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Impact of Inventory Management on the Profitability of the Firms

Project Report

Course Title Fundamentals of Finance Instructor Sir Nauman Waheed Submitted by Ambreen Butt Faiza Malik Waheeba Jamil Misbah Ishaq MPA-III

Fatima Jinnah Women University Rawalpindi

Impact of Inventory Management on the Profitability of the Firms

Table of Contents
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Impact of Inventory Management on the Profitability of the Firms

Acknowledgements Thanks to almighty Allah for enabling us to fulfill all the requirements for the completion of our project report. This would not be a justice in presenting this report without mentioning the important people around us who had been inextricably related with the completion of this report. For assisting and helping us in all respect and regard to complete this report our heartfelt thanks to our teacher Sir Nauman Waheed, who enriched us with wealth led ideas to pursue and power of writing this report. It could have been impossible to accomplish this research without his thoughtful guidance and expertise. It is also a pleasure to record respected and honorable regards to all those people who helped us lot in learning and enhancing our knowledge and ability during the project. Finally for all possible mistakes, errors and shortcomings in writing of this report only we are responsible for which we all hope that the concerning regards of this report will forgive us.

Impact of Inventory Management on the Profitability of the Firms

Abstract This Report analyses the impact of Working Capital Managements one component Inventory Management upon the Profitability of firm. The data was collected by the help of Secondary Source i.e. Internet.Ten Base Articles were studied thoroughly to prove this research. The finding of this research is that profitability of the firm is very much dependent on the inventory management which is an essential part of the working capital. The main highlighted outcome in this research is that for any firm who wants to seek Maximum profits, Inventory must be managed properly to ensure the best organizational performance and profits as well which is the ultimate goal of every firm.

Impact of Inventory Management on the Profitability of the Firms

Introduction Topic: Impact of Inventory Management on the Profitability of the Firms Working Capital Management is defined as the management or the administration of the companys/firms current assets and the financing needed to support those current assets so the Working Capital Management can be defined as an accounting strategy in which a firm/company always seeks to maximize its cash flows so as to pay for its operating expenses and its current liabilities

Different components of the WCM

Accounts Receivable

Accounts Payable

Inventory Management

Cash Management

Few Examples of working capital management may include active monitoring of accounts receivable and maintaining little short-term debt. Working capital management, if properly done can help a company improve its earnings and maintain a healthy financial state to compete with others. And all these components have impact on the Profitability of Firms .The component we have selected is Inventory Management and its impact on the profitability of the Firms. According to Kotler (2000), inventory management refers to all the activities involved in developing and managing the inventory levels of raw materials, semi-finished materials (work in-progress) and finished good so that adequate supplies are available and the costs of over or under stocks are low

Impact of Inventory Management on the Profitability of the Firms

.Inventory management is primarily much essential about specifying the size and the placement of stocked goods. Inventory management therefore is required at different locations within a facility or within multiple locations of a supply network to protect the regular and planned course of production against the random disturbance of running out of materials or goods. Effective inventory management is all about knowing what is on hand means how much stock is left, where it is in use, and how much finished product results. So Inventory management is the process of efficiently overseeing the constant flow of units into and out of an existing inventory. Successful inventory management or in other words the businesses that play around with the best Inventory management practices involves balancing the costs of inventory with the benefits of inventory. Any business that manages inventory lives and dies by stock levels. Knowing how much inventory is on hand is important and easy to obtain with a physical inventory count. But to know what items of the inventory are selling fastest, and how long does it takes to receive the new stock from the suppliers, and what sales are seasonal is most crucial information that is more harder/difficult to acquire and understand.Therefore a good inventory management means the respective firm hold just enough inventory in its warehouse to ensure its Firm can meet sales, but not so little that its Firm run into "stock-outs" where Firm may lose sales (and hence profitability) because it might have no inventory left to sell. The Firm can also lose customer goodwill which may be a great loss to the business because customers are considered as the King in the Market; they are true creators and destroyers of a business. On the other hand, holding too much inventory ties down the cash with which the owner can do something else with. The sector which we wanted to study in terms of Inventory Management and Profitability is the Industrial Sector related to Eatables and that company is Engro Foods because we think this

Impact of Inventory Management on the Profitability of the Firms

sector needs proper Inventory Management in the current Circumstances and has greater importance in our daily life. Engro Foods, being a wholly owned subsidiary of Engro Chemical Pakistan Limited had its first full year of operations in 2007. The portfolio of the company now includes many impressive brands; Olper's milk, Olpers cream, Olwell, Tarang, O'more, and Tarka. Basically Engro Foods entered the Food business through milk processing and sale with the companys vision to pursue growth opportunities based on country fundamentals and own strengthSo this company also needs to maintain a best inventory Management due to its excessive demand of Best products in the shape of Milk, Cream It is very important for store or a Go down that it has to maintain sufficient stock of all the related parts / goods to make the factory continue its production and functions of other departments without any problem or hurdle in the continuation of the Production. There are two types of variables are used in this research. One is Dependent and the other is independent. The Inventory Management is considered as the Independent Variable under which subheads may include the Stock Valuation Model and the Economic Order Quantity. So they are all independent means these all dont depend upon anything on the other hand the dependent variables include the Profitability which depends upon many components and Our field of research is the Inventory Management(IV) impact on Profitability(DV). Main Objective of the Study To see the relationship between the Inventory management and the profitability of a firm. To study those inventory management practices which affect the profitability by the help of an evidence( sample Firm)

Impact of Inventory Management on the Profitability of the Firms

Problem Statement Inventory management has issues that affect sometimes profitability .Our research will examine what are those contributing factors regarding Inventory management that either affect positively or affect negatively in terms of profitability of the firm This researchs purpose is to find ways to improve inventory management, thereby increasing customer satisfaction and mainly the Profitability. Formulation of Null and Alternative Hypothesis H1: There exists a relationship between the Inventory Management and Profitability of a firm H0: There is no relationship between the Inventory Management and Profitability of a firm Literature Review Working capital management is an important issue from the corporate perspective, thats why many researchers from different areas study it with different views and in different environments. International experiences show that working capital management practices are considered to be very imperative and have a strong impact on the performance, profitability and risk of organization. Organizations have to maintain optimum level of working capital in order to avoid risk and maintain profitability. Available literatures related to this study are as below. Dr. Neel Kamal Purohit, (2011) in his research paper Essentiality of Working Capital & Its management in A Business Concern stated that working capital is difference between total current assets & current liabilities. In order to remain in market it is essential that an organization successfully manages their working capital. Working capital can be seen as a metric for evaluating a company's paying capacity in short term. On other hand high ratio of working

Impact of Inventory Management on the Profitability of the Firms

capital shows its operating efficiency. All companies should therefore focus on the tight management of working capital. Inventories, Accounts receivables and Accounts payables are of specific importance since they can be influenced most directly by operational management. According to a research paper Working Capital Approaches and Firms Returns in Pakistan written by Dr. Talat Afza investigates the relationship between the

aggressive/conservative working capital policies. The study found significant differences among the different companys working capital investment and financing policies across different industries. The aggressive investment working capital policies are accompanied by aggressive working capital financing policies. Finally, they found a negative relationship between the profitability measures of firms and degree of aggressiveness of working capital investment and financing policies. The study would contribute a better understanding of working capital management policies in an emerging market like Pakistan. The firms yield negative returns if they follow an aggressive working capital policy. According to the research study Effective Working Capital Management Affects Profitability conducted by Hyder Ali Khawaja, Niaz Ahmed Bhutto2, Falahuddin Butt3& Ghulam Abbas focused on the effect of working capital management on profitability of Asian manufacturing firms. After analyzing the data for 332 firms for the period of 5 years from 20062010 by using regression and correlation analysis it is found that profitability of firms depends upon effective working capital management. Gross operating profitability is negatively related with account receivables collection period, whereas it also has a negative relation with inventory period and cash conversion cycle. On the other hand it is positively correlated with payment period, it's better to delay payables because it gives opportunity to invest that specific amount at some other place which gives more profitable opportunities.

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Impact of Inventory Management on the Profitability of the Firms Mian Sajid Nazir and Talat Afza had conducted a research on Working Capital Requirements and the Determining Factors in Pakistan Working capital management is highly important in firms as it is used to generate higher returns for the stakeholders. If the working capital is too low, the company may miss a lot of profitable investment opportunities or suffer short-term liquidity crisis, leading to the degradation of company credit, as it cannot respond effectively to temporary capital requirements. The study finds that operating cycle, leverage, ROA and is the internal factors which are influencing the working capital requirements significantly. Efficient management of working capital is very essential in the overall corporate strategy in creating shareholder value. According to research paper Working Capital management and Profitability written by Ahsen Saghir Working capital management is important part in firm financial management decision. The purpose of this study is to establish a relationship that is of statistical significant between profitability, the cash conversion cycle and its components (Number of days Accounts receivables, Number of days Accounts payables and Number of days Inventory). The results of our research showed that there is statistically negative significance between profitability, measured through Return on Asset, and the cash conversion cycle. The negative relationship between accounts receivables and firms profitability suggests that less profitable firms will pursue a decrease of their accounts receivables in an attempt to reduce their cash gap in the cash conversion cycle. Aggressiveness and Conservativeness of Working Capital Atif Hussain , Syed Umar Farooq ( 2012) Working Capital Management is crucial component in firm financial management decision. Adequate working capital is essential as it directly affect the profitability and liquidity position of the firm. The result revealed that low investment in current assets and

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Impact of Inventory Management on the Profitability of the Firms

low current liability financing increases the profitability of firms. The study also suggested that company size, sale growth and leverage ratio significantly affect the profitability of the firm. It is also concluded that company size and sale growth positively affect the profitability, leverage ratio has negative effect while GDP growth has no effect on the profitability of companies in Pakistan. According to a research paper International Working Capital Practices in Pakistan Umara Noreen stated that; this study is geared towards finding out international working capital management practices of multinational firms in Pakistan. Reasons that why management of working capital is important is that typical manufacturing firm contains half of its total assets, also, most of the small firms support their assets through current liabilities as a means of external financing. Thats why most of the firms suggested that firms should maintain an optimal level of working capital in order to maximize their value. In an article International Working Capital Practices in Pakistan presented by Umara Noreen stated that ; firms have shifted their concerns towards low cost and efficient methods related to international working capital management decisions and there was found no significant difference when analyzed with respect to different sectors. In this case study they found that there was no such difference between working capital management practices which are being implemented in foreign countries and in multinational organizations in Pakistan. Almost they are using same practices for management of working capital. According to a research study Working capital management and firms profitability in Pakistan (2012) it stated that there is a strong negative relationship between the variables of working capital management including the average collection period, inventory turnover in days,

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Impact of Inventory Management on the Profitability of the Firms

average payment period with corporate profitability. he results of regression analysis show that every sector has its own dynamics because working capital variables react different with profitability in each sector. The efficient management of working capital has importance and it is indisputable. Furthermore, sufficient level of working capital has an essential impact on net operating profitability and liquidity of firm. In the research Impact of Aggressive Working Capital Management Policy on Firms Profitability conducted by Mian Sajid Nazir and Talat Afza stated that Firms with more aggressive policy towards working capital may not be able to generate more profit. So, 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. On 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 research paper Working Capital Management And Profitability Case Of Pakistani Firms presented by Abdul Raheman and Mohamed Nasr stated that Working Capital Management has its effect on liquidity as well on profitability of the firm. They found that there is a significant negative relationship between net operating profitability and the average collection period, inventory turnover in days, average payment period and cash conversion cycle. They suggest that managers can create value for their shareholders by reducing the number of days accounts receivable and inventories to a reasonable minimum. If these firms properly manage their cash, accounts receivables and inventories in a proper way, this will ultimately increase.

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Impact of Inventory Management on the Profitability of the Firms

Many of the research papers that are quoted above focus on the impact of working capital management on firms profitability. The base article that is selected is Working Capital Management and Profitability Case of Pakistani Firms as it has focused on all the working capital management practices in the organizations. This base research article serves as an inspiration tool in conducting the research on impact of inventory management on Profitability. Methodology Data In this research data has been collected through secondary sources which are less expensive and a quick method to gain information. Most of the information is gathered through internet for the purpose of this study. Variables Independent Variable Inventory Management LIFO FIFO Average Method EOQ Profitability Dependent Variable

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Impact of Inventory Management on the Profitability of the Firms

Theoretical Framework Theoretical Model of the Study Independent Variables

Dependent Variable

Inventory Management Profitability Valuation Model

EOQ

Valuation Model

Valuation Model Average Method

LIFO
Analysis and Results

FIFO

In this research the impact of various variables of the Inventory management which includes Valuation Models (LIFO, FIFO, and Average Method) and EOQ on the Profitability has been studied. These variables have different impacts on the inventory management in relation with profitability. Inventory is the physical asset of the company that changes constantly as quantities

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Impact of Inventory Management on the Profitability of the Firms are sold and replenished. As it shows a considerable amount of companys asset on financial statements so it is very much important that the accounting methods used to hold the record of the inventory must be appropriate and should be in the best interest of the company. One of the first methods which are used for this purpose is LIFO (last in first out) in which inventory is managed by selling the stock which is recently purchased and not the old one. In the stance of Engro Foods Industry, LIFO usually produces a lower gross profit than FIFO only because the costs of the goods purchased or produced by the industry have been increasing over the past decades. So LIFO is a better approach to match the current cost with the current revenues. Due to increase in inflation in the economy, the LIFO method records the sale of the most expensive items in inventory first.

In case of FIFO, the oldest goods are sold first and the newest goods are sold last in order to save goods from deterioration .This method is more appropriate when prices are stable in the economy. If FIFO is used in case of inflation then it will generate only inventory profits from just holding onto inventory and physical assets. However, it is beneficial for the smaller companies to use FIFO for inventory management during inflation because as previously held inventory is sold by them and new stock which is more expensive comes on the face of financial record so they can better attract businesses and mergers and value of their stock will be increased also which will definitely effects their profits. If these two methods are compared ,it can be concluded that in case of FIFO, there is a better estimation of value of inventory but as more profit are recorded in the financial statements so company have to pay more taxes at the end of the year. Whereas in case of LIFO, it is not a very good indicator of inventory value because old inventory is ignored due to which its value will probably lower than the current price and as

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there are less profits on the record so company will have to pay less taxes accordingly. Due to this reason most of the companies switched from FIFO to LIFO after experienced some growth.

Cost Profitability

Profitability Cost

LIFO

FIFO

Average Cost Method is another method for inventory management in which the value of a pool of assets or expenses is assumed to be equal to the average cost of the assets or expenses in the pool. In this method all available inventories are represented by a weighted average cost. Whenever new stock comes into go downs the average cost of inventory is recalculated. In case of selling of inventory, the average price is calculated until the new stock arrives. So the weighted average results in a profit that lies in between LIFO and FIFO. EOQ (Economic Order Quantity) is another important variable which can affect the profitability of the company. It is very much important financial metric to calculate the optimal quantity of inventory to order and store. The profitability of the company will suffer whether it has too much stock or too little stock. In case of too much inventory stock, the holding or carrying cost of the company will increase. Similarly in case of too much little inventory the company will definitely be stock out and will lose customer goodwill. Both these situation will impact the profitability of the firm to the great extent. In the Economic Order Quantity model the costs of placing and receiving an order are called Ordering costs. If a company wants to maximize its profit, It has to

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minimize its ordering cost and inventory holding cost. So it can be concluded that there is an inverse relation of ordering cost cost with and the

carrying

profitability of the firm.

So after conducting this research it can be concluded that the profitability of the firm is very much dependent on the inventory management which is an essential part of the working capital and our alternative hypothesis i.e. H1 is proved to be true through this research. There can be many other factors which affects the profitability but along with that importance of the Inventory Management cannot be ignored in this context. Moreover, there are different methods of inventory management which are used by companies according to their situations and demands. All these methods can help a firm to manage its inventory affairs efficiently and to maximize its profitability.

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References Teruel PJG and Solano PM. (2007). EFFECTS OF WORKING CAPITAL MANAGEMENT ON SME PROFITABILITY, International Journal of Managerial Finance, Vol. 3, No. 2, pp. 164-177, 2007 Raheman A and Nasr M. (2007). Working Capital Management and Profitability Case of Pakistani Firms, International Review of Business Research Papers Vol.3 No.1. March2007, Pp.279 300. Afza T and MS Nazir (2008). ON THE FACTOR DETERMINING WORKING CAPITAL REQUIREMENTS, The Icfai Journal of Applied Finance, Vol. 15, No. 4, pp. 28-38, April 2009. Afza T and MS Nazir (2007a). Working Capital Management Policies of Firms: Empirical Evidence from Pakistan, In the Proceedings of 9th South Asian Management Forum (SAMF) on February 24-25, North South University, Dhaka, Bangladesh. Afza, T. and M. S. Nazir, (2008). Working Capital Approaches and Firms Returns. Pakistan Journal of Commerce and Social Sciences. 1(1), 25-36. Karaduman Hasan Agan, Halil Emre Akbas, Arzu Ozsozgun Caliskan and Salih Durer (2011). The Relationship between Working Capital Management and Profitability: Evidence from an Emerging Market. International Research Journal of Finance and Economics, ISSN 1450-2887, Issue 62.

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Impact of Inventory Management on the Profitability of the Firms Afza and Nazir (2007). IS IT BETTER TO BE AGGRESSIVE OR CONSERVATIVE IN MANAGING WORKING CAPITAL? Management , 11-21 Further used Web links Retrieved from www.Brandalyzer.wordpress,com on 9th June 2012 http://brandalyzer.wordpress.com/2011/12/07/working-capital-management-and-profitability/ Retrieved from www.Bizreasearchpapers.com on 10th June 2012 http://www.bizresearchpapers.com/Paper%2019.pdf Retrieved from www.Wikipedia.org on 10th June 2012 Journal of Quality and Technology

http://en.wikipedia.org/wiki/Working_capital