Relationship between Working Capital Management and Firm Return: Role of Firm Size as moderator

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1 ASIAN JOURNAL OF EDUCATIONAL RESEARCH & TECHNOLOGY Vol. 6 (2), April 2016: ISSN (Print) : Website: ISSN (Online): RESEARCH ARTICLE Relationship between Working Capital Management and Firm Return: Role of Firm Size as moderator Muhammad Manazir 1, Misbah Noreen 1, Muhammad Asif 1, Qurat ul Ain 2 and Bilal Aziz 3 1 Research Scholar LSAF, University of Lahore, Pakistan 2 Visiting Lecturer University of Sargodha Mianwali Campus 3 Incharge PDC, IBM University of Engineering and Technology Lahore, Pakistan manazirmaju@gmail.com, asif6463@hotmail.com, biiilal@live.com Received: 16 th Feb. 2016, Revised: 15 th March 2016, Accepted: 17 th March 2016 ABSTRACT The paper seeks to extend the findings regarding the relationship between Working Capital Managment and firm return. A sample of 98 listed manufacturing companies of Pakistan, Karachi Stock Exchange, and selected period was 7 years from 2004 to It is concluded in this study that there is positive significant relationship between firm return and working capital management. Return f firm is measured through ROA (return on asset). It is also concluded that managers can increase firm profit and shareholders wealth by critically managing working capital. It can be said that firm can get higher profit by manager ability to manage account receivable. This study contributed in the literature about relationship of firm return and working capital management. And we use firm size as moderator which results negative impact on the relationship. Key words: Working Capital management, corporate return, Size of firm, Pakistan INTRODUCTION The effective Working Capital Management can prevent over investment in assets, Planning & controlling current assets / liabilities, maintaining optimal level of Liquidity and Significant effects on firm return and overall financial performance of the organization. Beside the effective working capital management, nowadays term lean working capital management is used which is selecting the best methods: (i) the profit of the company does not diminish, (ii) the rate of cash circulation improve and (iii) the costs diminish. The main thought of the working capital management is improving cash flow rate, diminishing bad debts of receivables and diminishing the expenses to create opportunities to increase the wealth of firm. There is little difference between working capital and net working capital; as working capital is included the items which are current assets on the balance sheet. In net working capital current liabilities are deducted from current asset. Net working capital is useful gauge in measuring the availability of cash to meet current needs of money of companies. Return of total assets is a measure used to find out activity level of the organization (Mehmet Sen & Eda Oruc, 2009). Some studies also support that quick ratio and current ratio can also be used instead of working capital management. It is concluded from different studies that working capital is managed by manager in day to day issues and managers consume much time about management of working capital. The logic about this management is that current assets have very short lives and they are converted into other types of assets in short time (Rao 1989). When we see current liabilities that should be paid timely and should be management in working capital management. When liquidity is seen no one see about total assets liquidity but it is only seen the operating liquidity which can be achieved by working capital management (Soenen, 1993). It can be concluded from above discussion that working capital management is most important area. So current assets and current liabilities composition is critical for performance of any organization. Current assets are used to meet current liabilities.

2 OBJECTIVE TO MANAGE THE WORKING CAPITAL The main objective of a firm is to increase the market value, for this purpose efficient management of working capital is a fundamental part of the overall corporate strategy in creating the shareholders value. On the other hand maintenance of optimal level of liquidity is not only the lifeblood of corporation but it also has long term significant effects on firm return and financial performance. Firms try to keep an optimal level of working capital that maximizes their value (Howorth & Westhead, 2003; Deloof, 2003; Afza & Nazir, 2007). As we know that each organization has a single objective which is to maximize shareholders wealth. But there is another liability of each organization that is to maintain liquidity. The thing which is to be considered is that to earn profit on scarifying liquidity may lead to serious problems. It means a firm has to do tradeoff between these both objectives. It means firm should not prefer one objective on the cost of second objective. It means both objectives should be achieved. It means when profit is sacrifice an organization cannot be survived. And if we do not focus on liquidity then operations will disturbed and survival will also be in questionable form. In this way firm will go to bankruptcy. Therefore evidently working capital management comprises an important part of firm s financial management, and if the management is not carried out properly, a possible over-investment can reduce firm s firm return, and underinvestment can lead to losing sale opportunities or a default on debt payment deadline. The crucial part in managing working capital is required maintaining its liquidity in day-today operation to ensure its smooth running and meets its obligation (Eljelly, 2004). Yet, this is not simple task since managers must take sure that business operation is running in efficient and profitable manner. This will further lead to financial distress and finally firms can go bankrupt (Zariyawati et al., 2009). For these reasons working capital management should be given proper consideration and will ultimately affect the firm return of the firm. Accounts Receivable in days, Inventory / Stocks in days and Accounts Payable in days directly affect the working capital and working capital management. Large inventory and a generous trade credit policy may lead to high sales. Larger inventory reduces the risk of a stock-out. Trade credit may stimulate sales because it allows customers to assess product quality before paying. Another component of working capital is accounts payable. Delaying payments to suppliers allows a firm to assess the quality of bought products, and can be an inexpensive and flexible source of financing for the firm. On the other hand, late payment of invoices can be very costly if the firm is offered a discount for early payment. A popular measure of Working Capital Management (WCM) is the cash conversion cycle, i.e. the time lag between the expenditure for the purchases of raw materials and the collection of sales of finished goods. The longer this time lag, the larger the investment in working capital (Deloof 2003). A longer Working Capital Management might increase firm return because it leads to higher sales. However, corporate firm return might also decrease with the cash conversion cycle, if the costs of higher investment in working capital rise faster than the benefits of holding more inventories and/or granting more trade credit to customers. A great emphasis on the importance of working capital management has been notice in recent years. For the purpose to attain a desirable working capital management, the manager should control the tradeoff between firm return and liquidity accuracy (Zariyawati et al., 2009). Dilemma in working capital management is to achieve a balance between liquidity and firm return of a firm. Explanations about why working capital management is significant for a firm generally focus on the relationship between efficiency in working capital management and firm firm return. Efficient working capital management includes planning and controlling of current liabilities and assets in a way it avoids excessive investments in current assets and prevents from working with few currents assets insufficient to fulfill the responsibilities. In relevant studies the measure taken as an indicator of efficiency in working capital management is usually cash conversion cycle. Working Capital Managment for a firm is the period during which it is transited from money to good and again to money and this cycle can be demonstrated (Mehmet Sen & Eda Oruc, 2009). Therefore evidently working capital management comprises an important part of firm s financial management, and if the management is not carried out properly, a possible over-investment can reduce firm s firm return, and underinvestment can lead to losing sale opportunities or a default on debt payment deadline. ~ 108 ~

3 Referring to theory of risk and return, investment with more risk will result to more return. Therefore, firms with high liquidity of working capital may have low risk then low firm return. Conversely, firm that has low liquidity of working capital, facing high risk results to high firm return. The issue here is in managing working capital, firm must take into consideration all the items in both accounts and try to balance the risk and return (Zariyawati et al., 2009). Evidence suggests that relatively few small firms utilize basic working capital management routines and they show a greater prevalence of ad hoc or subjective working capital decision-making. That is in spite of the fact that smaller firms must use working capital management in order to reduce the odds for their business termination and also for improving the business performance. The firm s ability in continuing the operations over a long period depends on how it treats the working capital. LITERATURE REVIEW Besides capital structure and capital budgeting there is also great need to manage working capital in corporate sector because working capital has affect on firm return. The management of working capital is defined as the management of current assets and current liabilities, and financing these current assets. Working capital management is important for creating value for shareholders. Management of working capital was found to have a significant impact on both firm return and liquidity in studies in different countries. Mona Al-Mwalla (2012) made an attempt to study the impact of working capital management policies on firm s value and firm return by using variables AIP (aggressive investment policy), AFP (aggressive financing policy), Turbin q, ROA. Control variables were leverage, GDP, sales growth and size. He used descriptive statistics and regression analyses. They found that firms aggressive working capital policy has negative effect on firms value and firm return. Bana AbuZayed (2011) investigated the effect of working capital management on firms performance listed in Amman stock exchange. He used the variables CCC, DAR, DI, DAP and control variables were size, sales growth, leverage, FATA and GDP growth. His results were different from normal trend. He found that the firms with high profit are less concerned with efficient working capital management. Muhammad Alipour (2011) worked to find out relationship between efficient working capital management policy and firm firm return. He also found the relationship between firm return and Working Capital Managment (also with components of cash conversion cycle) by using regression analyses. He used GOP as dependent variable and Cash Conversion Cycle, Inventory turnover in Days, Average collecton period, Average payment period, as independent variable and control variables were SIZE, Current Ratio and Debt Ratio. He found that Working Capital Managment and its components have negative relationship with firm return. Ikram ul Haq and Muhammad Sohail (2011) made attempt to check effect of working capital management on firm firm return in cement sector of Pakistan. He used corporate firm return, working capital and financial ratios as variables. He found moderate relationship between working capital management and firm return in cement sector Pakistan by using correlation and multiple regressions. Hasan, Halil and Arzu (2010) evaluated the relationship between working capital management and firm firm return of selected companies registered in Istanbul Stock exchange in period He used Return on Assets (ROA), Working Capital Managment (CCC), Accounts Payable Days (AP), Accounts Receivables Days (AR), Inventory Days (IN), Size (Natural log of Sales), Debt and GDP Growth as variables. He found the relationship that by decreasing Working Capital Managment firm can improve its firm return. Adina Elena (2010) worked on Alba County companies to find out relationship between working capital and firm firm return. He used Return on equity (ROE), Return on Assets (ROA), Return on Sales (RS), Net Working Capital (NWC), Working Capital Necessary (WCN), Net Treasury (NT), Days Sales Outstanding (DSO), Days Inventory Outstanding (DIO), Days Payable Outstanding (DPO) and Days Working Capital (DWC) as variables. He found weak negative relation between working capital management indicators and firm return. ~ 109 ~

4 Huynh Phuong (2010) found the relationship between working capital and firm return in Vietnam. Gross operating firm return, number of days account receivable, number of days account payable, number of days inventory, Working Capital Managment and FATA as variables. He used regression analyses and correlation analyses in his study. He found negative relationship between firm firm return and working capital. Sajid and Talat (2009) found the relationship between aggressive working capital and firm firm return by using regression analyses. They concluded that firms have negative relationships with firm return if it follows aggressive working capital policy. Ajao and Adebayo (2008) had investigated the study that aggressive working capital policy is better or conservative for nestle Nigeria PLC. They used regression analyses between operating profit, inventory turnover in days, account receivable in days, Working Capital Managment and current ratio. They concluded that there is significant negative relationship between Working Capital Managment and firm return which means conservative policy is better. Raheman and Nasr (2007) have selected a sample of 94 Pakistani firms listed on Karachi Stock Exchange for a period of 6 years from to study the effect of different variables of working capital management on the net operating firm return. From result of study, they showed that there was a negative relation between variables of working capital management including the average collection period, inventory turnover in days, average collection period, Working Capital Managment and firm return. Besides, they also indicated that size of the firm, measured by natural logarithm of sales, and firm return had a positive relationship. Vedavinayagam (2007) had investigated the study of relationship between firm return and working capital management in telecommunication industry. He used current ratio, Days working capital and cash conversion efficiency. He concluded that there is negative relationship between days working capital and firm firm return but this is insignificant for telecommunication industry. (Eljelly, 2004) elucidated that efficient liquidity management involves planning and controlling current assets and current liabilities in such a manner that eliminates the risk of inability to meet due short-term obligations and avoids excessive investment in these assets. The relation between firm return and liquidity was examined, as measured by current ratio and cash gap (cash conversion cycle) on a sample of joint stock companies in Saudi Arabia using correlation and regression analysis. The study found that the Working Capital Managment was of more importance as a measure of liquidity than the current ratio that affects firm return. The size variable was found to have significant effect on firm return at the industry level. The results were stable and had important implications for liquidity management in various Saudi companies. First, it was clear that there was a negative relationship between firm return and liquidity indicators such as current ratio and cash gap in the Saudi sample examined. Our research questions are a) how working capital management effect firm performance b) What is role of firm size on as moderator on the relationship between CCC and firm return. METHODOLOGY Data Collection In this paper we use data collected from the financial statements of sugar, textile, chemical, cement, tobacco, oil & vanaspati and paper & board sector of Pakistan that was given on the site of state Bank of Pakistan. We use data from and total 125 companies data was given but only data of 98 companies was sufficient for tests requirements. And total observations were 686 out of which some observations were outliers and we use 581 observations for our tests. Variables: In order to understand the relationship between the management of the working capital and firm return we have calculated the following variables: Account Receivable Days: Account receivable days are calculated because this is the main factor of working capital. And its formula is- Account Receivable Days= Receivables/(sales/365) ~ 110 ~

5 Account Payable Days: Accounts Payable days are also used as proxy of account payable and this also a part of working capital. And to calculate accounts payable days following formula is used: Account Payable Days= Payables/(CGS/365) Inventory Turnover in Days Inventory turnover in days is the proxy used for inventory because this is also a part of working capital and its formula is: Inventory Turnover in Days= 365/inventory turnover ratio Cash Conversion Cycle: Working Capital Managment is used as a whole in working capital and its formula is given below: Working Capital Managment = ARP+ITID-APP Where ARP= Account Receivable in Days ITID= Inventory turnover in Days APP= Account payable in days CCC= Cash Conversion Cycle Return on Assets Return on asset is used as measure of firm return and its formula is ROA=Return on Assets = Net Income/Total Assets Other than these variables we also used current ratio to check liquidity. And firm size as control variable as well as its affect on the relation between CCC and ROA as a moderator and the firm size is calculated by taking log of sales. Another control variable is used leverage. We used descriptive statistics, regression and unit root tests as statistical tools to measure relationships. Results Descriptive Statistics: N Min. Max. Mean Std. Deviation Skewness Kurtosis Statistic Statistic Statistic Statistic Statistic Statistic Std. Error Statistic Std. Error ROA ID ARP APP CCC FS CR LEV PCCC Valid N 581 (listwise) Descriptive statistics of data shows that data is symmetrical for tests. Because when we see data s skewness which is near to 0. And also when we see kurtosis that is also below 3 and that is also near to standard. ~ 111 ~

6 Unit Root Test: Series Name ADF P-value PP test P-value APP ARP ID CCC ROA CR FS LEV Test critical values: 1% level % level % level Unit root test tells us that weather time series is stationary or not and if it is stationary then on which level. If ADF and PP values are lower than critical values then data is stationary at that level. If we see our time series data we conclude that our data is stationary at level. Regression Model Summary (b): Adjusted R Std. Error of the Model R R Square Square Estimate Durbin-Watson 1.582(a) a Predictors: (Constant), FS, LEV, CR, PCCC b Dependent Variable: ROA Summary of this model tells us that R Square is.339 which means that our independent variables explain 33% of our independent variables. And DW which should be greater than 1.39 so according to this summary our model is correct. ANOVA(b): Model Sum of Squares Df Mean Square F Sig. 1 Regression (a) Residual Total a Predictors: (Constant), PCCC, LEV, FS, CR b Dependent Variable: ROA Coefficients(a): Unstandardized Coefficients Standardized Coefficients T Sig. Model B Std. Error Beta B Std. Error 1 (Constant) FS CR LEV PCCC ~ 112 ~

7 The result of regression shows that our ROA depends upon our independent variables which are predicted values of CCC, CR, LEV and FS. We use predicted values of CCC conversion cycle because this depends upon ARP, APP and ID. And results tell us that ROA is positively related with firm size and current ratio. As we taken log of sales as size of firm so high sales will give high profits. But leverage and predicted value of CCC is negatively related with ROA which means ROA can be enhanced by decreasing cash conversion cycle. Moderator Descriptive Statistics N Minimum Maximum Mean Std. Deviation Skewness Kurtosis Std. Stat istic Statistic Statistic Statistic Statistic Statist ic Erro r Statistic Std. Error ROA FS PCCC FSPCCC Valid N (listwise) 581 After regression on time series data of 98 companies we try to check role of firm size as moderator for which we create one more variable with name of FSPCCC, which is the multiplication of firm size and cash conversion cycle. Descriptive statistics of these variables are also shows that data is approximately symmetrical. Skewness and Kurtosis values are near to 0 and below 3 respectively. ANOVA(b): Sum of Model Squares Df Mean Square F Sig. 1 Regression (a) Residual Total a Predictors: (Constant), FSPCCC, FS, PCCC b Dependent Variable: ROA Coefficients(a): Model Unstandardized Coefficients Standardized Coefficients T Sig. B Std. Error Beta B Std. Error 1 (Constant) PCCC FS FSPCCC Residuals Statistics(a) Minimum Maximum Mean Std. Deviation N Predicted Value Residual Std. Predicted Value Std. Residual ~ 113 ~

8 ROA = PCCC FS -.009CCCFS To check role of firm size as moderator we use regression tool. And found that firm size moderate negatively. And also results are also significant. But sign of PCCC becomes positive which so minor that is ignorable. Evaluating the effect of X: δy/δx = FS The effect of X on Y decreases when M increases. Evaluating the effect of X Levels Moderator (FS) Mean-3S.D Mean-2S.D Mean-1S.D Mean Mean+1S.D Mean+2S.D Mean+3S.D After that we evaluate the moderator effect by adding and subtracting S.D in mean of moderator and calculate the results that tell us the change between relationship of CCC and ROA. This shows decreasing trend in relationship. More Complex Case ANOVA(b): Sum of Model Squares Df Mean Square F Sig. 1 Regression (a) Residual Total a Predictors: (Constant), SWRFSPCC, FS, PCCC, FSPCCC, SQRFS b Dependent Variable: RO Coefficients(a): Mod el Standardized Coefficients T Sig. Unstandardized Coefficients B Std. Error Beta B Std. Error 1 (Constant) PCCC FS FSPCCC SQRFS SWRFSPCC 6.07E Residuals Statistics(a): Minimum Maximum Mean Std. Deviation N Predicted Value Residual Std. Predicted Value Std. Residual ROA CCC -.623FS+.258FS CCCFS+ 6.07E-007CCCFS2 ~ 114 ~

9 Then we use a more complex case to find out that if moderator affect decreasing with decreasing rate or decreasing with increasing rate and found that moderator affect is decreasing with increasing rate. CONCLUSION Study explores that working capital management has significant impact on firm return. We conclude that we can improve our profits by decreasing account receivable days and inventory turnover in days and also by making negotiation with supplier that gives you longer period to pay your debt. And if firm size is greater then also firm return is high. LEV also negatively affects the firm return. And firm size also play role as moderator on the relationship between profit and capital profit. REFERENCES 1. Abdul Rahman & Mohammad Nasr (2007), Working Capital Management & Firm Return: Case Of Pakistani Firms: International Review Of Business Research Papers March Adina Elena (2010) Working Capital Management And Firm Return: A Case Of Alba County Companies, Annales Universitatis Apulensis Series Oeconomica, 12(1), Afza T and Nazir M S (2007), Is it Better to be Aggressive or Conservative in Managing Working Capital?, Journal of Quality and Technology Management, Vol. 3, No. 2, pp Ajao And Adebayo (2008), The Study Of Working Capital Management As A Financial Strategy (A Case Study Of Nestle Nigeria Plc) Asian Journal Of Business And Management Sciences, vol. 2 no Bana Abuzayed (2011) Working Capital Management Andfirms Performance In Emerging Markets: The Case Of Jordan, International Journal Of Managerial Finance Received September 2010 revised july 2011 accepted july Deloof, M. (2003). Does Working Capital Management Affect Profitability of Belgian Firms? Journal of Business, Finance and Accounting, 30(3), Eljelly, (2004),Liquidity Firm Return Tradeoff: An Empirical Investigation In An Emerging Market: International Journal Of Commerce And Management,Ijcm Vol. 14, no. 2, Hasan, Halil And Arzu (2010) Effects Of Working Capital Management On Firm Return: The Case For Selected Companies In The Istanbul Stock Exchange ( ). International Journal of Economics And Finance Studies, Vol 2, no 2, Howorth, C., and Westhead, P. (2003). The Focus of Working Capital Management in UK Small Firms. Management Accounting Research, 14(2), Huynh phuong (2010) The Relationship Between Working Capital Management And Firm Return: A Vietnam Case, International Research Journal Of Finance And Economics Issn issue 49 (2010). 11. Ikram Ul Haq and Muhammad Sohail (2011) The Relationship Between Working Capital Management And Firm Return: A Case Study Of Cement Industry In Pakistan, Mediterranean Journal Of Social Sciences vol.2, no.2, may Mona al-mwalla, (2012) The Impact Of Working Capital Management Policies On Firm's Firm Return And Value: The Case Of Jordan, International Research Journal Of Finance And Economics.Issn issue 85 (2012). 13. Muhammad Alipour (2011) Working Capital Management And Corporate Firm Return: Evidence From Iran, World Applied Sciences Journal 12 (7): , Rao, R. K. S Fundamentals of Financial Management, 3 rd Ed. Macmillan publishers, pp Sajid And Talat (2009) Impact Of Aggressive Working Capital Management Policy On Firms Firm Return: The Iup Journal Of Applied Finance, vol. 15, no. 8, Soenen, L.A. (1993). Cash Conversion Cycle and Corporate Profitability. Journal of Cash Management. 13, Vedavinayagam (2007), An Analysis Of Working Capital Management Efficiency In Telecommunication Equipment Industry: Rivier Academic Journal, Volume 3, number 2, fall ~ 115 ~