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Working capital management and firm's performance--a study of Indian manufaturing companies.
Abstract:
The aim of this study is to analyze the effect of working capital management on firm's performance. In accordance with this aim to consider statistically significant relationship between firms Operating Profit Margin and the component of Working Capital Management of Indian Manufacturing companies for the period of2003 to 2008 has been analyzed under a multiple regression model. The findings of the study indicate that current asset to total asset, total debtors to total asset and inventory days are directly related variables with working capital management, and have significantly negative effects on firm profitability and the other variables included in the regression model (Asset Turnover, Gearing, Current liability to total asset, accounts payable and current ratio) have no statistically significant effect on firms profitability.

Key Words: Working Capital, Profitability, Operating profit, current asset, current liability.

Article Type:
Report
Subject:
Profitability (Investigations)
Working capital (Management)
Corporations (Finance)
Corporations (Analysis)
Authors:
Negi, Pushpa
Sankpal, Shilpa
Chakraborty, Anindita
Mathur, Garima
Pub Date:
04/01/2010
Publication:
Name: Abhigyan Publisher: Foundation for Organisational Research & Education Audience: Academic Format: Magazine/Journal Subject: Business; Social sciences Copyright: COPYRIGHT 2010 Foundation for Organisational Research & Education ISSN: 0970-2385
Issue:
Date: April-June, 2010 Source Volume: 28 Source Issue: 1
Topic:
Event Code: 980 Legal issues & crime; 200 Management dynamics Computer Subject: Company legal issue; Company business management
Geographic:
Geographic Scope: India Geographic Code: 9INDI India
Accession Number:
233291552
Full Text:
[ILLUSTRATION OMITTED]

Introduction

Working capital management is a very important component of corporate finance because it directly affects the liquidity and profitability of a company. The corporate finance literature has traditionally focused on the study of long term financial decisions. Researchers have particularly offered studies analyzing investments, capital structure, dividends or company valuation, among other topics. But the investment that firms make in short-term assets, and the resources used with maturities of under one year, represent the main share of items on a firm's balance sheet (Pedro and Pedro, 2007). A firm is required to maintain a balance between liquidity and profitability while conducting its day to day operations. Liquidity is a precondition to ensure that firms are able to meet its short-term obligations and its continued flow can be guaranteed from a profitable venture (Kesseven, 2006).

Review of Literature

Moss and Stine (1993) revealed that firm size was a factor in the length of the CCC and the study indicated that larger firms have shorter CCC. Further the study revealed that when the CCC was compared to the current and quick ratios, a significant positive relationship was found. While Jose et al. (1996) examined the relationship between aggressive working capital management and profitability of US firms using Cash Conversion Cycle (CCC) as a measure of working capital management where a shorter CCC represents the aggressiveness of working capital management. The results indicated a significant negative relationship between the cash conversion cycle and profitability indicating that more aggressive working capital management is associated with higher profitability.

Chiou and Cheng (2006) analyzed the determinants of working capital management and explored that how working capital management of a firm was influenced by the different variables like business indicators, industry effect, operating cash flows, growth opportunity for a firm, firm performance and size of firm. The study has depicted consistent results of leverage and operating cash flow for both net liquid balance and working capital requirements while variables like business indicator, industry effect, growth opportunities, performance of firm, and size of firm were unable to produce consistent conclusions for net liquid balance and working capital requirements of firms. In the study of Uyar (2009) he examined industry benchmarks for cash conversion cycle (CCC) of merchandising and manufacturing companies and found that merchandising industry has shorter CCC than manufacturing industries. He further examined the relationship between the length of the CCC and the size of the firms and the findings indicated a significant negative correlation between the length of CCC and the firm size, in terms of both net sales and total assets. The study further showed significant negative correlation between the length of CCC and the profitability.

Nazir and Afza (2008) used external and internal factors to explore the determinants of working capital requirements of a firm. Internal factors were operating cycle, operating cash flows, leverage, size, ROA, Tobin's q and growth while industry dummy and level of economic activity as external macroeconomic factors. They found that operating cycle, leverage, ROA and q had an influence on the working capital requirements significantly. The study further revealed that working capital management practices are also related to industry and different industries are following different working capital requirements. While Rehman (2006) studied the impact of the different variables of working capital management including Average Collection Period, Inventory Turnover in Days, Average Payment Period and Cash Conversion Cycle on the Net Operating Profitability of firms and concluded that there was a strong negative relationship between above working capital ratios and profitability of firms. Furthermore the study stated that managers can create a positive value for the shareholders by reducing the cash conversion cycle up to an optimal level.

Ramachandran and Janakiraman (2009) found negative relationship between EBIT and the cash conversion cycle (ccc). The study revealed that operational EBIT dictates how to manage the working capital of the firm. Further, it was found that lower gross EBIT was associated with an increase in the accounts payable days. Thus the study concluded that less profitable firms wait longer to pay their bills, taking advantage of credit period granted by their suppliers. While the positive relationship between average receivable days and firms EBIT suggested that less profitable firms will pursue a decrease of their accounts receivable days in an attempt to reduce their cash gap in the CCC. In the study of Ganesan (2007) he depicted that the working capital management efficiency was negatively associated to the profitability and liquidity. The study revealed that when the working capital management efficiency was improved by decreasing days of working capital, there was improvement in profitability of the firms in telecommunication firms in terms of profit margin. Padachi (2006) examined the trend in working capital needs and profitability of firms to identify the causes for any significant differences between the industries. The results showed that high investment in inventories and receivables was associated with lower profitability. The findings also revealed that an increasing trend in the short-term component of trend in the short-term component of working capital financing. In the study of Raheman and Nasr (2007) they studied the effect of Working Capital Management on liquidity as well on profitability of the firm. The results showed that there was a negative relationship between variables of the working capital management and profitability of the firm. Further the study also found that there was a negative relationship between liquidity and profitability and a positive relationship between size of the firm and its profitability and negative relationship between debt used by the firm and its profitability.

Afza and Nazir (2007a) found the negative relationship between working capital policies and profitability. In line with the study Afza and Nazir (2007b) further investigated the relationship between the aggressive/conservative working capital policies profitability as well as risk of public limited companies. They found a negative relationship between the profitability measures of firms and degree of aggressiveness of working capital investment and financing policies. The firms yield negative returns if they follow an aggressive working capital policy. Lazaridis and Tryfonidis (2006) investigated the relationship of profitability and working capital management. The results of showed that there was a negative relationship between profitability (measured through gross operating profit) and the cash conversion cycle which was used as a measure of working capital management efficacy. Thus managers can create profits for their companies by handling correctly the cash conversion cycle and keeping each component like accounts receivables, accounts payables, inventory to an optimum level. Samiloglu and Demiraunes (2008) analyzed the effect of working capital management on the profitability of the firms. The study depicted the accounts receivable period, inventory period and leverage affects the profitability of the firm negatively while growth affects firm's profitability positively.

Objectives of the Study

1) To analyze the Operating profit margin of Indian manufacturing industry.

2) To analyze the Working Capital of Indian manufacturing industry.

3) To investigate the impact of Working Capital Management on profitability of Indian manufacturing Companies.

4) To open new vistas for further research.

Research Methodology

The primary intend of this paper was to investigate the impact of Working Capital Management on profitability of Indian manufacturing firms. This was achieved by developing a similar empirical framework first used by Shin and Soenen (1998) and the subsequent work of Deloof (2003).

The study and sample: The study was descriptive in nature. The total population was Indian manufacturing companies which are listed in BSE and NSE. The sample size was of fifty companies--ten each from Aluminum, Cement, Electric, Plastic and Pharma, selected on the basis of purposive sampling technique. The period of the study was five years from 2003 to 2008.

Data Collection: The data was collected through secondary sources i.e. websites of BSE, NSE and moneycontrol.com. The dependent variable was the Operating Profit Margin (PBIT/Sales) as a measure of Profitability. In this study eight independent variables were taken to measure the Working Capital. These variable includes; Asset turnover (Sales/Total Assets), Gearing (Total Debt/Total Assets), CA to TA (Current Assets to Total Assets), T D to T A (Trade Debtors to Current Assets), CL to TA (Current Liabilities to Total Assets), Inv. Days (Stocks * 365)/Cost of Sales), S to Ac. P (Accounts Payable * 365)/ Sales) and C.A. to C.L. (Current Asset to Current Liabilities).

Data Analysis Tool: As stated above in order to fulfill the objective of quantifying the effect of Working Capital Management on firm's performance Multiple Regression using SPSS has been applied.

Hypothesis of the Study

The study was undertaken with the following hypotheses:

1. H01: There is no relationship between Operating Profit Margin and Asset Turnover of Indian manufacturing companies of India.

2. H02: There is no relationship between Operating Profit Margin and Gearing of Indian manufacturing companies of India.

3. H03: There is no relationship between Operating Profit Margin and Current asset to Total Asset of Indian manufacturing companies of India.

4. H04: There is no relationship between Operating Profit Margin and Trade debtors to Total Asset of Indian manufacturing companies of India.

5. H05: There is no relationship between Operating Profit Margin and Current liability to Total Asset of Indian manufacturing companies of India.

6. H06: There is no relationship between Operating Profit Margin and Inventory Days of Indian manufacturing companies of India.

7. H07: There is no relationship between Operating Profit Margin and Accounts Payable of Indian manufacturing companies of India.

8. H08: There is no relationship between Operating Profit Margin and Current Ratio of Indian manufacturing companies of India.

Results and Discussion

The study investigates the effects of Asset Turnover, Gearing, Current asset to Total Asset, Trade debtors to total asset, Current liability to total asset, inventory days, accounts payable and current ratio on Profitability of Indian Manufacturing companies. The dependent variable of the regression model is Operating Profit Margin. Three of totally eight independent variables of the regression model are directly related with the performance of the manufacturing companies.

The regression model is as follows:

O.P.[M.sub.i] = [[??].sub.i] + [[??].sub.il] As.[Tur.sub.i] + [[??].sub.i2] [Gearing.sub.i] + [[??].sub.i3] [CAtoTA.sub.i] + [[??].sub.i4] [TDtoTA.sub.i] + [[??].sub.i5] [CLtoTA.sub.i] + [[??].sub.i6] [Inv.Days.sub.i] + [[??].sub.i7] [StoAcP.sub.i] + [[??].sub.i8] [CLtoCL.sub.i] + [*.sub.i]

Where, [[??].sub.i] is constant; [[??].sub.i1-7] are coefficients of variables and *i is residual term.

O.P.M. indicates Operating Profit Margin (PBIT/Sales)

As. Tur indicates Asset turnover (Sales/Total Assets)

Gearing indicates gearing (Total Debt/Total Assets)

CAtoTA indicates Current Assets to Total Assets (Current Assets/Total Assets

TD toTA indicates Trade Debtors to Current Assets (Trade Debtors/ Current Assets)

CLtoTA indicates Current Liabilities to Total Assets (Current Liabilities to Total Assets)

InvDays indicates No. of Inventory days ((Stocks * 365)/Cost of Sales)

StoAcP indicates No. of days Accounts payable ((Accounts Payable * 365)/ Sales)

CAtoCL indicates Current Asset to Current Liabilities (Current Asset/Current Liabilities)

In the multiple regressions the data of dependent variable and independent variables of different manufacturing companies for five years are averaged and considered for the study. The R square value (0. .636) of the multiple regression models with Return on Asset as dependent variable shows that the model can predict 63 percent of variance in the dependent variable. The regression was found to be significant with ANOVA (F=8.967, P= 000). This indicates that all the independent variables have a significant influence on the Return on Asset of the Indian manufacturing companies.

[H.sub.01]: There is no relationship between Operating Profit Margin and Asset Turnover of Indian manufacturing companies of India.

The findings indicate that at 5 percent level of significance (t = -0.200, significant at 84 percent) the null hypothesis is accepted. The beta value (-0.024) indicates insignificant relationship between the Operating Profit Margin and Asset Turnover. Results of the multiple regressions clearly show that, the Asset Turnover does not have significant influence on the Operating Profit Margin of Indian Manufacturing Companies.

[H.sub.02]: There is no relationship between Operating Profit Margin and Gearing of Indian manufacturing companies of India.

The findings indicate that at 5 percent level of significance (t = -0.972, significant at 33 percent) the null hypothesis is accepted. The beta value (-0.096) indicates insignificant relationship between the Operating Profit Margin and Gearing. Results of the multiple regressions clearly show that, the Asset Gearing does not have significant influence on the Operating Profit Margin of Indian Manufacturing Companies.

[H.sub.03]: There is no relationship between Operating Profit Margin and Current Asset to Total Asset of Indian manufacturing companies of India.

The findings indicate that at 5 percent level of significance (t = -2.542, significant at 1 percent) the null hypothesis is rejected. The beta value (-0.266) indicates significant negative relationship between the Operating Profit Margin and Current asset to Total Asset. Results of the multiple regressions clearly show that, the Current asset to Total Asset have significant influence on the Operating Profit Margin of Indian Manufacturing Companies.

[H.sub.04]: There is no relationship between Operating Profit Margin and Trade Debtors to Total Asset of Indian manufacturing companies of India.

The findings indicate that at 5 percent level of significance (t = -3.333, significant at 0 percent) the null hypothesis is accepted. The beta value (-0.424) indicates significant negative relationship between the Operating Profit Margin and Trade debtors to Total Asset. Results of the multiple regressions clearly show that, the Trade debtors to Total Asset have significant influence on the Operating Profit Margin of Indian Manufacturing Companies.

[H.sub.05]: There is no relationship between Operating Profit Margin and Current Liability to Total Asset of Indian manufacturing companies of India.

The findings indicate that at 5 percent level of significance (t = -0.267, significant at 79 percent) the null hypothesis is accepted. The beta value (-0.036) indicates insignificant relationship between the Operating Profit Margin and Current liability to Total Asset. Results of the multiple regressions clearly show that, the Current liability to Total Asset does not have significant influence on the Operating Profit Margin of Indian Manufacturing Companies.

[H.sub.06]: There is no relationship between Operating Profit Margin and Inventory Days of Indian manufacturing companies of India.

The findings indicate that at 5 percent level of significance (t = -3.770, significant at 0 percent) the null hypothesis is rejected. The beta value (-0.423) indicates significant negative relationship between the Operating Profit Margin and Inventory Days. Results of the multiple regressions clearly show that, the Inventory Days have significant influence on the Operating Profit Margin of Indian Manufacturing Companies.

[H.sub.07]: There is no relationship between Operating Profit Margin and Accounts Payable of Indian manufacturing companies of India.

The findings indicate that at 5 percent level of significance (t = -0.096, significant at 92 percent) the null hypothesis is accepted. The beta value (-0.015) indicates insignificant relationship between the Operating Profit Margin and Accounts Payable. Results of the multiple regressions clearly show that, the Accounts Payable does not have significant influence on the Operating Profit Margin of Indian Manufacturing Companies.

[H.sub.08]: There is no relationship between Operating Profit Margin and Current Ratio of Indian manufacturing companies of India.

The findings indicate that at 5 percent level of significance (t =0.786, significant at 43 percent) the null hypothesis is accepted. The beta value (0.077) indicates insignificant relationship between the Operating Profit Margin and Current Ratio. Results of the multiple regressions clearly show that, the Current Ratio does not have significant influence on the Operating Profit Margin of Indian Manufacturing Companies.

The findings of the study clearly indicate that current asset to total asset, total debtors to total asset and inventory days are directly related variables with working capital management, and have significantly negative effects on firm profitability. This means that while current asset to total asset, total debtors to total asset and inventory days increase profitability decrease and when current asset to total asset, total debtors to total asset and inventory days decrease the profitability of the companies' increases. The other variables included in the regression model (Asset Turnover, Gearing, Current liability to total asset, accounts payable and current ratio) have no statistically significant effect on firms profitability. This paper adds to existing literature such as Shin and Soenen (1998) who found a strong negative relationship between the inventory days, current asset to total asset, total debtors to total asset and corporate profitability for listed American firms for the 1975- 1994 period and Deloof (2003) who found negative relationship between profitability and inventory days, current asset to total asset, total debtors to total asset.

conclusion

It is important to study the role of working capital management policies on profitability of a company. Normally, it has been seen that if a company desires to take a greater risk for bigger profits and losses, it reduces the size of its working capital in relation to its sales. If it is interested in improving its liquidity, it increases the level of its working capital. Therefore, a company should strike a balance between liquidity and profitability (Vishnani &. Shah, 2007). In this paper the effect of working capital management on the profitability of Indian manufacturing companies during the period 2002-2003 to 2007-2008 has been examined by regression analysis. The findings of the study indicate that current asset to total asset, total debtors to total asset and inventory days are directly related variables with working capital management, and have significantly negative effects on firm profitability.

References

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* Pushpa Negi

* Shilpa Sankpal

* Anindita Chakraborty

* Garima Mathur

* Lecturer, Prestige Institute of Management, Gwalior.
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