Reflection Essay on Working Capital Management

This thesis tests the impact of working capital management on firm’s profitability in sugar industry of Pakistan for years 1999 to 2009. To analyze this, data of 19 sugar mills which are listed at Karachi Stock Exchange is used. The result shows that the Sales Growth, Current Ratio, No of Days Inventory and No of Days Accounts Payables are significantly affecting the profitability of the firms while Sales, Gearing Ratioand No of Days Account Receivables are insignificant in the research. Pearson Correlation and Multiple Linear Regression are used in this research to study the relationship between variables.

Working Capital Management

Overview In manufacturing sector of Pakistan 70% of goods are produced by the large scale industries which include mainly cement, automobiles, sugar, textile, oil and gas and etc. As the manufacturing sector includes so many sub sectors therefore in depth analysis is required for the industry as a whole and also of every firm at micro level. Though agriculture contributes to the major chunk in the economy of Pakistan but Sugar sector also plays a vital role.

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Sugar sector is the second biggest sector in the manufacturing sector which contributed 2% to the overall GDP of Pakistan and 13% to manufacturing sector. Sugarcane production has increased by 12 percent to 55. 3 million tons in 2010-11 from 49. 4 million tons last year whereas sugar production increased by 3. 8 million ton showing an increase of 26. 5 % (Economic Survey of Pakistan, 2011). One of the main sectors in manufacturing sector is sugar sector. More than 100,000 labor works in sugar sector and more than 9 million people earn their living through the production of sugarcane.

Mills producing sugar in Pakistan are capable enough to produce country’s requirement for next 3 years. Government should not entertain any application of opening a new sugar mill rather they should concentrate on financing the working capital for the 69 firms working in Pakistan which desperately in need of that financing. Commercial bank will be approximately be needing Rs. 2. 7 billion to finance the working capital of these working sugar firms (Rizvi, 2009). Most of the sugar firms are owned by the persons who have political influence and were built by those development finance institutions which were themselves facing

Working Capital Management 3 working capital issues out of few have already been closed and few are near to be closed. Further shutdown of sugar mills will result in loss of national assets, less sales tax and unemployment will increase. There has been a crisis in the sugar industry of Pakistan especially the sugar mills in Sindh from last 3 years. This crisis has affect owners of the sugar mills, employees of the sugar mills and raw material suppliers. As the profit of these sugar mills are not improving which result in low value to shareholders and affects the owners of sugar mills.

Suppliers of raw material complain of not getting good prices of raw material and very late payments from the sugar mills and in last the employees of sugar mills are not getting paid because profits has converted in to negative. Sugar mills are facing severe liquidity problems they don’t have enough cash to pay a good price to suppliers and above all pay their suppliers on time. This problem has gone so worst that they are not able to pay their legal liabilities. Considering the situation of the sugar mills banks are not willing to advance any further loans.

Solution to all the problems mention above lies in the efficient management of working capital. Components of working capital which includes inventory management, receivable management, payables management and cash conversion cycle if controlled efficiently than all of the problems will be solved and the sugar industry of Pakistan will once again progress and contribute to the GDP of Pakistan in a better way than past. Many researchers have worked on the importance of working capital management. The work of Shin and Soenen(1998), Deloof(2003) and Padachi(2006) are most important.

The results concluded that working capital management is essential to increase the profitability of the firm. There have been very few researches with the Working Capital Management 4 respect to sugar industry in Pakistan which is a motivating force to work on this issue with reference to the sugar industry of Pakistan. Considering the importance of working capital management objective of this research is to find that which factors of working capital management plays important role and affect the profitability of sugar mills in Pakistan.

Variables taken for conducting this research are sales, sales growth, current ratio measure of liquidity, gearing ratio measure of debt and working capital componentsno of days accounts receivables, no of days accounts payable and no of days inventory. For the research data sample of 19 firms which are currently enlisted at Karachi Stock Exchange for the years 1999 – 2009 is taken. 1. 2 Problem Statement The objective of this study is to examine does working capital management affect the firm profitability in the sugar industry of Pakistan? 1. 3 Outline of the Study

The first chapter of the research focuses on giving basic view of the research and provides information on the overview, issues, purpose and basic theories on the working capital management. In the second chapter existing work by various researchers and past empirical studies is discus. The third chapter provided details regarding practically carrying out of the research and described data collection and analysis procedures. The fourth chapter gives details regarding the results of the research. Finally the fifth chapter includes the conclusion of the research.

Working Capital Management

Working capital management has been a concern for all firms but small firms should give more importance to this issue because they cannot afford to survive without cash (Peel, Wilson and Howorth, 2000). Many researchers have worked on the same issue but pioneer study of Shin and Soenen (1998) and Deloof (2003) have found that working capital management stronglyaffects the corporate profitability. Therefore sugar mills should address this issue seriously. Maccini and Blinder (1991) suggested that conventional approach that is to invest highly in working capital can also increase profitability.

Maccini and Blinder (1991) suggested that if more investment is done on inventory than it will save supply time and money due to availability and fluctuations in prices and production process is also not disturbed. Hicks and Czyzewski(1992) analyzed that the firms which have greater cash balances have high return on assets. Jose, Lancaster and Stevens (1996) performed the research to find out the relationship between working capital management and firm’s profitability by taking net trading cycle as a measure of working capital management on specific industry, the result was not that significant.

After observing the Industry nature and size of the industry Jose et al. (1996) suggested that aggressive liquidity management increases the profitability. Shin and Soenen (1998) took a sample of United States firms. To analyze the relationship between profitability and working capital Shin and Soenen (1998) use Net Trading Cycle as a measure of working capital management. The result suggested that Net Trading Cycle is indirectly related to profitability while in previous research on specific industry, the result was not that significant (Shin and Soenen, 1993).

The general thought which prevails is that profitability can be increase by decreasing the working capital investment. It can be done by decreasing the portion of current Working Capital Management 6 assets. Wang (2002) took a sample of Taiwanese and Japanese firms and Deloof (2003) took a sample of Belgium Firms. The results suggested that profitability depends on how the working capital management is handle by the management. Deloof(2003) stated that no of days inventory and no of days accounts receivable is indirectly related to profitability.

Deloof (2003) also stated that if the cash conversion cycle is shorter than the profitability will be increased. Thus efficient working capital management is very important to increases the value of the shareholders (Wang, 2002; Deloof, 2003). Tryfonidis and Lazaridis(2006) carried out a research for the companies listed in Athens Stock Exchange. Tryfonidis and Lazaridis (2006) analyzed the relationship between working capital management and profitability of the firms. The variable for the measurement of profitably was gross operating profit in their research.

Significant relationship between the cash conversion cycle and profitability was reported. Tryfonidis and Lazaridis (2006) stated that the profit can be maximize by taking care of every component of working capital at individual level. Padachi(2006) studied different behaviors in the working capital management for a sample of 58 small Mauritian firms for the year 1998 – 2003. Padachi (2006) stated that if the working capital is managed efficiently than it will add up to the firms value and increase profitability.

The research showed that no of days inventories and no of days receivable are indirectly related to profitability. Uyar(2009) evaluate the relationship between the firm size, profitability and the cash conversion cycle by using correlation and annova techniques for the companies enlisted in Istanbul Stock Exchange. The outcome was that that the cash conversion cycle of manufacturing sector was greater as compared to the whole sale industry. In addition to that it was analyzed that the size of the firm and profitability has significant negative relation with cash conversion cycle. Gill, Biger and Mathur(2010) studied the relationship between working capital management and firm’s profitability for the sample of 88 firms listed at New York stock exchange for the period of 2005 to 2007 and found significant relationship between the two variables. Zuberi (2010) took a sample of Pakistan’s automobile sector and concluded that the growth and current ratio of the firms in automobile sector have direct relation with the profitability of the firms.

Ding, Guariglia and Knight (2010) took a sample of over 120,000 Chinese firms and concluded that working capital management significantly affects the profitability of firms. Alipour (2011) took a sample of 1063 top firms listed in Tehran stock exchange and found a negative significant relationship between no of days accounts receivable, Inventory Turnover and cash conversion cycle where as positive significant relation with no of days accounts payables with profitability and hence concluded that working capital management significantly affects the profitability of the firms.

Enqvist, Graham, Nikkinen (2012) worked on the sample of Finland firms and studied the relationship of working capital management and profitability on different business cycles and concluded that there is a significant negative relationship between cash conversion cycle and profitability of firms. The results suggested that efficient management of inventory and accounts receivable days significantly affects the corporate profitability of the firms. In Pakistan there have been few researches on working capital management. Sana and Shah (2006) worked on oil and gas sector.

They took a very small sample of consisting only 7 firms and they concluded that profitability and value of shareholders can be increased by managing the working capital efficiently. Nazir and Afza (2007) in their research analyze the relationship between aggressive and conventional way of Working Capital Management 8 investing in working capital for 205 firms for 17 different sub sectors. Results showed that there is a negative relationship between aggressive approach in working capital investment and the profitability of the firms.

Nasr and Rehman(2007) analyzed the relationship between the profitability and components of working capital management which includes no of days inventory, no of days accounts receivable, no of days accounts payable and cash conversion cycle. The result showed that there is negative relationship between them. In the year Nazir and Afza(2008) analyzed the working capital management for 204 firms. Though researchers have studied the relationship between the components of working capital management and the corporate profitability with reference to Pakistan but it’s not enough.

There is still lack of evidence of relationship between the two variables. This reason has been a motivational force to do a research on the sugar sector of Pakistan. For this purpose sample of 19 sugar firms listed on Karachi stock exchange has been taken during 1999-2009. Method of Data Collection The secondary data necessarily required to perform the research was gathered from the official sites of the sugar firms. Additionally, some of the required data was abstracted from the library of State Bank and Karachi stock exchange.

Rest of the data is collected from annual reports, SBP analysis reports and economical surveys. 3. 2 Sample Size There are 35 Sugar mills listed at Karachi Stock Exchange out of which 19 are selected. Those firms are not included whose data was not available or observations were missing for few years. The data used for the purpose of research consisted of 11 years annual data of the variables used in research. Data of all the variables belonged to period starting from fiscal year 1999 to fiscal year 2009 because this is the period where many of new sugar mills were installed and many of them were shutdown.

Many researchers which include Shin and Soenen(1998),Deloof(2003) and Padachi(2006) used same components for analyzing working capital management. S - Sales are expressed in millions of PKR. Natural log of Sales are included in the research to measure the size of the firms. It is assume that bigger the size more the profit. Shin and Soenen(1998), Deloof(2003) and Padachi(2006) also included sale as a measure of firm size and found positive and highly significant relation between sales and corporate profitability. Working Capital Management 11 SG - Sales growth is (current year’s sales - last year’s sales)/last year’s sales.

Sales growth is added in the research to measure the investment growth opportunity in the industry. Deloof(2003) included sales growth in his research and found positive and highly significant relation with profitability. CR - Current ratio is current asset/current liabilities. Current ratio is taken as the measure of liquidity in the firm. More the liquidity of the firm less will be investment in working capital and firm will easily pay its immediate liabilities and creditors but on other hand more liquidity means that less investment in inventory and less sales.

It is found that current ratio have direct and significant relationship with profitability (Rehman and Afza, 2010). GR - Gearing ratio is total fixed liability/total capital employed. Gearing ratio is used to measure the leverage of the firm. Rehman and Afza(2010) used gearing ratio in the research and find negative relationship with profitability it means higher the debt less the profit. NDAR - No of days accounts receivable is (A/R x 365)/sales. No of days accounts receivable is included as a component of working capital management.

Generous credit terms can increase sales as it allows more time for customers to check the goods from the supplier before paying the cost (Long, Malitz and Ravid, 1993; Deloof and Jegers, 1996). Customers enjoy advantage from longer credit terms as compare to taking a loan from financial institution (Petersen and Rajan, 1997). Therefore no of days accounts receivable significantly affect the profitability of the firm (Deloof 2003). Working Capital Management 12 NDI - No of days inventory is (inventory x 365)/cost of goods sold.

Firms have different optimal level of investing in working capital some invest more some invest less. On one hand keeping low inventory result in high liquidity but on other hand keeping high inventory saves firm from stock out and also result in more sales. Many researchers have included NDI as one of the component of working capital management as NDI has a negative relation with NOI and significantly affect the profitability. The negative relation shows that low profit means less sales and less sales result in more inventory (Deloof, 2003).

NDAP - No of days accounts payable is (A/P x 365)/purchases. No of days accounts payable is also an important component of working capital management. Firm enjoys more liquidity and gets the chance to examine the quality of goods before paying to their suppliers if they pay late but on other hand they miss the discount offered by the suppliers which they can avail by prompt payment. Padachi(2006) and Deloof(2003) in theirresearches found that no of days accounts payable significantly affect the profitability of the firm. 3. 5 Hypothesis

This research primarily focused on following hypothesis: H1: Sales has a significant impact on NOI. H2: Sales Growth has a significant impact on NOI. H3: Current Ratio has a significant impact on NOI. H4: Gearing Ratio has a significant impact on NOI. H5: No of Days Accounts Receivable has a significant impact on NOI. Working Capital Management 13 H6: No of Days Inventory has a significant impact on NOI. H7: No of Days Accounts Payable has a significant impact on NOI. 3. 6 Statistical Technique Pearson Correlation and Multiple Linear Regression are used in this research to study the relationship between variables.

Log of sales (lnS) hasproved statistically insignificant. Positive sign with its coefficient shows that bigger the size of the firm or more sales result in more profitability. Gearing Ratio (GR) is statistically insignificant in this research but it has a negative relationship with net operating income which shows that higher will be the leverage Working Capital Management 18 low will be the operating profitability of the firm. Same result was concluded by Deloof(2003), Shin and Soenen (1998), Rajan and Zingales (1995) and Myers and Majlof (1984) but in this case it is insignificant.

Current Ratio (CR) has proved statistically significant and has impact on NOI. It is according to the findings of Deloof (2003). It is the measure of liquidity so if the firms have ample cash available it will pay its creditors soon which will result in more profits. No of Days Accounts Receivable (NDAR) has proved statistically insignificant. Its negative relation shows that if number of days accounts receivable is increased by 1 day there will be a loss in net operating income (divided by total assets) by 0. 27 %. It is according to the findings of Raheman and Afza (2010).

A very strong significant indirect relation between net operating income and number of days accounts payable (NDAP) is shown by the regression analysis. The negative correlation between operating income and number of days accounts payable is confirmed by this negative relation in regression analysis. It is according to the findings of Deloof (2003). It also shows that if the firm pays to their creditors soon they will avail big discounts hence increasing the profitability. No of Days Inventory (NDI) has proved statistically significant and has impact on NOI.

This shows that by reducing the no of days inventory profitability can be improved or profitability can be increase by keeping the inventory for shorter period. Mostly researchers have found a significant negative impact of no of days inventory on the profitability of firms. It is according to the findings of Deloof(2003). Working Capital Management 19 For further analysis sugar firms were divided in to 5 groups according to the firm’s size. The firm’s size was decided on the basis of two variables annual sales and value of total assets.

Conclusion

In this research no ofdays accounts receivable, no of days account payable and no of days inventory are taken as a comprehensive components of working capital management, by using these variables the efficiency of working capital management can easily be check. The results shows that longer these components lesser will be the net operating profit as these have a negative relationship with net operating income. Firms can easily increase value for the shareholders by keeping the days to optimal level. In this research no of days payable and no of days inventory is significant and are affecting the operating profitability.

Deloof (2003) concluded the same result for the study of Belgian firms. Current Ratio (CR) has proved statistically significant and has impact on NOI whereas gearing ratio is statistically insignificant in this research but it has a negative relationship with net operating income which shows that higher will be the leverage low will be the operating profitability of the firm. Same result was concluded by Deloof (2003), Shin and Soenen (1998), Rajan and Zingales (1995) and Myers and Majlof (1984) but in this case gearing ratio is insignificant.

Sales growth and natural log of sales have positive relationship with profitability but sales growth in significant whereas natural log of sales has proven to be insignificant. 5. 2 Discussions Sugar sector which is the second biggest sector in manufacturing sector of Pakistan contributes to the economy significantly. Keeping in mind the importance of Working Capital Management 22 sugar sector in the economy of Pakistan objective of this research is to analyze the affect of working capital management on firm’s profitability in the sugar sector of Pakistan.

To carry out the research data from 19 sugar mills which are currently listed at Karachi Stock Exchange is analyzed. The results shows that profitability of sugar mills are significantly affected by the efficient management of working capital and working capital management play a vital role in creating a value for the shareholders. 5. 3 Implications Many recommendations can be drawn from the above research results. Every sugar mill should give due importance to working capital management. Sugar mills should make such collection and payment policies which are in favor of the firm and existing policies should be thoroughly reviewed.

Sugar mills should decrease there payment and receivable cycle. This can only be done when there will be professional management. The results suggest that sugar mills should keep optimum level of inventory and cash conversion cycle. This could only be possible when sugar mills will give due importance to every component of cash conversion cycle. Sugar mills should hire professional human resource to take decisions related to finance. There are many sugar mills where only one person is looking after the whole department. In order to maximize the profit sugar mills should manage there working capital efficiently. . 4 Future Research Every sector in manufacturing sector should be analyzed at micro level for efficient working capital management so it can be understand that which factors affects the working capital management more and how can working capital management can increase profitability in different sectors of our country. Working Capital Management 23 REFERENCES Alipour, Mohammad. (2011). Working Capital Management and Corporate Profitability: Evidence from Iran. World Applied Sciences Journal, 12 (7), 1093-1099. Blinder, A. S. & L. Macinni. (1991).

The Relationship of Cash Conversion Cycle with Firm Size and Profitability: An Empirical Investigation in Turkey. International Research Journal of Finance and Economics, 24. Wang, Y. J. (2002). Liquidity Management, Operating Performance, and Corporate Value: Evidence from Japan and Taiwan. Journal of Multinational Financial Management. 12, 159-169. Zubairi, H. Jamal (2011). Impact of Working Capital Management and Capital Structure on Profitability of Automobile Firms in Pakistan. Finance and Corporate Governance Conference. Working Capital Management 25 Appendix 7. 1 Firms Size (Sales) – Group wise analysis

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