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Impact of Working Capital Management on Firms’ Performance:

Evidence from Non-Financial Institutions of KSE-30 index

Dr. Muhammad AZAM Assistant Professor, Department of Business Administration,

Iqra University, Karachi-75300, Pakistan

Syed Irfan HAIDER Iqra University, Karach-75300, Pakistan

Abstract The purpose of this study is to investigate the impact of working Capital Management on

firms’ performance for non-financial institutions listed in Karachi Stock Exchange (KSE-

30) Index. A panel data has been used in this study for 21 Kse-30 Index listed firms over a

period for the year 2001 to 2010. The results are obtained by using Canonical Correlation

Analysis for identifying the relationship between working capital management and firms’

performance. The findings show that working capital management has significant impact

on firms’ performance and it is concluded that managers can increase value of share holder

and return on asset by reducing their inventory size, cash conversion cycle and net trading

cycle. Increase in liquidity and time period to supplier will also lead firms’ overall

performances.

Key Words: Working Capital Management, Firms’ Performance, KSE-30 Index.

1. Introduction

Working capital management is considered to be a very important element to analyze the

organizations’ performance while conducting day to day operations, by which balance can

be maintained between liquidity and profitability. Maintaining liquidity on daily base

operation to make sure it’s running and meets its commitment is a crucial part required in

managing working capital. It is a difficult task for mangers to make sure that the business

function running in well-organized and advantageous manner. There are chances of

inequality of current assets and current liability during this procedure Firm’s growth and

profitability will be affected if this occurs and firm manger wouldn’t be able to manage it

efficiently.

According to Harris (2005) Working capital management is a simple and straightforward

concept of ensuring the ability of the firm to fund the difference between the short term

assets and short term liabilities. Nevertheless, complete mean and approach preferred to

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cover all its company’s activities related to vendors, customer and product. (Hall, 2002).

Now a day working capital management has considered as the main central issues in the

firms and financial managers are trying to identify the basic drivers and level of working

capital management (Lamberson, 1995).

The purpose of this study is to identify whether the performance of firms are affected by

working capital management in Karachi Stock Exchange (KSE-30) Index companies. It has

to establish the relationship between liquidity and firm’s performance considering Return

on Assets (R.O.A) and Return on Equity (R.O.E). This study is very important for the

manager non-financial institute of KSE-30 index firms because it will help them to set

tradeoff between their liquidity and their performance of firms. They would come to know

that at what extend they should increase their liquidity in order make their performance up

to the mark. It will also help them to know the optimal level of receivables and inventory

level which will be helpful for their receivable control management and their inventory

control management.

The remainder of the paper is organized as follows. A review of the relevant literature

regarding the working capital management and firm’s performance is given in section 2,

and section 3 presents the data and methodology to be applied while section 4 contains the

empirical results. Lastly, the conclusion will be given in section 5.

2. Literature Review Dong (2010) reported that the firms’ profitability and liquidity are affected by working

capital management in his analysis. Pooled data are selected for carrying out the research

for the era of 2006-2008 for assessing the companies listed in stock market of Vietnam. He

focused on the variables that include profitability, conversion cycle and its related elements

and the relationship that exists between them. From his research it was found 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 found that if the

number of days of account receivable and inventories are diminished then the profitability

will increase numbers of days of accounts receivable and inventories.

Mohammad Neab and Noriza BMS (2010) worked on crating the relationship between

Working Capital Management (WCM) and performance of firms. For their analysis they

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chose the Malaysian listed companies. They administered the perspective of market

valuation and profitability. They used total of 172 listed companies from the databases of

Bloomberg. They randomly selected five year data (2003-2007). This research likewise the

researches quoted before studied the impact of the dimensions of working capital

component i.e. C.C.C., current ratio (C.R.), current asset to total asset ratio (C.A.T.A.R),

current liabilities to total asset ratio (C.L.T.A.R.), and debt to asset ratio (D.T.A.R.) in

effect to the firm’s performance whereby firm’s value dimension was taken as Tobin Q

(T.Q.) and profitability i.e. return on asset (R.O.A.) and return on invested capital

(R.O.I.C). They applied two different techniques for analyzing the data that are multiple

regression and correlations. They found that there is a negative relationship between

working capital variables and the firm’s performance.

Saswata Chatterjee (2010) focused on the importance of the fixed and current assets in the

successful running of any organization. It poses direct impacts on the profitability liquidity.

There have been a phenomenon observed in the business that most of the companies

increase the margin for the profits and losses because this act shrinks the size of working

capital relative to sales. But if the companies want to increase or improve its liquidity, then

it has to increase its working capital. In the response of this policy the organization has to

lower down its sales and hence the profitability will be affected due to this action. For this

purpose 30 United Kingdom based companies were selected which were listed in the

London Stock exchange. The data were taken of three years 2006-2008. It analyzed the

impact of the working capital on the profitability. The dimensions of working capital

management included in this research which is quick ratios, current ratios C.C.C, average

days of payment, Inventory turnover, and A.C.P (average collection period. on the net

operating profitability of the UK companies.

Mathuva (2009) studied the impact of working capital management on the performance. He

took almost 30 listed firms as a sample and all these companies were listed in Nairobi stock

exchange and the data was taken from 1993 to 2008. There were certain findings of his

research by analyzing the fixed effects regression models. Firstly, there is a negative

relationship between the time when the cash is collected from the customers and the firm’s

productivity. This depicts, firms that are more profitable enjoys less time period for the

collection of cash from the customers as compare to ones which are less profitable.

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Secondly, there is a positive relationship between the inventories when they were brought

in and the period to which they are sold and the firm’s profitability. The interpretation

comes out as that the firms or the organizations which take more time to keep the

inventories it reduces the costs of the disruption in the process of production and usually the

business losses as there is the insufficiency in the goods. This situation decreases the

operating cost of the firm. The third assumption of the research was the association between

the average payment period and profitability and found out to be positive (p<0.01). The

more the time taken to disburse the creditors, the profitability will increases

Sen. M (2009) examined the ISE (Istanbul Stock Exchange) listed firms and checked out

the relationship with the working capital. According to them there is negative relationship

among variables. His research uncovered the importance of the finance directors who act as

moderators or catalysts to increase the productivity of the firm in other words they

positively affect the firm’s performance

Terual and Martinez–Solano (2007) also provided the empirical relationship between both

the variables. They chose the small and medium sized Spanish firms, a sample of about

8872 small to medium sized enterprises for 1996 to 2002. After the in depth view it was

found out that the negative relationship between the profitability of SME’s and the number

of days account receivable and days of Inventory. But it did not provide the exact impact of

no. of days account payable affect and SME’s return on Assets.

Ganesan (2007) selected telecommunication equipment industry to study the effectiveness

of working capital management. The sample included for his research paper included 443

annual financial statements of 349 telecommunication equipment companies covering the

period 2001 to 2007. The statistical tests used included correlation, regression analyses and

Analysis of variance (ANOVA). The results showed that days of the working capital

negatively affects the profitability of these firms but in reality it does not affect the

transportability of firms in telecommunication equipment industry.

Sayaduzzaman MD. (2006), examined that the management of British American Tobacco is

highly reasonable due to the constructive cash inflows, designed approach in running the

major components of working capital by evaluating five years data from 1999-2000 to

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2002-2003. Appliance of multi-dimensional modal of existing assets mix may have

optimistic impact on the nonstop expansion & extension of this multinational enterprise.

This also depends on collaboration of the stakeholders and business environment in the

framework of globalization.

Filbeck G. et al. (2005) investigated the data of 26 industries by taking the data of 970

companies during 1996 to 1999. They found out that firms are able to decrease financing

cost and/or augment the funds obtainable for development by reduce the amount of funds

attached to the current assets. They revealed that significant difference exist between

industries in working capital measures across time. In addition, we determine that these

measures for working capital vary extensively with in industry with the passage of time.

It is concluded that negative relationship was also found out between profitability and

liquidity of companies of United Kingdom. Conversely a positive relationship was seen

between debt and firm’s profitability. The researchers propose that profitability can be

increase by managers if reduction in the day’s of accounts receivable and inventories

occurred. Therefore the companies whose profitability is less opt to take much longer time

to pay their bills. The aim of this heading is to discuss the work being done by the

researchers and scholars in different industries and firms so as to reveal the contents or the

variables and in their dimensions in depth.

3. Data and Methodology

The current research is aimed to find out the impact of working capital over the firm’s

profitability. The quantitative method has been followed in order to find better results and

outcomes that can be implemented in the future. Panel Data have been taken from the

annual financial statements of the firms; these reports are collected from reliable sources

including Federal Bureau of Statistic, State bank of Pakistan and Karachi stock exchange.

The data contain all non financial firms listed in KSE-30 index of Karachi Stock Exchange.

The analysis will be conducted for the period 2001 to 2010.

Multivariate correlational strategy has been applied on the pooled data. Collection of the

data in order to determine whether and to what degree a relationship exists between two or

more quantifiable variables. Degree of relationship is expressed as a correlation coefficient.

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The statistical technique used in this research is Canonical correlation. This technique is

preferable because research is focused on the effect of two metric dependent variables on

number of metric independent variables. Canonical regression is an extension of multiple

regression analysis the only difference is that number of metric dependent variables is more

than one in canonical regression. This technique is more appropriate for our research

because it measures the strength of the overall relationships between the linear composites

(canonical variates) for the independent and dependent variables. In effect, it represents the

bivariate correlation between the two canonical variates. The results have been got by

applying the statistical tools namely Statistical Package for Social Science (SPSS) and

Statistical Analysis System (SAS). The Table 3.1 reports the variables description and tells

us how to measure them? The hypothesis of this study is written as;

3.1. Research Hypothesis:

H0: Working Capital Management has insignificant impact on Firms’ Performance.

H1: Working Capital Management has significant impact on Firms’ Performance.

3.2 Measurement of Variables: Table 3.1: Measurement of Variables

Variables How to Measure Abbreviation Types of Variables Average Collection Period

Account Receivable/Net Sales*365 ACP

Independent

Inventory Turnover (in Days)

Inventory/ Cost of Goods Sold * 365 ITD

Independent

Average Payment Period (in days)

Accounts Payable/ Purchases* 365 APP

Independent

Cash Conversion Cycle ACP + ITD - APP CCC

Independent

Net Trading Cycle ACP + (Inventory/ Net Sales*365) - (Accounts Payables / Purchases * 365)

NTC Independent

Gross Working Capital Turnover Ratio Net Sales/ Current Assets GTA

Independent

Current Assets to Total Assets Ratio Current Assets/ Total Assets CTR

Independent

Current Liabilities to Total Asset Ratio Current Assets/ Total Liabilities CLT

Independent

Current Ratio Currents Assets/ Current Liabilities CR Independent

Return on Assets Net Income / Total Assets ROA Dependent

Return on Equity Net Income / Total Share Holders Equities ROE Dependent

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4. Data Analysis

Table 4.1: Summary Statistics Sr. No. Variables N Mean Std. Dev Min. Max.

1 Inventory Turnover (in Days) 177 29.159 28.003 0.000 112.889 2 Average Payment Period (in Days) 177 107.294 97.230 8.055 595.292 3 Cash Conversion Cycle 177 -28.778 76.945 -390.561 190.209 4 Net Trading Cycle 177 6.142 69.378 -236.295 211.113

5 Gross Working Capital Turnover Ratio 178 2.621 1.584 0.115 9.194

6 Current Assets to Total Assets Ratio 178 0.539 0.588 0.091 6.623 7 Current Liabilities to Total Assets 177 0.397 0.399 0.042 4.847 8 Current Ratio 177 1.696 1.450 0.142 12.063 9 Return on Assets 178 0.112 0.105 -0.353 0.437

10 Return on Equities 178 0.246 0.293 -1.429 2.157

The above table 4.1 shows the results of summary statistics of all the taken variables in the analysis. It provides the information about number of observation included and mean its dispersion and variability in the data.

Table 4.2: Correlation Analysis between Working Capital Management and the Firms’ Performance

Correlation between Working Capital Management and the Firms’ Performance

Return on Assets Return on Equity Correlation -0.288** -0.205** Inventory Turnover

(in Days) p- Value (0.00) (0.01) Correlation 0.053 0.261** Average Payment

Period (in days) p- Value (0.48) (0.00)

Correlation -0.067 -0.281** Cash Conversion Cycle p- Value (0.38) (0.00)

Correlation -0.079 -0.172* Net Trading Cycle

p- Value (0.29) (0.02) Correlation -0.118 0.001 Gross Working

Capital Turnover Ratio p- Value (0.12) (0.94)

Correlation 0.275** 0.131 Current Assets to Total Asset Ratio p- Value (0.00) (0.08)

Correlation -0.073 0.042 Current Liabilities to Total Assets Ratio p- Value (0.33) (0.54)

Correlation 0.577** 0.161 Current Ratio

p- Value (0.00) (0.18) **Correlation is significant at the 0.01 level (2-tailed). *Correlation is significant at the 0.05 level (2-tailed).

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The above table 4.2 displays the correlation analysis among the Working Capital

Management variables and the Firms’ Performance variables. The result shows that firms’

performance variable Return on Assets has significantly affected on Current Ratio with

positive correlation of 0.577 and Inventory Turnover with negative correlation of 0.288.

These finding are very consistent with the result of Sen & Eda (2009). Net Trading Cycle is

also negative correlated by Return on Assets as it was found by Soenen (1993). On the

other hand, firms’ performance variable Return on Equity is found to be negatively

associated by significant correlation with two most important dimensions working capital

management, i-e, Cash Conversion Cycle and Inventory Turnover in Days with the value of

0.281 and 0.205 respectively.

Table 4.3 Canonical Correlation Analysis (Test of H0)

The table 4.3 shows that first dependent variable Return on Assets (ROA) is moderate

positively correlated with independent variables showing value 0.6365 and the remaining

correlation with second dependent variable Return on Equity (ROE) is 0.3466. The adjusted

canonical correlation is the value which is obtained after the subtraction of the approximate

standard error. The value after deduction of the standard error gives the more accurate

Eigenvalues of Inv(E)*H = CanRsq/ (1- CanRsq)

Eigenvalue Difference Proportion Cumulative

0.6811 0.5445 0.833 0.833 0.1365 0.167 1

Canonical

Correlation

Adjusted Canonical

Correlation

Approximate Standard

Error

Squared Canonical

Correlation

1 0.6365 0.6149 0.0450 0.4051 2 0.3466 0.3076 0.0665 0.1201

Test of H0: The canonical correlations in the current row and all that follow are zero

Likelihood Ratio Approximate F Value

Num DF Den DF Pr > F

0.52339253 7.93 16 332 (<.0001) 0.87986304 3.26 7 167 (0.0029)

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information about the model fitness if one can further adjust the model by his own. And the

values of adjusted canonical in this table are 0.6149 and 0.3076 respectively. The values of

squared canonical correlation are 0.4051 and 0.1201. It depicts that how much model is

representing the accuracy of data. The Eigen’s value represents the amount of variance that

is captured by the component. The column of Eigen value shows 0.6811 which is more than

that of other Eigen value that is 0.1365 given in second row. Further likelihood ratios are

0.52339 and 0.8798 respectively. The F value in the first column shows the value of 7.93

and the p-value is given by 0.0001 which is less than 0.05 and similarly in the second case

F- value is 3.26 having p-value 0.0029 which also less than 0.05. So we reject our null

hypothesis. This shows that Working Capital Management is significantly correlated with

the Firms’ Performance. Table 4.4 Multivariate Statistics and F Approximation

The table 4.4 shows the four multivariate statistical test information for all independent

variables. The four tests are numbered on top of the output table. For each of the four test

statistics, an F statistics and related p- value also demonstrate.

Wilks’ Lambda is first of the four multivariate statistics to test the null hypothesis that the

canonical correlations are zero (which, in turn, mean there is no linear relationship between

two specified groups of variables). The F value of this test in 7.93 and the p- value is

0.0001 which is less than 0.05, so this value assure that our null hypothesis is rejected

showing that canonical correlation is not zero and there is a significant relationship between

two specific groups.

The second test in this table is Pillai’s trace. It is the sum of their squared canonical like

0.63652 + 0.34662 that is equal to 0.5253 with the F- value of 7.44 and the p- value is

0.0001 which is also smaller then 0.05 and rejecting our null hypothesis. The third test to

S=2 M=2.5 N=82

Statistic Value F Value Num DF Den DF Pr > F

Wilks' Lambda 0.523 7.93 16 332 (<.0001)

Pillai's Trace 0.525 7.44 16 334 (<.0001)

Hotelling-Lawley Trace 0.818 8.44 16 268.07 (<.0001)

Roy's Greatest Root 0.681 14.22 8 167 (<.0001)

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test the null hypothesis is Hotelling Lawley Trace. It is the sum of the value of (canonical

correlation 2 / (1 - canonical correlation 2). The value of this test is calculated by 0.63652 /

(1- 0.63652) + 0.34662/ (1- 0.34662) resulted in 0.818 with the F- value of 8.44 alongwith p-

value of 0.0001. So, we are rejecting our null hypothesis because p- value is smaller than

0.05. The fourth test of Roy’s Greatest Root is based on the largest Eigenvalue. The value

of test is 0.681 and F value is 14.22 with p- value is 0.001 which is also less than 0.05 and

rejecting our null hypothesis. The entire four tests are rejecting our null hypothesis. So, we

conclude that there is a significant impact of working capital management on firms’

performance.

5. Concluding remarks and Policy implications

The present study has investigated the impact of Working Capital management on firms’

performance for non- financial institutes listed in Karachi Stock Exchange (KSE-30) Index.

Panel data have been analyzed by applying Canonical correlation for the time period of

2001 to 2010. It was found that inventory turnover in days has negative relationship with

both indicators of firm performance i.e. Return on Assets and Return on Equity which

means that companies performance can be increased by reducing inventory in days. APP is

found to be significant positive association with both Return on Assets and Return on

Equities, indicating that if time period of supplier’s payment is increased then overall firm’s

performance also improves. Cash Conversion Cycle and Net Trading Cycle shows

significant negative relation with Return on Assets and Return on Equities showing that

firms’ performance can be increased with short size of both of them. Lastly liquidity

(Current Ratio) is positively associated with both performance dimensions. These findings

are very consistent with the results of Raheman et al (2010) and Zubairi H.J (2010).

This research indicates that there should have proper inventory management system to

avoid over stock of inventory resulting efficient outcome of investment. It has to make sure

certain standards and levels which will stop us piling up inventory. Companies should

engage in relationship with those suppliers who allow long credit time period and those

customers who allow short payment period. There is still need in the future to indentify the

sector wise relationship between working capital management and firms’ performance in

Pakistan.

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