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EFFECTS OF WORKING CAPITAL MANAGEMENT ON PROFITABILITY: (THE CASE OF
PRIVATE LARGE SCALE MANUFACTURING FIRMS IN HAWASSA CITY)
A Thesis Submitted to the Department of Accounting and Finance to undertake a study for
Partial Fulfillment of the Requirements for the Award of a Master Science (M.Sc.) Degree
in Accounting and Finance.
BY: BATILE BARNAKA
RBE/RMA/005/07
Supervisors:
1. D/r .Srinivasa Rao :- Principal advisor
2. Mr. Lisanework Amare :- Co-advisor
Arba Minch, Ethiopia
©2016
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DECLARATION AND RECOMMENDATION
Declaration
This thesis is my original work and has not been presented in any other institution for the award of a
degree or diploma. All sources and materials used for this thesis have been duly acknowledged.
Batile Barnaka
RBE/ RMA/005/07
Siganature_________________________________________Date_______________
Recommendation
We confirm that this thesis has been submitted for examination with our approval as the University
Supervisors.
Principal advisor: - Dr. Srinivasa Rao
. Signature_________________________________________Date________________
Co- advisor: - Mr. Lisanework Amare
Signature_________________________________________Date________________
External examiner’s name
----------------------------Signature--------------------Date--------------------------------------
Internal examiner’s name
---------------------------------Signature--------------------------------Date------------------------
Chair person’s name
------------------------------Signature------------------------------------Date-----------------------
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DEDICATION
This research work is dedicated to Sunday school students of Beto St. Sillase church.
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ACKNOWLEDGEMENT
First and foremost, I wish to profoundly thank my Supervisors, Dr. Srinivasa Rao and Mr. Lisanework
Amare for their steadfast support, guidance and encouragement during the entire research period. My
gratitude goes to all my lecturers who successfully took me through the course units and in the same
breadth provided advice that proved invaluable in achieving my goals.
I would like to express my special gratitude and thanks to the six firms‟ responsible persons, giving me
their precious time and all necessary documents for study purpose; even if it was difficult to them (due
to time and confidentiality).
I owe my deepest gratitude to my parents who realize my dream of studying overseas. I am grateful to
their supports both in financial and mental support.
My appreciation also extends to the Muluken Girma for his support with constructive idea and
encouragement.
Special thanks are extended to my loving Sunday school students of Beto St, Sellase church for their
endurance, unfailing support, continued encouragement, and understanding.
To all the numerous people whom I have not mentioned individually, I say thank you for your invaluable
support and may God bless you.
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ABSTRACT
Working capital management involves the management of the most short-term assets and liabilities of the
firm which includes cash and cash equivalents, Inventories and trade and other receivables. Most firms
do not hold the required amount of working capital and this has been a major obstacle to their overall
profitability. The study used a quantitative research design of the six (6) selected private limited large
scale manufacturing firms operating in the Hawassa city. For this purpose, balanced panel data obtained
from document analysis of annual financial reports of years ending June 30: 2011-2015. Multiple
regression and correlation analyses were carried out on the data to determine the relationships between
components of working capital management and the gross operating profit of the firms. The study
established that gross operating profit was positively correlated with Average Collection Period and
Average Payment Period but negatively correlated with Cash Conversion Cycle. The relationship
between Inventory Turnover in Days and gross operating profit was insignificant. Based on the key
findings from this study it has been concluded that the management of firms are capable of gaining
sustainable competitive advantage by means of effective and efficient utilization of the resources of the
organization through a careful reduction of the cash conversion cycle to its minimum and can create
value for their shareholders by investing account payables in short-term financings. In so doing, the
profitability of the firms is expected to increase.
Keywords: Working Capital Management, Average Collection Period, Average Inventory Period,
Average Payment Period, Cash Conversion Cycle, Private limited large scale manufacturing firms.
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Table of Contents
ACKNOWLEDGEMENT ........................................................................................................................................... 3
ABSTRACT ........................................................................................................................................................... 4
LIST OF TABLES ...................................................................................................................................................... 8
LIST OF FIGURES .................................................................................................................................................... 9
ABBREVIATIONS .................................................................................................................................................... 1
CHAPTER ONE ....................................................................................................................................................... 1
1. INTRODUCTION ................................................................................................................................................. 1
1.1 Background of the study.................................................................................................................. 1
1.2 Statement of the problem ................................................................................................................ 2
1.3 Objectives of the study..................................................................................................................... 4
1.3.1 General objective .................................................................................................................................. 4
1.3.2 Specific objectives................................................................................................................................. 4
1.4 Research Hypotheses ....................................................................................................................... 4
1.5 Significance of the Study ................................................................................................................. 5
1.6 Scope of the Study............................................................................................................................ 6
1.7 Definition of Significant Terms Used in the Study ......................................................................... 7
1.8 Research structure ........................................................................................................................... 8
CHAPTER TWO ................................................................................................................................................. 10
LITERATURE REVIEW ..................................................................................................................................... 10
2.1 Introduction ........................................................................................................................... 10
2.2 Review of Theories ................................................................................................................ 10
2.2.1 Operating Cycle Theory ............................................................................................................... 11
2.2.2 The Importance of Operation Cycle Theory .......................................................................... 11
2.2.3 Cash Conversion Cycle Theory .................................................................................................... 12
2.2.4 Measuring WCM - A distinction between operating cycle and CCC .................................... 14
2.2.5 Net Trade Cycle Theory ............................................................................................................... 15
2.2.6 Transaction Cost Economics Theory .......................................................................................... 15
2.3 Working capital management concept ............................................................................... 16
2.4 Components of the Working Capital management ............................................................. 17
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2.4.1 Receivable management ............................................................................................................... 17
2.4.2 Inventory management ............................................................................................................... 18
2.4.3 Cash management ........................................................................................................................ 19
2. 4.4 Accounts Payables management............................................................................................... 20
2.5 Factors determining working capital requirements ........................................................ 21
2.6 Working Capital Management Policies ............................................................................... 23
2.7 Distinction between profit and profitability of a company .............................................. 25
2.8 Review of empirical studies ................................................................................................................... 27
2.8.1. Relationship between Average Collection Period and Profitability ............................. 27
2.8.2. Relationship between Inventory Turnover in Days and Profitability.......................... 28
2.8.3. Relationship between Average Payment Period and Profitability ............................... 29
2.8.4. Relationship between Cash Conversion Cycle and Profitability ................................... 30
2.9 Summary and Gaps in Literature Review ........................................................................... 31
2.10. Conceptual framework ........................................................................................................ 33
CHAPTER THREE .................................................................................................................................................. 35
RESEARCH METHODOLOGY ................................................................................................................................. 35
3.1. INTRODUCTION ..................................................................................................................... 35
3.2. Research Design ........................................................................................................................ 35
3.3. Population of the Study ............................................................................................................. 36
3.4. Sample Selection method ............................................................................................................................. 36
3.5. Motivation for the Selected Location .................................................................................................... 37
3.6. Model Selection Criteria ........................................................................................................... 37
3.6.1 Correlation analysis ............................................................................................................................ 37
3.6.2 Regression analysis ............................................................................................................................. 37
3.6.3 Ordinary Least Square regression ........................................................................................................ 38
3.6.4 Fixed Effects Model regression ........................................................................................................... 38
3.7. Model Specifications ................................................................................................................. 39
3.8. Choosing variables and their measurements: .......................................................................... 40
3.8.1 Independent variables ......................................................................................................................... 40
3.8.2 Dependent variable ............................................................................................................................. 41
3.8.3 Control variables: ............................................................................................................................... 42
CHAPTER FOUR ............................................................................................................................................... 44
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4. DATAANALYSIS, PRESENTAION AND DISCUSSIN ................................................................................ 44
4.1 Introduction................................................................................................................................ 44
4.2 Descriptive statistics ................................................................................................................... 44
4.3 Correlation between the variables .......................................................................................................... 45
4.4 Regression Models ...................................................................................................................... 46
4.4.1 Effect of Average Collection Period on Profitability ............................................................................ 46
4.4.2 Effect of inventories turnover in days on probability ............................................................ 48
4.4.3 Effect of average payment period on probability................................................................... 50
4.4.4 Effect of Cash Conversion Cycle on Profitability ................................................................................ 52
CHAPTER FIVE ..................................................................................................................................................... 54
5. SUMMARY OF FINDINGS, CONCLUSSIONS AND RECOMMENDATIONS ........................................... 54
5.1. Introduction............................................................................................................................... 54
5.2. Summary of the Findings .......................................................................................................... 54
5.3. Conclusions ................................................................................................................................ 55
5.4. Recommendations ..................................................................................................................... 56
5.5. Limitations of the Study ............................................................................................................ 56
5.6. Directions for Further Studies .................................................................................................. 57
REFERENCES ................................................................................................................................................... 58
Appendix A: - large scale private limited manufacturing firms included in the study ............................................ 64
........................................................................................................................................................................... 65
Appendix B: - Co-operation letter from the Arba Minch Unversity -------------------------67
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LIST OF TABLES Table 2.1 Example of Statement of Income------------------------------------------------------------------------26
Table 3.1 Summery of variables chosen for the study------------------------------------------------------------43
Table 4.2: Descriptive statistics--------------------------------------------------------------------------------------44
Table 4.3: Correlation Matrix for the Variables-------------------------------------------------------------------45
Table 4.4.1: Regression Results for the Effect of Average Collection Period on Profitability -------------47
Table 4.4, 2: Regression Results for the Effect of Inventories Turnover in Days on Profitability ---------49
Table 4.4.3: Regression Results for the Effect of Average Payment Period on Profitability----------------51
Table 4.4.4: Regression Results for the Effect of Cash Conversion Cycle on Profitability-----------------53
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LIST OF FIGURES Figure 1.1 Research Structure-----------------------------------------------------------------------------------------9
Figure 2.1 Operating Cycle-------------------------------------------------------------------------------------------11
Figure 2.2Cash flow time lines the short- term operating activities of a typical manufacturing firm------13
Figure 2.3 Economic Order Quantities (Behavior of ordering, carrying and total cost) ---------------------18
Figure 2.4 Conceptual Framework of the Relationship between WCM firms Profitability-----------------34
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ABBREVIATIONS ACP - Average Collection Period
APP - Average payment period
CCC - Cash conversion cycle
CR - Current Ratio
DR - Debt Ratio
EFM- Effect Fixed Model
EOQ - Economic Order Quantity
FATA- Financial Assets to Total Assets
NOP – Net Operating Profit
ITID -Inventory turnover in days
JIT - Just-in-Time
LOP - Logarithm of Profit
LOS -Logarithm of Sales
OLS – Ordinary Least Square
WCM - Working Capital Management
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CHAPTER ONE
1. INTRODUCTION
The first chapter of this thesis introduces the area of study, providing a background for the paper. This
chapter is organized under different sections in which background of the study, statement of the problem,
objectives of the study, research hypothesis, significance of the study, scope of the study, definition of
significant terms used in the study and finally structure of the paper also presented.
1.1Background of the study
Corporate financial management primarily deals with three core areas that have a bearing on a firm‟s
financial goals. As postulated by Firer etal(2008), the three core areas of corporate finance are (1) capital
budgeting, which encapsulates the process of planning and managing firm‟s long-term investments; (2),
capital structure, which outlines the specific mixture of long-term debt and equity maintained by a firm
and (3) working capital management, which deals with management of firm‟s short-term assets and
liabilities.
One of the most important factors for a firm to consider is the management of working capital, which is
related to short term financing and investment decision of a firm. The function of obtaining efficient
working capital management is to maintain current assets and current liabilities in respect to each other
and to generate maximum returns.
Working Capital Management (WCM) is an important corporate financial decision since it directly
affects the profitability of the firm. Working capital management efficiency is vital especially for
manufacturing firms, where the major part of assets and liabilities are composed of current assets
especially inventory and trade receivables, and current liabilities; trade payable (Arunkmar and Ramanan,
2013).
Working capital refers to part of the firm‟s capital, which is required for financing short term or current
assets such as cash, marketable securities, debtors and inventories. Funds thus, invested in current assets
keep revolving fast and are constantly converted into cash and this cash flow out again in exchange for
other current assets. Working capital is also known as revolving or circulating capital or short-term
capital (Deloof, 2003). When a business entity takes the decisions regarding its current assets and current
liabilities it can be termed as working capital management. The management of working capital can be
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defined as an accounting approach that emphasize on maintaining proper levels of both current assets and
current liabilities. Working capital management provides enough cash to meet the short-term obligations
of a firm (Raheman and Nasr, 2007).
In their respective studies of working capital management, Deloof (2003); Rahman and Nasr (2007)
found that current assets of a typical manufacturing firm accounts for more than half of the total assets
and that the high levels of current assets within a firm directly affects its profitability and liquidity.
Efficient management of working capital plays an important role of overall corporate strategy to create
shareholder value. The way of managing working capital can have a significant impact on both the
liquidity and profitability of the company (Shin &Soenen, 1998). The main purpose of any firm is to
maximize profit. Also, maintaining liquidity of the firm is an important objective. The problem is that
increasing profits at the cost of liquidity can bring problems to the firm. Thus, there is a trade-off
between these two objectives and disregarding liquidity may result in insolvency and bankruptcy
(Raheman and Nasr, 2007).
Every business requires working capital for its survival. Working capital is a vital part of business
investment which is essential for continuous business operations. It is required by a firm to maintain its
liquidity, solvency and profitability (Lazaridis and Tryfonidis, 2006).
Working capital management explicitly affects both the profitability and level of desired liquidity of a
business. Hence, it has both negative and positive impact on firm‟s profitability, which in turn, affects the
shareholders‟ wealth (Rahman and Nasr, 2007). Therefore, it is a critical issue to know and understand
effects of working capital management on firm‟s profitability.
1.2 Statement of the problem
Working capital management is an important issue in any organization. This is because without a proper
management of working capital components, it‟s difficult for the firm to run its operations smoothly.
That is why Brigham and Houston (2003) mentioned that about 60 percent of a typical financial
manager‟s time is devoted to working capital management. Hence, the crucial part of managing working
capital is maintaining the required liquidity in day-to-day operation to ensure firms smooth running and
to meet its obligation (Eljelly, 2004).
Most of the researchers also identify significant association between working capital management and
firms‟ performance. However, it has been discovered that some methods that managers use in practice to
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make working capital decisions do not rely on the principles of finance, rather they use vague rules of
thumb or poorly constructed models (Emery, Finnerty and Stowe, 2004). This, however, makes the
managers not to effectively manage the various mix of working capital component which is available to
them, and as such, the organization may either be overcapitalized or undercapitalized or worst still,
liquidate.
Egbide (2009) finds that large number of business failures in the past has been blamed on the inability of
the financial manager to plan and control the working capital of their respective firms. These reported
inadequacies among financial managers are still practiced today in many organizations in the form of
high bad debts, high inventory costs etc., which adversely affect their operating performance (Egbide,
2009).
Lack of proper research study on the area gives a chance for Ethiopian companies‟ managers to have
limited awareness in relation to effects of working capital management on firm‟s profitability. For
instance, if firm has higher level of account receivable due to the generous trade credit policy, it will
bring high profitability, but it would result to longer cash conversion cycle. In this case, the longer cash
conversion cycle will increase profitability and thus, the traditional view of managers cannot be applied
to all circumstances. In effect, most company managers thought regarding working capital management
is, to shorten the cash conversion cycle (traditional views) to increase firm‟s profitability.
Working capital management has been major issue especially in developed countries. As a result, in order
to explain the relationship between working capital management and firm‟s performance, different
researches have been carried out in different parts of the world of developed countries.
However, despite the above importance this issue failed to attract the attention of most researchers in
Ethiopia. And, whether searching on internet, browsing through the books and journals the researcher
didn‟t find sufficient directly related research outputs carried out in parts of Ethiopia especially in
Hawassa city. But currently, the study is very important for a developing country like Ethiopia because,
the Government‟s Growth and Transformation Plan II (GTP II, 2015-20), to be launched at this year, has
as its ultimate goal for Ethiopia to reach middle-income status by 2025. GTP II targets 11 percent growth
per year (underpinned by strong manufacturing and exports), an improved external balance, and higher
foreign reserves. Specially, the government gives high attention to the big manufacturing firms like;
Brewery, textile, and other big manufacturing sectors and, of course, particularly to small and medium
manufacturing, to increase value added and job creation.
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According to the federal democratic republic of Ethiopia central statistical agency annual report
September 2015, Large and Medium Scale Manufacturing Industries are manufacturing industries that
employ 10 or more persons and use power – driven machines for production. Therefore, the researcher
strongly believes that the problem is not sufficiently addressed and there is a knowledge gap on the area.
Hence, the lack of clear-cut evidence on the effect of the components of working capital management on
firm‟s profitability in Ethiopia provide a strong motivation for evaluating the relationship between
working capital management and firm profitability in detail (Mekonnen,2011). Therefore, the current
study will focus on determine effects of working capital management on profitability of manufacturing
firms. This study will include all private limited large scale manufacturing firms in Hawassa city based
on the data for the last five years period (2011 – 2015). Therefore, by keeping the above problem in
mind, the study will try to find out effects of working capital management on profitability of private
limited large scale manufacturing firms in the Hawassa city.
1.3 Objectives of the study
1.3.1 General objective
The general objective of the study was to determine the relationship between working capital
management and the profitability of private large scale manufacturing firms in the Hawassa city.
1.3.2 Specific objectives
The study was guided by the following specific objectives:
1. To analyze the relationship between average collection period and profitability of private
manufacturing firms.
2. To assess the relationship between inventories turnover in days and profitability of private
manufacturing firms.
3. To analyze the relationship between average payment period and profitability of private manufacturing
firms.
4. To assess the relationship between cash conversion cycle and profitability of private manufacturing
firms.
1.4 Research Hypotheses
The following hypotheses were purposed to test at α=0.05.
H1: There is a negative statistically significant relationship between average collection period and
profitability of private limited manufacturing firms.
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H2: There is a negative statistically significant relationship between average inventory conversion period
and profitability of private limited manufacturing firms.
H3: There is a positive statistically significant relationship between average payment period and
profitability of private limited manufacturing firms.
H4: There is a negative statistically significant relationship between cash conversion cycle and
profitability of private limited manufacturing firms.
1.5 Significance of the Study
Working capital is so important for business day-to-day operations. A decision made on one of the
working capital components has an effect on the other components. In order to maximize the profitability
of a business, the working capital management should be integrated into the short-term financial decision
making process (Crum, Klingman, &Tavis, 1983).
Therefore, the findings of this study help in the first place the management of the target companies to
make a better decision in the future on their working capital. Also, it uses as a reference for other
companies who are trying to- make decision regarding the working capital reform model. It also serves as
a base for practitioner, policy maker, academician and firm managers with regards to issue associated
with the effect of working capital management on profitability of firm, as it enables minimization of
firm‟s cost of finance and further planning being conducted in order to maximize firm‟s profitability and
shareholders‟ wealth.
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1.6 Scope of the Study
This study delimited to investigate the effect of working capital management on firms‟
profitability of six (6) selected private limited manufacturing companies in the Hawassa city and the
study took 5 years financial data from year 2011 – 2015. It is because the researcher couldn‟t found any
related study, regarding the effect working capital management profitability for such huge manufacturing
firms in this city which contributes significantly to the economy.
The study incorporates big private limited manufacturing firms found in this city. The variables delimited
to three types: profitability, working capital management components and control variables, which are
specific to firms and/or general to the economy as a whole and clearly pinpointed in the
methodology part. As a measurement of profitability the study applied only net operating profit (NOP)
since its result allows the researcher to find all income generated from operation (of course before interest
& tax) by deducting only costs related to the activities. At last the methodology delimited to quantitative
method with correlation and regression analysis.
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1.7 Definition of Significant Terms Used in the Study
The following terms assumed the meaning in the context of the study
Average collection period (ACP): refers to the average time required for changing the company‟s
receivable into cash. It is calculated as:
ACP = Receivable accounts ×365
Sales
Average payment period (APP): refers to average number of days a company takes to off credit
purchases. It is calculated as:
APP= Payable accounts ×365
Cost of goods sold
Cash conversion cycle (CCC): the sum of days of sales outstanding (average collection period) and days
of sales in inventory less days of payables outstanding (keown et al, 2003). It is calculated as:
Cash days of sales days of sales days of
Conversion = outstanding + inventory - payables
Cycle outstanding
Inventory turnover in days (ITD): is the average required time to change the materials into the product
and then sell the goods. It is calculated as:
ITID = Inventory ×365
Cost of goods sold
Working capital: working capital also known as net working capital or NWC is calculated as current
assets minus liabilities. The major components of working capital are receivable, inventories cash and
cash equivalent and account payable.
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1.8 Research structure
The paper is organized in five chapters;
Chapter one provides an introductory overview of the full study comprising the statement of the problem,
objectives of the study, research hypothesis, significance of the study, scope of the study, definition
significant of terms used in the study, and how the study was organized also captured in this chapter.
The second chapter, theoretical review gives an extensive literature study on working capital and the
managements of its different parts.
Chapter three presents the methodology used for the study and gives a detailed overview of the research
design, population of the study, research sample selection, data analysis and presentation, model
specification. It also provides the description of the relevant variables that was included in the model,
model selection criteria and other diagnostic test on the model specification used for the study. Chapter
four focuses on the data analysis, result presentation and discussions. Chapter five summarizes,
concludes and offer recommendations for the study.
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Figure 1.1 Research Structure
ion
INTRODUCTION
LITERATURE
REVIEW
METHOLOGY
ANALYSIS &
FINDINGS
CONCULSION
Research background
Problem statement
Objective of the study
Research hypothesis
Scopes of the study
Significance of the study
Definition of terms
Research structure
Review of theories
concepts and components WCM
Working capital policy
Factors determining working capital requirements
Distinction between profit and profitability
Review of empirical studies
Summary and gaps in literature
Conceptual framework
Review of empirical studies
Summary and Gaps in literature
Conceptual framework
Summary and Gaps in literature
Research design
Population study
Sample selection method
Model selection criteria and model specification
Measurement of variables
Variables and their measurements
Correlation analysis
Regression analysis
Summary , conclusion and Recommendation
Limitation of study
Directions for future research
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CHAPTER TWO
LITERATURE REVIEW
2.1 Introduction
This chapter reviews literature relating to working capital management on firms profitability. The
sections will be organized to cover the theoretical and empirical literature on working capital
management and its effect on firms‟ profitability.
2.2 Review of Theories Working capital management techniques used by business managers aids them in effectively managing
working capital. Techniques such as intersection of carrying costs and shortage cost, working capital
financing policy, cash budgeting, EOQ and JIT are applied to manage different components of working
capital like cash, inventories, debtors and account payables. High performing companies understand the
company and industry specific drivers behind each component of operative working capital and focus on
optimizing the most promising ones.
During this process, they consider the entire value chain to reveal the root causes of tied up cash and take
into account all interdependencies between the respective components. They apply a holistic approach in
which they do not randomly reduce costs but consider all trade-offs with costs and capital employed to
optimize the company value. By applying the appropriate levers of each component, obstacles that slow
cash flow can be removed and overall company process can be improved (Buchman and Udo, 2011).
A company can be endowed with assets and be profitable but short of liquidity if its assets cannot readily
be converted into cash. Positive working capital is required to ensure that a firm is able to continue its
operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming
operational expenses. The management of working capital involves managing inventories, accounts
receivable, payable and cash. An increase in working capital indicates that the business has either
increased current assets (it has increased its receivables, or other current assets) or has decreased current
liabilities (has paid off some short-term creditors).
Pioneer studies of (Baumol, 1952) about an inventory management model and (Miller, 1966) about a
cash management model could be considered as the best-known studies in this field, with the
assumptions of these models informing managers about problem related with working capital
management practices.
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2.2.1 Operating Cycle Theory
To estimate the gross working capital requirements, the understanding of the operating cycle is very
important. The function of any trading unit is to procure material, process the same, sell the finished
goods and realize money and utilize the money so received, to procure material again and to continue the
cycle all over again. Thus the process starts with purchase of materials required for the trading. The
process purchase of material may take some time due to the number and nature of material transportation,
the material once procured are made to undergo the several processes, the duration of which may range
from a day to months.
During this period, various materials will be in different stages of production in different forms. Besides,
the cost of material, labour charges, electricity, water, rent etc. are also incurred during the period of
processing.
All these required funds/capital once the goods are produced it may not be sold immediately and it may
have to be stored in a go down for some days before they are sold. Storing of such finished goods
involves cost of materials used in such finished products, labour and other manufacturing expresses
incurred in producing them. It is not necessary that all the goods will be in cash.
Some goods will be sold on credit till such time sale proceeds are not realized, find are blocked in such
receivable. Finally when the sales proceeds are realized the funds are again used to procure materials as
above and the whole process cycle starts all over again. The total time taken from the purchase of
materials, till realization of sale proceeds is called the operating cycle and amount of capital required to
sustain this cycle is called gross working capital (Ghosh et al, 2004)
2.2.2 The Importance of Operation Cycle Theory Operating Cycle is important because it determines the amount of working capital a business needs.
If you can have the operating cycle, you will have the working capital requirement of the business. If the
turnover period for inventories and account receivable lengthen, or the payment period to account
payable shortens, then the operating cycle will lengthen and the investment in working capital will
increase (Ghosh et al, 2004)
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Figure 2.1 operating cycle
Source: Ghosh, et al, 2004
2.2.3 Cash Conversion Cycle Theory
The cash conversion cycle, this represents the interaction between the components of working capital and
the flow of cash within a company, can be used to determine the amount of cash needed for any sales
level. Gitman (1974) developed cash conversion cycle as part of operating cycle which is calculated by
adding inventory period to accounts receivables period and then subtracting accounts payables from it. Its
focus is on the length of me between the acquisition of raw materials and other inputs and the inflows of
cash from the sale of finished goods, and represents the number of days of operation for which financing
is needed.
The CCC is a dynamic measure of ongoing liquidity management, since it combines both balance sheet
and income statement data to create a measure with a time dimension (Jose and Lancaster, 1996). While
the analysis of an individual firm„s CCC is helpful, industry benchmarks are crucial for a company to
evaluate its CCC performance and assess opportunities for improvements because the length of CCC may
differ from industry to industry. Therefore the correct way is to compare a specific firm to the industry in
which it operates (Hutchinson, 2007).
Cash
Debtor
Finished goods
W.I.P
Raw materials
Advance
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The cash conversion cycle is used as a comprehensive measure of working capital as it shows the time
lag between expenditure for the purchase of raw materials and the collection of sales of finished goods
(Padachi, 2006). Day-to-day management of a firm„s short term assets and liabilities plays an important
role in the success of the firm. Firms with growing long term prospects and healthy bottom lines do not
remain solvent without good liquidity management (Jose and Lancaster, 1996).
By approximating these three periods with the financial ratios of inventory days, trade receivables days
and trade payables days, the length of the cash conversion cycle (CCC) is given by:
CCC = Inventory days + Trade receivables days − Trade payables days
Richards and Laughlin (1980) argued that traditional ratios such as current ratio, Quick acid test and cash
ratios has not been able to provide accurate information about working capital and insisted on using
ongoing liquidity measures in working capital management, where ongoing liquidity refers to the inflows
and outflows of cash as a product of acquisition, production, sales, payment and collection process done
over time. The firm„s ongoing liquidity is a function of its cash conversion cycle, hence the
appropriateness of evaluation by cash conversion cycle, rather than liquidity measures.
According to Arnold (2008) the shorter the CCC, the fewer are the resources needed by the company. So
the longer the cycle the higher will be the investment in the working capital. But also a longer cycle
could increase sales, which could lead to higher profitability. But this longer cycle, will also lead to
higher investment and could rise faster than the benefits of the higher profitability. Many authors like
Shin and Soenen (1998) have argued that it is important for firms to shorten the CCC, as managers can
create value for their shareholders by reducing the cycle to a reasonable minimum. They also argued that
a longer cash conversion cycle might indicate that a company„s sales are rising and that the company can
compete by having lax credit policies or high inventories. But on the contrary, a higher CCC can actually
hurt a company„s profitability by increasing the time that cash is tied to non-interest bearing accounts
such as accounts receivables. By shortening the CCC the company„s cash flows will have a higher net
present value because cash is received quicker. The numbers of day‟s accounts receivables; inventories
and accounts payables are used as the operationalization of the management of trade credit and inventory
(Sharma and Kumar, 2011).
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2.2.4 Measuring WCM - A distinction between operating cycle and CCC
Short-term finance is concerned with short-term operating activities such as buying materials, paying
cash for purchases, manufacturing the product, selling the product or collecting cash. These activities
create patterns of cash inflows and cash outflows that are both unsynchronized and uncertain. They are
unsynchronized because the payment of cash for raw materials does not happen at the same time as the
receipt of cash from selling the product. Additionally, those activities are uncertain since future sales and
costs are both known with uncertainty.
Figure 2.2 cash flow time lines, the short- term operating activities of a typical manufacturing firm
Finished goods sold cash received
Raw material
Purchased
Order stock
Placed arrive
Accounts Inventory period accounts receivable period time
Account payable period
Firm receives cash paid
Invoice for materials
Operating cycle
Cash conversion cycle
Source; Hillier et al, 2010, p.724
The cash flow time line depicts an operating cycle and a cash conversion cycle. Operating cycle is the
interval between the order of inventory stock and the date when cash is collected from receivables.
In the meantime, cash conversion cycle begins when the company pays cash to suppliers for the materials
purchased and ends when cash is collected from customers for credit sales. (Hillier et al, 2010, p.724). In
general, cash conversion cycle is computed as operating cycle minus accounts payable period.
Alternatively, cash conversion cycle is the sum of inventory period and accounts receivable period less
accounts payable period.
Cash Conversion Cycle = Operating Cycle – Accounts Payable Period
CCC= (Inventory Period + Accounts Receivable Period) – Accounts Payable Period.
Cash conversion cycle tells us how cash is moving through a company in terms of duration.
The cycle starts with a cash outflow by which the company pays back to suppliers for obtaining raw
materials then ends with a cash inflow when receiving money back from its customers for selling its
15
goods or services. In other words, the cycle indicates the number of days it takes the company to convert
its operating activities requiring cash into cash returns.
Therefore, a downward trend in this cycle is a positive signal whereas a negative signal is blamed for the
upward one. When the cash conversion cycle shortens, cash becomes free for other usages such as
investing on equipment and infrastructure or innovating manufacturing and selling processes. In contrast,
when the cash conversion cycle lengthens, cash tied up in the firm's operation activities, leaving little
chance for other investments of this cash flow. In an ideal case, a company should attempt to keep its
cash conversion cycle as close to zero as well. In other words, the company is trying to maintain its
production to be internally financed. However, the cash tied up in inventory and receivables will be
almost practically exceed the cash supplied by creditors and accrued liabilities (Melicher& Leach, 2009,
p.184).
2.2.5 Net Trade Cycle Theory
The net trade cycle theory is basically equal to the cash conversion cycle where the three components of
the cash conversion cycle (receivables, inventory and payables) are articulated as a percentage of sales,
this makes the net trade cycle easier to calculate and less complex comparing with the cash conversion
cycle and weighted cash conversion cycle. Soenen (1993) investigated the relationship between the net
trade cycle as a measure of working capital and return on investments in the US firms. The results of chi-
square test indicated a negative relationship between the length of net trade cycle and return on assets.
Furthermore, this inverse relationship was found different across industries depending on the type of the
industry. A significant relationship about for about half of the industries studied indicated that results
might vary from industry to industry.
2.2.6 Transaction Cost Economics Theory
The optimum level of inventory should be determined on the basis of a trade-off between costs and
benefits associated with the levels of inventory. Costs of holding inventory include ordering and carrying
costs. Ordering costs is associated with acquisition of inventory which includes costs of preparing a
purchase order or requisition form, receiving, inspecting, and recording the goods received. However,
carrying costs are involved in maintaining or carrying inventory and will arise due to the storing of
inventory and opportunity costs. There are several motives for lower or higher levels of inventories and
highly depends on what business a company is in. The most widely and simple motive of managing
inventories is the cost motive, which is often based on the Transaction Cost Economics (TCE) theory
(Emery and Marques, 2011). To be competitive, companies have to decrease their costs and this can be
16
accomplished by keeping the costs of stocking inventory to a reasonable minimum. This practice is also
highly valued by stock market analysts (Sack, 2000).
2.3 Working capital management concept In the development of the normal business, managers have the task to decide what will be the perfect
capital structure that will better fit in the firms‟ needs. Managers tend to underestimate the working
capital management and commonly look on long term perspective, focusing on long-term investments.
The short-term financial management had been forgotten or avoided by managers, but recent studies
(ALShubiri, 2011) have been proving the importance of the management between current assets and
current liabilities. When financial needs arise, claiming for long term debt is preferable instead of
changing the cash management policies in the firms. During several years, working capital management
was neglected (Darun, 2008) because of the excessive effort required to change short-term policies
comparing with increment profit.
There are several authors (Weinraub and Visscher, 1998) supporting the importance working capital
management referring to the importance of the management of the short-term needs and the importance
of the financial slack for firms. When the working capital needs are positive, it is a necessary investment
in working capital and the managers will have to capture funds and incur in incremental capital costs. If
the working capital needs are negative, then the firms are getting credit from the suppliers. Emery (1998)
suggests an integration of the short-term management with the long-term policies. This integration allows
the improvement of the financial flexibility, market conditions and growth strategies, “The amount and
timing of a company‟s intra-year cash flow surpluses and shortages largely depend on the results of the
operations although short-term policy also has an effect. These policies guide decisions about how much
financial slack is required to meet unexpected requirements for cash and decisions about the use of
permanent versus temporary financing. This means a short-term financial plan must integrate principles
and practice just as a long-term financial plan does.” (Emery, 1998) Since the subprime crisis, the firms
witnessed a deteriorating environment where managers were forced to take rigid measures, cutting costs
and delaying investments in order to respond to the decrease in demand and the consequent reduction in
production. At this level, the cash and the working capital were under higher monitoring and control.
Working capital management has been changing and common policies and usual trends had to be adapted
to the new economic conditions. Due to rapid changes in economy, firms are reacting and the working
capital management is one of the most important issues to lead with.
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Working capital management also became an important topic because firms have been exploring
different ways to finance their activities since in the past years the cost of long term debt increased and
the new costs levels were difficult to afford. ” Working capital management is relevant in the way it
influences the firm profitability and risk” (Smith, 1980).
2.4 Components of the Working Capital management
2.4.1 Receivable management Businesses have either products or services to sell to their customers; they also want to maximize their
sales. So, in order to increase the level of their sales they use different policies to attract customers and
one of them is offering a trade credit. Trade credit basically refers to a situation where a company sells
its product now to receive the payment at a specified date in the future. Fabozzi and Peterson (2003 p.
651) mentioned that when a firm allows customers to pay for goods and services at a later date, it creates
accounts receivable or refers to trade credit. Account receivables (trade credit) also have opportunity cost
associated with them, because company can‟t invest this money elsewhere until and unless it collects its
receivables. More account receivables can raise the profit by increasing the sale but it is also possible that
because of high opportunity cost of invested money in account receivables and bad debts the effect of this
change might turn difficult to realize. Hence, it calls for careful analysis and proper management is
compulsory task of company‟s credit managers.
Therefore, the goal of receivables management is to maximize the value of the firm by achieving a
tradeoff between risk and profitability. For this purpose, the finance manager has to obtain optimum
(non-maximum) value of sales, control the cost of receivables, cost of collection, administrative
expenses, bad debts and opportunity cost of funds blocked in the receivables. Further, financial manager
has to maintain the debtors at minimum according to the credit policy offered to customers, offer cash
discounts suitably depending on the cost of receivables and opportunity cost of funds blocked in the
receivables (Gallagher and Joseph, 2000). Indeed trade credit management has to look through cost and
benefit analysis including credit and collection policies of companies in maintaining receivable.
Monitoring account receivable
Companies can monitor how well accounts receivable are managed using aging schedules and financial
ratios. In aging analysis, a company‟s account receivables are classified into different categories based on
number of days they are past due after sales such as 1 to 30 days, 31 to 40 days, 41 to 50 days and so on
and it helps managers to get a more detailed picture of collection efforts. The schedule can represent the
18
receivables according to how many there are in each age group or according to the total dollars the
receivables represent in each age group. Hence, the higher the numbers of accounts or dollars in the
shortest term groups, the faster the collection or efforts are made (Fabozzi and Peterson, 2003 p. 660).
Whereas, financial ratio can be used to get an overall picture of how fast credit manager collect accounts
receivable. Therefore, the average collection period (ACP) represents the average number of days for
which a firm has to wait before its debtors are converted into cash. It is calculated by dividing accounts
payable by purchases and multiplying the result by 365 and written as:
Average collection period (ACP) = Receivables / (Sales/365)
This ratio measures the quality of debtors. A short collection period implies prompt payment by debtors.
It reduces the chances of bad debts. Similarly, a longer collection period implies too liberal and
inefficient credit collection performance. It is difficult to provide a standard collection period of debtors
(Brigham and Houston, 2003, p. 691).
2.4.2 Inventory management
Inventory is an important component of current assets. It is the stock of physical goods for eventual sale.
It consists of raw material, work-in-process, and finished goods available for sale. As is the case with
accounts receivable, inventory levels depend heavily upon sales. However, whereas receivables build up
after sales have been made, inventory must be acquired ahead of sales. This is a critical difference, and
the necessity of forecasting sales before establishing target inventory levels makes inventory management
a difficult task (Brigham and Houston, 2003, p. 707).
Inventory management refers to an optimum investment in inventories. It should neither be too low to
effect the production adversely nor too high to block the funds unnecessarily. Excess investment in
inventories is unprofitable for the business and both excess and inadequate investments in inventories are
not desirable (Fabozzi and Peterson, 2003 p. 658). Hence, the firm should operate within the two danger
points. Additionally, proper inventory management requires close coordination among the sales,
purchasing, production, and finance departments. The sales/marketing department is generally the first to
spot changes in demand. These changes must be worked into the company‟s purchasing and
manufacturing schedules, and the financial manager must arrange any financing needed to support the
inventory buildup. Lack of coordination among departments, poor sales forecasts, or both, can lead to
disaster (Brigham and Houston, 2003 p. 707). In general, the purpose of inventory management is to
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determine and maintain the optimum level of firm‟s investment on inventory. At the same time, it helps
to hold the costs of ordering and carrying inventories to the lowest possible level.
As it can be discussed in the above section, it is not necessary for a firm to hold high level of raw
material inventory, in fact a firm can order raw material on the daily basis but the high ordering cost is
associated with firms‟ policy. Moreover, the delay in supply might stop the production. Similarly, firm
can reduce its finished goods inventory by reducing the production and by producing the goods only to
meet the current demand. However, such a strategy can also create trouble for the company if the demand
for the product rises suddenly. Further, such a situation might cause the customer dissatisfaction and even
a loyal customer can switch to the competitors brand. Therefore, the firm should have enough inventories
to meet the unexpected rise in demand but the cost of holding this inventory should not exceed its benefit
(Brealey and Myers, 2003, p.821).
Monitoring inventory management
Companies can monitor its inventory by looking through its financial ratios like that of monitoring
receivables. Inventory turnover ratio in days (ITID) indicates the number of time the stock has been
turned over sales during the period and evaluates the efficiency with which a firm is able to manage its
inventory. This ratio indicates whether investment in stock is within proper limit or not (Brigham and
Houston, 2003, p. 691). Hence, the ration is calculated by dividing inventory by cost of goods sold and
multiplying with 365 days and depicted as follows:
Inventory Turnover in Day (ITID) = Inventory / (Cost of sales/365)
In general there is no rule of thumb or standard for interpreting the inventory turnover ratio. The norms
may be different for different firms depending upon the nature of industry and business conditions.
However the study of the comparative or trend analysis of inventory turnover is still useful for financial
analysis.
2.4.3 Cash management
Brealey and Myers (2003) indicated that cash is the oxygen which enhances a survival and prosperity,
and is the basic indicator of business health. Cash includes both cash in hand and cash at bank. A
company needs cash for transaction and speculation purposes. It also provides the liquidity to the
company but the question is why company should have cash reserves when it has an option to utilize it by
investing it in short term securities. The answer to this question is that it provides more liquidity than
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marketable securities. Cash should be considered as an inventory which is very important for the smooth
running of the business. No doubt a company can earn some interest if cash is invested in some
marketable securities but when it has to pay its liabilities it needs cash and in order to convert marketable
securities into cash it has to pay some transaction cost. So, there is a fair possibility that cost of holding
marketable securities might exceed their benefit.
Holding a cash reserve is justifiable for all the businesses but how much cash a company should have? It
is a big and very important question because too little cash might push a company in a situation where it
will not be able to pay its current liabilities. On the other hand having high cash balance will not produce
any return. The minimum level of cash reserve depends on the ability of a company to raise cash when it
is required, future cash needs and companies will to keep cash to safeguard future unexpected events.
Companies also want to have enough cash reserve to exploit the investment opportunities available in the
future but having a very high level of cash reserve can turn out to be an idle resource.
The maximum level of cash reserve depends on investment opportunities available in the future, return
on these investments and transaction cost of making the investments (Gallagher and Joseph, 2000).
2. 4.4 Accounts Payables management
Account payable is defined as a debt arising from credit sales and recorded as an account receivable by
the seller and as an account payable by the buyer. Firms generally make purchases from other firms on
credit, recording the debt as an account payable. Accounts payable is the largest single category of short-
term debt, representing about 40 percent of the current liabilities of the average nonfinancial corporation
(Brigham and Houston 2003, p. 720)
Arnold (2008 pp.479-482) described that account payable is the cheapest and simplest way of financing
an organization. Accounts payable are generated when a company purchases some products for which
payment has to be made no later than a specified date in the future. Accounts payable are a part of all the
businesses and have some advantages associated with it e.g. it is available to all the companies regardless
of the size of the company and earlier payment can bring cash discount with it. Companies not only need
to manage their account payables in a good way but they should also have the ability to generate enough
cash to pay the mature account payables. This is because, in case if a company fails to generate enough
cash to fulfill the mature account payables then such a situation will pass the negative signal to the
market and it will directly affect the share price, relationship with creditors and suppliers. Hence, in this
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situation it will be difficult for the company to raise more funds by borrowing money or get more
supplies from the suppliers. Such a financial distress will lead to the death of the non- living entity.
Therefore, one way of monitoring accounts payables is by the Average payment period (APP) or day‟s
payables outstanding ratio which measures the average length of time between the purchase of materials
or labor and the payment of cash for supplies (Brigham and Houston 2003, p. 720). It can be calculated
as: Average Payment period (APP) = Payables / (Cost of Goods Sold/ 365).
In general, if a company has a small number of accounts payable days, it could mean that the company is
paying the bills very early or is taking advantage of purchase discounts (requiring early payment). On the
other hand, if a company has a large number of accounts payable days, it could mean that the company
has low cash flows not sufficient to pay bills on time.
2.5 Factors determining working capital requirements
The total working capital requirement of a firm is determined by a wide variety of factors.
These factors affect different organizations differently and they also vary from time to time. In general
factors influencing working capital decisions of a firm may be classified as two groups, such as internal
factors and external factors (Paramasivan and Subramanian, 2009). The internal factor includes nature of
business, size of business, firm‟s product policy, credit policy, and growth and expansion of business.
The external factors include business fluctuations, changes in the technology, infrastructural facilities,
import policy and the taxation policy. These factors are discussed in brief in the following lines:
Internal factors
These are factors that the companies will take in to account while determining the optimal level of
working capital needed for the business concern by looking inherent factors related to the business and
they are presented as follows:
Nature and size of the business: The working capital requirements of a firm are basically influenced by
the nature and size of the business. Size may be measured in terms of the scale of operations. A firm with
larger scale of operations will need more working capital than a small firm. Similarly, the nature of the
business influences the working capital decisions. Trading and financial firms have less investment in
fixed assets. But require a large sum of money to be invested in working capital. Retail stores, business
units require larger amount of working capital, whereas, public utilities need less working capital and
more funds to invest in fixed assets.
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Firm‟s production policy: The firm‟s production policy (manufacturing cycle) is an important factor to
decide the working capital requirement of a firm. The production cycle starts with the purchase and use
of raw material and completes with the production of finished goods. On the other hand production
policy is uniform production policy or seasonal production policy, also influences the working capital
decisions. If the company maintains continues or uniform production policy, there is a need of regular
working capital. If the production policy of the company depends upon the situation or conditions like
season, working capital requirement will depend upon the conditions laid down by the company and
changing demand.
Firm‟s credit policy: The credit policy of a firm influences credit policy of working capital. A firm
following liberal credit policy to all customers requires funds. On the other hand, the firm adopting strict
credit policy and grant credit facilities to few potential customers will require less amount of working
capital.
Growth and expansion of business: Working capital requirement of a business firm tend to increase in
correspondence with growth in sales volume and fixed assets. A growing firm may need funds to invest
in fixed assets in order to sustain its growing production and sales. This will, in turn, increase investment
in current assets to support increased scale of operations. Thus, a growing firm needs additional funds
continuously.
External factors
Sometime firm‟s working capital requirement can be affected by external factor which will not be
controlled through the business internal administration and management process and they are discussed
as follows:
Business fluctuations: Most firms experience fluctuations in demand for their products and services.
These business variations affect the working capital requirements. When there is an upward swing in the
economy, sales will increase, correspondingly, the firm‟s investment in inventories and book debts will
also increase. Under boom, additional investment in fixed assets may be made by some firms to increase
their productive capacity. This act of the firm will require additional funds. On the other hand when, there
is a decline in economy, sales will come down and consequently the conditions, the firm try to reduce
their short-term borrowings. Similarly, the seasonal fluctuations may also affect the requirement of
working capital of a firm.
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Changes in the technology: The technological changes and developments in the area of production can
have immediate effects on the need for working capital. If the firm wish to install a new machine in the
place of old system, the new system can utilize less expensive raw materials, the inventory needs may be
reduced there by working capital needs may be affected.
Taxation policy: The amount of tax to be paid is determined by the prevailing tax regulations and very
often taxes have to be paid in advance. Hence, the tax policies of the
Government will influence the working capital decisions. If the Government follows regressive taxation
policy, that imposing heavy tax burdens on business firms, they are left with very little profits for
distribution and retention purpose. Consequently the firm has to borrow additional funds to meet their
increased working capital needs. When there is a liberalized tax policy, the pressure on working capital
requirement is minimized. In general, if tax liability increases, it will lead to an increase in the level of
working capital and vice versa. In summary, firm‟s financial manager should have to take in to account
the above determinants while deciding on the optimal level of working capital needed and the timing for
day to day activities of the business operations.
2.6 Working Capital Management Policies
Working capital policy can be best described as a strategy which provides the guideline to manage the
current assets and current liabilities in such a way that it reduces the risk of default (Afza & Nazir, 2007).
Working capital policy is mainly focusing on the liquidity of current assets to meet current liabilities.
Liquidity is very important because, if the level of liquidity is too high then a company has lot of idle
resources and it has to bear the cost of these idle resources. However, if liquidity is too low then it will
face lack of resources to meet its current financial liabilities (Arnold, 2008). Current assets are key
component of working capital and the WCP also depends on the level of current assets against the level
of current liabilities (Afza & Nazir, 2007). On this base the literature of finance classifies working capital
policy into three categories as defensive or hedging, aggressive and conservative working capital policy
(Arnold, 2008 pp.535-36) and discussed as follows:
Defensive policy: Company follows defensive policy by using long term debt and equity to finance its
fixed assets and major portion of current assets. Under this approach, the business concern can adopt a
financial plan which matches the expected life of assets with the expected life of the sources of funds
raised to finance assets (Paramasivan and Subramanian 2009). Inventory expected to be sold in 30 days
could be financed with a 30-day bank loan; a machine expected to last for 5 years could be financed with
24
a 5-year loan; a 20-year building could be financed with a 20 year mortgage bond; and so forth (Weston
and Brigham, 1977, P. 716).
Defensive policy reduces the risk by reducing the current liabilities but it also affects profitability
because long term debt offers high interest rate which will increase the cost of financing (Arnold, 2008
p.530). This means a company is not willing to take risk and feel it appropriate to keep cash or near cash
balances, higher inventories and generous credit terms. Mostly companies that are operating in an
uncertain environment prefer to adopt such a policy because they are not sure about the future prices,
demand and short term interest rate. In such situation it is better to have a high level of current assets.
Which means, keeping higher level of inventory in the stock, to meet sudden rise in demand and to avoid
the risk of stoppage in production.
This approach gives a longer cash conversion cycle for the company. It also provides the shield against
the financial distress created by the lack of funds to meet the short term liability but as the researcher
discussed earlier long term debt have high interest rate which will increase the cost of financing.
Similarly, funds tied up in a business because of generous credit policy of company and it also have
opportunity costs. Hence, this policy might reduce the profitability and the cost of following this policy
might exceed the benefits of the policy (Arnold, 2008 p.530).
Aggressive policy: Companies can follow aggressive policy by financing its current assets with short
term debt because it gives low interest rate. However, the risk associated with short term debt is higher
than the long term debt. Paramasivan and Subramanian
(2009) pinpointed that in aggressive policy the entire estimated requirement of current assets should be
financed from short-term sources and even a part of fixed assets financing be financed from short- term
sources. This approach makes the finance mix more risky, less costly and more profitable. Furthermore,
few finance managers take even more risk by financing long term asset with short term debts and this
approach push the working capital on the negative side.
Managers try to enhance the profitability by paying lesser interest rate but this approach can be proved
very risky if the short term interest rate fluctuates or the cash inflow is not enough to fulfill the current
liabilities (Weston and Brigham, 1977, P. 716). Therefore, such a policy is adopted by the company
which is operating in a stable economy and is quite certain about future cash flows. A company with
aggressive working capital policy offers short credit period to customers, holds minimal inventory and
25
has a small amount of cash in hand. This policy increases the risk of default because a company might
face a lack of resources to meet the short term liabilities but it also gives a high return as the high return
is associated with high risk (Arnold, 2008 p.536).
Conservative policy: Some companies want neither to be aggressive by reducing the level of current
assets as compared to current liabilities nor to be defensive by increasing the level of current assets as
compared to current liabilities. So, in order to balance the risk and return these firms are following the
conservative approach. It is also a mixture of defensive WCP and aggressive WCP. In these approach
temporary current assets, assets which appear on the balance sheet for short period will be financed by
the short term borrowings and long term debts are used to finance fixed assets and permanent current
assets (Weston and Brigham, 1977 P. 718). Thus, the follower of this approach finds the moderate level
of working capital with moderate risk and return. It is called as “low profit low risk” concept
(Paramasivan and Subramanian, 2009). Moreover, this policy not only reduces the risk of default but it
also reduces the opportunity cost of additional investment in the current assets.
On the other hand apart from the above points the level of working capital also depends on the level of
sale, because, sales are the source of revenue for every companies. Sales can influence working capital in
three possible ways (Arnold, 2008 p.534-35).
As sales increase working capital will also increase with the same proportion so, the length of
cash conversion cycle remains the same.
As the sales increase working capital increase in a slower rate.
As the sales increase the level of working capital rises in misappropriate manner i.e. the working
capital might raise in a rate more than the rate of increased in the sale.
Company with stable sale or growing sale can adopt the aggressive policy because it has a confidence on
its future cash inflows and is confident to pay its short term liabilities at maturity. On the other hand a
company with unstable sale or with fluctuation in the sale can‟t think of adopting the aggressive policy
because it is not sure about its future cash inflows. In such a situation adoption of aggressive policy is
similar to committing a suicide. Hence, searching other method might be the best choice.
2.7 Distinction between profit and profitability of a company In general, profit refers to the gain in business activity, which is served for the benefit of business
owners. It is usually measured for a given period of time such as a financial year, and calculated by the
26
revenues obtained from business activities minus the expenses used to achieve those revenues (Ildiko and
Tamas, 2009).
Profit= Revenues- Expenses
There is several important profit measures in common use. Bodie, kane and Marcus (2004) mention some
of them as below:
= Gross profit is calculated by operating revenue (sales) minus cost of goods sold;
= Operating profit is remained with the company after the subtraction of total operating expenses
(including cost of goods sold, selling, general and administrative expenses, depreciation and amortization
and other expenses from operating revenue;
= Earnings before interest and taxes (EBIT) are equal to operating profit plus non-operating profit, when
a firm has zero non-operating profit, then operating profit is sometimes used as a synonym for EBIT.
People usually miss-distinguish between those two types of profit;
= Net profit is equal to EBIT minus interest expense and income tax expense.
Table 2.1 Example of Statement of Income
STATEMENT OF INCOME
Revenue A
Sale Revenue A
Operating Expenses F = B + C + D + E
Cost of Goods Sold B
Selling, General and Administrative Expenses C
Depreciation and Amortization D
Other Expenses E
Operating Profit G = A – F
Non-operating Profit H
Earnings before Interest and Taxes (EBIT) I = G + H
Interest Expense J
Income Tax Expense K
Net Profit L = I – J - K
Source: Bodie, Kane and Marcus, 2004, p.452
Different from profit, profitability is interpreted as a ratio explaining the rate of some profit amount
which is benchmarked against some point of reference such as Assets, Investment or equity of the
27
company. Percentage (%) is used as the unit measure of those ratios. As decision tools, profitability ratios
can be used to assess the financial healthiness of a business (Ildiko and Tamas, 2009).
Profitability = profit
Base measurement
A business without profitability cannot survive where as a business which is highly profitable is fully
capable to reward its owners with a large investment return. Increasing profitability is one of the most
important tasks of the business managers. They have been constantly looking for ways to improve their
business profitability (Ildiko and Tamas, 2009).
The objectives of working capital management include: To set the optimal level of cash, debtors and
stocks to be maintained by a firm, to reduce the long term costs associated with working capital
financing, to maintain the liquidity of the firm so that it can be able to meet its financial obligations as
and when they fall due.
2.8 Review of empirical studies
2.8.1. Relationship between Average Collection Period and Profitability
Average collection period refers to the average length of time required to convert the firm‟s receivables
into cash following a sale. It is calculated by dividing accounts receivable by the average credit sales per
day. This ratio measures the length of time it takes to convert the average sales into cash. This
measurement defines the relationship between accounts receivable and cash flow. A longer average
collection period requires a higher investment in accounts receivable. A higher investment in accounts
receivable means less cash is available to cover cash outflows, such as paying bills.
Mekonnen (2011) shows that there is statistically significant negative relationship between profitability
and average collection period. This result suggests that firms can improve their profitability by reducing
the number of day‟s accounts receivable outstanding. Also this can be interpreted as the less the time it
takes for customers to pay their bills, the more cash is available to replenish inventory hence the higher
the sales realized leading to high profitability of the firm.
The negative relationship between average collection period and profitability suggests that an increase in
the number of day‟s accounts receivable by 1 day is associated with a decline in profitability. Through
this, managers can improve profitability by reducing the credit granted to their customers, Lazaridis and
Tryfonidis (2006).
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The study by Deloof (2003), states that managers can increase corporate profitability by reducing the
average collection period. The longer the number of day‟s accounts receivable outstanding, the greater
the chance that the firm may lose its profitability. If firms don't manage debtors, they gradually lose
control due to reduced cash flow and could experience an increased rate of bad debts. So the longer
someone owes firm‟s money, the greater the chance the firms never get paid. As a result, profit may only
be called real profit after the receivables are turned into cash. Therefore, the management of account
receivables is inevitable and largely influenced by the credit policy and collection procedure. A credit
policy specifies requirements to value the worthiness of customers and a collection procedure provides
guidelines to collect unpaid invoices that will reduce delays in outstanding receivables, Brigham and
Houston (2003). So, there exists a highly significant negative relationship between the time it takes for
firms to collect cash from their customers (receivables collection period) and profitability.
Other authors with the same results of negative relationship between profitability and average collection
period include (Mathuva, 2010; Lazaridis and Tryfonidis, 2006; Falope and Ajilore, 2009; Mansoor and
Muhammad, 2012; Naimulbari, 2012, Raheman and Nasr, 2007; Dong, 2010; Arunkmar and Ramanan,
2013). This leads to propose the following general hypothesis:
H1: There is negative relationship between average collection period and profitability.
2.8.2. Relationship between Inventory Turnover in Days and Profitability Inventory turnover in days refers to the average time required to convert materials into finished goods. It
is calculated as: (inventory/ (cost of goods sold) x 365.
Inventory turnover ratio, which represents the efficiency of inventory management, is expected to be high
for firms with greater profitability. A low inventory turnover ratio could indicate either poor sales or an
excess amount of inventory, Ruichao (2013). Mansoor and Muhammad (2012) on their study show that
managers can improve firms‟ profitability by shortening inventory collection period.
Dong (2010) focuses on the variables that include profitability, conversion cycle and its related elements
and the relationship that exists between them. The research finds that the relationships among these
variables are strongly negative. This denote that decrease in the profitability occur due to increase in cash
conversion cycle. It is also finds that if the number of days of account receivables and inventories are
diminished then the profitability increases.
29
Although most empirical research suggest a negative relation between inventory turnover in days and
profitability (Ruichao, 2013; Lazaridis and Tryfonidis, 2006; Falope and Ajilore, 2009; Mansoor and
Muhammad, 2012; Raheman and Nasr, 2007; Dong, 2010), find contradictory findings on the
relationship between inventory turnover in days and profitability. Gill, Biger and Mathur (2012) and
Mathuva (2010) suggest a positive relationship between inventory turnover in days and profitability.
Maintaining sufficiently high inventory levels reduces costs of possible interruptions in the production
process and loss of doing business due to scarcity of products (Mathuva 2010), while investing too much
in inventories unnecessarily blocks the funds in working capital that could be invested in revenue
generating activities. Since inventory determines the level of activities in a company, managing it
strategically contributes to profitability (Brigham and Houston, 2003). The key to manage inventory of a
business is to know how quickly firm‟s overall stock is moving, how long each item of stock sits on
shelves before being sold. Managing inventory is a juggling act. Excessive stocks can place a heavy
burden on the cash resources of a business. Insufficient stocks can result in lost sales, delays for
customers etc. The key issue for a business is to identify the fast and slow stock movers with the
objectives of establishing optimum stock levels for each category and, thereby, minimize the cash tied up
in stocks.
The stock sitting on shelves for long periods of time ties up money which may reduce the profitability of
firms. Thus, in light of the above theoretical grounds, the following research hypothesis is developed:
H2: There is a negative relationship between inventory turnover in days and profitability.
2.8.3. Relationship between Average Payment Period and Profitability Average payment period can be defined as the average length of time between the purchase of materials
and labor and the payment of cash for them. It is calculated as; (payables/ (purchase) x365. Account
payables plays a critical role in managing working capital because delaying bill payments is one of the
tools for management to have access to an inexpensive source of financing. However, the opportunity
cost of keeping high account payables may hurt the business if an early payment discount is offered,
Ruichao (2013). Payment period tend to be longer for countries in insufficient and smaller capital
markets like Tanzania whereby there are only 20 listed companies which includes 13 domestic companies
and 7 foreign companies, Porta et al‟s study as cited in Ruichao (2013).
Working capital management rule states that firms should strive to lag their payments to creditors as
much as possible, taking care not to spoil their business relationship. Through this, Mathuva (2010) in the
study “the influence of working capital management components on corporate profitability: a survey on
30
Kenyan listed firms” shows that average payment period has a positive relationship with profitability.
The positive relationship suggests that an increase in the number of day‟s accounts payable by 1 day is
associated with an increase in profitability.
Delaying payment of accounts payable to suppliers allows firms to access the quality of branch products
and could be inexpensive and flexible source of financing. On the other hand, delaying of such payables
can be expensive if a firm is offered a discount for the early payment. So, there exists a highly significant
positive relationship between the time it takes the firm to pay its creditors (average payment period) and
profitability, Naimulbari (2012). Although studies by (Ruichao, 2013; Muthuva, 2010; Naimulbari,
2012, Gill, Biger and Mathur, 2012) show positive relationship between accounts payment period and
profitability other more research by (Ray, 2012; Mekonnen, 2011; Deloof, 2003; Reheman & Nasr, 2007;
Vural, Sökmen and Çetenak, 2012; Saghir, Hashmi and Hussain, 2011; Reheman et al, 2010) suggest a
negative relationship between average payment period and the firm profitability. Garcia-Teruel and
Martinez-Solano (2007) failed to provide the relationship that exists between average payment period and
profitability. In view of the earlier explanations the researcher hypothesizes as follows: H3: There is a
positive relationship between average payment period and profitability.
2.8.4. Relationship between Cash Conversion Cycle and Profitability Cash conversion cycle equals the length of time between the firm‟s actual cash expenditures to pay for
productive resources (materials and labor) and its own cash receipts from the sale of products (that is, the
length of time between paying for labor and materials and collecting on receivables). The cash
conversion cycle thus equals the average length of time a shilling is tied up in current assets. It is
calculated as; (Average Collection Period + Inventory turnover in days - Average Payment Period)
Brigham and Houston (2003).Cash conversion cycle can be shortened in three ways: One, by reducing
inventory conversion period by processing and selling goods more quickly. Two by reducing receivables
period by speeding up collections from sales and three by lengthening payables or deferral period through
slowing down firm‟s own payments.
Naimulbari (2012) in the study “The impact of working capital management on profitability” of
pharmaceuticals sector in Bangladesh” shows that there is a negative relationship between cash
conversion cycle and profitability. As the cash conversion cycle has the negative relationship with the
profitability, this cycle should be short as much as possible without hurting the operations. This would
improve profits, because the longer the cash conversion cycle, the greater the need for external financing,
and that financing has a cost.
31
The study by Dong (2010), reports that the firms‟ profitability and liquidity are affected by working
capital management. From the research it is found that the relationship between CCC and profitability is
strongly negative. This denotes that decrease in the profitability occurs due to increase in cash conversion
cycle.
Despite many authors postulating a negative relationship between cash conversion cycle and profitability,
(Azam and Haider, 2011; Mansoor and Muhammad, 2012; Mekonnen, 2011; Dr. Ray, 2012; Vural,
Sökmen and Çetenak, 2012; Saghir, Hashmi and Hussain, 2011; Niresh, 2012; Rehemanet al., 2010;
Naimulbari, 2012), there are studies which indicate a positive relationship between cash conversion cycle
and profitability (Gill, Biger and Mathur, 2012; Lyroudi & Lazaridis, 2000). This leads to the following
hypothesis: H4: There is a negative relationship between cash conversion cycle and profitability.
2.9 Summary and Gaps in Literature Review Working capital management requires the management of the most liquid resources of a firm with a view
to maintain the firm‟s liquidity, enhance profitability and promote business growth.
Working capital management concentrates on the management of inventories, cash and cash equivalents
and accounts receivable. The proper management of these items is critical to the success of an
organization
The management of inventories is aimed at determining the optimal level of stocks an organization
should hold. It ensures that the organization is holding the right quantity of inventories at the right time
and in the right location. Proper management of inventories is meant to check on costs associated with
holding incorrect quantity of stocks which includes damages to stocks, high capital tied up in stocks,
stock holding costs and lost goodwill and profitability associated with being out of stocks.
The management of cash on the other hand is aimed at determining the optimal level of cash an
Organization should hold so that it can be able to meet its day to day operating expenses, meet its short
term financial obligations, ensure that funds are available to ensure investments in expansion projects and
that excess cash balances not immediately required for use are invested in income generating activities
i.e. money market instruments. Cash should not be left idle in the bank accounts. This is because cash
balance in the bank is a non- earning asset. This cash should be converted into an earning asset by either
investing in short term marketable securities or investing for business growth. Inadequate or excessive
cash balance has negative impact on the operations of the firm. Inadequate balances causes financial
32
distress to a firm leading high cost of finance, inability to meet profit targets and inability to undertake
expansion projects which limits the overall performance. Excessive cash balances on the other hand leads
to lost profitability due to forgone investment income that would have been earned if the idle cash were
invested.
Accounts receivable management refers to the determination of the optimal level of debtors an
Organization should hold. It involves a cost benefit analysis of selling on credit. It involves evaluating
the credit policies of an organization with a view of selecting and implementing a policy that yields the
maximum benefits to a firm. A firm selling on credit terms increases it turnover therefore increases it
profits, however there are costs associated with the credit sales. A trade off should therefore be made
between the benefits of credit sales and the cost associates with such credit sales. An organization should
carry out a cost benefit analysis of either selling in cash or on credit. Such a decision can only be done
after evaluating the credit policy of the firm. Any policy adopted should be the one which leads to a
lower cost associated with credit sales.
High level of debtors has high incidence of bad debts and debt administration costs. Low level of debtors
on the other hand implies low level of sales therefore low profitability. Debtor‟s management policy
impacts on the firm‟s profitability, liquidity, growth and the level of operating and financial risk of an
organization. A problem therefore arises as to what should be the optimal level of debtors and the credit
policy that an organization should adopt in order to reap maximum benefits.
In general, the literature review indicates that working capital management has impacts on profitability of
a firm. Having optimum level of working capital components will help firms to meet its day to day
operations and vital for maximizing value and profitability.
Hence, almost all studies did in Ethiopia in the past focuses on the impacts on working capital on
profitability studies for small and medium business firms. While, this study focuses on the big private
limited manufacturing firms and try to find out effects of working capital management on its profitability.
Here also the study includes the following variables (day sales outstanding, days payable outstanding,
cash conversion cycle, inventory conversion period, current ratio, size of the company and date ratio),
running the regression by including all variables would enhance the reliability of the findings and fill the
problem of missing important variables which was observed in previous studies. In general, the
researcher believed that the above actions would fill the gap identified in this study.
33
2.10. Conceptual framework Working capital management calls for the effective management of working capital which is critical to
the survival and profitability of any business organization.
Working capital refers to investments in short term assets commonly referred to current assets (Non-
fixed assets). Non- fixed assets are essential for the day to day running of a business. Working capital
management focuses on the management of such current assets like debtors or account receivables,
inventories and cash and cash equivalents.
Good working capital management is enhanced by well management of current assets of the
organization. This ensures that there is adequate working capital to finance the daily operations of the
firm, the company meets its financial obligations as and when they fall due and that there is enough
capital for investments to promote business growth. When a firm has adequate cash to meet its day to day
operations and its financial obligations without difficulty then the level of operating risk and financial
risk is minimized.
Figure 2.4 shows the conceptual framework showing how the variables depend on each other.
34
Figure 2.4: Conceptual framework of the relationship between working capital management components
and firm‟s Profitability.
Source: Author‟s Own Conceptualization.
Dependent
Net Operating
Profit (NOP)
Control variables
1. Current Ratio (CR)
2. Company Size (CS)
3. Financial assets
to Total assets(FATA)
4. Debt Ratio (DR)
Independent Variables
1. Average collection period
(ACP)
2. Inventory turnover in
Days (ITID)
3. Average payment Period
(APP)
4. Cash Conversion Cycle (CCC)
(CCC)
35
CHAPTER THREE
RESEARCH METHODOLOGY
3.1. INTRODUCTION
This chapter is going to explain which techniques and procedures that the study used to define the sample
and to analyze the data. There are two main data analyses shall be employed. Firstly, it used Pearson
correlation analysis to express whether working capital management is associated with company
profitability. Secondly, the study shall further analyzed the effect of working capital management on
company profitability by using multiple regression models, using Fixed Effects framework and Ordinary
Least Square for panel data of 6 firms across five years of experience. Those two models are kinds of
regression analysis which the researcher used to answer his problem of statement. It is because in order to
determine whether working capital management can affect company profitability, the regression analysis
must be used to identify the relationship between variables. Finally, there are other diagnostic tests to
determine the problems of multicolinearity, in regression analysis shall be employed. It is for
strengthening the regression outcomes. The rationale for applying those all kinds of analysis or test
together with the way to construct them shall be clearly discussed in the sub-sections below.
After reading this chapter, readers are expected to see the reasons why the researcher chooses those types
of data analysis to answer the problem statement and to obtain a general awareness on those statistical
techniques.
3.2. Research Design
The study adopted the quantitative research design. The study was concerned with the effects of working
capital components on profitability. It aimed at identifying the effect of working capital management
efficiency proxies, that is, the Average collection period (ACP); Inventory conversion period (ICP);
Average payment period (APP) and Cash conversion cycle (CCC) on profitability. Quantitative research
tries to determine the association of the subject matter with something else (Kothari, 2004). The design
enabled the researcher to identify the relationship that existed between the independent variables and the
dependent variable. The collected secondary data in this study required panel data analysis to find out the
relationships among the independent and dependent variables. In addition, Statistical Package for Social
Science (SPSS) (Version 20.00) Windows Software was used to process and analyze the data collected.
36
3.3. Population of the Study
The population of this study comprised all the large scale private limited manufacturing firms operating
in the Hawassa city. Operating firms were appropriate for the study since they are private entities
operating under strict corporate governance regulations, making their financial and accounting
disclosures largely reliable. There are nine (9) large scale private limited manufacturing firms in the
Hawassa city. Out of them the secondary data was collected from six (6) firms actively operating as well
as financial data are available in this city. (Appendix A).
3.4. Sample Selection method
To select sample firms, the researcher planned to employ convenience and purposive sampling
techniques. It is because of the following requirements: Convenience sampling involves drawing samples
that are both easily accessible and willing to participate in a study. Theoretically, there are two types of
convenience samples that are captive samples and volunteer samples. Purposive sampling techniques
have also been referred to as non- probability sampling or purposeful sampling or „„qualitative
sampling.‟‟ As noted above, purposive sampling techniques involve selecting certain units or cases
„„based on a specific purpose rather than randomly‟‟ (Tashakkori & Teddlie, 2003). Several other authors
(e.g., Kuzel, 1992; LeCompte & Preissle, 1993; Miles & Huberman, 1994; Patton, 2002) have also
presented typologies of purposive sampling techniques.
The researcher involves such sampling, because of the following criteria‟s‟. The first criterion that is used
to select sample units to be included in the study is putting restriction criterion. The study considers large
scale private limited manufacturing firms which are located in the Hawassa city and convenient to reach
them easily and relevant to the study.
Secondly, the data for the study period of 5 years from 2011 – 2015 collected from secondary sources i.e.
audited Annual reports of the companies. The reason for restricting periods is to get the latest data for
investigation is available for the study period. As a result continuity and homogeneity in the available
data is a prerequisite for studying the trend of working capital formation in firms, hence those firms
whose data is not available for the entire study period or whose financial years are not in uniform will be
excluded from sample selection.
The researcher tried to make the sample representative of the population operating in the Hawassa city.
The researcher, therefore, selected and collected six (6) firms‟ financial statements, located in this city.
The use of the secondary data enabled the researcher to collect reliable information from the sampled
37
population. These reports enabled the researcher to save time in data collection; they were cost effective
and contained the required information.
3.5. Motivation for the Selected Location
Since, Hawassa is being the commercial area of South nation nationality and peoples of Ethiopia the most
businesses are concentrated with a good mix of trading and manufacturing companies. Second, the
selection of location also influenced by the researcher; due to its nearness and availability of compiled
data to selected sample as compared to conducting the study outside this city.
3.6. Model Selection Criteria
3.6.1 Correlation analysis
The study use Pearson correlation analysis to define the relationship between firm profitability and
working capital management. There is a majority of previous researches have chosen to employ Pearson
correlation analysis to first see the correlation between variables before conducting regression analyses
(Deloof, 2003; Huynh & Su, 2010;Padachi 2006; Hayajneh, &Yassine, 2011). However, one of the
shortcomings of correlation analysis is that it cannot identify a cause-and-effect relationship. In addition,
examining simple bivariate correlation in a conventional matrix does not take into account each
variable‟s correlation with all other explanatory variables (Padachi, 2006). It is accordingly the
consequence for employing regression analyses as the next step.
3.6.2 Regression analysis
Literature review on regression models employed by other scholars
To investigate the effect of working capital management on company profitability, other researchers have
employed different regression analyses with different models. Huynh & Su (2010) only chose Fixed
Effects Model (FEM) to conduct regression analysis for investigating the effect of WCM on corporate
profitability. According to them, FEM assumes firms‟ specific intercepts which capture the effects of
variables that are particular to each firm and constant over time. Different from Huynh & Su (2010),
Sharma & Kumar (2011) selected Ordinary Least Square (OLS) as their choice for conducting regression
analysis. As a combination, Deloof (2003); Garcia-Teruel& Martinez- Solano (2007) and Padachi (2006)
used both FEM and OLS to investigate the effect of WCM on corporate profitability.
38
The literature review shows that OLS and FEM are mostly chosen to analyze the effect of WCM on
companies‟ profit. In the context of this thesis, the researcher shall also choose those two types of
analysis together with explaining the rationale behind his choice.
3.6.3 Ordinary Least Square regression
OLS regression is simply a linear regression applied to the whole data set. One of the biggest advantages
of pooled OLS method is that it relaxes the restriction of an enough large data set (Schmidt 1997, 156).
Therefore, with an average data set compared to other relevant studies, this regression method appears to
be suitable for the study. Panel data, also called longitudinal data or cross-sectional time series data, are
data where multiple cases (people, firms, countries, etc.) are observed at different periods of time.
Accordingly, data obtained in this study are classified as panel data where the researcher observed 6
different companies across five years. Accordingly, another regression is additionally chosen to
strengthen the research for that panel data. There are several techniques to analyze panel data, in which
Fixed Effects Model or Random Effects Model (REM) are usually chosen because of their advantages.
3.6.4 Fixed Effects Model regression
Use FEM whenever you are only interested in analyzing the effect of variables that vary over time. FEM
determine the relationship between predictor (independent) and outcome (dependent) variables within an
entity (country, person, company and so forth). When using FEM, the researcher assumes that something
which is time-invariant characteristics within the entity may effect or bias the predictor or outcome
variables and needed to control for this purpose. FEM remove the effect of those time-invariant
characteristics from the predictor variables then the researcher can assess the net effect of predictor
variables on the outcome variable. Another important assumption of the FEM is that those characteristics
are unique to the entity and should be correlated with other individual characteristics. If they are not
correlated then FEM is not suitable since inferences may not be correct and you need to model that
relationship by probably using REM. This is the main rationale for the Hausman (1978) test being
employed (Kohler &Frauke, 2009).
Why Fixed Effects instead of Random Effects? - Rationale for employing a Hausman test.
Hausman test examines whether the unique errors (ei) are correlated with the regressors (Independent
variables). The null hypothesis for the test is not correlated to each other E (ei/xit) = 0. If the test rejects
this null hypothesis then the decision is taken to employ a FEM (Padachi, 2006). If the effects are
considered to be fixed, the model is then estimated by OLS. If the null hypothesis is not rejected, then the
study has used random effects, and the model is then estimated by Generalized Least Square (GLS)
39
(Garcia & Martinez, 2007). The p-value obtained from Hausman test is lower than 0.05, rejecting the null
hypothesis and accordingly indicating that there is a significant correlation between ei and regressors.
Therefore, then FEM shall be employed.
To conduct regression analyses using OLS and FEM, the researcher shall run four models in which each
independent variable is being interchanged respectively while keeping control variables constant. It is
because the study would like to determine the effect of working capital management on companies‟
profitability through finding the influence of each component of working capital management
individually. This choice of determining separate effects is of consistent with all researchers found in the
literature review (Tewodros, 2010; Deloof, 2003; Huynh & Su, 2010; Padachi, 2006; Garcia & Martinez,
2007; Nobanee, 2009; Hayajneh&Yassine, 2011).
3.7. Model Specifications
As mentioned above, the effect of working capital management on firms‟ profitability was projected as
follows:
. The general model was:
Yi = α+Σ βiXi + ei
Where
Yi = the ith observation of dependent variables (profitability)
α= the intercept of the equation
βi = coefficients of Xi variables
Xi = the different independent variables
ei = the error term
Specifically, when the above general model is converted into the specified Variables of this study the
following regression equations were run to estimate the effect of working capital management on the
profitability of selected private manufacturing firms:
To test the hypotheses of the study, the following 4 models were used to analyze the relationship between
the variables:
The first hypothesis test model; the relation between Average collection period and profitability:
Yit = α + β1 (ACP) it + β2 (LOS) it + β3 (CR) it + β4 (DR) it +β5 (FATA) it + e
The second hypothesis test model; the relation between Average payment period and profitability
Yit = α + β1 (APP) it + β2 (LOS) it + β3 (CR) it + β4 (DR) it +β5 (FATA) it + e
40
The third hypothesis test model; the relation between Inventory turnover in days (ITID) and profitability:
Yit = α + β1 (ITID) it + β2 (LOS) it + β3 (CR) it + β4 (DR) it +β5 (FATA) it + e
The fourth hypothesis test model; the relation between Cash Conversion Cycle and profitability:
Yit = α + β1 (CCC) it + β2 (LOS) it + β3 (CR) it + β4 (DR) it +β5 (FATA) it + e
Where:
α = Constant term for the independent variables
Y= Net operating profit (NOP)
it = Means the different components of WCM for firm i at time t
ACP = Average Collection Period
CR = Current Ratio
LOS = the size of the company (measured by logarithm of sales)
DR =Debt Ratio
FATA= Financial Assets to Total Assets
ITID =Inventory Turnover in Days
APP = Average Payment Period
CCC = Cash Conversion Cycle
e = the error term
β = Regression model coefficient
3.8. Choosing variables and their measurements:
In order to analyze the effects of WCM on company profitability, the researcher selected independent
variables, dependent variable and control variables as showed on the following sub- sections.
3.8.1 Independent variables: To measure the companies‟ WCM‟s efficiency of a company, the research
chooses Cash Conversion Cycle(CCC), Inventory conversion period (ICP), Average collection period
41
(ACP) and Average Payment period (APP) as independent variables. Please prefer the definition and
calculation of those variables mentioned previously in sub-section of chapter one (1.8). Those variables
are seen as the most suitable proxies measuring the WCM‟s efficiency. Cash conversion cycle is vital
because it tells us how cash is moving through a company in terms of duration. The cycle starts with a
cash outflow by which the company pays back to suppliers for obtaining raw materials then ends with a
cash inflow when receiving money back from its customers for selling its goods or services. In other
words, the cycle indicates the number of days it takes the company to convert its operating activities
requiring cash into cash returns.
If this number of days can be reduced to an optimal level which is specific to every company, then cash is
returned faster to the company and increasing liquidity and profitability as a result. To have an optimal
cash conversion cycle, companies should pay attention to managing each individual processing period
effectively, say, number of days in inventory, number of days in accounts receivable and number of days
in accounts payable. Therefore, this research studies how managing those periods can affect the
company‟s profitability.
Additionally, that choice is of consistence with a majority of researches found in previous literature
(Deloof, 2003; Huynh & Su, 2010; Padachi, 2006; Garcia-Teruel& Martinez-Solano, 2007; Sharma &
Kumar, 2011; Gril, Biger & Mathur; 2010; Hayajneh & Yassine 2011).
3.8.2 Dependent variable: Net operating profitability (NOP):- is a measure of profitability of the firm by
calculated as; NOP= Earnings before interest & tax
Total assets
To investigate the relationship between working capital management and firm‟s profitability, net
operating profit (NOP): The researcher used this variable instead of earnings before interest, tax,
depreciation and amortization (EBITDA). Moreover, this variable has a close relation with other
operating variables such as cash conversion cycle. Several studies have used NOP as a proxy for firm‟s
profitability such as Deloof (2003), Raheman and Nasir (2007).Furthermore; it is also the reason why
financial assets are subtracted from the total assets (Lazirdis and Tryfonidis, 2006).
42
3.8.3 Control variables:
Liquidity (CR): The companies with more liquidity have more profitability, so liquidity variable was
used as control variable in order to make its effect on profitability neutral. Current ratio was used as
liquidity criterion.
CR = Current Assets (CA)
Current Liability (CL)
The Company Size (LOS): The companies which have more sales naturally have more profitability too.
So the company size variable was used to control the effect of it. Since, it is a natural logarithm of sales.
Financial Assets (FATA): Financial assets are bought for profitability purposes, and so they may affect
profitability. Therefore this variable was used as control variable in order to make its effect neutral on the
company. Long-term and short-term investments in deposits, stock and bills of exchange of the
companies are considered as financial assets.
FATA= Financial Assets (FA)
Total Assets (TA)
Debt Ratio (DR): used as a proxy for leverage and is calculated by dividing Total Debt by Total Assets:
DR = Total Debt (TD)
Total Assets (TA)
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Table 3.1 Summery of variables chosen for the study
Types of variables Name of variable How to measure
Dependent
variable
Net operating profit (NOP) Earnings before interest & tax
Total Assets
Independent variables
Inventory conversion period(ICP) Inventories
Costs of Goods sold/365
Account receivable period(ACP) Receivable
Net sales/365
Account payable period (APP) Payables
Costs of Goods sold/365
Cash conversion cycle(ccc) Numbers of days inventory + number of days
Accounts receivable- number of days Accounts
payable
Control Variables
Firm size (LOS) Logarithm of sales
Financial assets to Total
assets(FATA)
Financial assets
Total assets
Current ratio (CR) Current assets
Current liabilities
Debt ratio (DR) Total debt
Total assets
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CHAPTER FOUR
4. DATAANALYSIS, PRESENTAION AND DISCUSSIN
4.1 Introduction
The purpose of this study is to analyze the relationship between working capital management and company
profitability. Therefore, this chapter is to test the null hypothesis defined in chapter one. The chapter begins
by testing the correlations between the variables under the study. To determine the effect of working capital
management on profitability regression models have been also made.
4.2 Descriptive statistics
Descriptive analysis shows the mean and standard deviation of the different variables of interest in this
study. It also presents the minimum and maximum value of the variables which help in getting a picture
about the maximum and minimum values a variable has achieved.
Table 4.2: descriptive statistics of variable for private limited manufacturing firms:-
No Variable Mean Median SD Minimum Maximum
1. NOP 0.157 0.135 0.104 -0.052 0.379
2. ACP 56.535 52.812 32.476 8.747 174.390
3. ICP 93.851 85.949 47.652 27.135 249.577
4. APP 96.503 86.099 49.846 18.969 264.555
5. CCC 53.883 48.612 54.538 -89.363 201.210
DR 0.161 0.149 0.185 -0.313 0.926
6. FATA 0.439 0.426 0.165 0.144 0.881
7. CR 2.513 1.719 2.628 0.803 14.681
8. LOS 15.668 15.826 1.180 12.782 17.815
Source: SPSS output from secondary data (2011-2015)
45
Table 4.2 presents the summary statistics of the variables used in the present study to thirty (30) firm year
observations where used. The mean value of NOP is 15.70% with a standard deviation of 10.4%. The
mean ACP is 56.535 days with a standard deviation of 32.476 days. On average, firm‟s takes 93.85 days
to convert their inventories into sales with a standard deviation of 47.652 days. The table also shows that
on APP the firm‟s take 96.503 days to play its creditors with standard deviation of 49.846 days. The
mean CCC is 53.883 days. The table further shows that on average firms has a size of 15.668 as
measured by the natural logarithm of its total assets. The mean average leverage ratio is 43.9 lagged by
total assets. The typical firm in the sample has a current assets ratio of 2.513. Together with this, the
firms have soon their sales growth by almost 16.1% annually on average.
4.3 Correlation between the variables
Table 4.3 Correlation matrix for the variables
ACP APP ITID CCC CR LOS DR FATA NOP
ACP 1
APP 0.1854 1
(0.3267)
ITID 0.3299 0.4358* 1
(0.0750) (0.015)
CCC -O.1447 -0.6453** 0.3380 1
(0.4454) (0.0001) (0.0677)
CR 0.5911** -0.1185 -0.3506 0.0239 1
(0.0006) (0.5328) (0.0575) (0.0003)
LOS -0.3673* 0.4367* 0.0742 -0.5641** -0.07531** 1
(0.0459) (0.0158) (0.6969) (0.0012) (0.0000)
DR -0.0051 (-0.0146) 0.6136** 0.7310** -0.3415 -0.8113** 1
(0.9830) 0.9514 (0.0040) (0.0003) (0.1406) (0.0000)
FATA 0.5492 0.3663 0.0039 -0.2892 0.6854** -0.3991 -0.0640 1
LOP 0.2018 0.6726** -0.0844 -0.7662** -0.3429 0.7602** -0.4528* 0.0251 1
(0.2850 (0.0000) (0.6575) (0.0000) (0.0636) (0.0000) (0.0450) (0.9211)
Source: SPSS output from secondary data (2011-2015).
46
Asterix * and ** indicate significance levels at 5% and 1% respectively, value parentheses are the P-
value.
From the table, relationship between profitability and components of working capital is obvious. The
table shows that net operating profit (NOP) is positively correlated with average payment period (APP),
company size (LOS), average collection period (ACP) and financial/total asset ratio (FATA), though the
correlations with ACP and FATA are statistically insignificant.
This means if firms delay their payments they will earn fewer profits. The strong positive correlation
between NOP and LOS confirms that gross profits are directly proportional to company size; that as firm size
increases, sales also translating to higher profits. On the other hand, inventory turnover in days (ITID), cash
conversion cycle (CCC) current ratio (CR) and debt ratio (DR) are negatively correlated with LOP which
shows that any increase in any of these factors will reduce operating profit of firms. However, the
correlations between ITID, CR and LOP are statistically insignificant. The matrix also tells significant
correlations between the predictor variables which could result to multicollinearity, thus have serious
ramifications on these parameters‟ that is, gross operating profit.
4.4 Regression Models
The previous section shows that some components of working capital correlate with companies‟ profitability.
This section determines how much of each of the variables of working capital effect on profitability. To
estimate the research models, pooled ordinary Least squares (OLS) method is used. As control variables,
Liquidity (CR); Company Size (Natural logarithm of sales (LOS) and Financial Assets/Total Assets ratio
(FATA) are used while the Debt Ratio (DR) is used to proxy for leverage. To avoid the effects of
multicollinearity due to the strong negative correlations between LOS and CR and DR and LOS, stepwise
remodeling is done by separately entering the variables in different models.
4.4.1 Effect of Average Collection Period on Profitability
To test the first regression model, the study hypothesized that there would be no statistically significant
relationship between average collection period (ACP) and Profitability.
47
Table 4.4.1 presents the results of the first regression model.
Regression result for the effect of average collection period on profitability
Dependent variable (net operating profit)
Independent A B C D
Variables DR dropped FATA dropped CR dropped full model
ACP . 0590535 .042204 .0959543 .096503
(5.28)*** (3.77)*** (11.01)*** (7.86)***
LOS 1.579755 1.562349 .202916 .136686
(3.18)*** (2.93)*** (0.38) (0.13)
CR . 0462364 .1458221 - .0492927
(0.21) (0.31) (0.08)
DR - 1.89165 -8.241398 -8.164119
(0.55) (-3.15)*** (-2.57)***
FATA 1.569174 - 21.41342 21.1669
(0.41) (3.80)*** (3.80)
CONSTANT -14.37849 -13.5502 5.985497 6.946506
(-1.75)* (-1.54) (0.470) (0.44)
Source: SPSS output from year (2011-2015)
The z-statistics are in parentheses. Asterix *.** indicate significance level of 10%, 5%, and 1%
respectively.
48
Multiple regression analysis was conducted using ACP as a predictor of operating profit (profitability)
and LOS, CR, DR and FATA as controls. The results show that an increase in average collection period
(ACP) increases the net operating profit (NOP). The values in column D show that if ACP increases by
1unit, net operating would increase by 0.097. Among the control variables the effect of the company size
(LOS) on the net operating profit (NOP) only becomes significant when DR and FATA are dropped
separately while the effect of FATA and DR are separately insignificant in the absence of each other as
shown in column A and B respectively. Otherwise significant where an increase of 1 in DR decrease
LOP by 8.164 while a similar increase in FATA would increase LOP by 21.167 the results indicate that
ACP has a positive relationship with LOP. Therefore the null hypothesis (H0) is rejected.
These findings mean that firms early in collecting their receivables earn higher profits as compared to
firms recovering receivable late. The findings are in agreement with Ghosh and maji (2003) who
analyzed the relationship working capital management efficiency and earnings before interest and taxes
(EBIT) and found an inverse relationship between collection period and EBIT indicating that credit
facility increase sales of firm which ultimately increase profitability. However, the finding contradict
Hyderfalahuddin & Ghulam (2007) who investigated the dependence of profitability on working capital
management of manufacturing firms listed on respective stock exchange in Asia including china Japan
India Pakistan Bangladesh Iran and Korea and establish a significant negative relationship between
receivable period and firm‟s probability Raheman and Nasr (2007) also established that most of the firms
invest huge amount of cash in their working capital thus probability was inversely related to receivable
collection period.
4.4.2 Effect of inventories turnover in days on profitability
To test second regression model the study hypothesized that there would be no statistically significant
relationship between inventories turnover in days (ITID) and Profitability.
49
Tables 4.4.2 present the results of the second regression model.
Regression results for the effect inventories turnover in days on profitability
Dependent variable (net operating profit)
Independent A B C D
Variables DR dropped FATA dropped CR dropped FULL model
ITID . 0050837 -.0024856 .0250021 .0211176
(0.87) (-0.35) (2.26)** (1.44)
LOS 2.228911 2.61847 4.482825 5.370443
(2.62)*** (3.88)*** (2.88)*** (2.13)*
CR . 5702273 -336407 - -1.071328
(1.55) (-0.04) (-0.48)
DR - 7.991454 13.90805 9.397045
(1.89) (1.93)* (0.76)
FATA -3.728866 - 36.67873 39.16816
(-0.55) (1.88)* (1.76)*
CONSTANT -23.36414 -28.32695 -62.50038 -74.4568
1.63) (-2.31)** (-2.48)** (-1.99)*
Source: SPSS output from year (2011-2015)
The z-statistics are in parentheses Asterix*,** and *** significant level of 10%, 5% , and 1%
respectively.
The results of the regression analysis conducted using ITID as a predictor of Operating Profit and LOS,
CR, DR and FATA as controls show that ITID has an insignificant effect on net operating profit (NOP).
The values in column C show that ITID only impacts on LOP when CR is dropped. In this case, a unitary
50
increase in ITID increases LOPs by 0.25. On the other hand, company size positively affects LOP where
an increase in LOS by 1 increases LOP by 5.37. CR, DR and FATA have insignificant impacts on LOP.
Since ITID only impacts LOP in the absence of FATA, the null hypothesis (H02) was therefore failed to
reject.
This means that inventory turnover in days had statistically insignificant effect on gross operating profits
of the assessed firms. Holding inventories incurs costs to the firm, such as the funds which are tied up in
inventories, cannot have the interest earnings.
Instead, storage and insurance costs have to be paid, furthermore, spoilage, damage and loss of goods
lead to the costs to firms. The findings were consistent with those of Roumiantsev and Netessine (2005b)
who did not find a relationship between return on assets and inventory levels but instead found that
superior earnings are associated with the speed of change/responsiveness in inventory management.
Roumiantsev and Netessine (2007) also report that the relationship both between days of work in process
inventory and LOS and between days of finished goods inventory and LOS is statistically insignificant.
However, they contradict the findings of Chen et al. (2005, 2007) who reported that firms with
abnormally high inventories have abnormally poor long-term stock returns and Gaur et al. (2005) who
equally reported that inventory turnover for retailing firms is positively associated with both capital
intensity and sales and is negatively associated with gross margins. Hyder et al. (2007); Raheman and
Nasir (2007) have also reported a negative relationship between Inventory period and profitability. A
limitation that could explain the variation in the findings is the fact that different manufacturing firms
report different types of inventories. Use of total inventories without regard to the type may therefore
explain the variation.
4.4.3 Effect of average payment period on profitability
To test the third regression model the study hypothesized that there would be no statistically significant
relationship between average payment period (APP) and profitability. Table 4.4.3 present the results of
the third regression model.
51
Regression results for the effect of average payment period on Profitability
Dependent variable (net operating profit)
Independent A B C D
Variables DR dropped FATA dropped CR dropped FULL model
APP 0115163 .0153429 .0189322 . 0189824
(2.89)*** 2.58)** (4.96)*** (3.43)***
LOS 1.778297 2.272046 3.500821 3.481045
(2.61)*** (4.25)*** (4.04)*** (2.10)**
CR .4875201 1.551299 -. 0204783
(1.72)* (2.00)** (0.02)
DR - 7.551746 4.693913 4.754879
(2.13)** (1.11) (0.75)
FATA -6.695494 - 24.42538 24.33543
(-1.23) (2.83)*** (2.09)**
CONSTANT -16.37986 -26.87986 -45.11853 -44.83961
(1.45) (-3.02)*** (-3.26)*** (-1.83)*
Source: SPSS output from year (2011-2015)
The z-statistics are in parentheses Asterix *, ** and ***indicate significant levels of 10%, 5% and 1%
respectively.
Multiple regression analysis was conducted using APP as a predictor of operating profit and LOS, CR,
DR and FATA as controls. The results in table 4.3.3 show that an increase in average payment period
(APP) leads to an increase in net operating profit (NOP). The value in column D show that if APP
increases by 1 , gross operating would increase by 0.019 on the other hand, if LOS increase by 1, then
NOP would increase by 3.481 while a unit increase in FATA would translate to 24.335 in LOP. DR. and
CR do not significant predict LOP. However, all the other independent variables significant predict LOP.
When FATA is dropped (column B) while only DR remains insignificant in the absence of CR (column
C). Conversely, APP, LOS and CR significantly predict LOP when DR is dropped.
Based on the foregoing findings, the null hypothesis (H03) is rejected. Firms with longer payment
period/delay their payment period earn higher profits as compared to firms with shorter payment period if
the firms invest in short term securities until due date of payment is arrived. Lazaridis and Tryfonidis
(2005) found that there was positive relationship between payment period and profitability; this means
52
profitable firms delay their payments. Ramachandran and Janakirama (2006), in their analysis of the
relationship between working capital management efficiency and earnings before interest and taxes
(EBIT) also found that there was a positive relation between Payable Period and EBIT, indicating that
profitable firms delay their payables.
In contrast, Falope and Ajilore (2009) found a significant negative relationship between net operating
profit and the average payment period, implying that companies with short payment period. The inverse
relationship could be explained by the discounts enjoyed by the firms by paying the suppliers in time,
thus reducing the cost of production.
4.4.4 Effect of Cash Conversion Cycle on Profitability
To test the fourth regression model, the study hypothesized that there would be no statistically significant
relationship between Cash Conversion Cycle (CCC) and profitability. Table 4.4.4 presents the results of
the fourth regression model.
The results of the regression analysis conducted using CCC as a predictor of net operating profit and
LOS, CR, DR and FATA as controls indicate that an increase in cash conversion cycle leads to a drop in
the gross operating profit. Colum D in Table 4.4 shows that if CCC increased by 1, gross operating
profits would drop by 0.078. With regard to the control variables, a unit increase in company size (LOS)
increases net operating profit (NOP) by 3.32 while similar increases in DR and FATA would decreases
NOP by 7.76 and 27.32 respectively. Almost similar effects would be observed if CR was dropped as
indicated by the results in column C. On the contrary, whereas CR has an insignificant impact on NOP,
all the other variables become insignificant in the absence of DR as shown in column A. The regression
results indicate that CCC has a significant negative relationship with operating profit that as CCC
increase profitability decrease this mean that firms with high cash conversion cycle earn low profit as
compared to firms with low cash conversion cycle. Therefore the null hypothesis (H04) was rejected.
53
Regression results for the effect of cash conversion cycle on profitability
Independent Dependent variable (net operating profit)
Variable A B C D
DR dropped FATA dropped CR dropped FULL model
CCC -0.116302 -.0228936 -.0771765 -.0779092
(-1.42) (-2.35)** (-32.43)*** (-23.87)***
LOS 1.579699 1.71806 3.400816 3.319662
(1.79)* (2.56)** (23.83)*** (12.69) ***
CR .3727155 .6032469 - .0835289
(1.07) (1.01) (0.39)
DR - 10.12978 -7.896266 -7.758174
(2.71)*** (-8.88)*** (-7.31)***
FATA -3.044518 - -26.4497 -27.32498
(-0.49) (-16.45)*** (-9.52)***
CONSTANT -11.62606 -14.18994 -35.70964 -34.48782
(-0.78) (-1.25) (-15.45)*** (-8.51)***
The z-statics are in parentheses Asterix *, ** and *** indicate significant levels of 10%, 5%.and 1%
respectively.
The findings above concur with those Ejelly (2004) who reported that cash conversion cycle is a better
measure of liquidity than current ratio and liquidity has a negative relation with profitability.
Ramachandran and Janakiram (2006) established a negative relationship between EBIT and
CCC.Nobanee (2009); Chatejee (22010);Nobanee et al (2010); Akgun and Melten (2010) and Rezazade
and Heidarain (2010) have all reported a negative relationship between CCC‟s components with the
profitability. The effective ways for shortening CCC is to shorten the period of receivable accounts,
delaying the payment of accounts and inventories. By shorting CCC, firm profitability improves. The
longer the cash conversion cycle, the more the firm must invest in working capital, while the shorter cash
conversion cycle, the fewer funds are tied up in the working capital. Corporate liquidity is influenced by
the cash cycle because cash cycle measures the average amount of time that cash is tied up in operations
process. Therefore, a firm with a short cash cycle is expected to have higher levels of cash and
marketable securities, all else being equal.
54
CHAPTER FIVE
5. SUMMARY OF FINDINGS, CONCLUSSIONS AND RECOMMENDATIONS
5.1. Introduction
The purpose of the study was to analyze the effects of working capital management on profitability of
private limited manufacturing firms operating in the Hawassa city.
This chapter is therefore a summary of the findings from the analysis of data, conclusions and
recommendations based on the findings of the study. The chapter also provides suggestions for further
research in the field of working capital management.
5.2. Summary of the Findings
Summary of the findings of the study are discussed under this section as per the objective areas.
The study established that an increase in average collection period to an increase in gross operating
profit. In the specified regression model, a unit increase in ACP would lead to an increase in gross
operating by 0.097 indicating that ACP had a positive relationship with LOP. This implied that firms
early in collecting their receivables earn higher profits as compared to those recovering receivables late.
The findings were contradicted with Hyder, Niaz, Falahuddin & Ghulam (2007); and Raheman and Nasr
(2007) who reported that profitability was inversely related to receivable collection period, but in
agreement Ghosh and Maji (2003) found a positive relationship between collection period and EBIT,
indicating that credit facility increases sales of firm which ultimately increases profitability.
Inventory turnover in days (ITID) had an insignificant effect on gross operating profit. However, ITID
only impacted on NOP when the credit ratio (CR) was dropped from the model in which case a unit
increase in ITID increased LOP by 0.25. The findings were consistent with those of Roumiantsev and
Netessine (2005b) who did not find a relationship between return on assets and inventory levels but
instead of that higher earnings are associated with the speed of change/responsiveness in inventory
management, but contradicted the findings of Chen et al. (2005, 2007) who reported that firms with
abnormally high inventories have abnormally poor long-term stock returns.
55
The study established that an increase in average payment period led to an increase in gross operating
profit. If APP increases by 1, gross operating would increase by 0.019 indicating that APP was positively
related with gross operating profit. These findings agreed with Lazaridis and Tryfonidis (2005) and
Ramachandran and Janakirama (2006) who also found that there was positive relationship between
payment period and profitability, meaning that profitable firms delay their payments. However, the
findings contrasted those of Falope and Ajilore (2009) found a significant negative relationship between
net operating profit and the average payment period which implying that companies with short payment
period. The inverse relationship could be explained by the discounts enjoyed by the firms by paying the
suppliers in time, thus reducing the cost of production.
The study also established that an increase in cash conversion cycle led to a drop in the gross operating
profit, indicating a negative relationship between the two variables.
A unit increase in translated to a drop in gross operating by 0.078. This implied that firms with high cash
conversion cycle earn low profits as compared to firms with low cash conversion cycle. The findings
concurred with those of Ejelly (2004), who reported that cash conversion cycle is a better measure of
liquidity than current ratio and liquidity has a negative relation with profitability.
The findings, also agreed with those of Ramachandran and Janakirama (2006); Nobanee (2009);
Chaterjee (2010); Nobanee et al (2010); Akgun and Meltem (2010) and Rezazade and Heidarian (2010)
all of them had earlier reported a negative relationship between CCC‟s components with profitability.
5.3. Conclusions
The study shows that profitability of private limited manufacturing firms depends upon effective working
capital management. Net operating profit is positively related with average collection period and average
payment period. It is therefore, profitable to delay payables and invest the money in different profitable
ventures/areas. On the other hand, firms should collect receivables as soon as possible because it‟s better
to receive inflows sooner than later.
Gross operating profit on the other hand is negatively correlated with the cash conversion cycle. This
means that by shortening CCC, firms‟ profitability improves.
The longer the CCC, the more the firm must invest in working capital.
The study therefore, concludes that there is a relationship between the various components of working
capital management and firms‟ profitability.
56
5.4. Recommendations
The study recommends that private limited manufacturing firms should adopt efficient and effective
working capital management policies to keep working capital at optimal level. Despite the statistically
insignificant relationship result of this study, the working capital management of firms in the Hawassa
city has not been effective and efficient. Nevertheless, the researcher recommends that there will be other
factors and the involvement of additional firms in the study might give us different results and, hence,
conclusion.
Otherwise, based on the result of the study the recommendations of the study were premised as follows:
The researcher recommended that inventories are used to provide moderately so that the
purchasing, production, and sales functions can proceeds at their own optimum paces. Further,
private limited firms of Hawassa city marketing, purchasing and production departments should
have create strong linkage and communications so as to feed each other in their firms‟ operations
and minimize costs.
The researcher recommended that better to enhance profitability of the firms‟ by reducing the
number of cash conversion cycle to a reasonable minimum by using credit policies and different
theoretical tools.
The researcher recommended that even if let payment have its own advantage to increase the
profitability of the firms‟; have to pay their obligations on time that not losing their venders in the
long run.
The researcher recommended that lowering working capital cycle as a measure of efficient
working capital management is the one to be assessed. This means that investment in working
capital could be optimized and cash flows could be improved by reducing the time frame of the
physical flow from receipt of raw material to shipment of finished goods, i.e. inventory
management, and by improving the terms on which firms‟ sells goods as well as receipt of cash.
In general, the results of the correlation and the regression model of the study recommend that firms‟
managers can create profits or value for their firms‟ and shareholders by handling correctly the working
capital cycle and keeping each different component of working capital such as accounts receivable,
inventory and accounts payable to a possible optimum level.
5.5. Limitations of the Study
The first limitation of the study was that three out of the nine firms targeted by the study were had in
complete records at the time of the study. It was therefore, not possible to obtain their consolidated
57
financial reports for the period covered by the study, thus the findings of the study may not be
generalized to these firms. Secondly, the financial managers of some firms studied were not willing to
provide all the financial records that designed the main data sources for the study. However, this
limitation was overcome by sourcing the missing information from the transactions of large scale private
limited firms that brought for the purpose of taxes to branch of Revenue Authority in the Hawassa city.
5.6. Directions for Further Studies
The following are some of the areas that further research may be focused:
Similar study done on the same topic with different firms over an extended sample period of
financial years.
A study undertaken on the impact of external factors on working capital management in
manufacturing firms.
Similar study with an extended scope to cover other components of working capital management
including cash, and marketable securities and measurement of profitability such as return on asset
(ROA) and return on investment (ROI).
58
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64
Appendix A: - large scale private limited manufacturing firms included in the study
N.
o
Name of firms Sector Activity
detail (u)
P. total capital Pla.
man.p
Currents status Act.t.capital Actu.man
power
Teleph
one
1. BGI Ethiopia PLC Industry Beer factor 99,300,000.00
0
29 Full operational 1,500,000,000,00 579 093006
9710
2.
Aleta land coffee PLC (plastic
bag)
Industry Plastic &
bag
production
25,000,000,00 9 Full operational 60,000,000,00 187 091272
2865
3. Hawassa flour factor PLC Industry Pasta &
bread
production
2,000,000,00 80 Full operational 27,818,189.00 115 091121
2087
4. Moha soft Drink (Hawassa
million)
industry Soft Drink 180,000,000,0
0
389 Full operational 316,000,000,00 419 096220
2950
5. Hawassa textile share company industry Textile 257,210,505.0
0
9 Full operational 132,000,000.00 976 091210
7331
6. Etab soap factor industry Soap factor 57,270,000.00 247 Full operational 260,000,000.00 400 093254
9336
65
