Pobinan Jara of Secial Seis (PISS) 0.36, No. 1 (2016) pp. 40-80 Impact of Working Capital on Performance of Textile Firms Listed on PSX ‘Nadeem Ahmed Sheikh, PhD ‘Aesstart Peter Insitute of Management Sciences Bahaudéin Zaria Univers, Mba ‘shesdeem@hotne| ees AtitRafique Research Scolar Insite of Management Sciences Bahousin Zane Unirerety as stifafiqueter @guaileom ‘Muhammad Nauman Abbasi, PaD Demcine Profs Insite of Management Scienoes ahousin Zane Unirerety as bhasinmaghauedugle Abstract This paper imestigates the impact of diferent measures of working capital (Le, current asset ratio, net working capital, cwerage age of inventory, average collection period, average payment period and cash conversion cycle) on performance of textile firms listed on Pakistan Stock Exchange Limited during 2008-2013. Both book-based (e.g. ‘gross profit margin, net profit margin, basic earning power and return on assets} and market-based fie. Tobin's Q) measures used to understand the impact of working capital on performance. For a ‘meaningfil analysis textile companies were divided into three sectors namely textile composite, textile spinning and textile weaving. Results indicate that current asset ratio and cash conversion cycle are postively linked to market-based and book-based measwes of ‘performance in all sectors. Net working capital and average age of inventory are positively linked to performance in all sectors except {textile weaving. Average collection period and average payment period cre negatively liked to performance in all sectors. In sum, working capital measures significanily affect the performance of ieuile firms however the observed relaionships are partially consistent to the explanations given in finance literature which suggest the need for ‘theoretical development. Keywords: Working Capital, Textile Industry, Pakistan I. Introduction Working capital management an important area of finance, The job of a finance manager isto create value for sharcholders, However the value creation process demands undivided attention of the finance manager on long-term as well as short-term investment and financing decisions, The importance of working capital can be assessed with the thetALO Pokiszan Jaumas of Sarit Seinces Vos. 36, No.1 that (in particular) in capital budgeting decisions the capital budgeting analysts should ‘consider the changes in current assets and current liabilities because of proposed capital expenditures otherwise they may select a project that devastates the shareholders wealth ‘Numerous studies have analyzed the effects of werking capital on performance but their resus are inconsistent. More importantly, results of earlier empirical studies on the relationship between working capital and performance are based on a curmulative sample ‘of non-financial firms rather to explore the impact using data of particular economic szoup. In order to fill the gap, this paper investigates the affect of working capital on performance of textile firms listed on Pakistan Stock Exchange Limited (PSX), The main reason for choosing textile industry is that it is the largest manuficturing industry of Pakistan and a major contributor in GDP, offering employment to workforce, and using 40 percent debt available to manufacturing sector. More importantly, testile industry further can be divided info three groups namely textile composite textile spinning and textile weaving, We expect that outcome of this study will enlighten the vision of managers regarding the effects of current ratio, net working capital, cash conversion cycle and ils components on corporate performance, ‘The remaining paper is structured as follows. The 2"! section explains the findings cof earlier ermpirical studies on the relationship between working capital and pecformance. ‘The 3° section descrines sample and methodology. The 4 section presents results. The 3° section provides discussion on results, Finally, conclusion is provided atthe end, IL Literature Review ‘This section briefly explains the findings of earlier empirical studies regarding the impact of different measures of working capital on performance. For instance, Wang, (2002) aratyzed the data of 1,55 Japanese firms and 379 firms in Taiwan during 1985- 1996 to explore the relationship between liquidity and corporate value, In addition, he explored the relationship between liquidity and operating performance, Resulls suggest hat cash conversion cycle is imversely linked to both return on assets and return on ‘equity. Moreover, results indicate that agoressive liquidity management can increase the ‘operating performance and comporate value of firms in both countries despite significant differences that exist in structural characteristics, In an empirical study on Belgium firms Deloof (2003) observed that working capital significantly affect the firm performance. More importantly, managers can maximize the shareholders wealth by reducing the inventory holling period and collection period to a reasonable rininnum Eljelly (2004) explored the relationship between profitability and liquidity using data of companies in Saudi Arabia. Results ingicate that liquidity is mversely related to profitability. More importantly, the relationship between liquidity and profitability is more obvious in firms with high current ratio and a long cash conversion cycle. Garcia ‘Teruel & Martinez-Solano (2007) amlyzed the data of SMEs to understand the relationship between working capital and profitability. The results indicate that reduction in cash conversion eycle to a reasonable minimum can improve the profitability. ‘Moreover, firm value can be created by increasing the inventory tumover and reducing the average collection period,Nadeem Anesthetic, Miva None Abbst aun Abuzayed (2012) used the data of Jordanian firms to analyze the effects of ‘working capital on performance, He found a direct relationship between cash conversion cycle and profitability. Moreover, he observed that profitable firms pay less atlention on working capital decisions. Furthermore financial markets failed to punish managers on inefficient working capital maragement (in particular) in emerging markets. Vahid et al (2012) explored the relationship between working capital and performance using data of medicine and cement companies in Iran. They found that average collection period, inventory turnover, average payment period and net trading ceycle are negatively linked to performance. Moreover, they observed that cash conversion cycle is unrelated to firm performance, In a study on Finnish firms on the relationship between working capital and performance during different business cycles Engvist etal (2014) suggest that working capital management does matter and it should be an integral part of a firm’s financial planning process. Moreover, they observed that the relationship between working capital and profitability i more obvious during ‘economic downturns than in economic booms. Ohman (2014) analyzed the data of 13,797 Swedish SMEs during 2008-2011 to investigate the linkage between cash conversion cycle and performance. Results indicate that cash conversion eycle significantly affects the profitability, In addition, size, age and industry characteristics also affect the profitability. Mun & Jang (2015) analyzed the data of 28 US restaurant companies during 1963-2012 to investigate the affect of working capital on profitability. They found a U-shape relationship between working capital and profitability. Moreover, they observed that interactive effects exist among working capital, cash levels and profitabitty Gara (2015) analyzed the data of 6,063 Portuguese SMBs during 2002-2009 to investigate the effets of working capital on profitability. Results indicate that reduction in average age of inventory, average collection period and number of days a firm take to satisfy its obligations leads to increase in profitability, Yunos et al (2015) analyzed the data of government-linkel listed firms in Malzysia during 2003-2014 to examine the effects of working capital on performance. They observed that working capital ‘management is unrelated to fiem performance when measured a8 return on assets, In contrast, their results indicate that average payment period is positively linked to gross ‘perating income, In ether words, ifa frm intends to increase ts gross operating income then it will have to stretch the payment period and use cash for other purpose. In synopsis, results of carlier empirical studies (as explained above) yield mixed results. Inconsistency in results isan important reason that suggests the need for this emp tical ‘investigation, TIT. Sample and Methodology ‘This paper investigates the affect of working capital measured as current asset ratio, net working capital, average age of inventory, average collection period, average payment period and cash conversion cycle on performance of textile firms listed on Pakistan Stock Exchange Limited (PSX) during 2008-2015. Book-based (ie. gross profit ‘margin, net profit margin, basic eaming power and retum on assets) and market-based Ge. Tobin's Q ) measures used to determine the financial performance, Notably, for a ‘meaningful analysis sample companies were divided into three groups namely textile12 —Pokiszn Jaumas of Sarit Seinces Vos 36, No.1 conposite, textile spinning and textile weaving, Total 157 firms were listed on PSX during the study period. Firms with insufficient data are eliminated from analysis, Final sample comprised of 777 observations relevant to 132 firms over a period of 8 years Dala of share price was taken fiom the publications of PSX. Table 1 presenis the definitions of variables. Congruent with earlier empirical studies panel data technique namely pooled OLS used for estimation purpose, ‘Table1: Definition of Vartables Vibe Proxy Benito Dependent varies BRS ENTING ep Opering Prot Taal Ass. Faun on Assis ROR Taming Bebe Tees Tea Assis Goss Pot Margin GPa hows Pct Nat Sao Net Bro arg NEw Eaming Bebe Tews Net Sls ‘Warket Value of Equity + Book Value of Liablties) 7 Tobin's @ rT] (Book Value of Equity + Book Value of Liabilities) Tadepandnt sarees Carat Rea Ra GAR Cue Sa Toi neering we urert Ase - Curent Uses ‘tage Age ol gay 360g Turover ven unover pene mmatuyadancoo goods 0 oni ine Average Colecion ace accounts Reshabl/ Average Cred Sales Per Dy age Paya — yop Aeon Paya Bvaage Cred Puchane Par oid toy Cath Canenion ggg Avtagh geo vera + Average Clacton exe onad ~avoge Beynon Soto intra sarees Tovwrage —1EV Toul ies Tota Ase rinses 82 Tatra! eget of oa ses ‘Market to book ratio MER Market Price Per Share / Book Value Per Share, 1V. Empirical Results A. Descriptive Statistics “Table 2 provides the summary statistics. Mean BEP, ROA, GPM NPMand TQ is 858% 3.904 9.2%, 1.38% and 60.43% respectively. The mean CAR is 41.86% which indicates that current assets are approximately 42% of total assets ermplayed by the sample fims. NC is simply the difference between the curent assets and current liabilities. The mean NWC is positive and indicates that textile finns maintain positive net ‘working capital due to volatile economic and political condition in the country. The mean AAI, ACP, APP and CCC are 75.76 days, 32.78 days, 41,77 days and 66.76 days respectively. The mean LEV, measured as total debt to total asses, is 63.67% Pakistan is a bank-based economy that is why firms prefer to borrow money from commercial and development banks rather to raise capital by issuing new shares because of underdeveloped capital market. More importantly, the importance of banking system can be assessed with the fact that textile sector is using 40% of total debt available toNadeem Anesthetic, Miva None Abbst a3 manufacturing sector in Pakistan, The maximurn value of LBV is 178,33°6 which is due to the fact that some companies have negative equity due to accumubited losses, The average of natural log of total assets (a measure of firm size) is 21.58. The average MBR (a measure of growth) is 0.3899 times. ‘Table 2: Deseriptive Statisties Variable Obs. ‘Mean ‘Std. Dev Minimum Maximum BEP 777 —~—«ON8SB ‘On4at 0.9654 14263 ROA 770.0380 01478 1788 1.3994 GPM 777.0829 01259 A797 05176 NPM = 770.0138 0.1568, -2,0063, o.grat TQ 77 0.8043 03183 0.0740 4.1807 CAR TIT .at86 01834 0.0043 0.8837 NWO TIT 1.240408 = 1.34e+09 «9.250409 140409 Aas 777 78.7621 46.6503, 03881 297.4069 ACP TIT. 32.7839 31,9165 0.0337 247 4069, APP TTT «44.7768 34,0050 1.0278 243.8151 ccc) 8 TTT 86.7682 635130 133.507 318.7821 Lev 770.8367 02258 0.1068 1.7833 Sz 77 21.8671 1.2464 17.7010 25.3387 MBR 770.3899 47700 108.968 504912 B. Regression Results Table 3 presents the effect of different measures of working capital on performance of firms in textile composite, textile spinning, textile weaving and overall sample of firms, Regression results of firms in textile composite indicate that current asset ratio (CAR) is significant and positively linked to book-baced and market-based ‘measures of performance. Net working capital (VAC) is significant and positively linked to net profit margin and Tobin's Q. Alternatively, N7FC is positively linked to basic ‘earning power and return on assets while itis negatively linked to gross profit margin but the relationship is insignificant. Average age of inventory (44/) is significant and positively linked to gross profit margin, net profit margin and Tobin's Q. Moreover, Ad! is negatively linked to basie eamings power and return on assets but relationship is insignificant Average collection period (ACP) is significant and negatively linked to all measures of performance. Average payment period (4PP) is significant and negatively related to basie eaming power, return on assets an net profit margin whereas it is positively linked to Tobin’s O- Finally, cash conversion cycle (CCC) is significantly positively linked to Tobin's Q only while its impact on other measures of performance found insignificant, In sum, CAR, NIFC, AAT, and CCC are significant anc positively while ACP and APP are significant and negatively related to performance in textile composite, Regression results of firms in textile spinning indicate that current asset ratio (CAR) is significant and positively linked to book-based as well as market-based measures of performance. Net working capital (VHC) is significant and positively linked to book-based measures of performance. Alteratively, VAC is negatively related toALA Pokiszan Jaumas of cit Since Vos. 36,Na.1 Tobin's @ however the relationship is insignificant. Average age of inventory (AA) is significant and positively linked to gross profit margin only. Average collection period ACP) is negatively linked to book-based measures of performance and positively linked to market-based measure of performance however the relationships are insignificant Average payment period (APP) is significant and negatively linked book-based measures of performance whereas it is significantly positively linked to market-based measure of performance. Finally, cash conversion eycle (CCC) is significant and positively linked to basic eaming power and gross profit margin. In synopsis, CAR NBC, Al, and CCC ate significant and positively while APP is significant and negatively linked to performance of firms in textile spinning. Regression results of firms in testile weaving indicate that current asset ratio (CAR) iss significant and negatively related to Tobin’s O. In contrast, CAR found insignificant with book-based measures of performance. Net working capital (VWC), average age of inventory (447) and average payment period (APP) have no material effects on book-based and market-based measures of performance. Average collection petiod (ACP) is significant and negatively linked to gross profit margin only. Finally, ‘cash conversion cycle (CCC) is significant and positively linked to gross profit margin only. In short, CCC is significantly positively while CAR and ACP significantly negatively linked to performance of firms in textile weaving. Finally, regression results of overall sample of firms (ie. textile industry) indicate that current asset ratio (CAR) is significant and positively linked to book-based and market-based measires of performance. Net working capital (NTC) is significant and positively linked to book-based measures of performance Alternatively, NAC is negatively linked to Tobin's Q but the relationship is insignificant. Average age of inventory (AAJ) is significant and positively related to gross profit margin, net profit margin and Tobin's Q. Average collection period (ACP) is significant and negatively telated to book-based measures of performance. In contrast, ACP is positively linked to Tobin's © but the relationship is insignificant. Average payment period (APP) is significant and negatively linked to book-hased measures of performance while tis significant and positively linked to market-based measures of performance, Cash conversion cyele (CCC) is significant and positively linked to gross profit margin and net profit margin In sum, CAR, NC, AAT and CCC are significantly positively while ACP and APP are significantly negatively Inked t performance of firms in textile inst. Notably, leverage (LEV) is negatively related to book-based an! positively linked to market-based measure of performance in all regressions. Firm size (SZ) and marketto- book ratio (MBR) are positively linked to both book-based and market-based measures of performance. Thus, resulls suggest that different measures of working capital have ‘material effects on financial performance of firms in textile industry. V. Discussion on Results ‘Regression results indicate that current asset ratio (CAR) is positively linked to book-based (ie, BEP, ROS, GPM NPM) and market-based (ie. TO) measures of performance in all sectors, The observed relationship is incongruent withthe explanations given in finance textbooks which suggest that an increase in CAR leads to reduction in Iiquidity risk as well as profitability. This may be true because firms cant support theirNadeem Anesthetic, Miva None Abbst ais operations with limited working capital during stable economic environment however they may have to hold more current assets under uneven business condition in the ‘country. Descriptive statistics presented in Table 2 indicates that current assets represent approximately 42% of tolal assets. The main reason for holding high percentage of ‘current assets is that textile sector isa capital intensive industry and needs more working capital to support their diversified operations. Moreover, energy crises in the country restrict the firms to hold more current assets to execute customers? orders timely. Furthermore, delays in payments fiom customers and uneven business ‘environment confine the ranagers to operate with more current assets which in turn enhance the financial performance. Net working capital (NIC) is positively linked to performance in all sectors except testike weaving, Descriptive statistics presented in ‘Table 2 indicate that NVC’ is positive, The positive net working capital indicates that sample firms believe on conservative working capital financing policy and tend to finance a part of current assets with long-term finds. This fhetor may improve the liquidity position ofthe firms and make them able to satisfy the contractual claims well in time. Thus, timely payment to creditors increases the firm's credlitability and thereby positively affects the performance. The positive relationship between NWC is consistent to the findings of Engqvist etal (2014), Average age of inventory (4A) is positively related to performance in all sectors except lextile weaving Generally, rise in production level denrands a corresponding increase in inventory level. Although, firms have to keep stock of inventory for more number of days and to bear the inventory carrying costs but tis thing increase the firm's ability to execute the customers’ orders well in time which leads to rise in sales and profitability. The positive relationship i consistent to the finding of Abuzayed (2012) and Deloof (2003), Average collection period (ACP) is negatively related to performance in all sectors. The negative relationship isin line with the explanations given in finance literate. Credit sales provide an opportunity to customers to assess the quality of the product before making final payment. That is why purchasers tend to stretch the payment period. On the other hand, it provides an opportunity to sellers to charge higher price of their products, Thus, charging high price from customer inereases the seller's profit ‘margin and in tum increases the financial performance. The negative relationship is consistent to the finding of Enavist et al 2014), Uknegbu (2014), Vahid et al (2012), Garcia-Tervel & Martnez-Salano (2007) and Deloaf (2003). Average payment period is negatively related to performance. The negative relationship is incongruent with the explanations given in finance textbooks which susgest that delays (ie. stretching) in payment to suppliers leads to rise in profitability Supplicss of inventory may tolerate the stretching in payment period under stable ecotiomni¢ conditions however they tend to collect payments on due date under uncertain ‘economic conditions. Thus unnecessary delays in payment to supplicrs reduce the firm's creditability which in tum negatively affects the performance. The negative relationship cconfirns the findings of Enavist et al, 2014), Abucayed (2012), Vahid et al 2012), Garcia-Tervel & Martinez-Solano (2007) and Deloof (2003). Finally, cash conversion eycle is positively related to performance in all sectors. Cash conversion eycle is measured as the difference between operating cycle ani average payment period,ALG Pokiscn Jeumas of Sarit Since Vos. 36, No.1 Operating cycle i measured as the sum of average age of inventory and average collection period. Descriptive statistics presented in Table 2 indicates that cash conversion cycle is positive however theoretically it should be negative. The positive cash conversion cycle indicates that firms rely on discretionary finance to support their operations. Moreover, descriptive statistics confirm that firms finance approximately 61% of their assets with debt. Thus, heavy reliance of firms on debt. may be dve to tax deductible interest paymens, Thus, lax savings on debt may encourage the profitable firms to rely on diseretionary finance which in tum increase the performance. The positive relationship between cash conversion cycle and performance is consistent to the findings of Abuzayed (2012). In general findings of this paper confirm that different measures of working capital sinifieanly afféet the financial performanee. Although resus are partially congruent with explanations given in finance literature but also suggest a need to take measures to fill a gap between theory and practice, Finally, we recommend that managers cof manufecturing firms carefully formulae short-term investwment and financing policies because of their significant impact on firm performance. VL Conclusion This paper investigates the impact of different measures of working capital namely ‘current asset ratio, net working capital, average age of inventory, average cellection period, average payment period and cash conversion cycle on performance of textile firms listed on Pakistan Stock Exchange Limited (PSX) during 2008-2015. Performance is measured using both book-based (@.g. gross profit margin, net profit margin, basic ‘earning power and retum on assets) and market-based (i. Tobin's Q) variables, Notably, fora meaningful analysis textile companies were divided into three sectors rarmely textile composite, textile spinning and textile weaving, Results indicate that current asset ratio (CAR) is positively linked to both book- based and market-based measures of performance in all sectors. Net working capital NIC) is positively linked to pecformance in all sectors except textile weaving, Average age of inventory (4A) is positively related to performance in all sectors except textile weaving. Average collection period (ACP) is negatively related to performance in all sectors. Average payment period (4PP) is negatively related to performance. Finally, ‘cash conversion cycle is positively related (0 perfortrance in all sectors. Generally, results confirm that different measures of working capital have material effects on pecformanee, Although results are partially congruent with explanations given in finance Iiterature but also necessitates the need for theoretical development to fill a gap in theory and practice. Finally, we recommend that managers of manufacturing firms carefully formulate short-term investment and financing policies because of their significant impact on firm performance.Nadeem Anesthetic, Miva None Abbst aur References ‘Abuzayed, B, (2012). Working capital management and firms performance in emerging ‘markets: The ease of Jordan. International Journal of Managerial Finance, 8(2), 155-179, Deloof, M. (2003). Does working capital management affect profitability of Belgian firm's? Jounal of Business Finance cout Accounting, 30(3) and (4), 573-87. Eljelly, A. M. (2004). Liquidity - profitability tradeoff: An empirical investigation in an emerging market. 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(2014), The significance of working capital management in determining firm profitability: Evidence from developing economies in Affica. Research in International Business Finance, 31,1-16. Vahid, T. K., Etham, G., Mohsen, A. K., & Mohammadreza, E. (2012), Working capital ‘management and comporate performance: Evidence from Iranian companies. Social and Behavioral Sciences, 62, 1313-1318. ‘Wang, ¥. J. (2002). Liquidity management, operating performance and corporate value: Evidence fiom Japan and Taiwan. Journal of Multinational Financial Management, 12, 159-168. ‘Yunos, R-M., Nazaruddin, N., Ghapar, F. A, Ahmad, 8. A., & Zakaria, N. B, (2013). Working capital managment in Malaysian Government-linked companies. Procedia Economics and Finenice, 31, 573-580.as Poizn Joumal af Social Setnces Vos. 36, No.1 Table 3 (I): Effects of Working Capital on Different Messures of Performance EF = faa a oe eo ae «ioe [she [dee [Se |e | ee | se se [iam |Gae |se | Ge |aa |u| ie se a & eee 188 [se Lie Lee [te ie s aay | 20 | casa | saa) | re, £m, ‘es a8 [ae fee [ae [an be = SB laa [ar [ae |e 2 f se lie lice lege (ie & on ge [ae [Ge [fe [ie a Rate: Spite at ot, #53 ard* 10 Perv Lav ls Ga given pares)Nadeem Anesthetic, Miva None Abbst a19 Table 3 (il: Effects of Working Capital on Different Messures of Performance ‘Varlable: BEDE r = ae | Ge |e 2 ae | te | Se | Se ae o |e | ee | e s._| #2 | de | oa eB = | $e | se | oe 2 po — ie ue = | 9B | Se | a 2 a ee | ae fa m =| SB | Se | ie a Note: Siptcantat 41, 5 and TO PeomELavas GF Saise piven pares)