The Impact of Working Capital Management On The Profitability of The Companies in Pakistan

The Impact of Working Capital Management on the Profitability of the
Companies in Pakistan
Submitted by
WAQAR ALI
L3F08MCOM5377
(Accounting and Finance)
Session: 2008 – 2010
Thesis Supervisor
Mr. Bilal Sarwar
Faculty of Commerce
University of Central Punjab
1 - Khayaban-e-Jinnah Road, Johar Town, Lahore, Pakistan

The Impact of Working Capital Management on the Profitability of
the Companies in Pakistan
Submitted by
Waqar Ali
L3F08MCOM5377
Session 2008- 2010
A thesis submitted in partial fulfillment of the requirements for the degree of

Master of Commerce
Thesis Supervisor
Bilal Sarwar
Faculty of Commerce
Faculty of Commerce
UNIVERSITY OF CENTRAL PUNJAB
CERTIFICATE OF APPROVAL
It is certified that the research work contained in this thesis titled “The Impact of Working
Capital Management on the Profitability of the Companies in Pakistan” has been carried out and
completed by Mr. WAQAR ALI, Roll No.L3F08MCOM5377, under my supervision during his
Masters in Commerce (accounting & Finance) studies at University Of Central Punjab, Lahore
Pakistan.
Date: _______________ _________________

Mr. Bilal Sarwar
(Supervisor)
Approved By:
_________________
Prof. Dr. Zahid Ahmad
Incharge Thesis Program
Faculity of Commerce
Lahore.
Submitted through:
_________________
Prof. Muhammad Azhar Ikram
Dean
Faculty of Commerce
Lahore.
Undertaking
I certify that the research work titled “The impact of working capital management on the
profitability of the companies in Pakistan” is my own work. The work has not been presented
elsewhere for assessment. Whenever the material has been used from other sources in the thesis,
it has been properly acknowledged / referred to the original author.
Signature of Student: ________________________
Name of Student: ___________________________
Registration Number of Student: _______________

Research Completion Certificate
It is certified that the research work contained in this thesis titled “The impact of working capital
management on the profitability of the companies in Pakistan” has been carried out and
completed by Mr. Waqar Ali, Registration No.L3F08MCOM5377 under my supervision during
his Master of Commerce.
Thesis Supervisor’s Signature
_________________
(Bilal Sarwar)
Thesis In-charge
___________________
(Prof. Dr. Zahid Ahmad)
Date: ____________________
Prof. Muhammad Azhar Ikram Ahmad

Dean
Faculty of Commerce
Lahore
Dedication
This Thesis is dedicated
To
My Loving Parents
&
Respected Teacher Who Helped Me
To Complete This Task

Acknowledgement
Firstly I would thank Allah for giving me the opportunity and the resources to be able to do
something productive with my live. Without His blessings I would not have been able to come as
far as I have.
I expressed my gratitude to my supervisor Mr. Bilal Sarwar the Guide of the project for guiding
and correcting various documents of mine with attention and care. I would also hardly thankful
to our Dean Prof. Muhammad Azher Akram and Dr. Zahid Ahmed as he has taken pain to go
through the project and make necessary correction as and when needed. He also helped me to
select the research topic.
Last but not the least I would like to thank my family for their incessant support and approval. I
would also thank my Institution and my faculty members without whom this project would have
been a distant reality. I also extend my heartfelt thanks to my family and well wishers.
Abstract
Working Capital Management has its effect on liquidity as well on profitability of the firm. In
this research, I have selected a sample of 25 Pakistani firms listed on Karachi Stock Exchange
for a period of 4 years from 2006 – 2009, I have studied the effect of different variables of
working capital management including the Debt ratio, size of the firm (measured in terms of
natural logarithm of sales), Average collection period, Inventory turnover in days, Average
payment period, Cash conversion cycle and Current ratio on the Net operating profitability of
Pakistani firms. Descriptive and Regression are used for analysis. The results show that there is a
strong negative relationship between variables of the working capital management and
profitability of the firm except the sales (Size of the company). We also find that there is a
positive relationship between size of the firm and its profitability. There is also a significant
negative relationship between debt used by the firm and its profitability.
Table of Contents
Chapter No. 1--------------------------------------------------------------------------------------------------1
INTRODUCTION--------------------------------------------------------------------------------------------1
1.1. Background of the Study:-------------------------------------------------------------------------1
1.1.1. Gross Working Capital:----------------------------------------------------------------------1
1.1.2. Net Working Capital:------------------------------------------------------------------------1
1.1.3. Way of optimizing investment in Current Assets:---------------------------------------1
1.1.4. Way of financing Current Assets:----------------------------------------------------------2
1.2. Working Capital:-----------------------------------------------------------------------------------2
1.3. Working Capital Management:-------------------------------------------------------------------3
1.4. Determinants of working capital-----------------------------------------------------------------4
1.4.1. Nature of business----------------------------------------------------------------------------4
1.4.2. Length of production cycle------------------------------------------------------------------4
1.4.3. Size and growth of business-----------------------------------------------------------------4
1.4.4. Business/ Trade cycle------------------------------------------------------------------------5
1.4.5. Terms of purchase and sales----------------------------------------------------------------5
1.4.6. Profitability------------------------------------------------------------------------------------5
1.4.7. Operating efficiency--------------------------------------------------------------------------5
1.5. Objectives of Working Capital:------------------------------------------------------------------6
1.6. Sources of Working Capital:---------------------------------------------------------------------7
1.6.1. Bank Loan-------------------------------------------------------------------------------------7
1.6.2. Factoring---------------------------------------------------------------------------------------7
1.6.3. Grants------------------------------------------------------------------------------------------7
1.6.4. Bonds-------------------------------------------------------------------------------------------7
1.6.5. Stock--------------------------------------------------------------------------------------------8
1.7. Sources of working Capital-----------------------------------------------------------------------8
1.7.1. Long Term Source of Working Capital----------------------------------------------------8
1.7.2. Short Term Source of Working Capital---------------------------------------------------8
1.8. Need of working capital management:--------------------------------------------------------10
1.9. Types of Working Capital:----------------------------------------------------------------------10
1.9.1. Gross working capital----------------------------------------------------------------------10
1.9.2. Net Working Capital------------------------------------------------------------------------11
1.9.3. Permanent Working Capital---------------------------------------------------------------11
1.9.4. Temporary Working Capital---------------------------------------------------------------11
1.10. Types of Working Capital Loan:------------------------------------------------------------11
1.10.1. Bank Overdraft Facility or Credit Line--------------------------------------------------11
1.10.2. Short-Term Loans---------------------------------------------------------------------------12
1.10.3. Equity Funding via Personal Resources or Investors-----------------------------------12
1.10.4. Accounts Receivable Loans---------------------------------------------------------------12
1.10.5. Factoring or Advances----------------------------------------------------------------------12
1.10.6. Trade Creditor-------------------------------------------------------------------------------13
1.11. Advantages of working capital:--------------------------------------------------------------13
1.11.1. Increase in debt capacity and goodwill:--------------------------------------------------13
1.11.2. Increase in production inefficiency:------------------------------------------------------13
1.11.3. Meeting contingencies adverse changes:------------------------------------------------13
1.11.4. Available cash discount:-------------------------------------------------------------------14
1.11.5. Solvency and efficiency fixed assets:----------------------------------------------------14
1.11.6. Attractive dividend to shareholders:------------------------------------------------------14
1.12. Objectives of the research:--------------------------------------------------------------------14
1.13. Research Aims:---------------------------------------------------------------------------------15
1.13.1. Liquidity:-------------------------------------------------------------------------------------15
1.13.2. Profitability:----------------------------------------------------------------------------------15
Chapter No. 2------------------------------------------------------------------------------------------------17
Literature Review--------------------------------------------------------------------------------------------17
Chapter No. 3------------------------------------------------------------------------------------------------31
Theoretical Framework-------------------------------------------------------------------------------------31
3.1. Working Capital----------------------------------------------------------------------------------31
3.2. Working Capital Cycle---------------------------------------------------------------------------32
3.3. Objectives of Working Capital Management-------------------------------------------------32
3.4. Working Capital Policy--------------------------------------------------------------------------32
3.5. Cash Management--------------------------------------------------------------------------------33
3.6. Inventory Management--------------------------------------------------------------------------33
3.7. Accounts Receivables----------------------------------------------------------------------------34
3.8. Accounts Payables--------------------------------------------------------------------------------35
3.9. The Cash Conversion Cycle---------------------------------------------------------------------36
3.10. Liquidity----------------------------------------------------------------------------------------37
3.10.1. Transaction Motive:------------------------------------------------------------------------37
3.10.2. Precautionary Motive:----------------------------------------------------------------------37
3.10.3. Speculative Motive:-------------------------------------------------------------------------37
3.11. Instruments for Liquidity Management-----------------------------------------------------38
3.12. Current Ratio-----------------------------------------------------------------------------------38
3.13. Quick Ratio-------------------------------------------------------------------------------------38
3.14. Liquidity, Risk and Profitability:------------------------------------------------------------39
3.14.1. Adequate liquidity--------------------------------------------------------------------------39
3.14.2. Minimization of Risk-----------------------------------------------------------------------40
3.14.3. Maximizing Profitability-------------------------------------------------------------------40
3.15. Liquidity, Risk and Profitability Trade-off-------------------------------------------------41
3.15.1. Conservative Policy-------------------------------------------------------------------------41
3.15.2. Aggressive Policy---------------------------------------------------------------------------41
3.15.3. Moderate Policy-----------------------------------------------------------------------------41
Chapter No. 4------------------------------------------------------------------------------------------------43
Methodology and Data Anaylsis--------------------------------------------------------------------------43
4.1. Data Set & Sample-------------------------------------------------------------------------------43
4.2. Variables-------------------------------------------------------------------------------------------43
4.2.1. Average Collection Period (ACP)--------------------------------------------------------43
4.2.2. Inventory turnover in days (ITID)--------------------------------------------------------44
4.2.3. Average Payment Period (APP)-----------------------------------------------------------44
4.2.4. The Cash Conversion Cycle (CCC)------------------------------------------------------44
4.2.5. Current Ratio (CR)--------------------------------------------------------------------------44
4.2.6. Size--------------------------------------------------------------------------------------------44
4.3. Hypotheses Testing-------------------------------------------------------------------------------44
4.3.1. Hypothesis 1---------------------------------------------------------------------------------44
4.3.2. Hypothesis 2---------------------------------------------------------------------------------45
4.3.3. Hypothesis 3---------------------------------------------------------------------------------45
4.4. Model Specifications:----------------------------------------------------------------------------45
4.5. Analysis Used in Study--------------------------------------------------------------------------46
4.5.1. Descriptive Analysis------------------------------------------------------------------------46
4.5.2. Regression Analysis------------------------------------------------------------------------46
4.6. Data Analysis and Discussion------------------------------------------------------------------46
4.6.1. Descriptive Analysis------------------------------------------------------------------------47
4.6.2. Regression Analysis------------------------------------------------------------------------48
Chapter No. 5------------------------------------------------------------------------------------------------51
Conclusions---------------------------------------------------------------------------------------------------51
Bibliography--------------------------------------------------------------------------------------------------53
IMPACT OF WORKING CAPITAL MANAGEMENT ON THE PROFITABILITY 1
Chapter No. 1
INTRODUCTION
1.1. Background of the Study:
The concept of Working Capital includes Current Assets and Current Liabilities. There
are two concepts of Working Capital which are Gross and Net Working Capital.
1.1.1. Gross Working Capital:
Gross Working Capital refers to the firm's investment in Current Assets. Current Assets
are the assets, which can be converted into cash within an accounting year or operating cycle. It
includes cash, short-term securities, debtors (account receivables or book debts), bills receivables
and stock (inventory).
1.1.2. Net Working Capital:
Net Working Capital refers to the difference between Current Assets and Current Liabilities
are those claims of outsiders, which are expected to mature for payment within an accounting
year. Net Working Capital can be positive or negative.
The concept of Gross Working Capital focuses attention on two aspects of Current Assets'
management. They are:
1.1.3. Way of optimizing investment in Current Assets:
Investment in Current Assets should be just adequate i.e., neither in excess nor deficit
because excess investment increases liquidity but reduces profitability as idle investment earns
nothing and inadequate amount of working capital can threaten the solvency of the firm because
of its inability to meet its obligation. It is taken into consideration that the Working Capital needs
of the firm may be fluctuating with changing business activities which may cause excess or
shortage of Working Capital frequently and prompt management can control the imbalances.
1.1.4. Way of financing Current Assets:
This aspect points to the need of arranging funds to finance Company Assets. It says
whenever a need for working Capital arises; financing arrangement should be made quickly. The
financial manager should have the knowledge of sources of the working Capital funds as wheel
as investment avenues where idle funds can be temporarily invested.[ CITATION AKP09 \l 1033 ]
1.2. Working Capital:
Vasarao (2010) Working capital is the life blood and nerve centre of a business. Just as
circulation of blood is essential in the human body for maintaining life, working capital is very
essential to maintain the smooth running of a business. No business can run successfully without
an adequate amount of working capital. Every business needs adequate liquid resources in order
to maintain day-to-day cash flow. Maintaining adequate working capital is not just important in
the short-term. Sufficient liquidity must be maintained in order to ensure the survival of the
business in the long-term as well. The working capital management plays an important role for
success or failure of firm in business because of its effect on firm’s profitability as well on
liquidity. The working capital ratio is calculated as:
Working Capital = Current Asset – Current Liabilities
Positive working capital means that the company is able to pay off its short-term
liabilities. Negative working capital means that a company currently is unable to meet its short-
term liabilities with its current assets (cash, accounts receivable and inventory).
Thousands of companies fail each year due to poor working capital management
practices. Entrepreneurs often don't account for short term disruptions to cash flow and are
forced to close their operations. Many of these companies have viable business models, and
would have otherwise succeeded had they better managed their working capital. The working
capital is the life-blood and nerve centre of a business firm. The importance of working capital in
any industry needs no special emphasis. No business can run effectively without a sufficient
quantity of working capital. It is crucial to retain right level of working capital. Working capital
management is one of the most important functions of corporate management.
1.3. Working Capital Management:
Kumar (2008) a firm must have adequate working capital, as much as needed the firm. It
should be neither excessive nor inadequate. Both situations are dangerous. Excessive working
capital means the firm has idle funds which earn no profits for the firm. Inadequate working
capital means the firm does not have sufficient funds for running its operations. It will be
interesting to understand the relationship between working capital, risk and return. The basic
objective of working capital management is to manage firms current assets and current liabilities
in such a way that the satisfactory level of working capital is maintained, i.e.; neither inadequate
nor excessive.
Kaur (2010) Working Capital Management refers to all management decisions and
actions that ordinarily influence the size and effectiveness of the working capital. It is concerned
with the most effective choice of working capital sources and the determination of appropriate
levels of the current assets and their use. It focuses attention to the managing of current assets,
current liabilities and the relationships that exist between them. In the present day of rising
capital cost and scarce funds, the importance of working capital needs special emphasis. It has
been widely accepted that the profitability of a business concern likely depends upon the manner
in which its working capital is managed. The inefficient management of working capital not only
reduces profitability but ultimately may also lead a concern to financial crises. On the other
hand, proper management of working capital leads to a material savings and ensures financial
returns at the optimum level even on the minimum level of capital employed. Both excessive and
inadequate working capital is harmful for a firm. Excessive working capital leads to UN
remunerative use of scarce funds. On the other hand, inadequate working capital usually
interrupts the normal operations of a business and impairs profitability.
Vasarao (2010) Working capital sometimes is referred to as “circulating capital”.

Operating cycle can be said to be t the heart of the need for working capital. The flow begins
with conversion of cash into raw materials which are, in turn transformed into work-in-progress
and then to finished goods. With the sale finished goods turn into accounts receivable, presuming
goods are sold as credit. Collection of receivables brings back the cycle to cash. The company
has been effective in carrying working capital cycle with low working capital limits. It may also
be observed that the PBT in absolute terms has been increasing as a year to year basis as could
be seen from the above table although profit percentage turnover may be lower but in absolute
terms it is increasing. In order to further increase profit margins, SSL can increase their margins
by extending credit to good customers and also by paying the creditors in advance to get better
rates.
1.4. Determinants of working capital
Kumar (2008) the amount of working capital is depends upon following factors
1.4.1. Nature of business
Some businesses are such, due to their very nature, that their requirement of fixed capital
is more rather than working capital. These businesses sell services and not the commodities and
that too on cash basis. As such, no founds are blocked in piling inventories and also no funds are
blocked in receivables e.g. public utility services like railways, infrastructure oriented project etc.
there requirement of working capital is less. On the other hand, there are some businesses like
trading activity, where requirement of fixed capital is less but more money is blocked in
inventories and debtors.
1.4.2. Length of production cycle
In some business like machine tools industry, the time gap between the acquisition of raw
material till the end of final production of finished products itself is quite high. As such amount
may be blocked either in raw material or work in progress or finished goods or even in debtors.
Naturally there need of working capital is high.
1.4.3. Size and growth of business
In very small company the working capital requirement is quit high due to high overhead,
higher buying and selling cost etc. as such medium size business positively has edge over the
small companies. But if the business start growing after certain limit, the working capital
requirements may adversely affect by the increasing size.
1.4.4. Business/ Trade cycle
If the company is the operating in the time of boom, the working capital requirement may
be more as the company may like to buy more raw material, may increase the production and
sales to take the benefit of favorable market, due to increase in the sales, there may more and
more amount of funds blocked in stock and debtors etc. similarly in the case of depressions also,
working capital may be high as the sales terms of value and quantity may be reducing, there may
be unnecessary piling up of stack without getting sold, the receivable may not be recovered in
time etc.
1.4.5. Terms of purchase and sales
Some time due to competition or custom, it may be necessary for the company to extend
more and more credit to customers, as result which more and more amount is locked up in
debtors or bills receivables which increase the working capital requirement. On the other hand, in
the case of purchase, if the credit is offered by suppliers of goods and services, a part of working
capital requirement may be financed by them, but it is necessary to purchase on cash basis, the
working capital requirement will be higher.
1.4.6. Profitability
The profitability of the business may be vary in each and every individual case, which is
in turn its depend on numerous factors, but high profitability will positively reduce the strain on
working capital requirement of the company, because the profits to the extent that they earned in
cash may be used to meet the working capital requirement of the company.
1.4.7. Operating efficiency
If the business is carried on more efficiently, it can operate in profits which may reduce
the strain on working capital; it may ensure proper utilization of existing resources by
eliminating the waste and improved coordination etc.
1.5. Objectives of Working Capital:
The objective of working capital management is to maintain the optimum balance of each
of the working capital components. This includes making sure that funds are held as cash in bank
deposits for as long as and in the largest amounts possible, thereby maximizing the interest
earned.
Surya (2010) has defined it as Working capital management involves the relationship
between a firm's short-term assets and its short-term liabilities. The goal of working capital
management is to ensure that a firm is able to continue its operations and that it has sufficient
ability to satisfy both maturing short-term debt and upcoming operational expenses. The
management of working capital involves managing inventories, accounts receivable and payable,
and cash.
Every business needs some amount of working capital. It is needed for following purposes:-
 For the purchase of raw materials, components and spares.

 To pay wages and salaries.
 To incur day to day expenses and overhead costs such as fuel, power, and office expenses
etc.
 To provide credit facilities to customers etc.
 Maintenance of working capital at appropriate level, and
 Availability of ample funds as and when they are needed.
In the accomplishment of these two objectives, the management has to consider the
composition of current assets pool. The working capital position sets the various policies in the
business with respect to general operations like purchasing, financing, expansion and dividend
etc. When considering these techniques and strategies, departments need to recognize that each
department has a unique mix of working capital components. The emphasis that needs to be
placed on each component varies according to department. For example, some departments have
significant inventory levels; others have little if any inventory.
1.6. Sources of Working Capital:
Horne and Wachowicz (2010) Working capital is a liquid asset available for use in the
production of goods and services for a business. Sources of money, or financing, to serve in this
role can take several forms. Obtaining money for working capital could consume much time and
effort from a business that is struggling with cash flow. Fortunately, business owners have
several sources from which to choose.
1.6.1. Bank Loan
Banks earn money by making loans to people and businesses that pay them back with
interest. They lose money by making loans to borrowers who default. So banks want assurance
that a borrower can and will pay them back. If a business has a track record of good credit and
revenue growth, a bank will likely be willing to provide a loan to help the company continue
operating.
1.6.2. Factoring
Factoring turns accounts receivables or invoices into cash. Companies offering factoring
services will either lend money against invoices that serve as collateral, or they will buy the
invoices from the company, turning promises of future income into immediate working capital.
1.6.3. Grants
Grants are sums of money awarded, usually with no obligation for repayment.
Organizations or wealthy individuals will award grants as part of charitable and tax-deductable
causes, or as part of proportioning themselves through public relations. With little or no
obligation attached to them, grants are popular, and many businesses may compete for a single
grant. An example is the small business grant the National Institutes of Health established to
promote the creation of new health-care products.
1.6.4. Bonds
Also called corporate notes, bonds are loans that private investors make to a company.
Unlike a bank, the investors cannot establish the terms of the note, such as the yield, with the
company. The investor either buys, or does not buy, a bond with the terms that the company
offers. However, bond purchasers have the flexibility to trade the bonds on an open market, just
like they might trade shares of stock in a company.
1.6.5. Stock
Investors can purchase a share of ownership, or stock, in a company. Unlike a loan, the
investor is promised no predictable rate of return on the investment. Instead, the owner of stock
is speculating that the value of the company will increase -- thus increasing the value of the
investment in stock as well. The company can receive funds for their sale of stock and use it as
working capital.
1.7. Sources of working Capital
There are two types of Sources of working Capital:
1.7.1. Long Term Source of Working Capital
Long term financing is a form of financing which is provided for a period of more than a
year. This financing should be taken from different sources i.e. Issue of shares, debenture, long
term debts and reserves etc.
1.7.2. Short Term Source of Working Capital
Short term financing is a form of financing which is provided for a period of less than a year.
This financing should be taken from different sources i.e. Banks credit, Trade credits, Public
deposits and Advances from customers etc.
1.8. Need of working capital management:
Vicky (2010) the need for working capital grosses or current assets cannot be over
emphasized. As already observed, the objective of financial decision making is to maximize the
shareholders wealth. To achieve this, it is necessary to generate sufficient profits can be earned
will naturally depend upon the magnitude of the sales among other things but sales cannot
convert into cash. There is a need for working capital in the form of current assets to deal with
the problem arising out of lack of immediate realization of cash against goods sold. Therefore
sufficient working capital is necessary to sustain sales activity. Technically this is refers to
operating or cash cycle. If the company has certain amount of cash, it will be required for
purchasing the raw material may be available on credit basis. Then the company has to spend
some amount for labor and factory overhead to convert the raw material in work in progress, and
ultimately finished goods. These finished goods convert in to sales on credit basis in the form of
sundry debtors. Sundry debtors are converting into cash after expiry of credit period. Thus some
amount of cash is blocked in raw materials, WIP, finished goods, and sundry debtors and day to
day cash requirements. However some part of current assets may be financed by the current
liabilities also. The amount required to be invested in this current assets is always higher than the
funds available from current liabilities. This is the precise reason why the needs for working
capital arise.
1.9. Types of Working Capital:
Titman, Martin, and Keown (2010) there are four types of Working capital.
1.9.1. Gross working capital
Total or gross working capital is that working capital which is used for all the current
assets. Total value of current assets will equal to gross working capital. In simple words, it is
total cash and cash equivalent on hand. But remember, we do not account of current liabilities in
gross working capital.
1.9.2. Net Working Capital
Net working capital is the excess of current assets over current liabilities.
Net Working Capital = Total Current Assets – Total Current Liabilities
This amount shows that if we deduct total current liabilities from total current assets, then
balance amount can be used for repayment of long term debts at any time. It also measure
of both a company's efficiency and its short-term financial health.
1.9.3. Permanent Working Capital
Permanent working capital is that amount of capital which must be in cash or current
assets for continuing the activities of business. It also shows the minimum amount of all current
assets that is required at all times to ensure a minimum level of uninterrupted business
operations.
1.9.4. Temporary Working Capital
Sometime, it may possible that we have to pay fixed liabilities, at that time we need
working capital which is more than permanent working capital, then this excess amount will be
temporary working capital. In normal working of business, we don’t need such capital.
1.10. Types of Working Capital Loan:
Ross and Westerfield (2009) we can also Fulfills the requirement by Taking Working
Capital Loans. Working capital loans are used by companies to finance their daily operations or
boost their cash flow. In times of financial difficulties, a business can seek this loan so that it will
have enough cash to pay for salaries, rent, mortgages and other expenses. This loan can be either
unsecured or secured. There are various types of loans; below are six of the most common types
of capital loans.
1.10.1. Bank Overdraft Facility or Credit Line
A good credit score, the interest rate and the maximum line of credit that you can get
depends on your company’s relationship with the lender. One advantage that this type of credit
facility has over other types of working capital loans is that the borrower only pays for the
interest applicable to the amount that has been overdrawn. The rates are typically set between 1
and 2 percent above the prime rate of the bank.
1.10.2. Short-Term Loans
Unlike a line of credit, a short term loan comes with a fixed interest rate and payment
period. The loan repayment period is typically 12 months. Among all types of working capital
loans, this particular credit facility is usually secured. However, if your business has a good
working relationship with the lender and you have a good credit history, you may be able to get a
short-term debt, even without any collateral.
1.10.3. Equity Funding via Personal Resources or Investors
This particular loan type is commonly obtained from personal resources, such as
investment from friends or family and home equity loans. This kind of working capital loan is
the most ideal for businesses that are just starting up. Also, equity loans may be the most
practical loan facility that you can get in case your company does not have a good credit history.
1.10.4. Accounts Receivable Loans
Another way to secure working capital is by applying for loans that take into
consideration the accounts receivable, or confirmed sales order value of your company. This type
of debt is ideal if your company lacks funds to fulfill a sales contract or order. However, lenders
usually provide this type of working capital loans only to businesses that are reputable or those
that have a proven track record for paying debts and fulfilling obligations.
1.10.5. Factoring or Advances
This type of working capital debt is very similar to the accounts receivable loan. The only
difference is that instead of confirmed orders or accounts receivable, the value of the loan is
based on future credit card receipts. This particular debt is only appropriate for businesses that
accept credit card payments.
1.10.6. Trade Creditor
A loan that is provided by a present or potential supplier is called a trade creditor working
capital loan. More often than not, suppliers will offer a trade credit facility if you place bulk
orders from them. However, before you can secure such a loan, you can expect that the trade
creditor will thoroughly check on your company’s credit history.
1.11. Advantages of working capital:
Eun and Resnick (2009) Adequate working capital provides certain benefits to the
company they are:
1.11.1. Increase in debt capacity and goodwill:
Adequate working capital represents the financial soundness of the company. If one
company is financially sound it would be able to pay its creditors timely and properly. It will
increase company’s goodwill. It crests confidence among investors and creditors. Thus a firm
with adequate working capital can raise requisite funds from market, borrow short term credit
form banks, and purchases inventories of raw material etc., for the smooth operations of its
business.
1.11.2. Increase in production inefficiency:
With adequate working capital the firm can smoothly carryout research and development
actives and thus adds to its production efficiency. Exploitation of favorable opportunities In the
presence of adequate working capital, a company can avail the benefits of favorable
opportunities. Adequate working capital will help the company to have bulk purchases, seasonal
storage of raw material etc., which would reduce the cost of production, thus adds to its profit.
1.11.3. Meeting contingencies adverse changes:
A company can easily face certain business and economic crises a company having
adequate working capital can successfully meet contingencies such as business oscillations,
financial crisis arising from heavy losses etc.,
1.11.4. Available cash discount:
Maintenance of adequate working capital enables a company to avail the advantage of

cash discount by making cash payment for to the suppliers of raw materials and merchandise.
Obviously it will reduce the cost of production and increase the profit of the company.
1.11.5. Solvency and efficiency fixed assets:
It helps to maintain the solvency of the company. So that payments could be made in
time as and when they fall due. Likewise, adequate working capital also increases the efficiency
for fixed assets insofar as their proper maintenance depends upon the availability of funds.
1.11.6. Attractive dividend to shareholders:
It enables the company to offer attractive dividend to the shareholders so that sense of
security and confidence will increase among them. It also increases the market values of its
shares.
1.12. Objectives of the research:
The purpose of this study is hopefully to contribute towards a crucial element in financial
management which is working capital management. Working capital management and its effects
on profitability is focused in this study. Specific objectives are to examine a relationship between
working capital management and profitability over a 4 years period, to establish a relationship
between the two objectives of liquidity and profitability of the firms and to investigate the
relationship between debt used by the a firm and its profitability.
The main objective of the study is to determine the effect of working capital on business
profitability which has to do with,
• To establish a relationship between Working Capital Management and Profitability over

a period of Four years of Pakistani Companies listed on Karachi Stock Exchange.
• To find out the relationship between profitability and size of the Pakistani Companies
listed on Karachi Stock Exchange.
• To find out the relationship between debt used by the Pakistani Companies listed on
Karachi Stock Exchange and its profitability
• To draw conclusion about relationship of working capital management and profitability

of the Pakistani Companies listed on Karachi Stock Exchange.
To accomplishment of these objectives, the management has to consider the composition

of current assets pool. The working capital position sets the various policies in the business with
respect to general operations like purchasing, financing, expansion and dividend etc,
1.13. Research Aims:
Bassey (2009) the subsidiary Objective of Working Capital Management is to provide

adequate support for the smooth functioning of the normal business operations of a company.
This Objective can be sub-divided into two parts:-
1.13.1. Liquidity:
The quantum of Investment in Current Assets has to be made in a manner that it not only
meets the needs of the forecasted sales but also provides a built in cushion in the form of safety
stocks to meet unforeseen contingencies arising out of factors such as delays in arrival of Raw
Material, sudden spurts in demand etc. Consequently, the investment in current assets for a given
level of forecasted sales will be higher if the management follows a conservative attitude than
when it follows an aggressive attitude. Thus, a company following a conservative approach is
subject to a lower degree of risk than the one following an aggressive approach. Further, in the
former situation the high amount of Investment in Current Assets imparts greater liquidity to the
company than under the latter situation wherein the quantum of investment in Current Asset is
less. This aspect exclusively covers the liquidity dimension of Working Capital.
1.13.2. Profitability:
Once we recognize the fact that the total amount of financial resources at the disposal of a
company is limited and these can be put to alternative uses, the larger the amount of investment
in current assets, the smaller will be the amount available for investment in other profitable
avenues at hand with the company. A conservative approach in respect of Investment in Current
Assets leaves fewer amounts for other Investments than an aggressive approach does. Further,
since the Current Assets will be more for a given level of Sales forecast under the conservative
approach, the turnover of Current Assets (calculated as ratio of Net Sales to Current Assets) will
be less than what they would be under the aggressive approach. Even if we assume the same
level of Sales Revenue, operating Profit before Interest and Tax and Net (Operating) fixed assets,
the company following a conservative policy will have a low percentage of operating
profitability as compared to its counterpart following an aggressive approach.
Chapter No. 2
Literature Review
Raheman and Nasr (2007) in that research, the authors are selected a sample of 94
Pakistani firms listed on Karachi Stock Exchange for a period of 6 years from 1999 – 2004. They
used such variables Average collection period, Inventory turnover in days, Average payment
period, Cash conversion cycle and Current ratio to find the relationship of the Net operating
profitability of Pakistani firms. Debt ratio, size of the firm (measured in terms of natural
logarithm of sales) and financial assets to total assets ratio have been used as control variables.
Pearson’s correlation and regression analysis are used for data analysis. The results show that
there is a strong negative relationship between variables of the working capital management and
profitability. It means that as the cash conversion cycle increases it will lead to decreasing
profitability of the firm. They find that there is a significant negative relationship between
liquidity and profitability. They also find that there is a positive relationship between size of the
firm and its profitability. There is also a significant negative relationship between debt used by
the firm and its profitability.
They have concluded that, Most of the Pakistani firms have large amounts of cash
invested in working capital. It can therefore be expected that the way in which working capital is
managed will have a significant impact on profitability of those firms. They have found a
significant negative relationship between net operating profitability and the average collection
period, inventory turnover in days, average payment period and cash conversion. These results
suggest that managers can create value for their shareholders by reducing the number of day’s
accounts receivable and inventories to a reasonable minimum. The negative relationship between
accounts payable and profitability is consistent with the view that less profitable firms wait
longer to pay their bills.
Uyar (2009) The purpose of that research was (1) to set industry benchmarks for cash
conversion cycle (CCC) of merchandising and manufacturing companies, and to examine the
relationship between (2) the length of the CCC and the size of the firms, and (3) the length of the
CCC and profitability. The data were collected from the financial statements of the corporations
listed on the Istanbul Stock Exchange (ISE) for the year 2007. ANOVA and Pearson correlation
analyses are used for empirical investigation. The major findings of the study are as follows. The
lowest mean value of the CCC is found in the retail/wholesale industry, with an average of 34.58
days, and the highest mean value is found in the textile industry, with an average of 164.89 days.
There is a significant negative correlation between the CCC and the variables; the firm size and
the profitability.
The paper showed that retail/wholesale industry has shorter CCC than manufacturing
industries. The main reason for this is that retail/wholesale industry do not manufacture goods,
rather it keeps ready-for-sale goods in its warehouse. Hence, it has shorter days in inventory.
Secondly, the retail/wholesale industry makes cash sales or credit sales with short maturity.
Moreover, the retail/wholesale industry is slower in paying its accounts payable to its suppliers.
Another important finding of the study is that the textile industry has the longest CCC; therefore,
the industry may have liquidity problems. Moreover, the finding indicated a significant negative
correlation between the length of CCC and the firm size. Lastly, the significant negative
correlation between the length of CCC and the profitability is another important finding of the
study. The message to the firms is that the longer CCC, the less profitable you are. The probable
reason are keeping inventory for a long time, being slow in collecting receivables, and paying
debts quickly.
Padachi (2006) in that research, the trend in working capital needs and profitability of
firms is 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 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. An analysis of the liquidity, profitability and operational
efficiency of the five industries shows significant changes and how best practices have
contributed to performance.
This research showed that, the working capital needs of an organization change over time
as does its internal cash generation rate. The paper and printing industry has been able to achieve
high scores on the various components of working capital and this has positively impact on its
profitability. Further that there is a pressing need for further empirical studies to be undertaken
on small business financial management. This study has come at an opportune time where the
Mauritian government is deploying resources to help the SME sector so that the latter can
positively contribute to the Mauritian economy. This analysis has been constrained by the sample
size and the nature of the data, which could have well affected the results.
Wongthatsanekorn (2010) this objective of this research is to investigate the impact of

Cash-to-Cash cycle time (C2C), inventory conversion period (INV), receivable conversion
period (AR), and payable deferral period (AP) of listed private hospitals in the Stock Exchange
of Thailand (SET). The data are obtained from the financial reports of the listed private hospitals
in SET across 13 private hospital populations, from 2002 to 2008. The hypothesis testing is
applied to determine the association between the dependent variable (asset turnover, AT) and
independent variables (INV, AR, AP, and C2C). The control variables are company size, sales
growth, financial debt level, and annual gross domestic product growth. The results from regular
regression, unexpectedly show that only the independent variable AP is negatively related to AT
under the control variables. The rest of the independent variables statically reveal no relationship
with AT on significance level 0.10. The results from panel data regression show that both AR
and AP are negatively related with AT on significance level 0.10. The results also suggest that
the listed firms in SET can increase corporate profitability by decreasing AR and AP.
This Research shows the results that the listed private hospital firms in SET can increase
corporate profitability, which implies through the parameter of asset turnover, by decreasing
receivables conversion period and payables deferral period. If the results can be applied in
practice, it can be beneficial to both drug distributors and the hospitals. The drug distributor will
be able to collect the payment sooner and invest more while the hospitals will increase the
profitability from the given discount with shorter deferral payment period.
Zariyawati, Annuar, Taufiq, and Rahim (2009) According to this research, to reach
optimal working capital management firm manager should control the tradeoff between
profitability and liquidity accurately. The intention of this research is to examine the relationship
between working capital management and firm profitability. Cash conversion cycle is used as
measure of working capital management. This study is used panel data of 1628 firm-year for the
period of 1996-2006 that consist of six different economic sectors which are listed in Bursa
Malaysia. The coefficient results of regression analysis provide a strong negative significant
relationship between cash conversion cycle and firm profitability. This reveals that reducing cash
conversion period results to profitability increase.
This research concluded that Working capital management is an important part in firm
financial management decision. The ability of the firm to continuously operate in longer period
is depends on how they deal with investment in working capital management. The optimal of
working capital management could be achieved by firms that manage tradeoff between
profitability and liquidity. Results of this research found that cash conversion cycle are
significantly negative associated to the firm profitability.
Lazaridis and Tryfonidis (2009) this research is about the relationship of corporate
profitability and working capital management. A sample of 131 companies listed in the Athens
Stock Exchange (ASE) is used for the period of 2001-2004. The purpose of this research is to
establish a relationship that is statistical significant between profitability, the cash conversion
cycle and its components for listed firms in the ASE. The results of research showed that there is
statistical significance between profitability, measured through gross operating profit, and the
cash conversion cycle. According to this research managers can create profits for their
companies by handling correctly the cash conversion cycle and keeping each different
component (accounts receivables, accounts payables, inventory) to an optimum level.
This research concludes that there is 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. According to research lower gross operating
profit is associated with an increase in the number days of accounts payables. 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. Therefore managers can create profits for their companies by
handling correctly the cash conversion cycle and keeping each different component (accounts
receivables, accounts payables, inventory) to an optimum level.
Falope and Ajilore (2009) The objective of this research is to provide the empirical
evidence about the relationship about impact of working capital management on the profitability
of the sample of Nigerian quoted non-financial firms for the period of 1996 to 2005. The data is
analyzed by the regression. It is found the there is a negative relationship between net operation
profit and the average collection period, inventory in days, average payment period and cash
conversion cycle of the sample of fifty Nigerian company listed on Nigeria stock exchange. This
reveals that reducing cash conversion period results to profitability increase.
Zubairi and Baig (2010) the purpose of this research is to investigate how profitability of
firms, in the automobile sector of Pakistan, is influenced by working capital management and
capital structure of firms. The study used sample data of 17 firms out of 13 automobile sector
companies listed on the Karachi Stock Exchange from the period 2000-08. The current ratio is
used as representative of the result of working capital management and financial leverage is used
as the benchmark for capital structure. The purpose of the research was to determine by the
observation and test basis using regression data analysis.
It is concluded that financial leverage has a significant positive impact on the profitability
of the firms. Operating leverage has a negative and statically significant influence on
profitability. The growth of profitability is positively associated with the size of the firm, and an
increase in liquidity ratio (CR) leads to an increase in firm profitability. The profit is directly
proportion on the size of the automobile firm, as the increase in the size will lead to higher
profits. The degree of operating leverage appears to be statistically significantly linked to
profitability in our model; the negative sign of the coefficient being in line with the Dynamic
Tradeoff Theory. The key factor for improving industry profitability in the future appears to be
an increase in capacity utilization which can get further impetus if interest rates also decline.
Sen, Koksal and Oruc (2008) this research is about; the effect of changes in management
efficiency in working capital management in to the change in working capital is compared by
company size and sectors. The data of this research were taken from the quarterly financial
statements of 55 manufacturing companies which were in operation in Istanbul Stock Exchange
(ISE) for the time period of 1993 and 2007. In their research they studied, for inventories, short
term commercial receivables and short term commercial liabilities and calculated the effect of
change in management efficiency on to the effect of working capital change.
This research is concluded that, management inefficiency in the issue of inventory

management related with ISE companies is seen as a major result. Bank managements prefer to
give credit for receivables rather than giving credit for inventories. Companies in Istanbul Stock
Exchange should give more attention to inventory management in the issue of working capital
management.
Ganesan (2007) this research analyses is about the working capital management
efficiency of firms from telecommunication equipment industry. A correlation and regression
analysis is used to examine the relationship between working capital management efficiency and
profitability. 443 annual financial statements of 349 telecommunication equipment companies
covering the period 2001-2007 are used for collection of data, this research found evidence that
even though “day’s working capital” is negatively related to the profitability, it is not
significantly impacting the profitability of firms in telecommunication equipment industry.
This research could be concluded that when the working capital management efficiency
is improved by decreasing days of working capital, there is improvement in profitability of the
firms in telecommunication firms in terms of profit margin. The inventory management among
the sample firms may not be efficient and research indicates that the management of DSO does
not have much impact on the return on assets and profit margin. There is a poor management of
accounts receivable and accounts payable. Overall there is evidence that the working capital
management efficiency in telecommunication industry is poor. Working capital management
efficiency could be improved by concentrating on reducing inventory and getting more credits
from suppliers.
Danuletiu (2010) the purpose of this research is to analyze the efficiency of working
capital management of companies from Alba County. A Pearson correlation analysis is used to
examine the relation between the efficiency of the working capital management and profitability
from sample of 20 annual financial statements of companies covering period 2004-2008. The
conclusion of research is that there is a weak negative linear correlation between working capital
management indicators and profitability rates.
From the study we can say that in the last year, half of the sampled companies had a
negative gap between stocks and claims’ liquidation. From the 20 analyzed companies, only nine
have applied an offensive policy of operating cycle management in 2005 and 11 companies have
adopted a defensive policy; the situation has changed in 2008. This situation results also from the
negative weak relation between working capital management indicators and profitability rates.
The number of companies that have implemented an offensive policy increased to 13 and the
number of companies that have applied a defensive policy fell to 7.
Garcia-Teruel and Solano (2008) the objective of the research is to provide empirical
relationship about the effects of working capital management on the profitability of a sample of
small and medium-sized (SMEs) Spanish firms. 8,872 SMEs is used in this research which is
covering the period 1996-2002. The results demonstrate that managers can create value by
reducing their firm’s number of day’s accounts receivable and inventories and by shortening the
cash conversion cycle also improves the firm’s profitability.
It is concluded that Working capital management is important in the case of small and
medium-sized companies. Most of the SMEs invested in there currents assets and current
liabilities are one of their main sources of external finance. According to the data analysis there
is a significant negative relation between an SME’s profitability and the number of day’s
accounts receivable and days of inventory. SMEs have to be concerned with working capital
management because they can also create value by reducing their cash conversion cycle to a
minimum and therefore they can be increases profitability of the firm.
Chatteriee (2010) this research tells us the relationship between the impacts of working
capital management of the profitability of the companies listed on London Stock Exchange. A
sample of 30UK companies listed on London stock exchange is taken for the time period of three
years 2006-2008. For the analysis different variable is taken which include Average collection
period, Inventory Turnover in Days, Average Payment Period, Cash Conversion Cycle, Current
Ratio and Quick Ratio. Debt ratio and size of the company is also used to compare the
Profitability. Pearson’s correlation is used as data analysis.
From the data analysis it is said that there is a strong negative relationship between the
variable of working capital management and profitability of the companies. That’s mean
increases in the cash conversion cycle will decrease the profitability of the company. There is
also negative relationship between the liquidity and the profitability of the companies. There is a
positive relationship between the size of the company and the profitability. That’s mean as the
size or sales of the companies are increases the profitability of the companies will also increase.
The result also shows that there is also negative relationship between the debt taken by the
company and the profitability of the company.
Appuhami (2008) the objective of this research is to examine the impact of firms’ capital
expenditure on their working capital management. The data is collected from listed companies in
the Thailand Stock Exchange. Regression analysis is used to examine the data. The empirical
research found that the firms’ operating cash flow has a significant relationship with working
capital management same as previous similar researches.
It is concluded in this research that inefficient working capital management results in

reduces the profitability of the firm and insufficient amount of working capital and results in
financial difficulty. The listed companies in Thailand change their working capital management
policies based on many factors, such as capital expenditure, operating cash flow, and sales
growth. It is recommended that firms operating in other countries consider the pattern of capital
expenditure in managing working capital. Especially, the findings suggest that companies
manage working capital efficiently when companies have growth opportunities so that they can
meet required capital expenditure to expand their business.
Nazir and Afza (2009) this research examines the relationship between working capital
management policies and a firm’s profitability. For this research data is using for the period of
1998-2005. 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. Aggressive Investment Policy
(AIP), Aggressive Financing Policy (AFP), Return on Assets (ROA) and Tobin’s q is used as
variable in this research. Aggressive Investment Policy (AIP) results in minimal level of
investment in current assets versus fixed assets. An Aggressive Financing Policy (AFP) utilizes
higher levels of current liabilities and less long-term debt. Return on Assets (ROA) and Tobin’s
q are used to examine the impact of working capital policies on the profitability through
accounting measures of profitability as well as market measures of profitability. The size of the
firm (SIZE) has been used as control variable.
From the research it is found that there is a negative relationship between the profitability
measures of firms and degree of aggressiveness of working capital investment and financing
policies. The results of Tobin’s q were almost similar results for working capital investment
policy. The market value of firms using high level of current liabilities in their financing is more
than the book value. Firms with more aggressive policy towards working capital may not be able
to generate more profit. Investors are found giving more value to the firms that adopt an
aggressive approach towards working capital financing policies.
Narware (2004) This research is conduct to examine the impact of working capital
management on the profitability of the firm and the interrelationship between profitability and
working capital, with the help of ratio analysis. According to this research 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 the firm improved its liquidity, it increases the level of its working capital.
In this research a fertilizer producing company for assessing the impact of working capital on its
profitability during the period 1990-91 to 1999-2000 and impact has been examined by
computing co-efficient of correlation and regression between profitability ratio and working
capital ratio.
Out of the nine ratios selected for the study three ratios, namely CTSR, WTR and DTR
registered negative correlation with the selected profitability ratio, ROI. The slopes of the ROI
equation depicted those positive and negative influences of variations in the independent
variables on the profitability of the company. Out of the five regression coefficients of the ROI
Line, only one coefficient which was associated with DTR revealed negative influence on the
profitability. WCL of the company concluded, the increase in the profitability of the company
was less than the proportion to decrease in Working Capital.
Mathuva (2009) this research examined the relationship of working capital management
and the corporate profitability. Sample of 30 companies is selected from Nairobi Stock Exchange
(NSE) for the time period of 1993-2008. Regression Model is used to analysis the data. It is
found during the research the there is highly significant negative relationship between the
account collection period and the profitability that’s mean profit will be increase as the collection
period is decrease. Another finding is that there is highly positive relation between the Inventory
Conversion period and its profitability. That’s mean as the Time period of the inventory
conversion in to cash is decrease it will lead to more profits to the company. There is also
significant positive relationship between average payment period and company’s profitability.
From the research it is concluded that the company should reduce number of days of
collection period. The management could makes more profit by maintaining the Inventory level
and management should try to reduce the period of cash conversion cycle.
Gill, Biger and Mathur (2010) the research examines the relationship between working
capital management and profitability. Sample of 88 American firms listed on New York Stock
Exchange for a period of 3 years from 2005-2007 were selected. Cash conversion cycle (CCC)
and profitability, measured through gross operating profit. It follows that managers can create
profits for their companies by handling correctly the cash conversion cycle and by keeping
accounts receivables at an optimal level. Number of Days Accounts Receivables, Number of
Days Accounts Payables, and Number of Days Inventory turnover, Cash Conversion Cycle, Firm
Size (Natural Logarithm of Sales) Financial Debt Ratio and Fixed Financial Asset Ratio are used
as variable of working capital management.
It is concluded that slow collection of accounts receivables is correlated with low

profitability and that can be improve by reducing the credit period. There is no statistically
significant relationship found between the average days of accounts payable and the profitability
of the firm. There is also not found any relationship between average number of days the
inventory is held and the profitability. There is a positive relationship between cash conversion
cycle and gross operating profit. There is no significant relationship found between firm size and
its gross operating profit ratio. Negative relationship found between the accounts receivables and
corporate profitability. The managers can create value for their shareholders by reducing the
number of days for accounts receivables.
Dong and Su (2010) the working capital management effects on firm’s profitability as
well on liquidity. Data is collected from listed firms in Vietnam stock market for the period of
2006-2008. The cash conversion cycle and its components are used as controllable variables. It is
found that there is a strong negative relationship between profitability, measured through gross
operating profit, and the cash conversion cycle. This means that as the cash conversion cycle
decreases, it will lead to increase the profitability of firm. By the adequate cash conversion cycle
and keeping each different component to an optimum level the managers can create a positive
value for the shareholders by handling.
In this research it is found that there is a strong negative relationship between the
measures of working capital management including the number of days accounts receivable,
number of days inventories and cash conversion cycle with corporate profitability. It is also
found that there was a positive relationship between number of day’s accounts payable and
profitability. It is concluded that by reducing the number of day’s accounts receivable and
inventories, the managers can increase value for share holders.
Zubairi (2009) this research examines how profitability of firms, in the automobile sector
of Pakistan, is influenced by working capital management and capital structure of firms. The
study used sample data of seven firms quoted on the Karachi Stock Exchange from the period
2000-08. The current ratio is used as variable for this research and financial leverage as the
bench mark for capital structure. Regression analysis is used to examine the relationship between
them. Degree of Operating Leverage (DOL) and Degree of Financial Leverage (DFL) is also
analyzed in the research.
It is concluded that; financial leverage has a significant positive impact on profitability of

the firms. Operating leverage has a negative and statically significant influence on profitability.
The growth of profitability is positively associated with the size of the firm, and an increase in
liquidity ratio (CR) leads to an increase in firm profitability. The firm size is found to have a
significant and direct effect on profitability of automobile firms in Pakistan. A firm can enhance
its profitability either by increasing its currents assets or by reducing its current liabilities. The
degree of operating leverage appears to be statistically significantly linked to profitability in the
model; the negative sign of the coefficient being in line with the Dynamic Tradeoff Theory.
There might be some room for further profit maximization by increasing financial leverage.
Dash and Hanuman (2010) this proposes of this research establish a goal programming
model for working capital management. Goal programming model is use to making working
capital decision to achieved balance between the conflicting objectives of liquidity and
profitability. Cash, Marketable Securities, Accounts Receivable, Inventory, Current Liabilities,
Fixed Assets, Sales, Profit, Current Ratio, Profit Margin, Working Capital Turnover Ratio and
Fixed Assets Turnover Ratio these are the variables which are used in the Model. The model
determines working capital turnover and fixed assets turnover ratios, how funds should be
maintained between working capital/current assets and fixed assets to achieve targeted levels of
liquidity and profitability, whilst minimizing the opportunity cost/loss of excess liquidity.
The model proposed of this research is to extend the scope of Agarwal’s model. The
results of the model tell that working capital, and inventory in particular, should be floating to
profitability. In particular, the relationship between different components of working capital,
fixed assets, sales, and profits needs to be examined in greater depth and modeled accordingly. It
considers a specific form of liquidity and profitability goals/constraints, which may not have
taken some other relevant parameters into consideration; and it assumes stable turnover ratios,
which may limit its applicability in practice.
Nobanee (2010) this research shows the relationship between the Cash conversion cycle
and the profitability of the firm. As the time period of the cash conversion cycle decrease the
profitability of the company will be increase. On the other hand shortening the cash conversion
cycle could harm the firm’s operations and reduces profitability. This could happen when taking
actions to reduce the inventory conversion period, a firm could face inventory shortages.
When reducing the receivable collection period a firm could lose its good credit
customers. The management should keep the optimal levels of inventory, receivables, and
payables. In this regard, we suggest an optimal cash conversion cycle as more accurate and
comprehensive measure of working capital management. However, achieving the optimal levels
of inventory, receivable, and payable will minimizes the carrying cost and opportunity cost of
holding.
Kaur (2010) this research is conducting to examine the importance of working capital
management. The research covers a production of 8 year, 1999-2007. For the purpose of
investigation both primary and secondary data is used. The collected data is analyzed by
applying research tool which include accounting tools like Analysis, Cash Flow Analysis,
Common Size and Trend Analysis. This is a two-dimensional study which examines the policy
and practices of cash management, evaluate the principles, procedures and techniques of
Investment Management, Receivable and Payable Management deals with analyzing the trend of
working capital management and also to suggest an audit program to facilitate proper working
capital management in Indian Tyre Industry.
The research shows that firms with a larger volatility of stock return tend to have an
implied volatility curve of less negative slope, and find that firm-specific variables such as
leverage ratio, firm size, beta, and traded volume provide useful explanations for the slope of the
smile. It is also examined how market-wide variables influence the slope of implied volatility of
individual stocks. In the analysis of robustness, the results indicate that the variable put-to-call
open interest ratio can best represent the sentiment of investors, even though we use the most
liquid data to test the robustness; we cannot show that investors wish to attain a larger position in
put options to hedge the downside risk.
Karaduman, Akbas, Ozsozgun and Durer (2010) the objective of research is to examine
the impact of working capital management on the profitability of 140 randomly selected
companies in the Istanbul Stock Exchange for the period of 2005-2008. The data is analyzed by
regression analysis. Return on assets is used as depended variable. Number of days account
receivable, Number of days account payable, Number of days of inventory and cash conversion
cycle is used as independent variables. Debt leverage, size of the company and GDP is used as
control variable.
The findings are similar to the previous studies. The companies should focus on working
capital management in order to increase their profitability by seriously and professionally
considering the issues on their cash conversion cycle which is derived from the number of day’s
accounts payable, the number of day’s accounts receivable, and the number of days of
inventories.
Ramachandran and Janakiraman (2008) the purpose of this research is to examine the
relationship between Working Capital Management Efficiency and Earnings before Interest&
Taxes (EBIT) of the Paper Industry in India during 1997–1998 to 2005– 2006. To measure the
Working capital management efficiency three index values, Performance Index, Utilization
Index, and Efficiency Index are computed, and Cash Conversion Cycle (CCC), Accounts
Payable Days, Accounts Receivables Days, Inventory Days are variables used in this research.
Further, Fixed Financial Assets Ratio, Financial Debt Ratio and Size (Natural log of Sales) are
considered as control variables in the analysis, and are associated with the EBIT.
The study reveals that the Paper Industry has managed the working capital satisfactorily.
The Accounts Payable Days has a significant negative relationship with EBIT, which indicates
that by deploying payment to suppliers they improve the EBIT. It is concluded that the Indian
paper firms perform remarkably well during the period. Industry overall efficiency index was > 1
in 3 out of 9 years for the study period. Further, it is found that lower gross EBIT is associated
with an increase in the account payable days. The positive relationship between account
receivable days and firms EBIT suggests that less profitable firms will pursue a decrease of their
account receivable days in an attempt to reduce their cash gap in the CCC.
Chapter No. 3
Theoretical Framework
In the theoretical framework of this study a discussion about the tools, strategies and
implications of cash management will be carried out in terms of company liquidity. Emphasis
will be put on how to improve firm liquidity and the usage of effective strategies and its benefits
to corporations.
3.1. Working Capital
Working capital plays an important role in firm’s growth and profitability and is tightly
interlinked with the concept of liquidity that is discussed later on in context with cash
management. In its simplest and probably the most common form working capital can be
expressed as a difference between firm’s current assets and current liabilities.[ CITATION Wor11 \l
1033 ]
Net Working Capital = Current Assets – Current Liabilities
Some authors defined working capital as a “time lag between the expenditure for the
purchase of materials and the collection for the sale of the finished products”. Working Capital
Management (WCM) refers to a wider concept that covers both inventory and work in progress
and thereby combining elements of operations, production and financial management.
All the components of the working capital formula above can be found from the balance
sheet. By definition, current assets are those assets that are expected to generate cash within one
year and when looking at the balance sheet they are usually grouped under cash and cash
equivalents, short-term investments, receivables, prepaid expenses and inventories, while current
liabilities are obligations due to mature within one year. Different components of current
liabilities on the balance sheet include trade payables, short-term debt and accrued liabilities.
Working capital represents a significant part of firm’s assets and liabilities. Medium and small
companies tend to have relatively larger amount of capital tied in current assets and liabilities
than bigger firms. In a recent study of Spanish SME’s it was discovered that current assets
comprise 69% and current liabilities over 52% of total assets and liabilities. Great variation
across the sectors can be also found when comparing working capital structure.
3.2. Working Capital Cycle
Harper (2009) Working capital-cycle which is typical for manufacturing firms but can be
applied for service companies by passing some steps. The cycle starts with the purchase of raw
material inventories for production that are later turned into finished products. Completed
products are then held in inventories before they are sold to customers. Selling transactions can
be made by cash or by trade credit and hence, providing a delay until cash is received. There are
several costs associated at each step of the cycle and these costs represent the opportunity cost
for working capital. The purpose of Working Capital Management is to balance those costs and
maintain optimal levels of cash, raw materials and finished goods. Different elements of the
cycle such as inventory management and trade debtors and creditors are explained more in detail
as they all are means to affect the working capital balance. Purpose of this figure is to give a
larger view of the several steps that together form a company’s working capital policy.
3.3. Objectives of Working Capital Management
Working Capital Management is an important part of financial management and its

primary task is concerned with the matching of asset and liability movements over time, which
takes us to the two main purposes of Working Capital Management; liquidity and profitability.
Profitability refers to the shareholders’ wealth maximization and liquidity is concerned with
fulfilling financial obligations.
3.4. Working Capital Policy
A well established goal for many companies is to have as small working capital balance
as possible and some well known companies pursue zero working capital strategies. Why should
companies have any working capital if some firms are doing fine without it and what are the
determinants of policies? Arnold (2008) has suggested three different working capital policies
determined by the levels of working capital. Companies having so called relaxed working capital
policy have large levels of cash or near-cash balances with usually more generous customer
credit terms and larger inventories. This kind of policy is suitable for companies operating in
uncertain industries where liquidity buffers are needed. Companies with aggressive policy can be
seen in business areas with more certain cash flows. Only minimal safety inventory and lower
cash balances are needed. Moderate policy falls in between relaxed and aggressive policies.
Concluding the above discussed, Working Capital Management has not been in focus for
recent years but its importance has become more obvious in association with the economic
downturn. Working capital policies vary across the industries and as discussed in the literature
depend on the nature of the business company operates. Several means to control and monitor a
Working Capital Management are discussed later in this chapter. Empirical part of this study
examines how companies monitor their liquidity, an important component of Working Capital
Management.
3.5. Cash Management
Cash management is one part of Working Capital Management and usually concerns the
different processes and procedures of handling a company’s liquidity and the monitoring and
planning of it. Larsson and Hammarlund define the different items included within this area as:
payables systems, receivables system, management of liquid funds, currency management and
risks, short term financing, accounts payables and accounts receivables. Improving a company’s
cash management can result in better profit margins and higher turnover ratio which in turn can
lead to higher profitability.
As this study has set out to measure change in liquidity strategies and how it affects
profitability one need to look at the cash management strategies that affects liquidity. The
following sections will further explain how the different parts of the cash flow timeline can be
made more effective and improve the cash flow of a company.
3.6. Inventory Management
Inventory management is one area which can significantly improve the cash flow of a
company as it portrays pools of cash. One easy way of improving inventory management is to
focus on sales forecasting and adapting a control system for this area. By accurately forecasting
sales, inventory levels can be cut down and cash levels can improve.
Nelson identified several step in improving a firms inventory management. This included
an analysis of the company’s inventory levels in order to reduce its size. This means that the firm
might be forced to accept a higher price for their inventory as their orders becomes smaller.
Furthermore, slow-moving items needs to be identified and sold off to stimulate cash flow. Other
steps include accepting more back orders which effectively reduces inventory levels. However,
this is usually done on the expense of customer service and needs to be weighed against the
benefits as it might be beneficial to other competitors. Moreover, reducing lead times which
includes picking, packing and shipping may also contribute to improving the cash flow of the
company, as this means that goods can be shipped sooner to customers and invoicing can take
place. Last but not least Nelson also mentions closer supervision as step towards identifying lost
inventory. By improving the supervision of warehouse and material-handling personnel lost
inventory or inventory which has not been accurately recorded can be located and sold.
When evaluating the efficiency of inventory management it is very common to calculate

“days inventory held” (DIH) which expresses the average time that a good is held in inventory
before it is sold to customer. Since goods laying idle in inventory represents costs for the
company, the shorter the DIH are more efficiently assets are managed.
Days Inventory Held (DIH) = Inventory / (Cost of sales/365)
3.7. Accounts Receivables
Accounts receivables can be seen as assets of the firm or as loans given to customers by
the company. When there is a build-up of receivables, funds are unavailable that could otherwise
be put to more efficient use within the company and earn a return. The credit arrow illustrates the
time that it takes for the company to transform receivables into cash. After the delivery time, the
time that receivables are tied up in can usually be divided into three categories. The first one is
concealed credit time which is the time the company has given the customers to pay. The second
is authorized credit time, which consists of the time between delivery of goods and invoicing.
The last category is when credit falls due.
When it comes to the credit time that the company has given to their customers’ one has
to realize that the longer authorized credit time the more risk the company faces. A customer’s
payment behavior can change with time and so can the credit evaluation that the company has
done on their customers. To minimize this risk companies should always try to shorten these
credit times and if that cannot be done an adjustment of the price of the goods or services should
be made to compensate for the added risk. It is common practice by corporations to shorten the
credit arrow in order to speed up collections. One reason for this is that the creditworthiness of
customers can change over time and therefore needs to be revaluated. If corporations did not
work actively with shortening down the credit arrow it would mean that it would take longer
time for them to receive payment and that would reduce cash flow and might even result in
liquidity problems.
Companies can effectively measure the time it takes for their customers to pay their
invoice by the days-sales-outstanding ratio (DSO).
Days Sales Outstanding (DSO) = Receivables / (Sales/365)
This ratio measures how long it takes for the company’s customers to pay for its goods
and services and an increasing ratio will thus be negative for the company. For companies
experiencing cash flow problems or just wanting to improve their cash flow, shortening of the
credit arrow will provide gains in this area.
3.8. Accounts Payables
Dolfe & Koritz states that a company’s short-term debt is very much influenced by the
cash outflow and the major part of this outflow is made up by accounts payables. Accounts
payables have many similarities with receivables and are mostly affected by changing the
routines which can offer great savings for the company, usually in the form of interest and a
reduction of penalty interest. Other step to improve the payment process is to try and keep
company funds on an interest bearing account for as long as possible until payment to earn as
much interest as possible.
One way of monitoring accounts payables are by the day’s payables outstanding ratio
(DPO) which measures how long it takes for the company to pay for its goods or services.
Days Payables Outstanding (DPO) = Payables / (Cost of Goods Sold/ 365)

One key element of cash management is to have a good policy concerning these issues
and that those responsible are aware of it. The flow of accounts receivables will at times give
raise to short term surpluses and sometimes short-term deficits in companies’ liquidity,
establishing a need for short-term financing, and it is therefore important to have a well
functioning payment routine.
Obviously negotiating better credit terms will improve this area and a good guideline is to
try and renegotiate all invoices with less than a 30 days credit and always aim for as long credit
time as possible. When it comes to accounts payables a thing to keep in mind is to pay vigilant
notice to the dates of the invoices and compare them to the delivery dates. If goods or services
have been held up the date on the invoice could be different from the actual delivery date and the
company should therefore immediately call the supplying company to have this corrected. It is
considered to be good policy to effectively use the credit times that have been given to the
company. Paying before the due date incurs loss in form of non-interest for the company and if
payables are paid too late, a penalty interest expense is incurred. One of the major reasons for
companies being charged with penalty interest is the late authorization of invoices. To improve
this process steps can be made for invoice authorization to take place on a daily basis and
through this avoid any penalty charges.
3.9. The Cash Conversion Cycle
The cash conversion cycle (CCC) is one measure that is available for companies when
examining their cash cycle. Basically the CCC will tell how long it takes for the company to
transform goods or services in to cash in the company account and hence a growing CCC ratio
will negative for the company. The longer the CCC becomes the less liquid the firm gets. In
order to calculate the CCC first three other ratios needs to be calculated and those are Days
Inventory Held, Days Sales Outstanding and Days Payables Outstanding which has been
discussed previously. The way to receive the CCC is to take DSO plus DIH minus DPO.
Cash Conversion Cycle (CCC) = Days Sales Outstanding + Days Inventory Held – Days
Payables Outstanding
One important note on the CCC is that since this measure is made up by several ratios
one have to be cautious about what causes a change in this ratio. If for example there is an
improvement of this ratio it can be because the DPO have increased and this is not a good sign.
Therefore companies should always analyze what it is that have cause the change in this ratio.
3.10. Liquidity
Lamberg and Valming (2009) as it is clear by now, liquidity is one of the most important
goals of Working Capital Management and central task of cash management. Several authors
have expressed their definition of liquidity but in general “a firm is liquid when it can pay bills
on time without undue cost”. Liquidity can also mean the extent to how quickly assets can be
converted into money but in this study when referred to liquidity the former definition applies.
Solvency and liquidity are two concepts that are closely related and reflect upon the actions of
company’s working capital policy.
The main counter-argument for holding cash is usually connected with the low return it
can offer. However, there are advantages for having liquidity reserves and three widely used
motives for holding cash can be found in the literature:
3.10.1. Transaction Motive:
Companies hold cash for their daily expenses i.e. paying salaries, materials and taxes etc.
Cash acts as a buffer for the mismatch between cash in- and outflows.
3.10.2. Precautionary Motive:
Future cash flows are uncertain and excess cash is hold to meet unexpected costs.
3.10.3. Speculative Motive:
Cash is kept easily available for profitable future opportunities that need to be undertaken
immediately
3.11. Instruments for Liquidity Management
There are several benefits from having an effective liquidity management strategy but
there are also some severe implications of misjudging the firms liquidity needs such as risk of
bankruptcy. In the following sections a discussion of the tools and strategies of handling a firm’s
liquidity will be conducted.
There are several measures for corporate liquidity and different ratios are more important
for different stakeholders. Also from which perspective one is examining the company’s
liquidity levels affects the use of different measurements. Some of the ratios are more interesting
for the bank than investors and accounting measures of liquidity adds another new perspective of
the liquidity. As our approach in this study is to examine the liquidity from financial
management perspective we have excluded accounting measures and concentrate on those ratios
that financial managers use most often.
3.12. Current Ratio
One of the most common and also the oldest measure of corporate liquidity is current
ratio. It was developed at the end of the 19th century in order to evaluate the credit-worthiness of
the companies. In its simplicity it expresses the liquid resources available when current liabilities
are met and is calculated as follows
Current Ratio = Current Assets/ Current Liabilities
Maness & Zietlow has expressed that historically a current ratio of 2.0 has been a norm,
meaning that company has approximately twice as much current assets as coverage for short
term creditors. As the critique towards this measure often goes, it simplifies the protection
available for short-term creditors as not all the current assets are easily liquidated but can be tied
in the inventory.
3.13. Quick Ratio
Quick ratio or acid-test ratio is very similar to current ratio and solves the liquidation
issues mentioned above by excluding inventories from calculation:
Quick ratio = (Current assets – Inventories) /Current liabilities
Usefulness of current and quick ratios for measuring working capital has been questioned
because of their static nature. As a balance sheet is a statement of stock instead of flows with the
result that ratios calculated from balance sheet accounts are liquidity stock measures at a certain
point in time. Shin and Soenen have studied alternative tools for measuring the effectiveness of
working capital and they suggested Cash Conversion Cycle.
Up to date several other measures are used in addition to current ratio and quick ratios.
On the other hand, even the importance of ratio analysis has been questioned and considered as a
weak tool for monitoring liquidity. A common practice is to combine several methods and use
ratios as a part of liquidity management, but not rely solely on them. There are several factors
that need to be taken into consideration when doing ratio analysis. Among the first conditions for
ratio analysis is the good quality of accounting data which is a natural premise since the analysis
relies exclusively on financial statements.
In summary, current and quick ratios have been traditionally most widely used tools
monitoring corporate liquidity. External users, such as banks and other credit issuers have used
them as measure for evaluation companies credit-worthiness, whereas internal users have
monitored how working capital policy is executed inside the company. These are only few
applications for ratios we have discussed. Usefulness of ratio analysis is questioned time to time
and one has to be careful when comparing companies across industries. In this study the focus is
to examine how companies have adapted their liquidity strategies and one way to do that is to
investigate the extent of the use of different cash management routines.
3.14. Liquidity, Risk and Profitability:
3.14.1. Adequate liquidity
Rahman (2009) Liquidity is an attribute that signifies the capacity to meet financial
obligations as and when required. Liquidity management is a routine function of finance which
deals with the effective management of the two components of working capital, viz. the current
assets and the current liabilities. The current assets may be defined as the money and other assets
that are readily convertible into cash. Cash itself is, by definition, the most liquid form of assets;
other assets having varying degree of liquidity depending on the case with which they can be
converted into cash. The current liabilities include all types of liabilities which will mature for
payment with in a period of one year such as bank overdraft, trade creditors, bills payable,
outstanding expenses, etc.
The importance of liquidity to meet the current obligations as and when they become due
for payment can hardly be over emphasized. In fact, liquidity is a prerequisite for the very
survival of the firm. The suppliers and short-term creditors are interested of the short-term
solvency of the firm. It is a constraint which must be satisfied both directly, in that firms must
settle their debts, and indirectly, in that they must also report an ability to continue to do so. If in
the annual accounts, a firm reports poor liquidity, this may cause such a fall in confidence that its
state becomes a self-fulfilling prophecy, as creditors demand immediate payment, the classic
example being ‘a run on the bank’.
3.14.2. Minimization of Risk
A firm should maintain adequate level of working capital to meet the current obligations
and maintain business operations. It should ensure that it does not suffer from lack of liquidity.
The failure of a firm to meet its obligations due to lack of sufficient liquidity is highly risky as it
will result in bad credit image, lose of creditors confidence high-cost emergency borrowing,
unnecessary legal battles or even closure of the firm. At the same time if the level of working
capital is more holding cost of current assets would be more, again would badly affect the
profitability. In other words, the working capital should not be either too high or too low. A well-
monitored minimum level of working capital at a calculated risk is always good for better
profitability.
3.14.3. Maximizing Profitability
Profitability is the relationship between profits and capital, i.e. the static resources set
aside to rearm those profits, if profitability exceeds the cost of the firm’s capital that is the
weighted average cost of firm’s equity and borrowed money, and it can call it successful. The
investment of excess cash, minimization of inventories, speedy collection of receivables, and
elimination of unnecessary and costly short-term financing all contribute to the maximization the
profitability.
3.15. Liquidity, Risk and Profitability Trade-off
In connection with the trade-off between liquidity, risk and profitability, a firm can adopt
three types of working capital policies:
 Conservative policy
 Aggressive policy, and
 Moderate policy.
3.15.1. Conservative Policy
In the case of conservative policy, a firm will hold a relatively high proportion of
working capital total assets to pay safe. As the rate of return on current assets is normally less
than the rate of return on lower profitability but at t he same time firms it will signify lower risk
of failure to meet the current obligations.
3.15.2. Aggressive Policy
Here, the firm opts for a lower level of working capital thereby investing in current assets
at a lower proportion to total assets. When a firm adopts this policy, the profitability is high but
at high risk in meeting the current obligations on an achieving the desired level of turnover.
3.15.3. Moderate Policy
A working capital policy adopted in between the conservative policy and aggressive
policy is termed as moderate policy. In this case, the investment in current assets is neither too
high nor too low. The profitability and risk are also moderate.
Expressed in terms of ratios, conservative policy and aggressive policy will result in low current
ratio with different degrees of financial flexibility. The three approaches can be farther explained
by this table:
Liquidity Profitability Risk
Conservative Policy High Low Low
Aggressive Policy Low High High
Moderate Policy Moderate Moderate Moderate
With the help of this table we can show that Risk is directly proportional to Profitability
as when the profit will increase it will lead to Risk and when the risk is low the profitability will
also goes down. Liquidity is reversely proportional to Risk and Profitability as liquidity is high
then Profitability and Risk will low but when the liquidity is low it will lead to Profitability and
Risk.
Chapter No. 4
Methodology and Data Anaylsis
The purpose of this research is to examine the relationship between the profitability and
working capital management of the Pakistani companies. Here we are using 25 Pakistani firms
listed on Karachi stock Exchange for a period of four years from 2006 - 2009. For this research
we are using the annual report of these firms.
4.1. Data Set & Sample
The data used in this study was acquired from Karachi Stock Exchange (KSE), internet
and web sites of these firms. Data of firms listed on the KSE for the most recent four years
formed the basis of our calculations. The period covered by the study extends to four years
starting from 2006 to 2009. The reason for restricting to this period was that the latest data for
investigation was available for this period. The sample is based on financial statements of the 25
Pakistani firms, listed on KSE including firms from different sectors of our economy. Because of
the specific nature of their activities, firms in financial sector, banking and finance, insurance,
leasing, Modarabas, business services, renting and other services are excluded from the sample.
Finally, the firms with data of the number of day’s accounts receivable, number of days
inventories, number of days accounts payable and operating income are included in sample.
4.2. Variables
This study undertakes the issue of identifying key variables that influence working capital
management of firms. Choice of the variables is influenced by the previous studies on working
capital management. All the variables stated below have been used to test the hypotheses of our
study.
4.2.1. Average Collection Period (ACP)
Used as proxy for the Collection Policy is an independent variable. It is calculated by

dividing account receivable by sales and multiplying the result by 365 (number of days in a
year).
4.2.2. Inventory turnover in days (ITID)
Used as proxy for the Inventory Policy is also an independent variable. It is calculated by
dividing inventory by cost of goods sold and multiplying with 365 days.
4.2.3. Average Payment Period (APP)
Used as proxy for the Payment Policy is also an independent variable. It is calculated by
dividing accounts payable by purchases and multiplying the result by 365.
4.2.4. The Cash Conversion Cycle (CCC)
Used as a comprehensive measure of working capital management is another independent

variable, and is measured by adding Average Collection Period with Inventory Turnover in Days
and deducting Average Payment Period.
4.2.5. Current Ratio (CR)
Which is a traditional measure of liquidity is calculated by dividing current assets by

current liabilities.
4.2.6. Size
(Natural logarithm of Sales (LOS)), here natural logarithm of sales is used instant of
whole value of sales.
4.3. Hypotheses Testing
Since the objective of this study is to examine the relationship between profitability and
working capital management, the study makes a set of testable hypothesis. {The Null Hypotheses
H0 versus the Alternative ones H1}.
4.3.1. Hypothesis 1
The first hypothesis of this study is as follows:
H0 1: There is no relationship between efficient working capital management and profitability of

Pakistani firms.
H1 1: There is a possible positive relationship between efficient working capital management

and profitability of Pakistani firms. Firms more efficient in managing their working capital is
expected to pose high level of profitability and vice versa.
4.3.2. Hypothesis 2
The second hypothesis of the study is as follow:
H0 2: There is no relationship between size of Pakistani firms and profitability.
H1 2: There may have positive relationship between the firm size and its profitability. This may
be due to the ability of large firms to reduce liquidity levels and cash gaps.
4.3.3. Hypothesis 3
The third hypothesis of the study is as follow:
H0 3: There is no relationship between debt used by Pakistani firms and profitability.
H1 3: There is a possible negative relationship between debt used by Pakistani firms and its
profitability. Firms with high level of debt usage are expected to post low level of profitability
and vice versa.
4.4. Model Specifications:
Here I am using the Regression data analysis. The general form of our model is:
NOP it = β0 + β1 (ACP it) + β2 (ITID it) + β3 (APP it) + β4 (CCC it) + β5 (CR it) + β6 (DR it) +
β7 (LOS it) + ε
Where:
NOP : Net Operating Profitability
ACP : Average Collection Period
ITID : Inventory Turnover in Days

APP : Average Payment Period
CCC : Cash Conversion Cycle
CR : Current Ratio
DR : Debt Ratio
LOS : Natural logarithm of Sales
ε : The error term.
4.5. Analysis Used in Study
In this research we have provided two types of data analysis; descriptive and Regression.
4.5.1. Descriptive Analysis
Descriptive analysis is the first step in our analysis; it will help us describe relevant
aspects of phenomena of cash conversion cycle and provide detailed information about each
relevant variable, which includes Mean, Standard Deviation, Maximum and Minimum value of
the data. SPSS software has been used for analysis of the different variables in this study.
4.5.2. Regression Analysis
I am using Regression analysis to estimate the causal relationships between profitability

variable, liquidity and other chosen variables. So again SPSS software has been used for
Regression analysis.
4.6. Data Analysis and Discussion
We have performed two types of analysis, Descriptive and Regression. The results of
these two types of analysis are discussed in this section.
4.6.1. Descriptive Analysis
Descriptive analysis shows the average, and standard deviation of the different variables
of interest in the study. It also presents the minimum and maximum values of the variables which
help in getting a picture about the maximum and minimum values a variable can achieve.
Descriptive Statistics
25 Pakistani Non - financial firms, 2006-2009 – year observations
N Minimum Maximum Mean Std. Deviation
Net Operating Profit 25 -1703.280 9022.105 2232.66614 2300.783494
Current Ratio 25 .785 3.315 1.67372 .802329
Average Collection Period 25 .000 88.275 18.80600 19.974542
Inventory Turnover in Days 25 1.638 135.560 53.27500 41.256160
Average Payment Period 25 .720 120.428 32.12170 31.742468
Cash Conversion Cycle 25 -39.853 127.513 40.87937 46.951919
Debt Ratio 25 .153 .744 .45316 .177868
Natural Log of Sales 25 3.220 5.642 4.26820 .550056
“Source: Calculations Based on Annual reports of firms from 2006-2009”
Descriptive statistics for 25 Pakistani non financial firms for a period of four years from
2006-2009 shows the result that, the mean value of net operating profitability is 2232.66614, and
standard deviation is 2300.783494. It means that value of the profitability can deviate from mean
to both sides by 2300.783494. The maximum value for the net operating profitability is 9022.105
for a company in a year while the minimum is -1703.280.
The cash conversion cycle used as a proxy to check the efficiency in managing working
capital is on average 41 days and standard deviation is 47 days. Firms receive payment against
sales after an average of 19 days and standard deviation is 20 days. Minimum time taken by a
company to collect cash from receivables is 0 day while the maximum time for this purpose is 88
days. It takes an average 53 days to sell inventory with standard deviation of 41 days. Here,
maximum time taken by a company is 136 days, which is a very large time period to convert
inventory into sales, the minimum time which firms takes to convert its inventory to sales is only
2 days which is a good sign for a firm. Firms wait an average 32 days to pay their purchases and
its standard deviation is also 32 days. Here, minimum time taken by a company is 1 day which is
unusual, and maximum time taken for this purpose is 120 days.
To check the size of the firm and its relationship with profitability, natural logarithm of
sales is used. The mean value of log of sales is 4.26820 while the standard deviation is .550056.
The maximum value of log of sales for a company in a year is 5.642 and the minimum is 3.220.
In the same way to check the liquidity of the companies, a traditional measure of liquidity
(current ratio) is used. The average current ratio for Pakistani firms is 1.67372 with a standard
deviation of 0.802329. The highest current ratio for a company in a particular year is 3.315 times
and in the same way the minimum ratio for a company in a year is 0.785.
To check the debt financing and its relationship with the profitability the debt ratio
(obtained by dividing the total debt of the company by the total assets) is used. The results of
descriptive statistics show that the average debt ratio for the Pakistani companies is 45.32% with
a standard deviation of 17.79%. The maximum debt financing used by a company is 74.40%
which shows that the firm is highly levered. The minimum level of the debt ratio is 15.30%.
4.6.2. Regression Analysis
Here Regression analysis is used to estimate the causal relationships between profitability
variable, liquidity and other chosen variables. Here I am using Net operation Profit as the
Dependent variable and Cash Conversion Cycle, Average Collection Period, Debt Ratio, Natural
Log of Sales, Current Ratio, Average Payment Period, Inventory Turnover in Days are used as
Independent variable.
Model Summary
Std. Error of the
Model R R Square Adjusted R Square Estimate
1 .764a .584 .413 1762.317415
a. Predictors: (Constant), Cash Conversion Cycle, Average Collection Period, Debt Ratio,
Natural Log of Sales, Current Ratio, Average Payment Period, Inventory Turnover in Days
From this result we can say that there is a significant positive relationship between the Net
Operating Profit and the Variable used for this research. As the value of R is 0.764 which shows
the positive results and explain that there is a significant positive relationship between the Net
Operating Profit and the Variable.
Coefficientsa
Unstandardized Standardized
Coefficients Coefficients
Model B Std. Error Beta t Sig.
1 (Constant) -6486.198 4288.897 -1.512 .149
Natural Log of Sales 2565.207 999.826 .613 2.566 .020
Current Ratio -440.047 780.402 -.153 -.564 .580
Debt Ratio -214.755 3921.673 -.017 -.055 .957
Average Payment -57.954 129.655 -.800 -.447 .661
Period
Average Collection -13.603 132.113 -.118 -.103 .919
Period
Inventory Turnover in 55.684 123.121 .998 .452 .657
Days
Cash Conversion Cycle -54.925 122.751 -1.121 -.447 .660
a. Dependent Variable: Net Operating Profit
From the results we can set the Regression Model should be:
Net Operating Profit = -6486.198 + 2565.207 Natural Log of Sales -440.047 Current
Ratio -214.755 Debt Ratio -57.954 Average Payment Period -13.603 Average Collection Period
+ 55.684 Inventory Turnover in Days -54.925 Cash Conversion Cycle.
From above data analysis we can describe that there is no significant relationship
between variable “Current Ratio, Debt Ratio, Average Payment Period, Average Collection
Period, Inventory Turnover in Days and Cash Conversion Cycle” and Net Operating Profitability
of the company. As the result shows ‘t’ value of the data should be above 1.96 and the ‘t’ value
of the Current Ratio, Debt Ratio, Average Payment Period, Average Collection Period, Inventory
Turnover in Days and Cash Conversion Cycle is -.564, -.055, -.447, -.103, .452 and -.447
respectively. The ‘Sig’ of the result should be below 0.05 and the ‘Sig’ value of the Current
Ratio, Debt Ratio, Average Payment Period, Average Collection Period, Inventory Turnover in
Days and Cash Conversion Cycle is .580, .957, .661, .919, .657 and .660 respectively.
So it’s only the Natural Log of Sales value which has the significant relationship with Net
Operating Profit. As the ‘t’ value of the Natural Log of Sales is 2.566 which is above 1.96 and
the ‘Sig’ value of Natural Log of Sales is .020 which is below 0.05. We can say that size of the
company is depending upon the profitability of the company.
Many researchers have been conducted to examine the relationship of working capital
management and profitability. Most of the researches extract the same result which I have
derived that only sales have the significant positive relationship with profit. During the analysis I
have I transform the values but it derives the same result that only sales is the only factor which
can affect the profits.
Chapter No. 5
Conclusions
From the result of above discussion it is concluded that Most of the firms have large
amounts of cash invested in working capital. Some companies had invested more cash in its
working capital then its fixed assets. It can therefore be expected that the way in which working
capital is managed will have a significant impact on profitability of those firms. I have found a
significant negative relationship between net operating profitability and the current ratio, debt
ratio, average collection period, inventory turnover in days, average payment period and cash
conversion cycle for a sample of Pakistani firms listed on Karachi Stock Exchange.
From the Hypothesis, it is concluded that Alternative Hypothesis (H1 1) that there is a
possible positive relationship between efficient working capital management and profitability of
Pakistani firms should be accepted so null Hypothesis (H0 1) should rejected. From the same
way it is concluded that alternative Hypothesis (H1 2) that there may have positive relationship
between the firm size and its profitability should be accepted so null Hypothesis (H0 2) should
rejected. From the results it is concluded that the null Hypothesis (H0 3) that there is no
relationship between debt used by Pakistani firms and profitability should be accepted so the
alternative Hypothesis (H1 3) should be rejected.
From the results of the research it is concluded that the manager can increase the firm’s
profitability by increasing the firm size. So they can increase the shareholder’s interest and
dividend by increasing the firm’s sales.
From the research the following points should be recommended:
1. The company should increase the sales in order to increase in their profitability as the
sales are directly related to their profits.
2. The company can stretches the accounts payable so that they can reduce the cash
conversion cycle period.
3. If the company can reduce cash conversion cycle so it can lead the company profitability
higher.
4. The company can improve the cash conversion cycle by better inventory management.
5. If the companies invest in their fixed assets then they can be more profitable than the
current situation.
6. The accounts receivable should be collect soon and they should stretched the payments
for better liquidity position
7.
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The Impact of Working Capital Management on the Profitability of the

(Accounting and Finance)

Session: 2008 – 2010

Mr. Bilal Sarwar

University of Central Punjab

1 - Khayaban-e-Jinnah Road, Johar Town, Lahore, Pakistan

A thesis submitted in partial fulfillment of the requirements for the degree of

Date: _______________ _________________

it has been properly acknowledged / referred to the original author.

Signature of Student: ________________________

Name of Student: ___________________________

Registration Number of Student: _______________

completed by Mr. Waqar Ali, Registration No.L3F08MCOM5377 under my supervision during

his Master of Commerce.

Thesis Supervisor’s Signature

Prof. Muhammad Azhar Ikram Ahmad

This Thesis is dedicated

Respected Teacher Who Helped Me

To Complete This Task

1.1.1. Gross Working Capital:

1.1.2. Net Working Capital:

1.1.3. Way of optimizing investment in Current Assets:

1.1.4. Way of financing Current Assets:

1.2. Working Capital:

Working Capital = Current Asset – Current Liabilities

1.3. Working Capital Management:

Vasarao (2010) Working capital sometimes is referred to as “circulating capital”.

1.4. Determinants of working capital

1.4.1. Nature of business

1.4.2. Length of production cycle

1.4.3. Size and growth of business

1.4.4. Business/ Trade cycle

1.4.5. Terms of purchase and sales

1.4.7. Operating efficiency

1.5. Objectives of Working Capital:

 For the purchase of raw materials, components and spares.

1.6. Sources of Working Capital:

1.6.1. Bank Loan

1.7. Sources of working Capital

There are two types of Sources of working Capital:

1.7.1. Long Term Source of Working Capital

1.7.2. Short Term Source of Working Capital

1.8. Need of working capital management:

1.9. Types of Working Capital:

1.9.1. Gross working capital

1.9.2. Net Working Capital

Net Working Capital = Total Current Assets – Total Current Liabilities

1.9.3. Permanent Working Capital

1.9.4. Temporary Working Capital

1.10. Types of Working Capital Loan:

1.10.1. Bank Overdraft Facility or Credit Line

1.10.2. Short-Term Loans

1.10.3. Equity Funding via Personal Resources or Investors

1.10.4. Accounts Receivable Loans

1.10.5. Factoring or Advances

1.10.6. Trade Creditor

1.11. Advantages of working capital:

1.11.1. Increase in debt capacity and goodwill:

1.11.2. Increase in production inefficiency:

1.11.3. Meeting contingencies adverse changes:

1.11.4. Available cash discount:

Maintenance of adequate working capital enables a company to avail the advantage of

1.11.5. Solvency and efficiency fixed assets:

Date: _ ___