceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 3WCM is among the most important decisions taken by the financial manger. It directly affectsthe profitability and is considered one of the most important parts of financial decision making(Haq et al 2011). Net working capital is the excess of current assets over current liabilities of afirm. It determines the strength of the business and its liquidity position means more the workingcapital more the liquidity of the firm. WCM could be permanent or temporary; former is theamount of current assets company must possess for longer period of time to offset its currentliabilities while later is the excess of current assets to meet seasonal current liabilities (Van Horn2005).According to Raheman and Nasr, (2007) Management of current assets to meet short termobligations of the company is WCM. Objective of the WCM is to make sure that firm meets theoperating requirements and also remain in a position to pay short term debt when they fall due(Mohamad & Noriza 2010). Mismanagement of working capital will lead a firm to liquiditycrisis by reducing its profitability and creditability, so managing working capital effectively isnecessary for going concern of the business and also for its profitability (Siddique & Khan2009). Earlier we have classified WCM as temporary and permanent, now we are classifying itas aggressive and conservative. Aggressive WCM refers to the firm’s strategy of having fewercurrent assets in proportion of total assets or having high proportion of current liabilities ascompared with the total liabilities of the company. It leads a company to low liquidity or higherprofitability (Van horne & Machowicz 2004). Conservative WCM technique appears with thephilosophy of using long term source should be used for the entire investment in the currentassets and short term should be used only for urgent situations. Distinct features of conservativeWCM are increased liquidity and less risk but more interest has to be paid on the seasonalrequirement for the entire period. Larger firm focus on higher sales with fewer on cash basisProceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 52009) Imports of chemical increased but not significantly as compared to the growth of industry.In 2007-08 Pakistan imported Rs. 329 billion worth of different chemicals. Demand of chemicalis increasing and the sector can grow in the long term but absence of clear policies andframeworks are a big hurdle in it. Pakistan is enriched with the cement resources and is ranked asthe 5th biggest exporter in the world. Many plants are working in the private sector and there is aprediction that India will import cement from Pakistan and till 2008 Pakistan has imported130000 tons of cement (according to Growth of Pakistan Cement Industry – Overview Friday, 26September 2008). Demand of cement has been increased significantly in the last decades.Cement Industry has captured African countries as well for its exports. Industry growth is 32%but exports increased by 111.86% (Pakistan Cement Industry Report 2009).It is evident from above discussion that textile, sugar, chemical and cement sectors are the majorcontributors of economic growth of Pakistan and WCM in these sectors plays a vital role inmanaging the affairs of their respective businesses. However, it is important to investigate thenature and processes of WCM strategies adopted by these industrial sectors of economy.Therefore, the present study is intended to investigate the empirical results of 4 major industries(Textile, sugar, chemical and cement) of Pakistan listed at KSE during period 2004 to 2009. Thisstudy will help us to analyze effect of accounting ratios on WCM and on profitabilitycollectively. We will also derive a conclusion about the relation between WCM and profitability.Rest of the article is arranged in the following order: Section 2 provides Literature Review,Methodology is given in section 3, section 4 provides Results while Conclusion is given in thelast section.2. Literature ReviewProceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 6Various studies have been done in the past to check the relationship between profitability andWCM. Mostly, researchers used the proxies for both WCM and profitability and it remaineddifficult to state one exact relationship between them as different studies contain differentdeterminants of WCM and those variables have shown different relationship with the proxies ofprofitability. Lazaridis & Tryfonidis (2006) worked on 131 listed companies of Athens stockexchange for four years from 2001 to 2004. Aim behind the study was to determine statisticallysignificant relation between CCC and profitability which is measured by gross operating profit.Accounts receivable turnover, accounts payable turnover and inventory management are thethree components of CCC. Pearson correlation and regression results showed that there is anegative relationship between accounts receivable turnover, accounts payable turnover &inventory management and profitability which is in line with the study of Deloof (2003).Raheman & Nasr (2007) analyzed the effect of several variables on Net Operating Profitabilitywhich includes average collection period, average payment period, ITO in days, CCC, ITO indays and CR in Pakistan. Control variables including debt ratio, size of the firm and financialasset over total asset ratio are used and they applied Pearson Correlation and Regression forpurpose of analysis. Sample of 94 Pakistani listed companies for 6 years from 1999-2004 hadbeen taken and concluded that managers can maximize shareholder value by efficientlymanaging components of CCC. It shows that there exists a strong negative relation betweenfirm’s profitability and measures of WCM.From emerging economy of Pakistan, Afza & Sajid (2008) investigated the relationship betweenaggressive/conservative working capital policies and Firm’s return. They took a sample of 263non financial companies from 17 industrial sectors after removing firms with negative equitylisted on KSE which constitute the whole population for analysis. They reported a negativeProceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 7relationship between measures of the profitability and degree of aggressiveness of financing andinvestment policies.According to Gill et al (2010) who extended Lazaridis & Tryfonidis (2006) study on relationshipbetween WCM and profitability, there exists a significant relationship between CCC andprofitability. They analyzed a sample of 88 firms listed on NYSE (New York Stock Exchange)for three years from 2005 to 2007 using correlation and regression analysis to conclude that theirstudy was in line with the study of Lazaridis and Tryfonidis study and said that if a managerefficiently manages accounts receivables, accounts payables and inventory he can increase theprofits of the firm.H. Jamal Zubairi (2010) studied Pakistan automobile sector and checked the impact of WCMand capital structure on profitability of the firm. To measure the profitability they used earningsbefore interest and taxes. Panel data set was analyzed using regression. The results showed thatprofitability variations due to the above mentioned four variables give three quarters of totalvariation. They also reported positive relation between profitability and size of the firm which isin accordance with the results of Raheman & Nasr (2007) study.In Malaysia, Mohamad & Noriza (2010) did their study by taking secondary data fromBloomberg’s 72 listed companies for 5 years from 2003-2007 to derive the relationshipempirically between WCM and profitability. Study was done to check effects of working capitalcomponents (such as CCC, CATA ratio, debt to asset ratio, CR and current liabilities over totalasset ratio) on firm’s performance and profitability measured by Tobin’s Q ratio, return oninvested capital and ROA. Correlation and Multiple Regression results showed a significantnegative relation between working capital components and company’s performance.Proceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 8Haq et al (2011) conducted a study in Pakistan on WCM of cement industry by taking a sampleof 14 cement firms listed on KSE (Karachi Stock Exchange) from year 2004-2009 in panel dataset. They used eight accounting ratios (CR, QR, CATA ratio, CATS, cash turnover ratio, ITOratio, DTO, creditor turnover ratio) as independent variables and ROI as the dependent variable.Estimated results based on Pearson correlation and Pooled Ordinary Least Square Regressionshows moderate relationship between WCM and profitability of firm.Karaduman et al (2011) studied this relationship of WCM and profitability by taking data of fiveyears of non financial companies listed at Istanbul Stock Exchange. A balanced panel sample of127 companies was analyzed which gives total of 635 observations. CCC was used as a measureof WCM and for profitability ROA acted as a measure. The result showed that efficientmanagement of CCC will give greater returns.From the previous studies it is evident that researchers used the accounting ratios as a proxy tocheck the relationship between WCM and profitability. Most frequently ROA, ROE, ROIC andTobin’s Q are the proxies used for profitability and CCC, CATA, ITO, DTO and CR are thevariables used for WCM. The methodology adopted by the majority of researchers to examinethe relationship is correlation analysis, OLS regression and multiple regression analysis. Theresults indicate that different contents of WCM show different relationship with profitabilityproxies and it is difficult to conclude the exact relationship of WCM with the profitability.3. Methodology3.1 Sample and DataThe study is based on checking the relationship between WCM and profitability in the all listednon financial sectors of Pakistan industry. For the analysis of the population the sample of 263Proceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 9companies from 4 major non financial sectors has been taken from the Balance Sheet Analysis ofJoint Stock companies listed on Karachi Stock Exchange from 2004-2009 published by StateBank of Pakistan. Initially, the whole population census was taken for study and the numbers ofobservations were 1578 but the descriptive analysis showed presence of various outliers in thedata which were removed by the procedure of 1% trimming. Finally, those firm yearobservations have been deleted where value of any variable found missing which reduces thesample size equal to 984 firm year observations.3.2 VARIABLES OF STUDY & HYPOTHESIS:The following ratios representing WCM have been analyzed in the study.1- Current Asset over Total Assets Ratio2- Current Assets over Total Sales Ratio3- Inventory turnover4- Debtors Turnover5- Current Ratio6- Quick RatioROE and ROA have been used as a proxy of firm’s profitability. The table 1 given belowpresents the definitions and expected signs of the variables.The relation between the variables had been examined by making the use of Binary LogisticRegression analysis on the unbalanced panel sample. The equation representing the relationshipis as follows:Proceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 10Where:ROE it represents ROE for firm i at time tROA it represents ROA for firm i at time tCATA it represents CATAR for firm i at time tCATS it represents CATSR for firm i at time tITO it represents ITO for firm i at time tDTO it represents DTO for firm i at time tCR it represents CR for firm i at time tQR it represents quick ratio QR for firm i at time tu itrepresents error term of the modelThe binary logistic regression has been used on the panel sample data. The advantage of usingthe binary logistic regression is that t gives the results in binary form say YES or NO whichcannot be explained by ordinary least square regression. In our study it helps to determine that afirm is in profit or loss in a particular year.3.3 ESTIMATION TECHNIQUES:Present study has used OLS as the primary estimation technique to investigate the impact ofWCM on firm’s performance. However, the chances of firm earning profit or suffer loss as aresult of its WCM policy is yet to be investigated in detail. Therefore, present study has alsoincorporated binary logistic regression to determine the probability of firm being profitable or inloss due to its WCM. Logistic regression is a method for determining the relationship betweenpredictor variables and a dichotomously coded dependent variable. It’s a linear model used forbinomial regression. Just like other forms of the regression analysis, it makes use of the predictorProceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 11variables that can be either numerical or categorical. For estimation purposes LOGIT model canbe explained by the following equation:The LOGIT specification of dependent variable is:Where Y, representing dependent variable, is equal to 1 if the company is profitable and 0 if thecompany is in loss. The probability that the company is profitable is given by:If we assume that error follows a logistic distribution to be standard than it will be represented:On the other hand if we say that the company will not be profitable or in loss than the equationwill be:The odd ratio i.e. P(Y=1)/1-P(Y=1) which states the ratio of probability that company will beprofitable to the probability that company will not be profitable would be equal to:Now if we take the log of the odd ratios it will be:Proceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 12Exponent raised to the power beta Exp (β) explains that if the value of Exp (β) is less than 1 thanincrease in independent variable will correspond to the decrease in the odd ratio and if the valueis greater than 1 than increase in independent variable will result in an increase in the odd ratio.4. Result and Analysis4.1 Descriptive AnalysisTable 2 of descriptive analysis reports the mean, median and standard deviation of the alldependant and independent variables.4.2 Pearson correlationPearson correlation is used to check the linear association among variables of the study. Wefound that ROE is having positive association with ROA, CATA, CR and QA at the significancelevel of 1%. It also has positive association with ITO and DTO but that is not significant. ROEhave the negative association with CATS but association is not significant .In case of ROA thereis positive association with CATA, ITO, DTO, CR and QR at the significance level of 1% andnegative association with CATS at the significance level 5% shown at the end in table 3.Collinearity statistics shows that there is no multicollinearity factor in the study.4.3 Regression Analysis:Regression Analysis is basically used to measure the relationship between dependent andindependent variables. In this study Regression analysis contains two dependent variables. InProceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 13table 4 regression results are shown by taking ROE as dependant variable. In table 4 ROE isreplaced by ROA.Table 4 shows that there is positive relationship with CATA, ITO, DTO and CR at thesignificance level of 1% shows that increase in these variables will significantly increase ROE ofthe firm. While there is negative relation with CATS at the significance level of 1%. Thisrelation shows that increase in CATS will significantly decrease ROE of the firm. The value ofR-square 0.122 shows that only 12.2% of the change in ROE is explained by the independentvariables. The F-statistic value is 27.08 and is significant at the level of 1%.The adjusted R-square value is 11.7%.Table 5 shows ROA has positive relationship with CATA, ITO, DTO and CR at the significancelevel of 1%. While there is negative relation of ROA with CATS at the significance level of 1%.The value of R-square .310 shows that only 31% of the change in ROA is explained by theindependent variables. The F-statistic value is 88.08 and is significant at the level of 1%.Thevalue of Durban Watson test is 1.45.To check the relationship between WCM and profitability we have seen regression results foreach sector individually. The results show that CATA and CATS strongly determines ROE andROA for the textile sector. Similarly DTO is most significant in Chemical sector and ITO showsmost significant results with both ROE and ROA in cement sector analysis. An important findingis that no variable shows significant results in sugar sector analysis. So, Regression was run onthe three sectors (textile, chemical and cement) excluding sugar sectors and that improves thevalue of R-square.4.4 Logistic RegressionProceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 14Logistic regression is used when the dependent variable is binary. In our study it has been usedto see that either the firm is profitable in a year or not. According to the results shown in table 6,1 unit increase in CATA will cause an increase of 20.863 in the probability that the ROE willincrease. CATS value gives an indication that 1 unit increase in CATS will decrease theprobability of an increase in ROE by 0.362. The value for exp (β) of ITO shows that 1 unitincrease in ITO will increase the probability of increase in ROE by 1.001. DTO value is givingan indication that an increase of 1 unit in DTO will decrease the chances of increase in ROE by0.998 units. Similar to ITO, CR exp (β) shows that 1 unit increase in CR will cause an increasein the probability of increase in ROE by 1.010 units. Result reveals CATA, CATS and CR arethe strong determinants of the WCM and highest value of CATA shows it the most significantdeterminant of WCM.ConclusionPresent study investigates the relationship between WCM and profitability of a firm of 263 nonfinancial stock listed companies at KSE (Karachi Stock Exchange). For analysis purposefinancial ratios of WCM are used to check their affect on the performance of the firm in thecontext of 4 major non financial sectors of Pakistan. The result suggests that out of the fiveselected components in regression analysis CATS ratio is only variable that shows significantnegative relationship with both ROE and ROA. CATA is having significant positive relationshipwith ROA and ROE which is in line with the studies of Noriza & Azhar (2010). ITO showspositive relationship with ROE but the results are not significant while shows significant positiverelationship with ROA. DTO is also having significant positive relationship and CR showssignificant positive relationship with both the proxies of profitability and these results areparallel to the study of Haq et al (2011). We hope that our results would be a contribution in theProceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 15study of WCM and profitability as logistic regression is first time used for analysis to the best ofour knowledge. It is recommended that future research should be done specifically on the sugarsector to identify the strong determinants of profitability in this sector and to use other variablesof WCM that better predicts the relationship with profitability.ReferencesAfza, Talat & Mian Sajid Nazir, 2008. “Working Capital Approaches and Firm’s Returns inPakistan”, Pakistan Journal of Commerce and Social Sciences, Vol.1, pp.25-36.Binti Mohammad nor Edi Azhar & Noriza Binti Mohd Saad (2010). “Working CapitalManagement: The Effect of Market Valuation and Profitability in Malaysia”.International Journal of Business and Management, Vol. 5, No. 11.Eljelly, A. (2004). “Liquidity-profitability tradeoff: an empirical investigation in an emergingmarket”. International Journal of Commerce and Management, Vol.14 (2), pp. 48- 61.Gill Amarjit, Nahum Biger & Neil Mathur (2010). “The Relationship Between Working CapitalManagement And Profitability: Evidence From The United States”. Business andEconomics Journal, Volume 2010: BEJ-10.Proceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 16Haq Ikram ul, Muhammad Sohail, Khalid Zaman &Zaheer Ala (2011). “The Relationshipbetween Working Capital Management and Profitability: A Case Study of CementIndustry in Pakistan”. Mediterranean Journal of Social Sciences, Vol.2, No.2.Karaduman Hasan Agan, Halil Emre Akbas, Arzu Ozsozgun Caliskan and Salih Durer (2011).“The Relationship between Working Capital Management and Profitability: Evidencefrom an Emerging Market”. International Research Journal of Finance and Economics,ISSN 1450-2887, Issue 62.Lazaridis I & Tryfonidis, D. (2006). “Relationship between working capital management andprofitability of listed companies in the Athens stock exchange”. Journal of FinancialManagement and Analysis, Vol.19 (1), pp 26 – 35.Narware P. C. (2004). “Working capital and profitability- an empirical analysis”. TheManagement Accountant, Vol, 39 (6), pp 120-127.Raheman, Abdul & Mohamed Nasr. (2007). “Working capital management and profitabilitycaseof Pakistani firms”. International Review of Business Research Paper, Vol 3, No1,pp.279-300.State Bank of Pakistan (2010). Balance Sheet Analysis Joint Stock Companies Listed on theKarachi Stock Exchange, online available at:www.sbp.org.pk/departments/stats/bsa.pdfZubairi H. Jamal (2010). “Impact of Working Capital Management And Capital Structure onProfitability of Automobile Firms in Pakistan”. Social Science Research Network. July31, 2010Finance and Corporate Governance Conference 2011 PaperProceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 17Tables:Table 1: Definitions, symbols and expected signs of the proxy variablesDependent Variables Definition Symbols ExpectedSignsReturn on EquityMeasures how much the shareholdersROEearned for their investment in the company.Return on AssetsMeasures the ability of firm to utilize itsROAassets to create profitsIndependent VariablesCurrent Asset overDescribes the proportion of current assets inCATARNegativeTotal Assets Ratiocomparison with total assetsCurrent Assets over Describes the ratio of current assets to the CATSR NegativeProceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 18Total Sales RatioInventory Turnovertotal revenues of firmIndicates the liquidity of the inventory ITO PositiveRatioDebtors TurnoverIndicates the liquidity of the receivables DTO PositiveRatioCurrent RatioDetermines the short term debt payingCRNegativeability of the firmQuick RatioDetermines the short term debt payingQRNegativeability of the firm excluding inventoriesTable 2: DescriptiveNo MEAN MEDIAN S.DROE 984 3.25 5.40 31.21ROA 984 2.88 1.70 9.21CATA 984 .46 0.46 .17CATS 984 .56 0.46 .38ITO 984 7.80 4.63 11.20DTO 984 26.20 13.16 21.80CR 984 108.05 92.50 70.92QR 984 64.54 46.15 58.79Proceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 19Table 3: Pearson correlationROE ROA CATA CATS ITO DT CR QRROE 1ROA .741** 1CATA .247** .302** 1CATS -.017 -.080* .343** 1ITO .057 .107** -.244** -.202** 1DTO .055 .097** -.263** -.144** .191** 1CR .271** .463** .531** .322** -.055 -.023 1QR .256** .431** .431** .320** .140** .029 .925** 1Proceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 20** Significant at level 1%; *Significant at level 5%Table 4: OLS Regression Table for ROEUnstandardized CoefficientsModelTB Std. Error Sig.CATA 42.392 7.074 5.993 .000CATS -10.687 2.694 -3.967 .000ITO .227 .088 2.579 .010DTO .084 .031 2.701 .007CR .087 .016 5.388 .000(Constant) -23.699 3.412 -6.945 .000Adjusted R square .117 Sig. F .000Std. Error 29.32 Durbin Watson 1.45Table 5: OLS Regression for ROAUnstandardised CoefficientsModelB Std. Error TSig.CATA 11.405 1.849 6.169 .000Proceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 21CATS -6.210 .704 -8.819 .000ITO .091 .023 3.964 .010DTO .030 .008 3.694 .007CR .057 .004 13.669 .000(Constant) -6.624 .892 -7.427 .000R-Square .310 F 88.07Adjusted R square .307 Sig. F .000Std. Error 7.66 Durbin Watson 1.16Table 6: Logistic RegressionModelB Df Sig. Exp(B) Wald S.ECATA 3.038 1 .000 20.86 21.35 .657CATS -1.017 1 .000 .362 16.23 .235ITO .001 1 .859 1.00 .032 .007DTO -.002 1 .318 .998 .997 .002CR .010 1 .000 1.01 19.16 .002(Constant) -.774 1 .007 .461 7.36 .285Proceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)

Impact of Working Capital Management on Performance 22Cox & Snell R-SquareNagelkerke R-Square.114.163-2 log likelihood 1011.08Chi square Df SigStep 114.21 5 .000Block 114.21 5 .000Model 114.21 5 .000Proceedings of 2 nd International Conference on Business Management (ISBN: 978-969-9368-06-6)