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The International Journal of Applied Economics and Finance 2 (1): 44-50,2008 ISSN 1991-0886 © 2008 Asian Network for

Scientific Information

The Effect ofW orking Capital Management on Firm Profitability: Evidence from Turkey
'F. Samiloglu and 2K. Dernirgunes 'Department of Business Administration, University of Aksaray, 2Department of Business Administration, University ofNigde,

68100, Aksaray, Turkey 51200, Nigde, Turkey

Abstract: The aim of this study is to analyze the effect of working capital management on firm profitability. In accordance with this aim, to consider statistically significant relationships between firm profitability and the components of cash conversion cycle at length, a sample consisting ofIstanbul Stock Exchange (ISE) listed manufacturing firms for the period of 1998-2007 has been analysed under a multiple regression model. Empirical findings of the study show that accounts receivables period, inventory period and leverage affect firm profitability negatively; while growth (in sales) affects firm profitability positively.

Key words: Working

capital, working capital management, conversion cycle, Istanbul stock exchange

firm profitability,


In general, it is possible to discuss finance theory under three main threads as capital budgeting, capital structure and working capital management. The first two of them are mostly related with financing and managing long-term investments. However, financial decisions about working capital are mostly related with financing and managing short -term investments and undertake both current assets and current liabilities simultaneously (Mueller, 1953; Scherr, 1989; Moyer et ol., 1992; Pinches, 1992; Brealey and Myers, 1996; Brigham and Gapenski, 1996; Damodaran, 2002; Aksoy, 2005). So, most of the time, it is reasonable to term short-term financial management as working capital management (Ross et al., 2003). Efficiency in working capital management is so vital for especially production- firms whose assets are mostly composed of current assets (Horne and Wachowitz, 1998) as it directly affects liquidity and profitability of any firm (Raheman and Nasr, 2007). According to Kargar and Bluementhal (1994) bankruptcy may also be likely for firms that put inaccurate working capital management procedures into practice, even though their profitability is constantly positive. Hence, it must be avoided to recede from optimal working capital level by bringing the aim of profit maximization in the foreground, or just in direct contradiction, to focus only on liquidity and consequently pass over profitability. While excessive levels of working capital can easily result in a substandard return on assets; inconsiderable amount of it may incur shortages and difficulties in maintaining day-to-day operations. Working capital is also a major external source of capital for especially small and medium sized and high-growth firms. These firms have relatively limited access to capital markets and tend to overcome this complication by short-term borrowing. Working capital position of such firms is not only an internal firm-specific matter, but also an important indicator of risk for creditors (Moyer et al., 1992). Higher amount of working capital enables a firm to meet its short-term obligations easier. This results increase in borrowing capability and decrease in default risk (and

Corresponding Author: Farnil ,<;:amiloglu,Department of Business Administration, University of Aksaray, 68100, Aksaray, Turkey


it will be more appropriate and accurate to evaluate effectiveness of working capital management by cash conversion cycle. Gentry et al. Cash available for trade activities of the firm has an important multiplier effect due to its turnover ratio. Hager (1976). As the firm's ongoing liquidity is a function of its cash (conversion) cycle (Pinches. 2008 decrease in cost of capital and increase in firm value). 2 (1): 44-50. Ongoing liquidity refers to the inflows and outflows of cash through the firm as the product acquisition. Traditional approach to interaction between cash conversion cycle and profitability posits that relatively long cash conversion periods tend to decrease profitability. in brief. Schilling (1996) and Boer (1999) have insisted on using ongoing liquidity measures in working capital management. It focuses on the length oftirne between the acquisition of raw materials and other inputs and the inflow of cash from the sale of goods (Arnold.. as a function of current assets and current liabilities. consequential Finance... Jose et al. Kamath (1989).. Emery (1984a).. Closely related with operating cycle.. payment and collection process takes place over time. InventDIy purchased InventDIy sold Accounts receivables period . 1: Operating 2003) and cash conversion cycles. the part of operating cycle financed by the firm itself (Mcl. 1992). production. Trade activities of a firm can be considered as a process in circulation where cash is converted into assets and assets into cash. the fewer resources the firm needs to tie up. The shorter this cycle. mentioned traditional ratios are also not meaningful in terms of cash flows (Richards and Laughlin. considering operating assets like receivables and inventories with cash and cash-equivalent assets is illogical for basic principles of cash management. Higher cash turnover ratios enable managers to minimize short-term investments whose rates of return are relatively lower compared to long-term investments and consequently increase profitability.AppliedEcon.. but also long-term financial performance (firm value maximization). Drawing attention to limitations of traditional liquidity ratios..• TIme Cash received Operating cycle Fig. Studies regarding working capital are mostly related with improving models to determine optimal liquidity and cash balance.. Cash conversion cycle as a part of operating cycle (Fig.. Formulas used for calculating them consider both liquid and operating assets in cornmon. is an important factor in determining working capital policies and indicates firm's capability of generating cash in case of need.aney. J. So. 1993.Int. acid-test and cash ratios as traditional measures of liquidity are incompetent and static balance sheet based measures that can not provide detailed and accurate information about working capital management effectiveness (Finnerty. (1990). cash conversion cycle is. 1997) and is simply calculated by adding inventory period to accounts receivables period and then subtracting accounts payables period from it. Fundamentals of corporate finance (Ross et al. 1996).. 1) is an ongoing liquidity measure developed by Gitman (1974). rather than analyzing underlying reasons of relationships between liquidity. Besides. Liquidity. rather than traditional liquidity measures. it is possible to state that performance efficiency in working capital management affects not only short-term financial (profitability). Current. 1998)..---.. 45 . sales.. 1980). However. __ Accounts payables period Cash paid for inventDIy Cash conversion cycle .. Richards and Laughlin (1980).

Johnson and Aggarwal (1998). Finance. cash conversion cycle affects profitability negatively. In a study by Kamath (1989) about working capital management practices in retailing firms. Results of the study have concluded that increases in all of these periods affect profitability negatively. As mentioned before.Int.AppliedEcon. These are 46 . Later on. the effectiveness (and quality) of working capital management practices in terms of firm profitability should be revised by components of cash conversion cycle. 5. accounts receivables and accounts payables periods). to investigate the effect of working capital management on firm profitability. an with the relationship MATERIALS AND METHODS Sample Selection and Data The aim of this study is. The results of a more detailed study by Soenen (1993) have shown that. According to the results of their study based on a sample of 131 Athens Stock Exchange listed companies for the period of 200 1-2004. cash conversion cycle. on firm profitability. In the multiple regression analysis. Regression Analysis This study investigates dependent the effects of accounts receivables period. there does not exist any statistically constant relationship between cash conversion cycle and profitability. the relationship between the mentioned variables has shown dissimilarities across industries as positive in some industries and negative in others. According to the findings of another study from a different perspective.843 firm/quarter data is used. Literature review consisting some of previous studies -though limited in scope and outnumbered-regarding between profitability and working capital management practices is given below. Three of totally seven independent variables of the regression model are directly related with working capital management. traditional measures of liquidity are in lack of expressing the effects of cash flows. In accordance with this aim. firm growth. it has been concluded that the effect of cash conversion cycle on profitability is stronger than the effect of current ratio on it (Eljelly. Pioneer studies of Baumol (1952) about an inventory management model and of Miller (1966) about a cash management model may be considered as the best-known studies in this field. a sample ofIstanbul Stock Exchange (ISE) listed manufacturing companies for the period of 1998-2007 is analysed. it has been concluded that there is a reverse relationship between cash conversion cycle and profitability. hence. similarly. 2004). 2008 working capital management practices and profitability. The variable of the regression model is return on assets. have developed a cash management model focusing on cash flows and argued that cash collection and cash payment processes should have to be handled independently. in case of considering industrial differences. they inform managers about problems related with working capital management practices. a sample consisting of American manufacturing firms for the period of 1974-1995 has been analysed and a statistically negative between cash conversion cycle and relationship between cash conversion cycle and profitability has been confirmed. Financial data is taken from the quarterly financial statements of listed companies in ISE database. This study aims to analyze the effect of working capital management indicator of short-term financial performance. firm size. inventory period. Though foundations and assumptions of these models are not well-established in terms of applicability. Empirical findings of Lazaridis and Tryfonidis (2006) 's study have been similar to Deloof(2003)'s. Deloof (2003) has discussed possible relationships profitability by dividing cash conversion cycle into its components (inventory. In another study of Shin and Soenen (1998). J. in case of overlooking industrial differences. leverage and fixed financial assets on firm profitability. as mentioned before. However. In a similar study to our study. 2 (1): 44-50.

849 Durbin-Watson 1.6490 0.067 -4.12710 0.709 0.310 N 5. have significantly negative effects on firm 47 . Dependent and independent variables are presented in Table 1. 19260 LEV 0. 2008 Calculation Net income/total assets [Accounts receivablesxJeoj/sales [Inventoriesx365]/cost of sales [ACRP+INVP]-[(Accounts payablesx365)/cost of sales] lnTotw.794 INVP 0.3328 19.006 -0. 2 (1): 44-50. The oilier four independent variables are variables that are frequently used as control variables in similar studies.7 are coefficients of variables 1 fum 7 and E.056 -4. *Significant at 0.974 0. Constant 1.03260 FIX 0. 3272±0. respectively accounts receivables period.5490 0.843 ISE Listed Manufacturing Finns-1998-2007) Mean±SD Variables Minimum -0.000'" FIX 0. inventory period and cash conversion cycle.5784 135. Regression model is as follows: where. 10370 ACRP 139.1020 -0. which are -as mentioned beforedirectly related variables with working capital management. J.01 and 0.6185±53.5562 17.8724 ROA O.128 9.0002 Maximum 0. is residual term. 0786±54.AppliedEcon.843 Adj. respectively.0600 0.745 '**. EMPIRICAL RESULTS The relationships between dependent and independent variables are analysed by the regression model mentioned earlier.015 0.~'t' (Natural logarithm oftotal assets) [Sales-S alesu]' sales.130 -9.2859 299.000) 42.2946 299. Descriptive statistics (Table 2) and empirical results are given in Table 2 and 3. Table 1: Definitions of Variables Variables Return on assets Accounts receivab les period Inventory period Cash conversion cycle Finn size Firm growth (in sales) Leverage Fixed financial assets Finance.5647±l.4990 0. is constant. 0206±0.048 F (sig.156 ACRP 0.0588 INVP 50.1316±48.427 CCC 0.018 l..000'" -0.013 l.669 SIZE 0.088* -0. R' 0.404 0.979 LEV 0. respectively.1000 Table 3: Empirical results of dependent variables Dependent Standardized coefficients variable ----------------------------------------------------------------------------------------------------------t-value ROA p-value Sig.0365±0. (x.160 GROWTH 0.4049±0.0425 59. Empirical findings of the study indicate that ACRP and INVP.6652 299. 0.903 7 50. Pd.000'" -0.1 levels.03540 SIZE 14. Total debt/total assets Fixed financial assets/total assets Symbol ROA ACRP INVP CCC SIZE GROWTH LEV FIX Table 2: Descriptive statistics (5.5120 CCC 153.5320 GROWTH O.Int.000'" -0.

The McGraw-Hill Companies. affecting it positively and negatively. Management. 1. Baumol. 1999. ISBN: 0-07-007417-8. Myers. The other variables that have significant effects on firm profitability are GROWTH and LEV.Int. respectively (Table 3). Ankara. liquid firms are less likely to demand trade credit and more likely to offer it. Accountancy.. it is possible to mention that studies regarding working capital management are not as popular as the ones related with capital budgeting and capital structure. 2 (1): 44-50. 2005. CONCLUSION In financial management. REFERENCES Aksoy. 5th Edn. inventory period and leverage significantly and negatively affect profitability of Turkish manufacturing firms.J. Corporate Financial ISBN: 0 273 63078 4. W. Turky. while firm growth (in sales) significantly and positively. However. The transaction demand for cash: An inventory theoretic approach. 1998.pp: 1-2. The negative relationship between accounts receivable period and profitability may be due to that customers want more time to assess quality of products they buy from firms with declining profitability (Deloof.. to transfer relatively high amounts of trade credit to their buyers. high-profit firms that are more liquid. Results suggest that firm profitability can be increased by shortening accounts receivables and inventory periods. a positive relationship between growth and profitability is expected. SIZE and FIX) have no statistically significant effects on firm profitability. Gazi Publications. 1996. Arnold. 2003).C. 2003). This finding may be explained by the suggestions that highly-leveraged firms are softer competitors that will curtail investment (Myers. in general. London. Because. more profitable short-term investments than marketable securities (Emery.. especially. From this perspective. accounts receivables period. profitability decreases. this empirical finding conflicts with some of financial models explaining trade credit. J.AppliedEcon. 66: 545-556. so their insufficient power of competition may lead decreases in profitability. Managing the cash gap. This means that while accounts receivables and inventory periods lengthen. it is also concluded that cash conversion cycle. In case of that firm may gain some advantages like monopoly or bargaining power due to growth as a reflection of economies of scale (Kiilter and Demirgunes. pp: 115. or vice versa. Brealey. Econ. Another empirical finding is similar. 48 . Trade credits are... for the mentioned sample and period. 1st Edn. This means that any increase in sales leads profits to grow. 2008 profitability. Principles of Corporate Finance. pp: 543. 2007). 188: 27-32. Finance. while any increase in debt causes profitability to fall. J. size and fixed financial assets have no statistically significant effects on firm profitability of Turkish manufacturing firms for the period of 1998-2007. as stated in Deloof (2003)'s study. so it is rational for.A. the negative relationship between inventory period and profitability and this may be the result of declining sales leading to lower profits and more inventory. 1st Edn.. Management. R. Leverage is another variable affecting firm profitability negatively. A. 1952. this study aims to analyze determinants of firm profitability by means of variables related with working capital management practices using a sample of Turkish manufacturing firms for the period of 1998-2007. However. Boer. Pitman Publishing. The other variables included in the regression model (CCC. New York. and S. 1984b). according to the liquidity theory. Empirical results show that. Working Capital ISBN: 975-8895-77-X. G. Inc. G. Q. The only variable in the model of the study that has significantly positive effect on profitability is firm growth (in sales).

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