presentasi 5 - impact of aggresive working capital management policy on firms profitability

7/23/2019 Presentasi 5 - Impact of Aggresive Working Capital Management Policy on Firms Profitability

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Impact of Aggressive Working Capital

Management Policy on Firms’ Profitability

Mian Sajid Nair! and "alat Afa!!

The present study investigates the traditional relationship between working capital management policies and a firm’s

profitability. Using the panel data set for the period 1998-!!"# the impact of aggressive working capital investment and

financing policies has been evaluated using return on assets as well as Tobin’s $. %anagers can create value if they adopt a

conservative approach towards working capital investment and working capital financing policies. The study also finds that

investors give weight to the stocks of those firms that adopt an aggressive approach to managing their short-term liabilities.

Introd#ction

The corporate finance literature has traditionally focused on the study of long-term financial

decisions, particularly investments, capital structure, dividends or company valuationdecisions. However, short-term assets and liabilities are important components of total assets

and need to be carefully analyzed. Management of these short-term assets and liabilities

warrants a careful investigation since the working capital management plays an important role

in a firms profitability and risk as well as its value !"mith, #$%&'. (fficient management of

working capital is a fundamental part of the overall corporate strategy in creating the

shareholders value. )irms try to keep an optimal level of working capital that ma*imizes their

value !+eloof, && Howorth and /esthead, && and 0fza and 1azir, &&2'.

3n general, from the perspective of 4hief )inancial 5fficer !4)5', working capital

management is a simple and straightforward concept of ensuring the ability of the organization

to fund the difference between the short-term assets and short-term liabilities !Harris, &&6'.

However, a Total approach is desired as it can cover all the companys activities relating to

vendor, customer and product !Hall, &&'. 3n practice, working capital management has

become one of the most important issues in the organizations where many financial e*ecutives

are struggling to identify the basic working capital drivers and an appropriate level of working

capital !7amberson, #$$6'. 4onse8uently, companies can minimize risk and improve the

overall performance by understanding the role and drivers of working capital management.

0 firm may adopt an aggressive working capital management policy with a low level of

current assets as a percentage of total assets, or it may also be used for the financing decisions

of the firm in the form of high level of current liabilities as a percentage of total liabilities.

(*cessive levels of current assets may have a negative effect on the firms profitability,

whereas

9 7ecturer, +epartment of Management "ciences, 45M"0T" 3nstitute of 3nformation Technology !433T', 7ahore, :akistan and is the

corresponding author. (-mail; snazir<ciitlahore.edu.pk 99 +ean, )aculty of =usiness 0dministration, 45M"0T" 3nstitute of

3nformation Technology !433T', 7ahore, :akistan. (-mail; talatafza<ciitlahore.edu.pk

> &&$ 3?: 0ll @ights @eserved.

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& The 3?: Aournal of 0pplied )inance, Bol. #6, 1o. %, &&$

a low level of current assets may lead to a lower level of li8uidity and stockouts, resulting in

difficulties in maintaining smooth operations !Ban Horne and /achowicz, &&C'.

The main obDective of working capital management is to maintain an optimal balance

between each of the working capital components. =usiness success heavily depends on thefinancial e*ecutives ability to effectively manage receivables, inventory, and payables !)ilbeck

and Erueger, &&6'. )irms can reduce their financing costs andFor increase the funds available

for e*pansion proDects by minimizing the amount of investment tied up in current assets. Most

of the financial managers time and efforts are allocated towards bringing non-optimal levels of

current assets and liabilities back to optimal levels !7amberson, #$$6'. 0n optimal level of

working capital would be the one in which a balance is achieved between risk and efficiency. 3t

re8uires continuous monitoring to maintain proper level in various components of working

capital, i.e., cash receivables, inventory and payables, etc.

3n general, current assets are considered as one of the important components of total assets

of a firm. 0 firm may be able to reduce the investment in fi*ed assets by renting or leasing

plant and machinery, whereas the same policy cannot be followed for the components ofworking capital. The high level of current assets may reduce the risk of li8uidity associated

with the opportunity cost of funds that may have been invested in long-term assets. Though the

impact of working capital policies on profitability is highly important, only a few empirical

studies have been carried out to e*amine this relationship. This study investigates the potential

relationship of aggressiveFconservative policies with the accounting and market measures of

profitability of :akistani firms using a panel data set for the period #$$%-&&6. The present

study is e*pected to contribute to better understand these policies and their impact on

profitability, especially in emerging markets like :akistan.

$iterat#re %evie&

Many studies have analyzed the financial ratios as a part of working capital managementhowever, very few of them have discussed the working capital policies in specific. Gupta

!#$$' and Gupta and Huefner !#$2' e*amined the differences in financial ratio averages

among industries. The conclusion of both the studies was that differences do e*ist in mean

profitability, activity, leverage and li8uidity ratios among industry groups. Aohnson !#$2&'

e*tended this work by finding cross-sectional stability of ratio groupings for both retailers and

primary manufacturers. :inches et al. !#$2' used factor analysis to develop seven

classifications of ratios and found that the classifications were stable over the #$6#-#$$ time

period.

)ilbeck and Erueger !&&6' highlighted the importance of efficient working capital

management by analyzing the working capital management policies of non-financial

industries in the ?". 0ccording to their findings, significant differences e*ist among industriesin working capital practices overtime. Moreover, these working capital practices, themselves,

change significantly within industries overtime. "imilar studies were conducted by Gombola

and Eetz !#$%', 7ong et al. !#$$', "oenen !#$$' and Ma*well et al. !#$$%'.

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3mpact of 0ggressive /orking 4apital Management :olicy on )irms :rofitability #

However, /einraub and Bisscher !#$$%' discussed the issue of aggressive and conservative

working capital management policies by using 8uarterly data for the period #$%C-$ of the ?"

firms. Their study considered #& diverse industry groups to e*amine the relative relationship

between their aggressiveFconservative working capital policies. Their study concluded that the

industries had distinctive and significantly different working capital management policies.

Moreover, the relative nature of the working capital management policies e*hibited

remarkable stability over the #&-year study period. The study also showed a high and

significant negative correlation between industry asset and liability policies and found that

when relatively aggressive working capital asset policies are followed, they are balanced by

relatively conservative working capital financial policies.

3n literature, there is a long debate on the riskFreturn tradeoff among different working

capital policies !:inches, #$$# =righam and (hrhardt, &&C Gitman, &&6 and Moyer et al.#

&&6'. More aggressive working capital policies are associated with higher return and risk,

while conservative working capital policies are associated with lower risk and return !Gardner

et al.# #$% and /einraub and Bisscher, #$$%'. /orking capital management is important

because of its effects on the firms profitability and risk, and conse8uently its value !"mith,

#$%&'. The greater the investment in current assets, the lower the risk, but also the lower the

profitability obtained. 4ontrary to this, 4arpenter and Aohnson !#$%' provided empirical

evidence that there is no linear relationship between the level of current assets and revenue

systematic risk of the ?" firms however, some indications of a possible nonlinear relationship

were found, which were not highly statistically significant.

"oenen !#$$' investigated the relationship between the net trade cycle as a measure of

working capital and return on investment in the ?" firms. The results of chi-s8uare test

indicated a negative relationship between the length of net trade cycle and return on assets.

)urthermore, this inverse relationship was found different across industries depending on the

type of industry. 0 significant relationship for about half of the industries studied indicated that

results might vary from industry to industry. 0nother aspect of working capital management

has been analyzed by 7amberson !#$$6' who studied how small firms respond to changes in

economic activities by changing their working capital re8uirements and level of current assets

and liabilities. 4urrent ratio, current assets to total assets ratio and inventory to total assets

ratio were used as a measure of working capital re8uirement, while the inde* of annual

average coincident economic indicator was used as a measure of economic activity. 4ontrary

to the e*pectations, the study found that there is a very small relationship between changes in

economic conditions and changes in working capital.

3n order to validate the results of "oenen !#$$' on a large sample and with a longer time

period, Aose et al. !#$$' e*amined the relationship between aggressive working capital

management and profitability of the ?" firms using 4ash 4onversion 4ycle !444' as a

measure of working capital management, where a shorter 444 represents the aggressivenessof working capital management. The results indicated a significant negative relationship

between the 444 and profitability, indicating that more aggressive working capital

management is associated with higher profitability. "hin and "oenen !#$$%' concluded that

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The 3?: Aournal of 0pplied )inance, Bol. #6, 1o. %, &&$

reducing the level of current assets to a reasonable e*tent increases a firms profitability.

"imilarly, +eloof !&&' analyzed a sample of large =elgian firms for the period #$$-#$$

and the results confirmed that =elgian firms can improve their profitability by reducing the

number of days accounts receivable are outstanding and reducing inventories. Teruel and"olano !&&6' suggested that managers can create value by reducing their firms number of

days accounts receivable and inventories. "imilarly, shortening the 444 also improves the

firms profitability.

3n the :akistani conte*t, @ehman !&&' investigated the impact of working capital

management on the profitability of $C :akistani firms listed on 3slamabad "tock (*change

!3"(' for the period #$$$-&&C. He studied the impact of the different variables of working

capital management, including average collection period, inventory turnover in days, average

payment period and 444 on the net operating profitability of firms. He concluded that there is

a strong negative relationship between working capital ratios mentioned above and profitability

of firms. )urthermore, managers can create a positive value for the shareholders by reducing

the 444 up to an optimal level. "imilar studies on working capital and profitability include

"mith and =egemann !#$$2', Howorth and /esthead !&&', (lDelly !&&C', Ghosh and MaDi

!&&C' and 7azaridis and Tryfonidis !&&'.

0fza and 1azir !&&2' investigated the relationship between the aggressive and

conservative working capital policies for #2 industrial groups and a large sample of public

limited companies listed on Earachi "tock (*change !E"(' using cross-sectional data for the

period #$$%-&&. ?sing 0nalysis of Bariance !015B0' and 7east "ignificant +ifference

!7"+' test, the study found significant differences among their working capital investment and

financing policies across different industries. Moreover, rank order correlation confirmed that

these significant differences were remarkably stable over the si*-year study period. )inally,

ordinary least regression analysis found a negative relationship between the profitability

measures of firms and the degree of aggressiveness of working capital investment and

financing policies. The present study further validates the impact of the degree of

aggressiveness of working capital policies on market measures of profitability, i.e., Tobins 8

using panel data approach.

%esearc' Met'odology

(ariables )sed in t'e St#dy

This study uses aggressive investment policy as used by /einraub and Bisscher !#$$%', who

analyzed working capital policies of # industrial firms in the ?" market. 0ggressive

3nvestment :olicy !03:' results in minimal level of investment in current assets versus fi*ed

assets. 3n contrast, a conservative investment policy places a greater proportion of capital inli8uid assets with the opportunity cost of less profitability. 3f the level of current assets

increases in proportion to the total assets of the firm, the management is said to be more

conservative in managing the current assets of the firm. 3n order to measure the degree of

aggressiveness of working capital investment policy, the following ratio was used;

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3mpact of 0ggressive /orking 4apital Management :olicy on )irms :rofitability

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03:Total 4urrent 0ssets !T40'

Total 0ssets !T0'

where a lower ratio means a relatively aggressive policy.

5n the other hand, an 0ggressive )inancing :olicy !0):' utilizes higher levels of current

liabilities and less long-term debt. 3n contrast, a conservative financing policy uses more long-

term debt and capital and less current liabilities. The firms are more aggressive in terms of

current liabilities management if they are concentrating on the use of more current liabilities

which put their li8uidity on risk. The degree of aggressiveness of a financing policy adopted by

a firm is measured by working capital financing policy, and the following ratio is used;

. __ Total 4urrent 7iabilities !T47'0): I -------------------------------- 5-- -- --

Total 0ssets !T0'

where a higher ratio means a relatively aggressive policy.

The impact of working capital policies on the profitability has been analyzed through

accounting measures of profitability as well as market measures of profitability, i.e., @eturn on

0ssets !@50' and Tobins 8. These variables of return are calculated as;

!@50 ' 1et (arnings0fter Ta*es !1(0T'

=ook Balue of 0ssets !=B0'

Tobins 8 compares the value of a company given by financial markets with the value of acompanys assets. 0 low 8 !between & and #' means that the cost to replace a firms assets is

greater than the value of its stock. This implies that the stock is undervalued. 4onversely, a high

8 !greater than #' implies that a firms stock is more e*pensive than the replacement cost of its

assets, which implies that the stock is overvalued. 3t is calculated as;

Tobins 8Market Balue of )irm !MB)'

=ook Balue of 0ssets !=B0'

where Market Balue of )irm !MB)' is the sum of book value of long plus short term and

market value of e8uity. Market value of e8uity is calculated by multiplying the number of shares

outstanding with the current market price of the stock in a particular year.

Control (ariables

3n working capital literature, various studies have used the control variables along with the

main variables of working capital in order to have an apposite analysis of working capital

management on the profitability of firms !7amberson, #$$6 "mith and =egemann, #$$2

+eelof, && (lDelly, &&C Teruel and "olano, &&6 and 7azaridis and Tryfonidis, &&'. 5n

the same lines, along with working capital variables, the present study has taken into

consideration some control variables relating to firms such as the size of the firm, the growth in

its sales, and its financial leverage. The size of the firm &'()*+ has been measured by the

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logarithm of its total assets, as the original large value of total assets may disturb the analysis.

The growth of firm &,/T0+ is measured by variation in its annual sales value with

reference to previous years sales J!"ulesi K 'ales# 1 +2'ales# _ A. Moreover, the financial

leverage &34,+ was taken as the debt to e8uity ratio of each firm for the whole sample

period. "ome studies, like +eloof !&&' in his study of large =elgian firms, also considered

the ratio of fi*ed financial assets to total assets as a control variable however, this variable

cannot be included in the present study because of unavailability of data, as most of the firms

do not disclose full information in their financial statements. )inally, since good economic

conditions tend to be reflected in a firms profitability !7amberson, #$$6', this phenomenon

has been controlled for the evolution of the economic cycle using the ,56, variable, which

measures the real annual G+: growth in :akistan for each of the study year from #$$% to

&&6.

Statistical Analysis

The impact of aggressive and conservative working capital policies on the profitability of the

firms has been evaluated by applying the panel data regression analysis. The performancevariables &7 and Tobins 8' as well as the T72T7 and T32T7 along with the control

variables were regressed using the ":"" software. The following regression e8uations are run

to estimate the impact of working capital policies on the profitability measures.

7# a : 0 ;T7 / T7#' L 0 &'()*#' L 0 &,/T0#' L 0 &34,#'L 0 &,56,#' L s M

!#'

Tobins $# a : 7<T72T7#' L 0&'()*#' L 0&,/T0#' L

0&34,#' L 0 &,56,#'L s

and

7# a : 7 &T32T7#' L 0 &'()*#' L 0 !,/T0#' L 0 &34,#'

L 0 &,56,#' L s

Tobins $# a : 7&T32T7#' L 0 &'()*#'L 0 &,/T0#'L 0

&34,#' L 0 &,56,#' L s

Total current assets to total assets ratio Total

current liabilities to total assets ratio @eturn

on assets Balue of 8

1atural log of firm size

Growth of sales

where,

T7FT7

T3FT7 #

7#1

Tobins

$ # '()*#1

,/T0 #



34,. )inancial leverage of firms

,56, . I @eal 0nnual G+: growth rate of :akistan a

I 3ntercept and

s I (rror term of the model

Sample and +ata

The sample of the study consists of all non-financial firms listed on the Earachi "tock

(*change !E"('. E"( has divided the non-financial firms into various industrial sectors based

on their nature of business. 3n order to be included in the sample, a firm must be in business for

the whole study period. 0lso, firms should neither have been delisted by the E"( nor merged

with any other firm during the whole window period. 1ew incumbents in the market during the

study period have also not been included in the sample. )urthermore, firms must have complete

data for the period #$$%-&&6. )irms with negative e8uity during the study period have also

been e*cluded. Thus, the final sample consists of &C non-financial firms from #2 variousindustrial sectors.

This study used annual financial data of &C non-financial firms for the period #$$%-&&6.

The panel data set was developed for eight years and for the &C sampled firms which

produced #, year-end observations. The re8uired financial data for the purpose of the study

was obtained from the respective companies annual reports and publications of "tate =ank of

:akistan. The data regarding annual average market prices was collected from the daily

8uotations of E"(.

Analysis

Table # presents the results of regression model in which the impact of working capital

investment policy on the performance measurements has been e*amined. The )-values ofregression models run are found statistically significant, whereas +urbin-/atson statistics of

more than #.% indicate less correlation among the independent variables of the regressions

models. The t-statistics of working capital investment policy is positive and statistically

significant at #N level for @eturn on 0ssets and Tobins 8. The positive coefficient of T72T7

indicates a negative relationship between the degree of aggressiveness of investment policy and

return on assets. 0s the T72T7 increases, the degree of aggressiveness decreases, and return

on assets increases. Therefore, there is a negative relationship between the relative degree of

aggressiveness of working capital investment policies of firms and both performance measures,

i.e., @50 and Tobins 8. This similarity in market and accounting returns confirms the notion

that investors do not believe in the adoption of aggressive approach in the working capital

management, hence, they do not give any additional weight to the firms on E"(.

Table reports regression results for working capital financing policy and the performance

measures. The )-value of regression models and +urbin-/atson statistics indicate similar

results as reported in Table #. The negative value of ! coefficient for T32T7 also points out the

negative relationship between the aggressiveness of working capital financing policy and

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return on assets. The higher the T32T7 ratio, the more aggressive the financing policy, that

yields negative return on assets. However, surprisingly, the relationship between Tobins 8 and

working capital financing policy has been established as positive and statistically significant.

3nvestors were found giving more weight to the firms which are adopting an aggressive

approach towards working capital financing policy and having higher levels of short-term and

spontaneous financing on their balance sheets.

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"able ,- %egression Analysis of Performance Meas#res and Working Capital Investment Policy

(ariables ROA "obin’s .

P t/val#e P t/val#e

T72T7 &.#6% .6&999 &.#C$ .#6999

'()* &.&% .999 &.&$ .22#999

,/T0 &.#2 .%&6 -&.&&C -&.#&C

,56, &.&C #.26$9 &.# .2999

34, -&.& -6.&999 &.&&C &.#&#

= -value #2.#999 #$.C6999

1 #, -

5-/ #.%26 #.$C%

Note- 999 and 9 indicate significance levels at #N and #&N respectively.



"able 0- %egression Analysis of Performance Meas#res and Working Capital Financing Policy

(ariables

ROA "obin’s .

P t/val#e P t/val#e

T32T7 -&.#2# -.$C&999 &.&%2 .6&999

'()* &.&C .&999 &.&%2 .6999

,/T0 &.## .&C999 &.&## &.#

G+:G@ &.&## &.CC& &.# .62%999

34, -&.#% -C.%999 -&.&# -&.6C

= -value #%.999 #.$C999

1 #, -

5-/ #.% #.$

Note- 999 and 9 indicate significance levels at #N and #&N respectively.



The control variables used in the regression models are natural log of firm size, sales growth, real G+:

growth and the average leverage. 0ll the control variables have their impact on the performance of the firms.

)irms size causes the returns of the firms to be increased and it is found to be statistically significant. Moreover,

,/T0 and 34, are found to be significantly associated with the book-based returns on assets which

confirm the notion that leverage and growth are strongly correlated with the book value-based performance

measures !+eloof, && and (lDelly, &&C'. @eal G+: growth may not affect the returns based on book values

however, investors may react positively to a positive change in the level of economic activity which is in

accordance with the findings of 7amberson !#$$6'.

The above results contradict the findings of Gardner et al. !#$%', +eloof !&&', (lDelly

!&&C' and Teruel and "olano !&&6' however, they are in accordance with 0fza and 1azir

!&&2' and produced a negative relationship between the aggressiveness of working capital

policies and accounting measures of profitability. Managers cannot create value if they adopt

an aggressive approach towards working capital investment and working capital financing

policy. However, if firms adopt aggressive approach in managing their short-term liabilities,

investors give more value to those firms. The degree of aggressiveness of working capital

policies adopted helps only in creating shareholders wealth through increased market

performance, whereas accounting performance cannot be increased by being aggressive in

managing the working capital re8uirements. The results of this study are somewhat different

from those conducted in the developed economies. :akistan is one of the emerging economies

and :akistani markets are not fully transparent and efficient to fully absorb the impact of

information. The study results confirm this state of :akistani markets.

Concl#sion

The present study investigates the relationship between the aggressiveFconservative working

capital asset management and financing polices and its impact on profitability of &C :akistani

firms divided into # industrial groups by E"( for the period #$$%-&&6. The impact of

aggressiveFconservative working capital investment and the financing policies has beene*amined using panel data regression models between working capital policies and

profitability. The study finds a negative relationship between the profitability measures of

firms and degree of aggressiveness of working capital investment and financing policies. The

firms report negative returns if they follow an aggressive working capital policy. These results

were further validated by e*amining the impact of aggressive working capital policies on

market measures of profitability, which was not tested before. The results of Tobins 8 were in

line of the accounting measures of profitability and produced almost similar results for

working capital investment policy. However, investors were found giving more value to those

firms that are more aggressive in managing their current liabilities.

The study used a new measure of profitability, i.e., Tobins 8 and panel data regression

analysis, to investigate the relationship between working capital management and firm returnsin :akistan. The findings of the present study are e*pected to contribute significantly to finance

literature. The results of the present study are in contradiction to those of some

earlier studies on the issue. This phenomenon may be attributed to the inconsistent and volatile

economic conditions of :akistan. The reasons for this contradiction may further be e*plored in

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future researches.

The study also suggests some policy implications for the managers and prospective

investors in the emerging market of :akistan. )irms with more aggressive policy towards

working capital may not be able to generate more profit. "o, as far as the book value performance is concerned, managers cannot generate more returns on assets by following

aggressive approach towards short-term assets and liabilities. 5n the other hand, investors are

found giving more value to the firms that adopt an aggressive approach towards working

capital financing policies. The market value of firms using high level of current liabilities in

their financing is more than the book value. The investors believe that firms with less e8uity

and less long-term loans would be able to perform better than the others. However, there are

various other factors like agency problem which may play a pivotal role in such cases, and so

these factors may further be e*plored in future. O

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eference B !1?C!!9C!8C!C!1

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