Proposal for the final project1.0 TITLE

“The impact of Working Capital Management on Profitability.”

2.0 INTRODUCTION

Working capital is a very important component of corporate finance because it

directly affects the liquidity and profitability of the company. It deals with the

current assets and current liabilities. Current assets of a typical manufacturing firm

accounts for over half of its total assets, and for a distribution company, they

account for even more. Companies with too few current assets may incur shortages

and difficulties in maintaining their smooth operations. Working capital

management involves the decision of the amount, composition and financing of

current assets. Current assets include all those assets that in the normal course of

business return to the form of cash within a short period of time, normally within a

year and such temporary investments may be readily converted into cash upon need.

The main focus of this research will be on working capital management and its

effects on profitability for a sample of 43 out of 100 top companies listed on Karachi

Stock Exchange as on May 07, 2010. The main objectives are:

To establish a relationship between Working Capital Management and

Profitability over a period of four years.

To find out the effects of different components of working capital

management on profitability.

To establish a relationship between liquidity and profitability.

To find out the relationship between profitability and size.

To draw conclusions about relationship of working capital management and

profitability.

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Proposal for the final project

3.0 LITERATURE REVIEW

Many researchers have studied working capital management and Profitability from

different views and in different environment. The following ones are useful for my

research.

3.1 GARCÍA-TERUEL AND MARTÍNEZ-SOLANO

They investigated the effect of Working Capital Management on Profitability for a

sample of 8,872 Small and Medium-Sized Spanish firms covering the period 1996-

2002. They studied the impact of Working Capital Management variables – number

of days Accounts Receivable (AR), number of days Accounts Payable (AP), number

of days Inventory (INV), and the Cash Conversion Cycle (CCC) – on the Return on

Assets (ROA). They concluded that there is a significant negative relation between

an SME’s profitability and the number of days accounts receivable and days of

inventory. They cannot, however, confirmed that the number of days accounts

payable affects an SME’s return on assets. According to them, the reason is that this

relation loses significance when we control for possible endogeneity problems. They

also concluded that SMEs have to be concerned with working capital management

because they can also create value by reducing their cash conversion cycle to a

minimum, as far as that is reasonable.

3.2 LAZARIDIS TRYFONIDIS

They investigated the relationship of corporate profitability and working capital

management. For this purpose they used a sample of 131 companies listed in the

Athens Stock Exchange (ASE) for the period of 2001-2004. They studied the impact

of working capital management variables – Cash Conversion Cycle (CCC), number

of days accounts receivables (A/R), number of days inventory (INV), and number of

days accounts payable (A/P) – on profitability, measured through gross operating

profit. They found a statistical significance between profitability and cash

conversion cycle. They concluded that there is a negative relationship between

profitability and working capital management. They observed that lower gross

operating profit is associated with an increase in the number days of accounts

payables. They argued that managers can create profits for their companies by 2

Proposal for the final projecthandling correctly the cash conversion cycle and keeping each different component

(accounts receivables, accounts payables, inventory) to an optimum level.

3.3 HAITHAM NOBANEE

He studied the relationship between Working Capital Management and firm’s

profitability and suggests an optimal Cash Conversion Cycle. He concluded 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. He also argued that 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. 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.

3.4 AFZA AND NAZIR (2007)

They investigated the relationship between the aggressive/conservative working

capital policies for large sample of 263 public limited companies (seventeen

industrial groups) listed at Karachi Stock Exchange for a period of 1998-2003.

Using ANOVA the study found significant differences among their working capital

investment and financing policies across different industries. Rank order correlation

confirmed that these significant differences were remarkably stable over the period

of six years of study. Finally, ordinary least regression analysis (OLS), found a

negative relationship between the profitability measures of firms and degree of

aggressiveness of working capital investment and financing policies.

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Proposal for the final project3.5 KESSEVEN PADACHI (2005)

The trend in working capital needs and profitability of firms are examined to

identify the causes for any significant differences between the industries. The

dependent variable, return on total assets is used as a measure of profitability and the

relation between working capital management and corporate profitability is

investigated for a sample of 58 small manufacturing firms, using panel data analysis

for the period 1998 –2003. The regression results show that high investment in

inventories and receivables is associated with lower profitability. The key variables

used in the analysis are inventories days, accounts receivables days, accounts

payable days and cash conversion cycle. A strong significant relationship between

working capital management and profitability has been found in previous empirical

work. An analysis of the liquidity, profitability and operational efficiency of the five

industries shows significant changes and how best practices in the paper industry

have contributed to performance. Their findings also reveal an increasing trend in

the short-term component of working capital financing.

4.0 RESEARCH METHODOLOGY

4.1 Data Collection

The data used in the study is acquired from the State Bank of Pakistan Peshawar

Branch. The period covered by this research is 18 years starting from 1990 to 2007.

The data comprises the balance sheets and income statements.

4.2 Sample Size

I have selected 35/100 top companies listed on Karachi Stock Exchange as on May

07, 2010 to find relationship between working capital management and the

profitability. Sample is based on the financial statements of these firms with data

such as current assets, current liabilities, sales, cost of goods sold, inventory,

accounts receivable, accounts payable, total assets, total liabilities, operating income

and depreciation.

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Proposal for the final project4.3 Analysis

MS Excel and SPSS have been used for descriptive and quantitative analysis in this

research study. First descriptive analysis will be done to find the average, standard

deviation, minimum and maximum values of different variables. Then I will apply

the statistical technique of regression to find the impact of the working capital

management on the profitability of the sample firms. Different types of the

regression analysis would be used in this research study.

5.0 HYPOTHESES TESTING

Since the objective of this research is to examine the relationship between

profitability and working capital management, the study makes a set of testable

hypotheses { the Null Hypotheses Ho versus Alternative ones H1 }

5.1 Hypotheses 1

The first hypotheses of this research is as follows

H01: There is no relationship between efficient working capital management and

profitability of Pakistani firms.

H11: There is a possible positive relationship between efficient working capital

management and profitability of Pakistani firms. Firms more efficient in

managing their working capitals are expected to pose high level of

profitability and vice versa.

5.2 Hypothesis 2

The second hypothesis of the study is as follow:

H02: There is no relationship between liquidity and profitability of Pakistani

firms.

H12: There may exist a negative relationship between liquidity of Pakistani firms

and profitability.

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Proposal for the final project5.3 Hypothesis 3

The Third hypothesis of the study is as follow:

H03: There is no relationship between size of firms in Pakistan and profitability.

H13: There may exist a positive relationship between the firm size and its

profitability.

5.4 Hypothesis 4:

The Fourth hypothesis of the study is as follow:

H04: There is no relationship between debt used by Pakistani firms and

profitability.

H14: There is a possible negative relationship between debt used by Pakistani

firms and their profitability.

6.0 DISCUSSION

Although a lot of research has been conducted on the relationship between efficient

Working capital management and firm profitability but very little research has been

done on this topic in Pakistan. I am going to conduct a research on Working capital

management of Pakistani firms. For this purpose, I took 100 top companies listed on

KSE as on May 07, 2010 and excluded banking and financial sector and some of the

companies were not listed on KSE during 1990-1996. So the final number of

companies I have left is 45. But to reach at more precise and accurate results, I am

taking the data of 18 years. These companies represent each and every sector

excluding banking and financial sector.

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