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Electronic copy available at: http://ssrn.com/abstract=1528894
1
Optimizing Working Capital Management
Haitham Nobanee
Department of Banking and Finance, The Hashemite University, P.O. Box 330221, Zarqa, 13133, Jordan. Tel:
+96253903333; Fax: +96253826613 E-mail: [email protected]
Maryam AlHajjar
Abstract
Although the operating cycle, the cash conversion cycle, and the net trade cycle are more
comprehensive measures of working capital management comparing with traditional
measures such as the current ratio and the quick ratio. These measures do not consider the
optimal points of payables, inventory, and receivables. In this study we suggest more accurate
measures of the efficacy of working capital management where optimal levels of inventory,
receivables, and payables are identified, and total holding and opportunities cost are
minimized and recalculating the operating cycle, the cash conversion cycle, and the net trade
cycle according to these optimal points. In this regard, we suggest an optimal operating cycle,
an optimal cash conversion cycle, and an optimal net trade cycle as more accurate and
comprehensive measures of working capital management.
Keywords: Working Capital Management; Optimal Cash Conversion Cycle; Net Trade Cycle: Cash Conversion Cycle; Receivable Collection Period; Inventory Conversion Period; Payable Deferral Period; Weighted Cash conversion Cycle; Net Trade Cycle
JEL classification: G30:G32:L25:O25
Although historical experiences show that the average firm has 40% of its assets
employed in current assets, and the typical corporate financial manager spends 80%
of his time in managing day-to-day short term financial resources (see Dandapani, etal,
Electronic copy available at: http://ssrn.com/abstract=1528894
2
1993), traditional focus in corporate finance was on the long-term financial decisions,
particularly capital structure, dividends, investments, and company valuation
decisions. However, the recent trend in corporate finance is the focus on working
capital management. See (Ganesan, 2007). Some of the existing literature suggests
that companies, on average, over-invest in working capital. For example, the U.S.
corporations had roughly $460 billion unnecessarily tied up in working capital. One
good example about the important the efficiency of a corporation’s working capital
management is given by Shin and Soenen (1998). They point out that Wal-Mart and
Kmart had similar capital structures in 1994, but because Kmart had a cash
conversion cycle of roughly 61 days while Wal-Mart had a cash conversion cycle of
40 days, that Kmart likely faced an additional $198.3 million per year in financing
expenses. Such evidence demonstrates that Kmart’s poor management of its working
capital contributed to its going bankrupt see (Moussawi et al, 2006).
Efficiency of working capital management is based on the principle of speeding up
collections as quickly as possible and slowing down disbursements as slowly as
possible. This working management principal based on the traditional concepts of
operating cycle, cash conversion cycle, weighted cash conversion cycle, and net trade
cycle. The operating cycle of a firm is the length of time between the acquisition of
raw materials and the collections of receivables associated with the sales of finished
goods. Although the operating cycle conceders the financial flows comes from
receivables and inventory, it ignores the financial flows comes from account payables,
in this regards, Richards and Loughlin (1980) suggest the cash conversion cycle that
considers all relevant cash flows comes from the operations. The cash conversion
cycle can be defined as the length of time between cash payments for purchase of
Electronic copy available at: http://ssrn.com/abstract=1528894
3
raw materials and the collection of receivable associated with the sale of finished
goods. However, the cash conversion cycle focuses only on the length of time
financial flows engaged in the cycle and does not consider the amount of fund
committed to a product as it moves through the cash conversion cycle. Therefore,
Gentry, Vaidyanathan, and Wai (1990) suggest a weighted cash conversion cycle that
takes into consideration both the timing of financial flows and the amount of fund
committed to each stage of the cycle. The weighted cash conversion cycle can be
defined as the weighted number of days funds are committed in receivables,
inventories and payables, less the weighted number of days financial flows are
deferred to suppliers. In addition to its' complexity, another limitation of the weighted
cash conversion cycle is the brake up of inventory into three components of raw
materials, work in process, and finished goods is not available for outside
investigators; hence, Shin and Soenen (1998) suggest the net trade cycle as an
alternative measure for working capital management. They argue that the cash
conversion cycle is an additive concept wares the denominators for the inventory
conversion period, the receivable collection period, and the payable deferral periods
are all different, making the addition of the cash conversion cycle components not
really useful. They suggest equalizing the denominators of the inventory conversion
period, the receivable collection period, and the payable deferral periods1. The net
trade cycle is basically equal to the cash conversion cycle where the three complaints
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 the weighted cash conversion cycle.
Shin and Soenen (1998) also argue that the net trade cycle is a better working capital
1 The cash conversion cycle formula is: (accounts receivables/sales)*365 +(inventory/CGS)*365 – (accounts payables/CGS)*365 The net trade cycle formula is :{accounts receivable + inventory – accounts payables}*365/sales
4
efficiency measure comparing with the cash conversion cycle and the weighted cash
conversion cycle because it indicates the number of "day sales" the company has to
finance its working capital and the working capital manager can easily estimate the
financing needs of working capital expressed as the function of the expected sales
growth.
Although the operating cycle, the cash conversion cycle, the weighted cash
conversion cycle, and the net trade cycle are powerful measures of working capital
management and firm's liquidity comparing with the static traditional ratios such as
the current ratio and the quick ratio that are inadequate and misleading in the
evaluation of firm's liquidity, these cycles does not considers the optimal levels of
receivables, inventories, and payables. The traditional link between these cycles (the
operating cycle, the cash conversion cycle, the weighted cash conversion cycle and
the net trade cycle) appears in the existing literatures (see, Shin and Soenen, 1998;
Gentry, et al, 1990; Richards and Loughlin, 1980, Deloof, 2003) and firm's
profitability, market value and liquidity is that shortening these cycles increases firms
profitability, liquidity, and market value. Fore example; a short cash conversion cycle
indicates that the company manage and process inventory more quickly, collects cash
from receivables more quickly and slowing down cash payments to suppliers. This
increases the efficiency of internal operations of a firm and results on higher
profitability, higher net present value of cash flows, and higher market value of a firm
(Gentry, et al, 1990).
The cash conversion cycle and the net trade cycle can be shortened by reducing the
time that cash are tied up in working capital. This could happen by shortening the
inventory conversion period via processing and selling goods to customers more
5
quickly, ore by shortening the receivable collection period via speeding up
collections, or by lengthening the payable deferral period via slowing down payments
to suppliers. On the other hand, shortening the cash conversion cycle could harm the
firm's profitability; reducing the inventory conversion period could increase the
shortage cost, reducing the receivable collection periods could makes the company's
lousing it's good credit customers, and lengthening the payable period could damage
the firm's credit reputation. Shorter cash conversion cycle (net trade cycle and
operating cycle) associated with high opportunity cost, and longer cash conversion
cycle (net trade cycle and operating cycle) associated with high carrying cost.
Achieving the optimal levels of inventory, receivable, and payable will minimize both
carrying cost and opportunity cost of inventory, receivable, and payable and
maximizes sales, profitability and market value of firms. In this regards, we suggest
an optimal cash conversion cycle, an optimal net trade cycle, and an optimal operating
cycle as more accurate and comprehensive measures of working capital management.
Optimal Operating Cycle
The optimal operating cycle is an additive function. It measures the optimal length of
inventory conversion period plus the optimal length of receivable collection period
(see equation 1 and 2)
Optimal operating Cycle = Optimal Inventory Conversion Period + Optimal
Receivable Collection Period ………………… ……………………………………(1)
Optimal Operating Cycle = (Optimal Inventory/Cost of Good Sold)*365 + (Optimal
Receivables/ Sales)*365 ………………………………………………………..….(2)
6
Optimal Cash Conversion Cycle
The optimal cash conversion cycle is an additive function. It measures the optimal
length of inventory conversion period plus the optimal length of receivable collection
period less the optimal length of payable deferral period (see equation 3 and 4)
Optimal Cash Conversion Cycle = Optimal Inventory Conversion Period + Optimal
Receivable Collection Period – Optimal Payable Deferral Period……………….… (3)
Optimal Cash Conversion Cycle = (Optimal Inventory/Cost of Good Sold)*365 +
(Optimal Receivables/ Sales)*365 – (Optimal Payables/Cost of Good sold)*365….(4)
Optimal Net Trade Cycle
The optimal cash conversion cycle is also an additive function. It measures the
optimal length of inventory conversion period plus the optimal length of receivable
collection period less the optimal length of payable deferral period, where optimal
inventory conversion period and optimal length of payable deferral period are
expressed on day’s sales. (see equation 5, 6 and 7)
Optimal Net Trade Cycle = Optimal Inventory Conversion Period + Optimal
Receivable Collection Period – Optimal Payable Deferral Period…………….…… (5)
Optimal Net Trade Cycle = (Optimal Inventory/Sales)*365 + (Optimal Receivables/
Sales)*365 – (Optimal Payables/Sales)*365…………………………………….(6)
7
Optimal Net Trade Cycle = {(Optimal Inventory + Optimal Receivables - Optimal
Payables)*365}/Sales………………………………………………………….(7)
Optimal Inventory Level
One of the best-known optimal inventory level approaches is the Economic Order
Quantity model (EOQ)2 (see Ross et al, 2008). The basic idea of this model is plotting
the total cost of currying inventory with different inventory quantities as in Figure 1.
As shown in Figure 1, inventory carrying costs increase and inventory shortage costs
decrease as inventory level increase and we attempt to identify the minimum total cost
point Q*.
2 There are many ways to find the optimal inventory level, in addition to the classic EOQ model, optimal inventory level could be identified using Shortages Permitted Model, Production and Consumption Model, Production and Consumption with Shortages Model , and EOQ with Shortages and Lead Time. Moreover, there are money other new optimal inventory models developed in the recent literature, for example, an EOQ model under retailer trade credit policy suggested by Huang and
Hsu (2007), this model identifies the optimal inventory level under permissible delay in payments where the supplier would offer the retailer trade credit and the retailer will also offer a trade credit to his clients.
8
Figure 1
Optimal Inventory Level
Optimal Accounts Receivable
An optimal credit amount could be identified by the point ware the incremental cash
flows from increased sales stimulated by offering credit to the customers equals the
costs of carrying additional investments in account receivables (see Ross et al, 2008).
Therefore, an optimal amount of credit extended could be identified by plotting the
total cost of associated with granting a credit with different amounts of credit
extended as in Figure 2.
Carrying Cost
Q*
Optimal Quantity
Shortage Cost
Total Cost
Inventory Quantity
Cost of Holding Inventory
Source: Ross, Westerfield, and Jordan, 2008, Corporate Finance Fundamentals, Eighth's Edition, McGraw Hill.
Carrying costs are increased as inventory level increased.
Shortage costs are decreased as inventory level increased.
Total costs are the sum of currying and shortage costs.
9
Figure 2
Optimal Amount of Receivables
As shown in Figure 2, carrying costs increase and opportunity costs decrease as
amount of credit extended increase and we attempt to identify the minimum total cost
point $*. The carrying costs associated with granting a credit essentially comes from
either the costs of cash discounts offered by the firm who grant the credit to it’s
customers who pay early, or its could come from losses of bad debts, or its could be
associated with managing credit and credit collections and running the credit
department. Opportunity cost is the additional profit results from credit sales that are
lost because credit is not granted (see Ross et al, 2008)3.
Optimal Accounts Payable
3 Although there is many optimal amount of credit is easy to identify but it’s difficult to quantify as pointed by Ross et al, (2008) there was some attempts to quantify the optimal amount of credit as in the study of Liebman (1972).
Carrying Costs
$*
Optimal Amount of Credit
Opportunity Costs
Total Costs
Amount of Receivables
Cost of Granting Receivables
Source: Ross, Westerfield, and Jordan, 2008, Corporate Finance Fundamentals, Eighth's Edition, McGraw Hill.
Carrying costs are increased when the amount of receivables granted are increased.
Opportunity costs are the lost sales resulting from not granting credit. These costs decreased when the amount of receivables are increased.
Total costs are the sum of currying and opportunity costs.
10
Trade credit is an alternative financing choice to the short-term borrowing, trade
credit is “free” but short-term borrowing is “costly”. When the company extends its
trade credit by increasing its accounts payable it will save the cost of short-term
borrowing. This means an increase of accounts payable associated with a decrease of
short-term borrowing cost or “opportunity cost of short-term borrowing”. When the
accounts payable increase some other kind of cost also increase, for example the
carrying cost which are the cost of managing and running the payable department
increases as the account payable increase. Other cost could also increase when
accounts payable increase, for example, the possibility that a company could delay
it’s payment to suppliers increase when the company extend it’s trade credit, this
could damage the company’s credit reputation and the company could lose some of
the cash discounts offered by suppliers.
As shown in Figure 3, carrying costs increase and opportunity cost of short-term
borrowing decrease as accounts payable amount increase and we attempt to identify
the minimum total cost point $*4.
4 There were some attempts to quantify the optimal amount of payables by Nerville and Tavis, (1973).
11
Figure 3
Optimal Amount of Payables
Some Empirical Evidence
Although the suggested optimal cash conversion cycle, optimal net trade cycle and
optimal operating cycle as more comprehensive and more accurate measure of the
efficiency of working capital management comparing with the operating cycle, the
cash conversion cycle, the weighted cash conversion cycle, and the net trade cycle,
the information needed to test for it’s effectiveness is not available for external
examiners. However, as a proxy, we test the stability of the effects of cash conversion
cycle, net trade cycle and operating cycle on corporate performance over time.
However, if our results show that the signs of operating cycle, the cash conversion
cycle, the weighted cash conversion cycle are not always positive and significant; this
Carrying Costs
$*
Optimal Amount of Payables
Opportunity Cost
of Short-Term
Borrowing
Total Costs
Amount of Payables
Cost of Payables
Carrying costs and delay of payments costs are increased when the amount of payables are increased.
Opportunity costs of borrowing decreased when the amount of payables are increased.
Total costs are the sum of currying and opportunity costs.
12
signify the importance of identifying optimal levels of inventory, receivables and
payables and the optimal cash conversion cycle, the optimal net trade cycle and the
optimal operating cycle as more accurate measure of working capital management.
Therefore, in the following sections, we seek to examine the relationship between the
length of the cash conversion cycle, the length of the net trade cycle and the length of
the operating cycle and the firm’s profitability for different periods of time.
Additionally, to examine the relationship between the lengths of receivable collection
period, inventory conversion period, payable deferral period and firm’s profitability.
A dynamic panel data analysis is used to test for the relationships between our
variables. Our analysis is based on a sample of 5802 U.S. non-financial firms listed in
the New York Stock Exchange, American Stock Exchange, NASDAQ Stock Market
and the Over The Counter Market for the period 1990-2004 (87030 firm-year
observations).
Data and Methodology
The data set obtained from the Datastream &World Scope. The data includes yearly
data of sales, cost of good sold, receivables, payables, inventory, and operating
income. This data is used to calculate the receivable collection period, the inventory
conversion period, the payable deferral period, the cash conversion cycle, and the
operating income to sales. The data includes all the non-financial firms listed in the
New York Stock Exchange, American Stock Exchange, NASDAQ Stock Market and
the Over The Counter Market. Some firms with missing values are excluded from the
sample. The final sample contains 5802 companies covering the period of 1990-2004
(87030 firm-year observations).
13
To investigate the relationships between our variables we use a Generalized Method
of Moment System Estimation (GMM) applied to dynamic panel data. We used this
estimation for the following reasons: first, our dependent variables are likely to be
measured using annual data, and it seemed desirable to use a dynamic specification to
allow for it, secondly, some of our exploratory variables (for example; the inventory
conversion period, the receivable collection period and the payable deferral period)
are likely to be jointly determined with the dependent variables in our model. Finally,
there is a possibility of unobserved province specific effects correlated with the
regressors, and it seemed desirable to control for such effects. De Granwe and
Skdenly (2000) mention that the lagged dependent variable in the dynamic panel data
estimation catch up some of the effects of omitted variables varying over time, so it
helps to correct for autocorrelation. The Generalized Method of Moment System
Estimation applied in this study is proposed by Arellano and Bover (1995) and
Blundell and Bond (1998), the authors have shown in Monte Carlo estimations that
the estimators behaves better than the GMM difference estimators proposed by
Arellano and Bond (1991) for the short sample period and for variables are persistent
over time. Roodman (2005) mentions that the Arellano-Bond estimators have one and
two steps variants. He argue that the two-step estimates of the standard errors tend to
be severely downward biased, therefore, we apply the finite sample correction for the
asymptotic variance of the tow step GMM estimator (see Windmeijer, 2005). This
estimation approach leads to the following estimation equations:
ititititititititit cccpdpicprcpsgtdeqroisoisit
εββββββββα +++++++++=− 87654321 1
(8)
itititititititititit nccpdpicprcpsgtdeqroisois εββββββββα +++++++++=− 87654321 1
(9)
14
ititititititititit ocicprcpsgtdeqroisois εβββββββα ++++++++=−− 11 8654321
(10)
Where (itois ) is the first deference the operating income to sales, the exploratory
variables in our model includes ( itois ) which is the differenced lagged dependent
variable of operating income to sales, (itrcp ) is the first difference of receivable
collection period that measure the average number of days from the sale of goods to
collection of resulting receivables. It is calculated as [(account receivable/sales)
*365]. ( iticp ) is the first difference of the inventory conversion period which is the
length of time on average needed to convert raw materials into finished goods and
selling these goods. It is calculated as [(inventory/cost of good sold)*365]. ( itpdp ) is
the first difference of the payable deferral period which is the average length of time
needed to purchase goods and the payments for them. It is calculated as [(account
payable/cost of goods sold)* 365]. ( itccc ) is the first difference of cash conversion
cycle which is simply calculated as [Receivable collection period + Inventory
conversion period - Payable deferral period]. ( itncc ) is the first difference of net trade
cycle which is simply calculated as [Receivable collection period + Inventory
conversion period - Payable deferral period] where inventory conversion period and
payable deferral period are expressed in the form of day’s sales. ( itoc ) is the first
difference of the operating cycle which is simply calculated as [Receivable collection
period + Inventory conversion period]. The exploratory variables in our models also
include some control variables such as ( itsg ), which represents sales growth [(this
year’s sales – previous year’s sales)/ previous year’s sales] and total debt to equity
ratio ( ittde ). In addition, we examine the relationship between profitability and
liquidity using a traditional measure of liquidity the quick ratio ( itqr ). In this study we
15
hypothesize that shortening the length of the cash conversion cycle improves the
company’s performance, we also hypothesize that shortening the length of the net
trade cycle improves the company’s performance, and shortening the length of the
operating cycle improves the company’s performance. This means that the coefficient
of the cash conversion cycle, the coefficient of the net trade cycle, and the coefficient
of the operating cycle should be significant and negative for the whale period of the
study and also for the sub periods. We also hypothesis that shortening the length of
the receivable collection period increases the company’s performance, and we expect
the coefficient of the receivable collection period to be significant and negative for the
whale period of the study and also for the sub periods. We also hypothesize that
shortening the length of the inventory conversion period increases the company’s
performance, and we expect the coefficient of the inventory conversion period to be
significant and negative for the whale period of the study and also for the sub periods.
And finally, we hypothesize that lengthening the payable deferral period should
increase the company's performance, and the coefficient of the payable deferral period
should be significant and positive for the whale period of the study and also for the
sub periods.
Empirical Results
In this section we present our estimation results concerning the determinants of
working capital management on corporate performance. The estimated coefficients
based on equation (1) reported on table (1) show that the length of the cash
conversion cycle ( itccc ) has negative and significant impact on firm’s performance
for the whole period. The results also show that the coefficient of the cash conversion
cycle for the first period is positive and insignificant, the coefficient of the cash
16
conversion cycle for the second period is positive and insignificant, and, the
coefficient of the cash conversion cycle for the third period is negative and
significant. These results indicate that shortening the cash conversion cycle does not
always improve the firm’s profitability. The results also show that the coefficients of
the payable deferral period ( itpdp ) for the whole period and all sub-periods of the
study are significant and negative; this indicates that lengthening the payable deferral
periods reduces the firm’s performance instead of improving it. The results reported
on table (1) show that the coefficients of the receivable collection period (1−it
rcp ) and
the length of the inventory conversion period (1−it
icp ) had positive impact rather than
negative impact on the companies performance measured using the operating income
to sales ( itois ). This indicates that shortening the cash conversion cycle (1−it
ccc )
shortening the receivable collection period (1−it
rcp ) and shortening the inventory
conversion period (1−it
icp ) by reducing the time that cash are tied up in working
capital and by speeding up collections results on low operating income to sales
( itois ). However, the results on the existing literature show that the cash conversion
cycle (1−it
ccc ), the receivable collection period (1−it
rcp ), and the inventory conversion
period (1−it
icp ) had a negative impact on the company's performance (itois ) (see
Deloof, 2003) the positive sign of coefficient of the inventory conversion period
(1−it
icp ) could be interpreted by the fact that shortening the inventory conversion
period (1−it
icp ) could increase the stock out cost (or shortage cost) of inventory which
results on losing sales opportunities and leads to poor performance. Similarly, the
positive sign of coefficient of the receivable collection period (1−it
rcp ) could be
interpreted by the fact that shortening the receivable collection period (1−it
rcp ) makes
17
the company to louse it’s good credit customers that results in a reduction of the
company’s sales. The results also show that the payable deferral period (1−it
pdp ) had
significant negative impact on performance ( itois ) instead of having a positive impact
as reported on the existing literatures (see Deloof, 2003). The negative sign of the
payable deferral period (1−it
pdp ) imply that slowing down payments to suppliers
causes damages the companies' credit reputation and result in a poor performance.
Looking at the lagged operating income to sales (1−it
ois ) indicates that the company's
performance in the previous period have a strong positive effect on the company’s
performance in the current period. We also examine whether the companies
performance is affected by other variables; the results show that increases in the quick
ratio ( itqr ) is negatively associated with firm’s performance ( itois ), this result certify
the traditional trade off between profitability and liquidity. Sales growth ( itsg ) is
positively related to the firm’s performance ( itois ), the results show that total debt to
equity ( ittde ), as a measure of capital structure is not significantly related to
profitability (itois ). The results of the Sargan test does not reject our instrument used,
and the results of Arellano-Bond test that the average autocoveriance in residuals of
order 1 and 2 is 0 does not reject the null hypothesis of no second-order serial
correlation.
18
Table 1
Tow-Steps Results of GMM System Estimation for the Relationship between Working Capital
Management Measures Including the Cash Conversion Cycle and Firm's Performance
Dependent Variable: OIS
Coefficients
Exploratory
Variables: Full period 1990-2004
First period 1990-1994
Second period 1995-1999
Third period 2000-1994
LOIS 0.1093742** 0.3891377 0.1754836** 0.0521925** QR -0.0209257* 0.0071134 -0.0309328* 0.0572961* TDE 6.04e-08 -2.97e-07 -4.49e-07 5.30e-07 SG 0.0027879 0.004226 0.0293055 0.0018839 RCP -0.0169117** 0.0002769 -0.001792 -0.0169529** ICP -0.0015936** 0.0011912 0.0023982** -0.0020329 PDP -0.0057129** -0.0014022 -0.0038863** -0.0069267** CCC -0.0024813** -0.0006869 -0.0014406** -0.002616**
Constant -0.0196783** 0.0017403 0.0016587 -0.0401378* Sargan 101.76 4.17 24.47 63.14
Order 1 -1.16 -1.67 -1.53 -1.14 Order2 0.79 -1.03 0.16 0.87
Note: * significant at 95% confidence level, * *significant at 99% confidence level Table 1 reports the results of Arellano-Bond dynamic panel-data two- steps GMM system estimation for the relationship between the components of working capital management and firm's performance for an unbalanced sample of 5802 U.S. non-financial firms listed in the New York Stock Exchange, American Stock Exchange, NASDAQ Stock Market and the Over The Counter Market for the period 1990-2004 and the three sub-periods. The dependent variable and all the independent variables are in the form of first difference. (OIS) is the dependent variable of operating income to sales, the exploratory variables are: (LOIS) is the lagged operating income to sales, (QR) is the quick ratio, (TDE) is the total debt to equity ratio, (SG) is the sale growth, (RCP) is the receivable collection period, (ICP) is the
inventory conversion period, (PDP) is the payable deferral period, and (CCC) is the cash conversion cycle. Sargan is the Sargan test of over-identifying restrictions, P> Chi2. Order 1 is the Arellano-Bond test that average autocovariance in residuals of order 1 is 0, and Order2 is the Arellano-Bond test that average autocovariance in residuals of order 2 is 0.
Table 2
Tow-Steps Results of GMM System Estimation for the Relationship between Working Capital
Management Measures Including the Net Trade Cycle and Firm's Performance
Dependent Variable: OIS
Coefficients
Exploratory
Variables: Full period 1990-2004
First period 1990-1994
Second period 1995-1999
Third period 2000-1994
LOIS -0.8633548** -1.877821** .0608843** -0.0459073
QR -0.2516475** -0.0145362** -.1053771** -0.0037797
TDE -1.37e-08 7.52e-09 -6.87e-06 3.12e-06
SG -0.2422801** -0.5252024** .0156748** -0.0167827
RCP 0.0082238** 0.002182** .0039755** 0.0058274
ICP -0.0302019** -0.0020263** -.01653** -0.0174298
PDP -0.0045405** -0.0112586** -.0036845** -0.0038884
NTC 0.0012844** -0.0003207** -.0021981** -0.001714
Constant -0.025087** -0.0502549** -.0201984** -0.0079269
Sargan 95.34 118.19* 108.15 124.41*
Order 1 -1.00 -1.26 -1.12 -1.49
Order2 -0.48 -0.97 -1.01 -1.50
Note: * significant at 95% confidence level, * *significant at 99% confidence level Table 1 reports the results of Arellano-Bond dynamic panel-data two- steps GMM system estimation for the relationship between the components of working capital management and firm's performance for an unbalanced sample of 5802 U.S. non-financial firms listed in the New York Stock Exchange, American Stock Exchange, NASDAQ Stock Market and the Over The Counter Market for the period 1990-2004 and the three sub-periods. The dependent variable and all the independent variables are in the form of first difference. (OIS) is the dependent variable of operating income to sales, the exploratory variables are: (LOIS) is the lagged operating income to sales, (QR) is the quick ratio, (TDE) is the total debt to equity ratio, (SG) is the sale growth, (RCP) is the receivable collection period, (ICP) is the
inventory conversion period, (PDP) is the payable deferral period, and (NTC) is the net trade cycle. Sargan is the Sargan test of over-
19
identifying restrictions, P> Chi2. Order 1 is the Arellano-Bond test that average autocovariance in residuals of order 1 is 0, and Order2 is the Arellano-Bond test that average autocovariance in residuals of order 2 is 0.
Table 3
Tow-Steps Results of GMM System Estimation for the Relationship between Working Capital
Management Measures Including the Operating Cycle and Firm's Performance
Dependent Variable: OIS
Coefficients
Exploratory
Variables: Full period 1990-2004
First period 1990-1994
Second period 1995-1999
Third period 2000-1994
LOIS 0.3568988** -0.2534245** 0.643047** 0.2360323**
QR 0.0592325** 0.1027286** -0.0325934** -0.0181161**
TDE -7.14e-07 6.18e-06** -5.46e-06* 4.56e-08
SG 0.1050283** -0.0413975** 0.0875618** 0.1721182**
RCP -0.0020604** -0.0038678** -0.0041003** 0.0020457**
ICP 0.0015482** 0.005273** 0.0020449** -0.0031134**
OC -0.0013115** -0.0017843** -0.0019953** -0.0001568
Constant 0.0033737* -0.0049928** 0.0031675* -0.0023532*
Sargan 110.81 99.26 90.10 124.34*
Order 1 -2.02* -0.91 -2.09* -0.99
Order2 -1.01 0.85 0.61 -1.16
Note: * significant at 95% confidence level, * *significant at 99% confidence level Table 1 reports the results of Arellano-Bond dynamic panel-data two- steps GMM system estimation for the relationship between the components of working capital management and firm's performance for an unbalanced sample of 5802 U.S. non-financial firms listed in the New York Stock Exchange, American Stock Exchange, NASDAQ Stock Market and the Over The Counter Market for the period 1990-2004 and the three sub-periods. The dependent variable and all the independent variables are in the form of first difference. (OIS) is the dependent variable of operating income to sales, the exploratory variables are: (LOIS) is the lagged operating income to sales, (QR) is the quick ratio, (TDE) is the total debt to equity ratio, (SG) is the sale growth, (RCP) is the receivable collection period, (ICP) is the
inventory conversion period, (PDP) is the payable deferral period, and (OC) is the operating cycle. Sargan is the Sargan test of over-identifying restrictions, P> Chi2. Order 1 is the Arellano-Bond test that average autocovariance in residuals of order 1 is 0, and Order2 is the Arellano-Bond test that average autocovariance in residuals of order 2 is 0.
The results of the empirical analysis of this paper suggest that shortening the cash
conversion cycle reduces rather than increases firm’s profitability. This signifies the
importances of identifying an optimal length of the cash conversion cycle were the
total holding and opportunities costs of current assets are minimized and profitability
of firms are maximized.
3. Conclusion
One of comprehensive measures of working capital management efficiency is the
cash conversion cycle that conceders all financial flows associated with inventory,
receivable and payables. The traditional link between the cash conversion cycle and
20
firm's profitability and market value is that reducing the cash conversion cycle by
reducing the time that cash are tied up in working capital improves firm’s profitability
and market value. This could happen by shortening the inventory conversion period
via processing and selling goods to customers more quickly, by shortening the
receivable collection period by speeding up collections, or by lengthening the payable
deferral period via slowing down payments to suppliers. On the other hand,
shortening the cash conversion cycle could harm the firm's profitability; reducing the
inventory conversion period could increase the shortage cost, reducing the receivable
collection periods could makes the company's to louse it's good credit customers, and
lengthening the payable period could damage the firm's credit reputation. However,
achieving the optimal levels of inventory, receivable, and payable will minimizes the
carrying cost and opportunity cost of holding inventory, receivable, and payable and
leads to an optimal length of the cash conversion cycle. Hence, we suggest an optimal
cash conversion cycle as more accurate and comprehensive measure of working
capital management that maximizes sales, profitability and market value of firms.
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