optimizing working capital management

Electronic copy available at: http://ssrn.com/abstract=1528894

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Optimizing Working Capital Management

Haitham Nobanee

Department of Banking and Finance, The Hashemite University, P.O. Box 330221, Zarqa, 13133, Jordan. Tel:

+96253903333; Fax: +96253826613 E-mail: [email protected]

Maryam AlHajjar

Abstract

Although the operating cycle, the cash conversion cycle, and the net trade cycle are more

comprehensive measures of working capital management comparing with traditional

measures such as the current ratio and the quick ratio. These measures do not consider the

optimal points of payables, inventory, and receivables. In this study we suggest more accurate

measures of the efficacy of working capital management where optimal levels of inventory,

receivables, and payables are identified, and total holding and opportunities cost are

minimized and recalculating the operating cycle, the cash conversion cycle, and the net trade

cycle according to these optimal points. In this regard, we suggest an optimal operating cycle,

an optimal cash conversion cycle, and an optimal net trade cycle as more accurate and

comprehensive measures of working capital management.

Keywords: Working Capital Management; Optimal Cash Conversion Cycle; Net Trade Cycle: Cash Conversion Cycle; Receivable Collection Period; Inventory Conversion Period; Payable Deferral Period; Weighted Cash conversion Cycle; Net Trade Cycle

JEL classification: G30:G32:L25:O25

Although historical experiences show that the average firm has 40% of its assets

employed in current assets, and the typical corporate financial manager spends 80%

of his time in managing day-to-day short term financial resources (see Dandapani, etal,


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1993), traditional focus in corporate finance was on the long-term financial decisions,

particularly capital structure, dividends, investments, and company valuation

decisions. However, the recent trend in corporate finance is the focus on working

capital management. See (Ganesan, 2007). Some of the existing literature suggests

that companies, on average, over-invest in working capital. For example, the U.S.

corporations had roughly $460 billion unnecessarily tied up in working capital. One

good example about the important the efficiency of a corporation’s working capital

management is given by Shin and Soenen (1998). They point out that Wal-Mart and

Kmart had similar capital structures in 1994, but because Kmart had a cash

conversion cycle of roughly 61 days while Wal-Mart had a cash conversion cycle of

40 days, that Kmart likely faced an additional $198.3 million per year in financing

expenses. Such evidence demonstrates that Kmart’s poor management of its working

capital contributed to its going bankrupt see (Moussawi et al, 2006).

Efficiency of working capital management is based on the principle of speeding up

collections as quickly as possible and slowing down disbursements as slowly as

possible. This working management principal based on the traditional concepts of

operating cycle, cash conversion cycle, weighted cash conversion cycle, and net trade

cycle. The operating cycle of a firm is the length of time between the acquisition of

raw materials and the collections of receivables associated with the sales of finished

goods. Although the operating cycle conceders the financial flows comes from

receivables and inventory, it ignores the financial flows comes from account payables,

in this regards, Richards and Loughlin (1980) suggest the cash conversion cycle that

considers all relevant cash flows comes from the operations. The cash conversion

cycle can be defined as the length of time between cash payments for purchase of


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raw materials and the collection of receivable associated with the sale of finished

goods. However, the cash conversion cycle focuses only on the length of time

financial flows engaged in the cycle and does not consider the amount of fund

committed to a product as it moves through the cash conversion cycle. Therefore,

Gentry, Vaidyanathan, and Wai (1990) suggest a weighted cash conversion cycle that

takes into consideration both the timing of financial flows and the amount of fund

committed to each stage of the cycle. The weighted cash conversion cycle can be

defined as the weighted number of days funds are committed in receivables,

inventories and payables, less the weighted number of days financial flows are

deferred to suppliers. In addition to its' complexity, another limitation of the weighted

cash conversion cycle is the brake up of inventory into three components of raw

materials, work in process, and finished goods is not available for outside

investigators; hence, Shin and Soenen (1998) suggest the net trade cycle as an

alternative measure for working capital management. They argue that the cash

conversion cycle is an additive concept wares the denominators for the inventory

conversion period, the receivable collection period, and the payable deferral periods

are all different, making the addition of the cash conversion cycle components not

really useful. They suggest equalizing the denominators of the inventory conversion

period, the receivable collection period, and the payable deferral periods1. The net

trade cycle is basically equal to the cash conversion cycle where the three complaints

of the cash conversion cycle (receivables, inventory, and payables) are articulated as a

percentage of sales, this makes the net trade cycle easier to calculate and less complex

comparing with the cash conversion cycle and the weighted cash conversion cycle.

Shin and Soenen (1998) also argue that the net trade cycle is a better working capital

1 The cash conversion cycle formula is: (accounts receivables/sales)*365 +(inventory/CGS)*365 – (accounts payables/CGS)*365 The net trade cycle formula is :{accounts receivable + inventory – accounts payables}*365/sales

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efficiency measure comparing with the cash conversion cycle and the weighted cash

conversion cycle because it indicates the number of "day sales" the company has to

finance its working capital and the working capital manager can easily estimate the

financing needs of working capital expressed as the function of the expected sales

growth.

Although the operating cycle, the cash conversion cycle, the weighted cash

conversion cycle, and the net trade cycle are powerful measures of working capital

management and firm's liquidity comparing with the static traditional ratios such as

the current ratio and the quick ratio that are inadequate and misleading in the

evaluation of firm's liquidity, these cycles does not considers the optimal levels of

receivables, inventories, and payables. The traditional link between these cycles (the

operating cycle, the cash conversion cycle, the weighted cash conversion cycle and

the net trade cycle) appears in the existing literatures (see, Shin and Soenen, 1998;

Gentry, et al, 1990; Richards and Loughlin, 1980, Deloof, 2003) and firm's

profitability, market value and liquidity is that shortening these cycles increases firms

profitability, liquidity, and market value. Fore example; a short cash conversion cycle

indicates that the company manage and process inventory more quickly, collects cash

from receivables more quickly and slowing down cash payments to suppliers. This

increases the efficiency of internal operations of a firm and results on higher

profitability, higher net present value of cash flows, and higher market value of a firm

(Gentry, et al, 1990).

The cash conversion cycle and the net trade cycle can be shortened by reducing the

time that cash are tied up in working capital. This could happen by shortening the

inventory conversion period via processing and selling goods to customers more

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quickly, ore by shortening the receivable collection period via speeding up

collections, or by lengthening the payable deferral period via slowing down payments

to suppliers. On the other hand, shortening the cash conversion cycle could harm the

firm's profitability; reducing the inventory conversion period could increase the

shortage cost, reducing the receivable collection periods could makes the company's

lousing it's good credit customers, and lengthening the payable period could damage

the firm's credit reputation. Shorter cash conversion cycle (net trade cycle and

operating cycle) associated with high opportunity cost, and longer cash conversion

cycle (net trade cycle and operating cycle) associated with high carrying cost.

Achieving the optimal levels of inventory, receivable, and payable will minimize both

carrying cost and opportunity cost of inventory, receivable, and payable and

maximizes sales, profitability and market value of firms. In this regards, we suggest

an optimal cash conversion cycle, an optimal net trade cycle, and an optimal operating

cycle as more accurate and comprehensive measures of working capital management.

Optimal Operating Cycle

The optimal operating cycle is an additive function. It measures the optimal length of

inventory conversion period plus the optimal length of receivable collection period

(see equation 1 and 2)

Optimal operating Cycle = Optimal Inventory Conversion Period + Optimal

Receivable Collection Period ………………… ……………………………………(1)

Optimal Operating Cycle = (Optimal Inventory/Cost of Good Sold)*365 + (Optimal

Receivables/ Sales)*365 ………………………………………………………..….(2)

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Optimal Cash Conversion Cycle

The optimal cash conversion cycle is an additive function. It measures the optimal

length of inventory conversion period plus the optimal length of receivable collection

period less the optimal length of payable deferral period (see equation 3 and 4)

Optimal Cash Conversion Cycle = Optimal Inventory Conversion Period + Optimal

Receivable Collection Period – Optimal Payable Deferral Period……………….… (3)

Optimal Cash Conversion Cycle = (Optimal Inventory/Cost of Good Sold)*365 +

(Optimal Receivables/ Sales)*365 – (Optimal Payables/Cost of Good sold)*365….(4)

Optimal Net Trade Cycle

The optimal cash conversion cycle is also an additive function. It measures the

optimal length of inventory conversion period plus the optimal length of receivable

collection period less the optimal length of payable deferral period, where optimal

inventory conversion period and optimal length of payable deferral period are

expressed on day’s sales. (see equation 5, 6 and 7)

Optimal Net Trade Cycle = Optimal Inventory Conversion Period + Optimal

Receivable Collection Period – Optimal Payable Deferral Period…………….…… (5)

Optimal Net Trade Cycle = (Optimal Inventory/Sales)*365 + (Optimal Receivables/

Sales)*365 – (Optimal Payables/Sales)*365…………………………………….(6)

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Optimal Net Trade Cycle = {(Optimal Inventory + Optimal Receivables - Optimal

Payables)*365}/Sales………………………………………………………….(7)

Optimal Inventory Level

One of the best-known optimal inventory level approaches is the Economic Order

Quantity model (EOQ)2 (see Ross et al, 2008). The basic idea of this model is plotting

the total cost of currying inventory with different inventory quantities as in Figure 1.

As shown in Figure 1, inventory carrying costs increase and inventory shortage costs

decrease as inventory level increase and we attempt to identify the minimum total cost

point Q*.

2 There are many ways to find the optimal inventory level, in addition to the classic EOQ model, optimal inventory level could be identified using Shortages Permitted Model, Production and Consumption Model, Production and Consumption with Shortages Model , and EOQ with Shortages and Lead Time. Moreover, there are money other new optimal inventory models developed in the recent literature, for example, an EOQ model under retailer trade credit policy suggested by Huang and

Hsu (2007), this model identifies the optimal inventory level under permissible delay in payments where the supplier would offer the retailer trade credit and the retailer will also offer a trade credit to his clients.

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Figure 1

Optimal Inventory Level

Optimal Accounts Receivable

An optimal credit amount could be identified by the point ware the incremental cash

flows from increased sales stimulated by offering credit to the customers equals the

costs of carrying additional investments in account receivables (see Ross et al, 2008).

Therefore, an optimal amount of credit extended could be identified by plotting the

total cost of associated with granting a credit with different amounts of credit

extended as in Figure 2.

Carrying Cost

Q*

Optimal Quantity

Shortage Cost

Total Cost

Inventory Quantity

Cost of Holding Inventory

Source: Ross, Westerfield, and Jordan, 2008, Corporate Finance Fundamentals, Eighth's Edition, McGraw Hill.

Carrying costs are increased as inventory level increased.

Shortage costs are decreased as inventory level increased.

Total costs are the sum of currying and shortage costs.

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Figure 2

Optimal Amount of Receivables

As shown in Figure 2, carrying costs increase and opportunity costs decrease as

amount of credit extended increase and we attempt to identify the minimum total cost

point $*. The carrying costs associated with granting a credit essentially comes from

either the costs of cash discounts offered by the firm who grant the credit to it’s

customers who pay early, or its could come from losses of bad debts, or its could be

associated with managing credit and credit collections and running the credit

department. Opportunity cost is the additional profit results from credit sales that are

lost because credit is not granted (see Ross et al, 2008)3.

Optimal Accounts Payable

3 Although there is many optimal amount of credit is easy to identify but it’s difficult to quantify as pointed by Ross et al, (2008) there was some attempts to quantify the optimal amount of credit as in the study of Liebman (1972).

Carrying Costs

$*

Optimal Amount of Credit

Opportunity Costs

Total Costs

Amount of Receivables

Cost of Granting Receivables

Source: Ross, Westerfield, and Jordan, 2008, Corporate Finance Fundamentals, Eighth's Edition, McGraw Hill.

Carrying costs are increased when the amount of receivables granted are increased.

Opportunity costs are the lost sales resulting from not granting credit. These costs decreased when the amount of receivables are increased.

Total costs are the sum of currying and opportunity costs.

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Trade credit is an alternative financing choice to the short-term borrowing, trade

credit is “free” but short-term borrowing is “costly”. When the company extends its

trade credit by increasing its accounts payable it will save the cost of short-term

borrowing. This means an increase of accounts payable associated with a decrease of

short-term borrowing cost or “opportunity cost of short-term borrowing”. When the

accounts payable increase some other kind of cost also increase, for example the

carrying cost which are the cost of managing and running the payable department

increases as the account payable increase. Other cost could also increase when

accounts payable increase, for example, the possibility that a company could delay

it’s payment to suppliers increase when the company extend it’s trade credit, this

could damage the company’s credit reputation and the company could lose some of

the cash discounts offered by suppliers.

As shown in Figure 3, carrying costs increase and opportunity cost of short-term

borrowing decrease as accounts payable amount increase and we attempt to identify

the minimum total cost point $*4.

4 There were some attempts to quantify the optimal amount of payables by Nerville and Tavis, (1973).

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Figure 3

Optimal Amount of Payables

Some Empirical Evidence

Although the suggested optimal cash conversion cycle, optimal net trade cycle and

optimal operating cycle as more comprehensive and more accurate measure of the

efficiency of working capital management comparing with the operating cycle, the

cash conversion cycle, the weighted cash conversion cycle, and the net trade cycle,

the information needed to test for it’s effectiveness is not available for external

examiners. However, as a proxy, we test the stability of the effects of cash conversion

cycle, net trade cycle and operating cycle on corporate performance over time.

However, if our results show that the signs of operating cycle, the cash conversion

cycle, the weighted cash conversion cycle are not always positive and significant; this

Carrying Costs

$*

Optimal Amount of Payables

Opportunity Cost

of Short-Term

Borrowing

Total Costs

Amount of Payables

Cost of Payables

Carrying costs and delay of payments costs are increased when the amount of payables are increased.

Opportunity costs of borrowing decreased when the amount of payables are increased.

Total costs are the sum of currying and opportunity costs.

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signify the importance of identifying optimal levels of inventory, receivables and

payables and the optimal cash conversion cycle, the optimal net trade cycle and the

optimal operating cycle as more accurate measure of working capital management.

Therefore, in the following sections, we seek to examine the relationship between the

length of the cash conversion cycle, the length of the net trade cycle and the length of

the operating cycle and the firm’s profitability for different periods of time.

Additionally, to examine the relationship between the lengths of receivable collection

period, inventory conversion period, payable deferral period and firm’s profitability.

A dynamic panel data analysis is used to test for the relationships between our

variables. Our analysis is based on a sample of 5802 U.S. non-financial firms listed in

the New York Stock Exchange, American Stock Exchange, NASDAQ Stock Market

and the Over The Counter Market for the period 1990-2004 (87030 firm-year

observations).

Data and Methodology

The data set obtained from the Datastream &World Scope. The data includes yearly

data of sales, cost of good sold, receivables, payables, inventory, and operating

income. This data is used to calculate the receivable collection period, the inventory

conversion period, the payable deferral period, the cash conversion cycle, and the

operating income to sales. The data includes all the non-financial firms listed in the

New York Stock Exchange, American Stock Exchange, NASDAQ Stock Market and

the Over The Counter Market. Some firms with missing values are excluded from the

sample. The final sample contains 5802 companies covering the period of 1990-2004

(87030 firm-year observations).

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To investigate the relationships between our variables we use a Generalized Method

of Moment System Estimation (GMM) applied to dynamic panel data. We used this

estimation for the following reasons: first, our dependent variables are likely to be

measured using annual data, and it seemed desirable to use a dynamic specification to

allow for it, secondly, some of our exploratory variables (for example; the inventory

conversion period, the receivable collection period and the payable deferral period)

are likely to be jointly determined with the dependent variables in our model. Finally,

there is a possibility of unobserved province specific effects correlated with the

regressors, and it seemed desirable to control for such effects. De Granwe and

Skdenly (2000) mention that the lagged dependent variable in the dynamic panel data

estimation catch up some of the effects of omitted variables varying over time, so it

helps to correct for autocorrelation. The Generalized Method of Moment System

Estimation applied in this study is proposed by Arellano and Bover (1995) and

Blundell and Bond (1998), the authors have shown in Monte Carlo estimations that

the estimators behaves better than the GMM difference estimators proposed by

Arellano and Bond (1991) for the short sample period and for variables are persistent

over time. Roodman (2005) mentions that the Arellano-Bond estimators have one and

two steps variants. He argue that the two-step estimates of the standard errors tend to

be severely downward biased, therefore, we apply the finite sample correction for the

asymptotic variance of the tow step GMM estimator (see Windmeijer, 2005). This

estimation approach leads to the following estimation equations:

ititititititititit cccpdpicprcpsgtdeqroisoisit

εββββββββα +++++++++=− 87654321 1

(8)

itititititititititit nccpdpicprcpsgtdeqroisois εββββββββα +++++++++=− 87654321 1

(9)

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ititititititititit ocicprcpsgtdeqroisois εβββββββα ++++++++=−− 11 8654321

(10)

Where (itois ) is the first deference the operating income to sales, the exploratory

variables in our model includes ( itois ) which is the differenced lagged dependent

variable of operating income to sales, (itrcp ) is the first difference of receivable

collection period that measure the average number of days from the sale of goods to

collection of resulting receivables. It is calculated as [(account receivable/sales)

*365]. ( iticp ) is the first difference of the inventory conversion period which is the

length of time on average needed to convert raw materials into finished goods and

selling these goods. It is calculated as [(inventory/cost of good sold)*365]. ( itpdp ) is

the first difference of the payable deferral period which is the average length of time

needed to purchase goods and the payments for them. It is calculated as [(account

payable/cost of goods sold)* 365]. ( itccc ) is the first difference of cash conversion

cycle which is simply calculated as [Receivable collection period + Inventory

conversion period - Payable deferral period]. ( itncc ) is the first difference of net trade

cycle which is simply calculated as [Receivable collection period + Inventory

conversion period - Payable deferral period] where inventory conversion period and

payable deferral period are expressed in the form of day’s sales. ( itoc ) is the first

difference of the operating cycle which is simply calculated as [Receivable collection

period + Inventory conversion period]. The exploratory variables in our models also

include some control variables such as ( itsg ), which represents sales growth [(this

year’s sales – previous year’s sales)/ previous year’s sales] and total debt to equity

ratio ( ittde ). In addition, we examine the relationship between profitability and

liquidity using a traditional measure of liquidity the quick ratio ( itqr ). In this study we

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hypothesize that shortening the length of the cash conversion cycle improves the

company’s performance, we also hypothesize that shortening the length of the net

trade cycle improves the company’s performance, and shortening the length of the

operating cycle improves the company’s performance. This means that the coefficient

of the cash conversion cycle, the coefficient of the net trade cycle, and the coefficient

of the operating cycle should be significant and negative for the whale period of the

study and also for the sub periods. We also hypothesis that shortening the length of

the receivable collection period increases the company’s performance, and we expect

the coefficient of the receivable collection period to be significant and negative for the

whale period of the study and also for the sub periods. We also hypothesize that

shortening the length of the inventory conversion period increases the company’s

performance, and we expect the coefficient of the inventory conversion period to be

significant and negative for the whale period of the study and also for the sub periods.

And finally, we hypothesize that lengthening the payable deferral period should

increase the company's performance, and the coefficient of the payable deferral period

should be significant and positive for the whale period of the study and also for the

sub periods.

Empirical Results

In this section we present our estimation results concerning the determinants of

working capital management on corporate performance. The estimated coefficients

based on equation (1) reported on table (1) show that the length of the cash

conversion cycle ( itccc ) has negative and significant impact on firm’s performance

for the whole period. The results also show that the coefficient of the cash conversion

cycle for the first period is positive and insignificant, the coefficient of the cash

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conversion cycle for the second period is positive and insignificant, and, the

coefficient of the cash conversion cycle for the third period is negative and

significant. These results indicate that shortening the cash conversion cycle does not

always improve the firm’s profitability. The results also show that the coefficients of

the payable deferral period ( itpdp ) for the whole period and all sub-periods of the

study are significant and negative; this indicates that lengthening the payable deferral

periods reduces the firm’s performance instead of improving it. The results reported

on table (1) show that the coefficients of the receivable collection period (1−it

rcp ) and

the length of the inventory conversion period (1−it

icp ) had positive impact rather than

negative impact on the companies performance measured using the operating income

to sales ( itois ). This indicates that shortening the cash conversion cycle (1−it

ccc )

shortening the receivable collection period (1−it

rcp ) and shortening the inventory

conversion period (1−it

icp ) by reducing the time that cash are tied up in working

capital and by speeding up collections results on low operating income to sales

( itois ). However, the results on the existing literature show that the cash conversion

cycle (1−it

ccc ), the receivable collection period (1−it

rcp ), and the inventory conversion

period (1−it

icp ) had a negative impact on the company's performance (itois ) (see

Deloof, 2003) the positive sign of coefficient of the inventory conversion period

(1−it

icp ) could be interpreted by the fact that shortening the inventory conversion

period (1−it

icp ) could increase the stock out cost (or shortage cost) of inventory which

results on losing sales opportunities and leads to poor performance. Similarly, the

positive sign of coefficient of the receivable collection period (1−it

rcp ) could be

interpreted by the fact that shortening the receivable collection period (1−it

rcp ) makes

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the company to louse it’s good credit customers that results in a reduction of the

company’s sales. The results also show that the payable deferral period (1−it

pdp ) had

significant negative impact on performance ( itois ) instead of having a positive impact

as reported on the existing literatures (see Deloof, 2003). The negative sign of the

payable deferral period (1−it

pdp ) imply that slowing down payments to suppliers

causes damages the companies' credit reputation and result in a poor performance.

Looking at the lagged operating income to sales (1−it

ois ) indicates that the company's

performance in the previous period have a strong positive effect on the company’s

performance in the current period. We also examine whether the companies

performance is affected by other variables; the results show that increases in the quick

ratio ( itqr ) is negatively associated with firm’s performance ( itois ), this result certify

the traditional trade off between profitability and liquidity. Sales growth ( itsg ) is

positively related to the firm’s performance ( itois ), the results show that total debt to

equity ( ittde ), as a measure of capital structure is not significantly related to

profitability (itois ). The results of the Sargan test does not reject our instrument used,

and the results of Arellano-Bond test that the average autocoveriance in residuals of

order 1 and 2 is 0 does not reject the null hypothesis of no second-order serial

correlation.

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Table 1

Tow-Steps Results of GMM System Estimation for the Relationship between Working Capital

Management Measures Including the Cash Conversion Cycle and Firm's Performance

Dependent Variable: OIS

Coefficients

Exploratory

Variables: Full period 1990-2004

First period 1990-1994

Second period 1995-1999

Third period 2000-1994

LOIS 0.1093742** 0.3891377 0.1754836** 0.0521925** QR -0.0209257* 0.0071134 -0.0309328* 0.0572961* TDE 6.04e-08 -2.97e-07 -4.49e-07 5.30e-07 SG 0.0027879 0.004226 0.0293055 0.0018839 RCP -0.0169117** 0.0002769 -0.001792 -0.0169529** ICP -0.0015936** 0.0011912 0.0023982** -0.0020329 PDP -0.0057129** -0.0014022 -0.0038863** -0.0069267** CCC -0.0024813** -0.0006869 -0.0014406** -0.002616**

Constant -0.0196783** 0.0017403 0.0016587 -0.0401378* Sargan 101.76 4.17 24.47 63.14

Order 1 -1.16 -1.67 -1.53 -1.14 Order2 0.79 -1.03 0.16 0.87

Note: * significant at 95% confidence level, * *significant at 99% confidence level Table 1 reports the results of Arellano-Bond dynamic panel-data two- steps GMM system estimation for the relationship between the components of working capital management and firm's performance for an unbalanced sample of 5802 U.S. non-financial firms listed in the New York Stock Exchange, American Stock Exchange, NASDAQ Stock Market and the Over The Counter Market for the period 1990-2004 and the three sub-periods. The dependent variable and all the independent variables are in the form of first difference. (OIS) is the dependent variable of operating income to sales, the exploratory variables are: (LOIS) is the lagged operating income to sales, (QR) is the quick ratio, (TDE) is the total debt to equity ratio, (SG) is the sale growth, (RCP) is the receivable collection period, (ICP) is the

inventory conversion period, (PDP) is the payable deferral period, and (CCC) is the cash conversion cycle. Sargan is the Sargan test of over-identifying restrictions, P> Chi2. Order 1 is the Arellano-Bond test that average autocovariance in residuals of order 1 is 0, and Order2 is the Arellano-Bond test that average autocovariance in residuals of order 2 is 0.

Table 2


Management Measures Including the Net Trade Cycle and Firm's Performance


Coefficients

Exploratory





LOIS -0.8633548** -1.877821** .0608843** -0.0459073

QR -0.2516475** -0.0145362** -.1053771** -0.0037797

TDE -1.37e-08 7.52e-09 -6.87e-06 3.12e-06

SG -0.2422801** -0.5252024** .0156748** -0.0167827

RCP 0.0082238** 0.002182** .0039755** 0.0058274

ICP -0.0302019** -0.0020263** -.01653** -0.0174298

PDP -0.0045405** -0.0112586** -.0036845** -0.0038884

NTC 0.0012844** -0.0003207** -.0021981** -0.001714

Constant -0.025087** -0.0502549** -.0201984** -0.0079269

Sargan 95.34 118.19* 108.15 124.41*

Order 1 -1.00 -1.26 -1.12 -1.49

Order2 -0.48 -0.97 -1.01 -1.50


inventory conversion period, (PDP) is the payable deferral period, and (NTC) is the net trade cycle. Sargan is the Sargan test of over-

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identifying restrictions, P> Chi2. Order 1 is the Arellano-Bond test that average autocovariance in residuals of order 1 is 0, and Order2 is the Arellano-Bond test that average autocovariance in residuals of order 2 is 0.

Table 3


Management Measures Including the Operating Cycle and Firm's Performance


Coefficients

Exploratory





LOIS 0.3568988** -0.2534245** 0.643047** 0.2360323**

QR 0.0592325** 0.1027286** -0.0325934** -0.0181161**

TDE -7.14e-07 6.18e-06** -5.46e-06* 4.56e-08

SG 0.1050283** -0.0413975** 0.0875618** 0.1721182**

RCP -0.0020604** -0.0038678** -0.0041003** 0.0020457**

ICP 0.0015482** 0.005273** 0.0020449** -0.0031134**

OC -0.0013115** -0.0017843** -0.0019953** -0.0001568

Constant 0.0033737* -0.0049928** 0.0031675* -0.0023532*

Sargan 110.81 99.26 90.10 124.34*

Order 1 -2.02* -0.91 -2.09* -0.99

Order2 -1.01 0.85 0.61 -1.16


inventory conversion period, (PDP) is the payable deferral period, and (OC) is the operating cycle. Sargan is the Sargan test of over-identifying restrictions, P> Chi2. Order 1 is the Arellano-Bond test that average autocovariance in residuals of order 1 is 0, and Order2 is the Arellano-Bond test that average autocovariance in residuals of order 2 is 0.

The results of the empirical analysis of this paper suggest that shortening the cash

conversion cycle reduces rather than increases firm’s profitability. This signifies the

importances of identifying an optimal length of the cash conversion cycle were the

total holding and opportunities costs of current assets are minimized and profitability

of firms are maximized.

3. Conclusion

One of comprehensive measures of working capital management efficiency is the

cash conversion cycle that conceders all financial flows associated with inventory,

receivable and payables. The traditional link between the cash conversion cycle and

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firm's profitability and market value is that reducing the cash conversion cycle by

reducing the time that cash are tied up in working capital improves firm’s profitability

and market value. This could happen by shortening the inventory conversion period

via processing and selling goods to customers more quickly, by shortening the

receivable collection period by speeding up collections, or by lengthening the payable

deferral period via slowing down payments to suppliers. On the other hand,

shortening the cash conversion cycle could harm the firm's profitability; reducing the

inventory conversion period could increase the shortage cost, reducing the receivable

collection periods could makes the company's to louse it's good credit customers, and

lengthening the payable period could damage the firm's credit reputation. However,

achieving the optimal levels of inventory, receivable, and payable will minimizes the

carrying cost and opportunity cost of holding inventory, receivable, and payable and

leads to an optimal length of the cash conversion cycle. Hence, we suggest an optimal

cash conversion cycle as more accurate and comprehensive measure of working

capital management that maximizes sales, profitability and market value of firms.

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