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Effect of Working Capital Management on Profitability

Conference Paper · January 2018

DOI: 10.5729/lnes.2018.13.53

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 2018 5th International Conference on Key Engineering Materials and Computer Science (KEMCS 2018)

Effect of Working Capital Management on Profitability

Asif Iqbala,* and Zhuquan Wangb

College of Management, Ocean University of China, Qingdao, Shandong, China
a
asifiqbal05@hotmail.com, bwangzhuquan@ouc.edu.cn
*Corresponding author: Asif Iqbal
doi:10.5729/lnes.2018.13.53

Keywords: Working capital management; Profitability; Account receivable days; Account payable
days; Inventories; Cash conversion cycle; Manufacturing sector of Pakistan.

Abstract. This research work is conducted in order to analyze the effect of working capital
management on profitability, in detail, in the manufacturing firms of Pakistan listed on Karachi Stock
Exchange (Pakistan Stock Exchange) for the period 2008 – 2014. We have found a diverging effect of
working capital management on the profitability of manufacturing firms of Pakistan. The findings of
our study suggest that “paying full attention to the cash conversion cycle” has enormous effect on
working capital. Agreeing shorter term payments, invoicing and investigating credit rating on a
regular basis gives good approach to the whole working capital process. Minimizing the inventory
level frees the capital for other use, centralizing and unifying procurement process gives the
opportunity to follow and agree similar terms for several sales. It is further added that the firm’s
managers can enhance the profitability of their firms by reducing the collection period and by
adopting effective credit policy.

1. Introduction
In recent years, due to profitability and liquidity, working capital has fortified a great importance and
vital position [1]. It is the utmost and prime responsibility of a firm’s financial manager to maximize
shareholders wealth and profit. Profitability and liquidity are the salient goals of working capital
management [2]. Both these objectives have their own significance and importance and thus needs
proper attention. A firm needs to have a balance between liquidity and profitability while performing
its daily operations [3]. Any higher or lower amounts invested in working capital will adversely affect
the profitability and liquidity of a firm. Thus an accurate implication of working capital is necessary
(funds to be invested in various current assets), and firms may have an optimal level of working
capital that maximizes their value. A firm will not survive if the profit is overlooked while on the
other hand bankruptcy and insolvency may happen if we do not care about liquidity [4]. Working
capital is the difference between current assets and current liabilities. Current assets consist of all
those assets that transformed to the form of cash within a year and all those investment that may be
easily altered into cash without any hassle when needed. Working capital management is “The
management of the short-term investment and financing of a company”. Working capital
management plays an important and vital role in the firm growth and profitability and it affect the
success and failure of a firm because of its influence on firm’s growth and profitability [5]. It is an
important and vital part of the corporate finance that directly affect the profitability and liquidity of a
firm [4]. The goal of our study is to provide empirical evidence on the impact of profitability on firm
performance with a view to knowing whether manufacturing firms in Pakistan become more efficient
when they manage their liquidity and working capital in a proper and efficient way or otherwise.
978-1-61275-517-5/$25.00 ©2018 IERI KEMCS 2018
53
2. Literature review
Although WCM and its relation with profitability have been studied in detail by different researchers,
the conflict still remains unsolved, whether effective and efficient management of working capital
effect profitability positively or negatively. Some of the academics are of the thought that efficient
WCM plays a significant and important role in the profitability of a firm and that the relationship
between WCM and profitability is a positive one, while some have the opinion that there is a negative
relationship between profitability and WCM. Rahman and Nasr (2007) [4] carried out a study on
WCM and Profitability and found strong negative relationship between variables of the working
capital management and profitability of the firm. Deloof (2003) [6] analyzed Belgium firms, using
correlation and regression analysis. Their empirical study found significant negative relationship
between Profitability and the variables of the study. Similarly, authors in [7-11], in their research also
found negative relationship between profitability and working capital management. On the other
hand positive relationship was found between working capital management and profitability by Gill
et al. (2010) [12] analyzing firms in USA, Sharma and Kumar (2011) [13] in Indian firms and
Mathuva (2010) [14] in Kenya.The above discussion demonstrates that from the empirical results of
their studies, researchers are not in agreement with each other in regards to their findings and have not
been able to establish similar and exact relationships between profitability and working capital
management. However, the literature confirms both positive and negative relations between WCM on
profitability and that proper management of working capital has strong influence on the firm’s
interests.

3. Methodology and variables of the study

This study provides a selective overview of the available literature on WCM and profitability of firms.
To evaluate the consequences of WCM on firm performance, we use a sample of 60 firms listed on
the KSE between 2008 and 2014. Statistical tools (Regression and Correlation analysis) were applied
using Eviews 8 software for our sample data. This paper analyzes the impact of WCM on profitability
and firm performance in manufacturing industry of Pakistan. The basic dynamic panel data empirical
models of WCM were used to test the effect of receivable, payables, inventory and cash conversion
cycle on sales revenue growth, shown in below model.
NOP = β + βWCTR + βCR + βQR + βACP + βITID + βAPP + βCCC (1)

3.1 Variables of the study

The formula and abbreviations used for measurement of all the variables are presented below.
Tab.1 Variables of the study
Variable Name Abbreviation Formula
NOP Net Operating Profitability Earnings before Interest and Tax + Depreciation) / Total Assets
ACP Average Collection Period Accounts Receivable / Net Sales × 365
ITID Inventory turnover in Days Inventory / Cost of Goods Sold × 365
APP Average Payment Period Accounts Payable / Purchases × 365
CCC Cash Conversion Cycle ACP + ITID – APP
WCTR Working Capital Turnover ratio Sales/Working Capital
CR Current Ratio Current assets/Current Liabilities
QR Quick Ratio Quick assets/ Current Liabilities

4. Descriptive analysis

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Table 2 shows the sector wise descriptive analysis of the variables used in our studies. The mean
values of our measure of performance “NOP” are the highest in Chemical (17%) and Food & PC
product sector (16%), with the standard deviation of 0.13 and 0.16 respectively. The table no.2
describes that the maximum value of CR (14.52) and minimum value of CR (0.11) comes out at Sugar
& Allied sector with the standard deviation of 2.07. The table describes that Cement sector took the
lowest time to collect their receivables while Power Gen allowed the longest period of time to their
customers to pay their dues. It is interpreted from the table that inventory stored for the longest period
of time in Pharmaceuticals sector followed by Food & PC product sector. For account payable, Power
Gen sector consumed the highest time while Textile & Composite sector took the shortest time to pay
their suppliers. Power Gen sector has the highest CCC of 1252 with the SD of 381.
Tab.2 Sector wise descriptive statistics of manufacturing sector of Pakistan
Food & Oil & Power Sugar & Textile &
Variables Sector Automobile Engineering Pharma Cement Chemical
PC Gas Gen Allied Composite
NOP Mean 0.07 0.08 0.16 0.11 0.11 0.01 0.06 0.07 0.06 0.17
Median 0.03 0.08 0.12 0.08 0.14 0.05 0.06 0.07 0.04 0.17
Maximum 0.46 0.31 0.63 0.35 0.2 0.18 0.53 0.25 0.31 0.41
Minimum -0.14 -0.14 0 -0.17 -0.18 -0.36 -0.49 -0.21 -0.09 -0.14
Std. Dev. 0.12 0.08 0.16 0.13 0.08 0.12 0.14 0.09 0.1 0.13
CR Mean 1.52 1.85 1.54 1.7 2.2 1.71 1.45 1.28 1.24 2.21
Median 1.33 1.57 1.25 1.31 1.91 1.04 0.97 1.12 1.08 2.1
Maximum 4.44 4.28 4.29 4.22 5.13 12.23 14.52 3.04 5.4 5.09
Minimum 0.56 1.17 0.61 0.76 0.73 0.26 0.11 0.32 0.23 0.91
Std. Dev. 0.79 0.71 0.86 1 1.07 2.45 2.07 0.58 0.98 0.93
QR Mean 0.8 1.21 0.7 1.39 1.15 1.60 0.88 0.56 1.08 1.53
Median 0.75 1.15 0.49 0.87 1.16 0.99 0.43 0.5 0.92 1.36
Maximum 1.67 2.87 3.24 4.2 3.11 10.73 11.09 1.83 5.17 3.64
Minimum 0.17 0.55 0.16 0.41 0.28 0.25 0.06 0.22 0.21 0.54
Std. Dev. 0.36 0.53 0.67 1.12 0.62 2.21 1.57 0.28 0.93 0.77
WCTR Mean 6.39 5.76 20.29 11.16 7 8.21 -23.8 0.32 5.64 5.62
Median 6.86 4.85 7.14 2.47 4.91 3.57 -1.98 5.75 1.74 4.8
Maximum 92.56 18.97 479 355 36.86 196.0 239 139 56.92 26.33
Minimum -85.06 0.77 -139 -66.9 -3.65 -188 -1395 -71.75 -51.53 -63.65
Std. Dev. 24.77 3.72 87.24 77.08 7.55 48.75 182 32.05 18.89 13.6
ACP Mean 55.04 75.26 16.2 50.63 37.42 267.6 9 29.44 5.98 44.18
Median 7.47 51.13 12.87 43.66 25.99 180.1 5.33 25.05 2.73 39.24
Maximum 580 254 116 126 132 2083 65 71.75 38.01 144.83
Minimum 0 8.1 0.59 17.96 5.29 15.68 0 7.89 0 3.95
Std. Dev. 110 66.66 17.34 26.27 35.23 381.0 11.68 15.34 8.28 37.34
ITID Mean 85.71 84.15 99.68 26.9 121.0 23.39 77.27 86.42 26.76 53.78
Median 76.68 68.68 97.9 28.15 110.1 12.07 57.31 88.51 26.28 52.16
Maximum 273.38 423.7 173.3 54.42 229.2 334.7 333.1 155.64 67.5 102.67
Minimum 18.52 1.84 17.29 3.42 35.67 1.71 1.75 31.71 4.11 14.16
Std. Dev. 52.68 82.06 36.13 15.47 56.26 55.3 63.09 25.77 12.92 24.07
APP Mean 124.72 112.17 69.81 106.0 89.96 243.3 63.8 28.66 66.01 60.05
Median 90.57 52.54 63.87 110.5 91.48 99.74 46.99 24.49 55.02 56.9
Maximum 1347 420.73 207.6 182.0 127.5 4121 256.8 82.84 188.29 106.3
Minimum 12.29 13.46 19.69 44.53 9.48 1.98 7.65 15.18 28.82 27.85
Std. Dev. 188.23 112.42 33.12 42.47 21.58 686.9 49.64 13.36 33.39 18.03
CCC Mean 16.03 47.23 46.07 -28.5 68.53 47.7 22.47 87.2 -33.27 37.91
Median 14.95 46.89 51.7 -10.5 69.57 53.68 11.1 84.86 -21.49 48.51
Maximum 551.94 304.87 134.6 18.27 158.6 1252 340.2 176.77 19.9 130.62
Minimum -953 -225 -128 -116 -29.19 -1703 -184 10.87 -168 -29.98
Std. Dev. 182.33 121.47 50.46 42.6 48.69 381 71.27 38.18 37.5 47.6

4.1 Correlation analysis

In Table 3 we tried to assess and judge the nature and amount of association between the variables of
the study and the measure of profitability (NOP) through correlation coefficients of the selected

55
manufacturing firms. The results describe a high level of positive relationship between CR, QR and
the measure of profitability (NOP). These results suggest that in most of the cases, CR, QR and NOP
moved in the same direction and it reveals that the majority of the manufacturing sector of Pakistan
were capable of meeting their immediate and current obligations and liabilities on spot and made
favorable and satisfactory contributions towards increasing their profitability. For accounts
receivables days, the coefficient of Chemical sector was found positive and statistically significant at
1%, while the coefficients of Automobile, Textile and Composite, Engineering and Sugar & Allied
sector were found to be negative and statistically significant. We failed to establish any confident
association between profitability and inventory turnover in days except the Pharmaceuticals sector
where the relationship was significant and negative. The table describe that the coefficients of Food
& PC products and Oil & Gas & Ref sector were positive and statistically significant at 1% and 5%
respectively, while the coefficients of Sugar & Allied sector and Textile & Composite sector were
negative and statistically significant at 5% and 1% respectively for NOP and account payable days.
Here, our results suggest that the relationship between NOP and account payable days in the majority
of manufacturing sector were adversely related to each other. The association between NOP and CCC
reveals that the profitability of most of the manufacturing firms of Pakistan increased with the
decrease in CCC and vice versa.
Tab.3 Correlation analysis
Auto Food & Oil & Gas & Power Gen Sugar & Textile
Probability Engineering Pharma Cement Chemical
Mobile PC Ref & Dist Allied Composite
Variable NOP NOP NOP NOP NOP NOP NOP NOP NOP NOP
WCTR -0.048 0.499** -0.209 0.001 -0.05 0.159 -0.105 0.196 0.412* 0.062
P Value 0.762 0.002 0.149 0.996 0.774 0.363 0.408 0.178 0.029 0.725
CR 0.213 -0.009 -0.21 0.775** 0.348* 0.423* 0.069 0.643** 0.345* 0.482**
P Value 0.176 0.96 0.148 0 0.04 0.011 0.589 0 0.072 0.003
QR 0.579** -0.008 -0.157 0.780** 0.494** 0.433** 0.095 0.436** 0.277 0.538**
P Value 0.000 0.963 0.282 0.000 0.003 0.009 0.455 0.002 0.154 0.001
ACP -0.42 -0.367* -0.224 -0.161 0.111 -0.282 -0.293* -0.392** -0.199 0.378*
P Value 0.006 0.03 0.122 0.414 0.525 0.101 0.019 0.005 0.31 0.025
ITID 0.14 0.157 -0.153 -0.206 0.336* 0.106 0.051 -0.038 -0.033 -0.266
P Value 0.377 0.368 0.295 0.293 0.049 0.545 0.689 0.794 0.869 0.122
APP -0.162 -0.193 0.654** 0.358* 0.033 -0.15 -0.243* -0.453** -0.104 0.204
P Value 0.305 0.267 0 0.061 0.85 0.391 0.053 0.001 0.599 0.239
CCC -0.247 -0.311* -0.711** -0.673** 0.007 -0.037 -0.089 -0.042 0.272 0.363*
P Value 0.116 0.069 0.000 0.000 0.968 0.833 0.482 0.777 0.162 0.032
Significant at 5% * and significant at 1%**
4.2 Regression analysis
In Table 4 we analyzed the selected variables of the study to judge the influence of these variables on
the overall profitability. We assume NOP as the overall profitability indicator in our study. Our
results suggest that WCTR has significant impact on the NOP of manufacturing firms of Pakistan.
Our results indicate that with the increase in WCTR, profitability of eight sectors increased and this
increase was highly significant in Cement (0.0022) and Chemical (0.0023) sector with p-value of
0.0136 & 0.0547 respectively. The coefficient of WCTR in Auto Mobile and Food & PC product
sector were found to be negative but it was only significant in Food & PC product sector (-0.0004
with p-value=0.0508). Our result states that the coefficients of CR and QR were found to be
statistically significant in Pharmaceutical and sugar & allied sector only. Our results describe that the
coefficients ACP were found to be positive but statistically insignificant in Auto Mobile and Oil &
Gas sector while the remaining coefficients of ACP were negative and statistically significant in
Pharmaceuticals (-0.0045, p-value=0.0148), Sugar & allied (-0.0138, p-value=0.002) and Cement
sector (-0.0110, p-value=0.0048). Here it is interpreted that profitability of manufacturing firms of
Pakistan were significantly affected by the increase or decrease in collection period and collection
policy. The outcome of our study failed to establish any confident association between profitability

56
 and inventory turnover in days except the Chemical (0.00003) sector where the relationship was
positive and highly significant with a p value 0.0044. Our regression analysis suggests that the
relationship between NOP and APP in the majority sectors were adversely related to each other. Our
result provides a strong evidence of negative association between Cash Conversion Cycle and
corporate profitability where the coefficient of Auto Mobile (-0.0011, p-value=0.0836), Food & PC
Product (-0.0023, p-value=0.0072) and Oil & Gas (-0.0040, p-value= 0.0758) sector were found to be
negative and highly significant. It is consistent with the view that decreasing the Cash Conversion
Cycle will generate more profits for the company. The values of Adjusted R-square varied between
20% and 66%. The lowest adjusted R-square (20%) was recorded for Sugar & allied sector whereas
the highest adjusted R-Square (66%) comes out for Food & PC product sector. The results of F
statistic show that it was statistically significant for all the manufacturing sectors of Pakistan
thorough out the study.
Tab.4 Sector wise regression analysis

Dependent
NOP = βWCTR + βCR + βQR + βACP + βITID + βAPP + βCCC + β
Variable: NOP

Sector Auto Food & Sugar & Textilr &

Engineering Oil & Gas Pharma Power Gen Cement Chemical
Variable Mobile PC Allied Compsoite

WCTR -0.0006 0.0109 -0.0004 0.0003 0.0025 0.0000 0.0000 0.0001 0.0022 0.0023
Prob. 0.3700 0.1317 0.0508 0.4562 0.2212 0.9665 0.6662 0.7263 0.0136 0.0547
CR -0.1647 -0.0728 -0.0522 0.3508 0.1062 -0.0672 -0.1570 0.0343 -0.1618 0.1557
Prob. 0.3859 0.6372 0.5907 0.3537 0.0784 0.7017 0.0460 0.5890 0.6297 0.2575
QR 0.3809 0.2435 0.0863 -0.3792 -0.2065 0.1077 0.2409 0.0757 0.1801 -0.2296
Prob. 0.3145 0.2935 0.5797 0.3558 0.0968 0.5800 0.0284 0.5482 0.6080 0.2175
ACP 0.0013 -0.0017 -0.0013 0.0012 -0.0045 -0.0046 -0.0138 -0.0037 -0.0110 -0.0062
Prob. 0.2566 0.2275 0.6773 0.9249 0.0148 0.2580 0.0022 0.4775 0.0488 0.1815
ITID 0.00004 0.00003 0.00001 0.00002 0.00003 0.00002 0.00005 0.00009 0.00006 0.00003
Prob. 0.5816 0.2010 0.4224 0.5040 0.4567 0.9884 0.6730 0.3423 0.1465 0.0044
APP -0.0012 0.0011 -0.0009 -0.0038 -0.0005 0.0041 0.0000 -0.0033 0.0059 0.0005
Prob. 0.1639 0.1452 0.4433 0.7424 0.7212 0.2683 0.9575 0.2350 0.1672 0.8502
CCC -0.0011 0.0002 -0.0023 -0.0040 0.0016 0.0044 0.0005 0.0009 0.0066 0.0041
Prob. 0.0836 0.7029 0.0072 0.0758 0.1126 0.2746 0.3364 0.5630 0.1206 0.1666
Constant 0.1820 -0.4587 0.2151 0.5437 0.6161 -0.0213 0.0962 0.0308 0.1062 0.7841
Prob. 0.5483 0.0240 0.4156 0.4510 0.1370 0.8865 0.2677 0.9023 0.6516 0.0206

R-squared 0.7416 0.5966 0.7472 0.7192 0.5994 0.7245 0.3587 0.6303 0.7457 0.7778
Adjusted
0.6347 0.3766 0.6629 0.4946 0.3809 0.5742 0.2078 0.5071 0.5423 0.6566
R-squared
F-statistic 6.9353 2.7113 8.8657 3.2022 2.7430 4.8214 2.3769 5.1156 3.6656 6.4186
Prob(F-statistic) 0.0000 0.0205 0.0000 0.0181 0.0194 0.0007 0.0161 0.0001 0.0100 0.0001

5. Conclusion
Our findings confirmed a diverse performance among the manufacturing sectors of Pakistan with
reference to profitability and measure of WCM. From the findings of our study it is suggested that the
manufacturing sector of Pakistan is required to pay full consideration to all the variables of the
working capital management. The findings of our study suggest that managers can create value for
their shareholder by minimizing their cash conversion cycle and reducing inventory days to the least

57
minimum through effective management of working capital. Putting emphasis on performing various
necessary actions, for example, a reduction in the collection period and adopting effective credit
policies by the firm’s managers can enhance the profitability of a firm considerably. Further actions,
such as agreeing shorter term payments, invoicing and investigating credit rating on a regular basis
provides an effective approach to the whole working capital process. Freeing up capital by
minimizing inventory allows for use in other areas more necessary. Invoicing needs to be requested
on a milestone/phase basis rather than the widely followed monthly basis. This will ensure the
smooth and steady transformation of capital. Procurement processes and policies are required to be
centralized as well as unified to provide the opportunity to follow and agree similar terms for several
sales. In short, to have a positive effect on the working capital of a firm and in turn minimize the
actions required to implement the cash conversion cycle, it is vital for the firm’s managers to pay full
attention to both the minor and major details of the working capital, and so the findings of our studies
suggest. Concluding, the need for financing is reduced if a firm receives its receivables faster and this
requires efficient credit management and collecting techniques. Getting receivables in a timely
manner unties capital vital for operative use. Primarily, customers’ credit rating could also be kept in
check with efficient credit control measures thus decreasing the risk of losing capital. Besides this,
the policy makers are required to formulate efficient and effective policies for all areas of working
capital in order to enhance the profitability.

Acknowledgement
This research work is supported by the Project (71372111) supported by NSFC.

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