THE IMPACTS OF WORKING CAPITAL MANAGEMENT ON THE PROFITABILITY OF PUBLIC MANUFACTURING AND TRADING ENTERPRISES IN NEPAL

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1 KAAV INTERNATIONAL JOURNAL OF LAW, FINANCE & INDUSTRIAL RELATIONS A REFEREED BLIND PEER REVIEW BI-ANNUAL JOURNAL (SPECIAL ISSUE OF INTERNATIONAL CONFERENCE ON INTEGRATING KNOWLEDGE AND TECHNOLOGY FOR SUSTAINABLE DEVELOPMENT, MARCH 24-25, 2018, DAV BUSINESS SCHOOL & DAV COLLEGE OF MANAGEMENT, KATHMANDU, NEPAL) KIJLFIR/JAN-JUN2018/ VOL-5/ ISS-1/ SIICIKTSD6 PAGE NO ISSN: IMPACT FACTOR (2017): THE IMPACTS OF WORKING CAPITAL MANAGEMENT ON THE PROFITABILITY OF PUBLIC MANUFACTURING AND TRADING ENTERPRISES IN NEPAL 1 NISCHAL RISAL 1 Lecturer, Nepal Commerce Campus, Tribhuvan University, Nepal ABSTRACT The research aims at providing empirical evidence of the effects of working capital management on the profitability of public manufacturing and trading enterprises in Nepal. The judgmental sampling technique has been used to select a panel data from 13 public manufacturing and trading enterprises for the period of , which led to total of 138 observations. The correlation and fixed effect regression model have been adopted in the study to analyze the data. The research has confirmed the positive relationship between receivables conversion period and gross profit margin and return on assets. The relationship between inventories conversion period and gross profit margin is found to be negative. The study also has concluded on finding the positive relationship between payables deferral period and gross profit margin. The study has revealed the negative relationship between cash conversion cycle and gross profit margin. The public trading enterprises and manufacturing enterprises are not managing liquidity in effective and efficient ways. The profitability of public trading enterprises and manufacturing enterprises has increased with increased size of the public enterprises. The relationship between payables deferral period and return on assets is found negative. The relationship between inventories conversion period and return on assets is found positive. The relationship between cash conversion cycle and return on assets is also found positive. Hence, the paper concludes that an efficient management of working capital has significant positive relationship with the profitability of Nepali public manufacturing enterprises and trading enterprises. Keywords: Public Enterprises, Working Capital Management, Liquidity, Profitability, Trading, Manufacturing INTRODUCTION Working capital management (WCM) is an area in making the liquidity and profitability comparisons among enterprises (Eljelly, 2004). WCM directly affects the profitability and liquidity of the enterprises (Raheman & Nasr, 2007). WCM means that the need for effective working capital management has become greater in recent years. Basically, business enterprises are established with 53

2 investments in the form of assets that can be classified on the basis of liquidity as current or fixed. Enterprises finance the total investment in assets with debt and/or owner s equity, the supply of which is limited. The principles of financial management form the basis of managing investments and relating financing with current debt, long-term debt, owner s capital contributions or retained earnings. However, liquidity and profitability management comes to the picture when an enterprise is faced with the dilemma of using short-term financing sources and investing in working capital levels. Liquidity and profitability management require fine tuning because they have offsetting risk-profit effects. The combination of liquidity and profitability depends upon management s risk attitude, based on which it can use maturity matching aggressive or conservative approach. Every individual component of working capitals including cash, marketable securities, account receivables and inventory management plays significant role in the performance of any enterprise. A popular measure of working capital management is cash conversion cycle, that is, the time span between the expenditure for the purchases of raw materials and the collection from sales of finished goods. Working capital management is defined here as a process of planning and controlling the levels of investment and financing current assets as well as related operations of purchasing and selling. The inefficient management of working capital leads to loss of profits in the short-run but it will ultimately lead to the downfall of the enterprise in the long-run. A deeper understanding on the importance of working capital can lead not only to material savings in the economical use of capital but can also assert in furthering the ultimate aim of business. An excessive investment in working capital lowers the rate of return while inadequate investment hampers the solvency position and growth, thereby affecting the smooth operation of business. The need for skilled working capital management practice has thus become greater in recent years. An enterprise is required to maintain liquidity in its day to day operations to ensure smooth running of the operations and to meet its short-term obligations. This is not a simple and straight forward task as it has to operate its business efficiently and profitably. In this process, the asset-liability mismatch may occur and it may increase the enterprise s profitability in the short-run but at a risk of its bankruptcy (Long, Malitz, & Ravid, 1993). The effective working capital management is essential for the increase in the corporate efficiency in terms of profit and other measures (Shin & Soenen, 1998; Deloof, 2003; & Quayyum, 2012). The management of receivables, inventory, and accounts payables has tremendous impacts on cash flows, which in turn affect the profitability of enterprises (Cote & Latham, 1999). The enterprises, which are better at managing working capital, are found to be able to make counter cyclical moves to build competitive advantage (Siddiquee & Khan, 2009). The management of working capital of any enterprise is concerned with the management of the enterprise s inventory, cash, marketable securities, receivables and payables in order to achieve a proper balance between risk and return. A well designed and implemented working capital management must contribute positively to the creation of an enterprise s value. The important objective of working capital management is to provide various current assets and short-term credit necessary to support anticipated sales. The current squeeze on cash and credit is threatening the survival of businesses as it is considered as the sources of company s working assets and the liabilities or collectively referred to as working capital. Hence, the study aims at analyzing the working capital management and its impacts on profitability of public manufacturing and trading enterprises in Nepal. LITERATURE REVIEW The prior empirical literature on working capital management had focused primarily on its effects on enterprises profitability which influenced corporate valuations. For example, Soenen (1993), Shin and Soenen (1998), Deloof (2003), and Gracia-Teruel and Martinez -Solano (2007) had provided evidence as that the profitability of an enterprise, measured by either return on assets or return on equity, was improved as the enterprise improved its management of working capital. Not only this, moving to more recent studies, Lazaridis and Tryfonidis (2005), found a relationship between working capital management efficiency and profitability and so did Shin and Soenen (1998), Deloof (2003) and many 54

3 others. Apart from the studies reviewed above, the studies, which are worth mentioning here and their relevant findings, are presented period-wise as under. Table 1 Review of Major Studies up to 1970s S.N. Study Major Findings 1 Sagan, J. (1955) The role and function of the money manager is to provide funds as and when needed and to invest excess funds as when available. The level of operational cash needs depends primarily on the scope of business. The more conservative management employs more working capital for a given volume of output. 2 A negative relationship exists between the level of working capital Walker, E.W. and the rate of return. (1964) If an enterprise wishes to reduce its risk to the minimum, it should employ more of equity capital. The risk would be low if the maturity period of the debt is longer. 3 4 Van Horne, J.C. (1969) Welter, P.(1970) 5 Knight, (1972) Merville & Tavis, (1973) Chakraborty, S.K.(1973) Gitman, L.J.(1974) Smith, K.V.(1974) Bierman,H., Chopra, K., & Thomas, J. (1975) 11 Firth, M.(1976) Yardeni, E.(1978) Lambrix & Singhvi, (1979) The lower the level of liquid assets, the greater the risk of not being able to meet current obligations. The risk of technical insolvency can be minimized by maintaining a high proportion of liquid assets. Assuming that the enterprise s current liabilities will remain constant, the decline in total current assets will reduce short-term financial liquidity in the business. Not only receivables and inventories are independent on each other but also on net sales and profits. The credit terms offered, inventory decisions, and short-term borrowing each has an impact on the optimal policies of the others because of the linkage among their associated cash flows. The prevailing one year temporal standard applied for classifying assets or liabilities as current is not universally valid. The cash conversion cycle is a key factor in working capital management. The job of financial managers is to achieve a tradeoff between profitability and liquidity. Profitability increases only slightly, a result only of lower interest expenses from lower levels of needed borrowings. The necessary borrowing can be reduced if receivables, payables and inventory policies are tightened. The working capital level affects both the expected earnings and the variances of earnings. The enterprises objective can be optimized only when there is some kind of overall control of working capital. This study offered a useful insight into the short-term decision making process of corporate portfolio managers and also provided scope in portfolio model of working capital. The enterprises can shorten the working capital cycle and improve cash flow by efficient inventory management. 55

4 Table 2. Review of Major Studies during 1980s S.N. Study Major Findings 1 Akhtar, The fluctuations in carrying costs have very significant effects on M.A.(1983) inventory investments. The efficiency in working capital management affects on short-term 2 financial performance (profitability) as well as long-term Shulman, J.M., & performance (maximum enterprise value). Cox, R.A.K.(1985) There is significant relationship between performance variable and the component of working capital. 3 Besley, S., & The enterprises can maximize profit by optimizing accounts Meyer, R.L.(1987) receivable management. 4 Scherr, F.C.(1989) The working capital is considered as the life blood of an enterprise and cash conversion cycle is the primary measure of working capital efficiency. Table 3. Review of Major Studies during 1990s S.N. Study Major Findings Belt, B., & Smith, K.V. (1991) Kim, H.K., Rowland, M., & Kim, S.H. (1992) Lyroudi, K., & McCarty, D.(1993) 4 Morris, L. (1994) Jose, M.L., Lancaster, C., & Stevens, J.L. (1996) Shin, H.H., & Soenen, L.(1998) Kim, Mauer & Sherman, (1998) Weinraub,H. J., & Visscher, S. (1998) Cote, J.M., & Latham, C.K.(1999) Ricci, C.W.(1999) The majority of enterprises follow informal working capital policy, both in Australia and USA. Larger enterprises have more formal policy and profitable enterprises follow more formal policy. Enterprises are less profitable because of informal working capital policy. The most important objective of working capital management by Japanese investors was to provide various current assets and short-term credit necessary to support anticipated sales. The cash conversion cycle was negatively related with current ration but positively related with quick ratio. The liquidity position of the enterprises increased slightly during economic expansion with no noticeable change in liquidity during economic slowdowns. The aggressive working capital policy indicated by shorter cash conversion cycle enhances profitability. A reasonable reduction in the cash conversion cycle could lead to an increase in the enterprises profitability. The enterprises with more volatile earnings and lower return on physical assets relative to those on liquid assets lead to have significantly larger position in liquid assets. When relatively aggressive working capital asset policies are followed, they are balanced by relatively conservative working capital financial policies. The management of receivables, inventory and accounts payable has tremendous impacts on cash flows, which in turn affect the profitability of enterprises. The enterprises use more than one method of receivable practice to determine to whom to grant credit, leading to the increase in administrative costs. 56

5 Table 4. Review of Major Studies during 2000s S.N. Study Major Findings Lyroudi, K., & 1 Lazaridis, J. (2000) Cheng, N.S., & Pike, R. (2001) Darina, S., & Mathew, T. (2002) Deloof, M. (2003) Eljelly, A.(2004) John, C. & Andrew (2005) Lazaridis, I., and Tryfonidis, D. (2006) Raheman, A., and Nasr, M.(2007) Gracia-Teruel, P.J., & Martinez- Solano, P.M.(2007) Falope, O.I., and Ajilore, O.T.(2009) Gill, A., Biger, N., & Mathur, N. (2010) Karaduman, H., Akbas, H., & Caliskan,A.(20 10) Mohamad, N. A., & Saad, N.B.(2010) Afeef, M.(2011) Mousavi, Z., & Jari, A.(2012) Quayyum, S.T.(2012) There was no relationship between cash conversion cycle and leverage ratio. The longer credit is taken where enterprises are smaller, customers concentration is lower, the market is highly competitive and customers are end-users. There are no formal policies and receivable management practices in international cash management concepts and the practice has become institutionalized and accepted as company s policy. Managers can increase corporate profitability by reducing ACP and inventories. The cash conversion cycle or the cash gap is of more importance as a measure of liquidity than current ratio, which affects profitability. The overall uses of international cash management techniques are different in different countries. The managers can create profits for their companies by correctly handling the cash conversion cycle and by keeping each component of conversion cycle at an optimal level. The enterprises are following conservative working capital management policy; and the efficient management and financing of working capital can increase the operating profitability of manufacturing enterprises. Managers can create value by reducing their inventories and the number of days for which their accounts are outstanding. Moreover shortening the cash conversion cycle also improves the enterprises profitability. A significant negative relationship was found in between net operating profitability and the average collection period, inventory turnover in days, average payment period and cash conversion cycle. There is significant relationship between cash conversion cycle and profitability, measured through gross operating profit. The decrease in cash cycle has positive effect on return on assets. There are significant negative associations between working capital variables with enterprises performance. The indicators of working capital management had a perceptible impact on profitability of the enterprises. There is positive relationship between working capital management and corporate profitability. There was significant relationship between the profitability indices and various working capital components and significant level of relationship varies from industry to industry. 57

6 Table 5. Review of Major Studies in Indian Context S.N Study Major findings of the study 1 NCAER, 1966 An inventory constitutes a major portion of the working capital. 2 Appandhanulu, V. The relationship between working capital and choice of techniques was 3 (1971) Chakraborty, S.K. (1973) 4 Misra, R.K. (1975) Agrawal, N.K. (1983) Anand, M., & Gupta, C.P. ( 2003) Ghosh, S.K., and Maji, S.G.(2003) 8 Amit, et al.(2005) Vishnani, S., & Shah, B.K. (2007) Anand, M., & Malhotra, K.(2007) Chakraborty, K.(2008) Singh, K., & Asress, F.C.(2010) found poor. The excessive working capital lowers the capital turnover ratio and so brings down the overall return on capital employed. An inventory constituted the most important element of the working capital of the public enterprises. The four-fifth of the total current assets of all industry finance emanates from short term sources. The presence of CCE, DOC and DWC capital in the overall working capital performance criterion helps in performance evaluation and capture the dynamics of risk-return trade off. A significant association was found in between effective and efficient use of current assets and profitability. No definite relationship could be established between liquidity and profitability. No established relationship between liquidity and profitability, although majority of the companies revealed positive association between liquidity and profitability. Association between the management of working capital and profitability was found to be slightly positive. A negative relationship exists between working capital and profitability. The enterprises with adequate working capital achieved better performance than those enterprises which have less working capital in related to their operational sizes. Table 6. Review of Major Studies in Nepali Context S.N Study Major findings of the study 1 Pradhan,R.S. (1986) Most of the selected enterprises were achieving trade-off between risk and return, thereby following neither an aggressive nor a conservative approach. Almost all the selected enterprises had a positive net working capital and the negative working capital was observed in a few cases. When quick assets were compared with current liabilities, it was revealed that the current assets were insufficient to cover current liabilities on many occasions. But, if standard current ratio taken as 2:1, most of the selected enterprises had current ratios of greater than two. Nepali manufacturing public enterprises had half of their total assets in the form of current assets. On the basis of the study of turnover ratios, there has been an improvement in utilization of current assets by the majority of the public manufacturing enterprises of Nepal but this was not the case with net working capital. The levels of working capital and its components, which an enterprises desires to hold, depend not only on sales but also on holding costs. 58

7 2. 3 Pradhan, R.S. (2003) Sharma, D.R. (2007) The results suggested strongly that the demand for inventories by corporations was a function of both sales as well as their holding costs. The size of receivables had increased in the majority of the selected enterprises in recent years. The average investment in inventories by manufacturing enterprises of Nepal had increased over a period of time. The low amount of sale might be affected in net working capital turnover ratio in Nepali enterprises. The increase in the average collection period over time indicates a liberal and weak credit policy adopted by most Nepali enterprises. Nepali enterprises were unable to maintain liquidity in appropriate way. Managers could create value for their shareholders by reducing the numbers day wise accounts of receivable and inventories. The negative relation between accounts payable and profitability was caused due to less profitable enterprises that waited longer to pay their bills. By reducing the cash conversion to a reasonable minimum was one way to create shareholders value. CONCLUDING REMARKS The historic results have proved the importance of working capital management for better profitability of the enterprise. The lack of sufficient empirical evidence on the working capital management practices in case of public enterprises is main motivating force to study in detail on the subject. Since earlier study was built on western data and then specific research studies exclusively on the impacts of working capital on enterprises value and profitability of companies in Nepal are scanty, this study has been conducted with an attempt to bridge the gap in the literature by offering empirical evidence to the extent of which the result in Nepal would be parallel to past studies. The literature review indicated that working capital management impacts on the profitability of the enterprise but there is still ambiguity regarding the appropriate variables that might serve as proxies for working capital management. The present study has investigated the relationship between a set of such variables and the profitability. In this study, attempt have been made to find the types of working capital policy being followed by Nepali enterprises and their practice in the different areas like cash, inventory, receivables, accounts payable and short-term loans. This study therefore is concentrated towards the study of working capital management practices in Nepal as well as the impacts of working capital management in the profitability and efficiency of those organizations and to determine the structure of working capital, and to assess the liquidity position of Nepali enterprises. Turning to the empirical literature on working capital management, a limited published study was found on the consequences of working capital management on enterprise s performance from Nepali perspectives. Pradhan (1986), Pradhan (2003) and Sharma (2007) explored the working capital management practices of some well-performed Nepali public and private manufacturing enterprises. All the past studies had provided a solid base and given an idea regarding working capital management and its components. Furthermore, this study has hoped to benefit where the result could contribute to the body of knowledge by identifying how market value and profitability of Nepali enterprises had been affected with their working capital. RESEARCH METHODOLOGY Research design The correlation and causal comparative research design has been adopted in the study. The study has used comparative design to examine the correlation among selected variables and the cause and effect 59

8 relation among profitability measures and other independent variables. The correlations among different variables are examined by deriving the Pearson s correlation coefficients. The cause and effect relation among dependent and independent variables are examined by estimating Fixed Effect Regression Model on panel data of selected enterprises. Population and sample size All the public enterprises operating in Nepal were considered as population. The seven public manufacturing enterprises and six trading enterprises are taken as sample. The samples are selected using judgmental sampling techniques. The total 13 enterprises are selected for the analysis and study. Because of the specific nature of their activities, enterprises relating with service sectors and others like banking and finance, insurance, public utility etc., are excluded in this study. Nature and sources of data The data are obtained through published annual reports of enterprises, office of the auditor general, annual reports from the government, Nepal stock exchange, Ministry of finance and Security board of Nepal. The sample size has focused only to public manufacturing and trading enterprises. The enterprises are selected on the basis of the criteria such as nature, ownership, financial statements, liquidation and private or public enterprises. The data are collected on panel data methodology basis. The total number of observation was 138 firm-year observations. Among the 37 enterprises, the study is confined to only 13 enterprises. These enterprises selected for the study are representative of large and small enterprises, i.e., 35 percent out of the total population. Table 7. Name of the Selected Public Enterprises and Study Period Name of the Company Study Period Number of Firm-Year Observations Public Trading Enterprises Agriculture Input Company Ltd (AIC) National Seeds Company Ltd (NSC) National Trading Corporation Ltd (NTC) Nepal Food Corporation Ltd (NFC) Nepal Oil Corporation Ltd (NOC) The Timber Corporation of Nepal Ltd (TCN) Public Manufacturing Enterprises Dairy Development Corporation (DDC) Herbs Production and Processing Co Ltd (HPPC) Hetauda Cement Industry Ltd (HCI) Janakpur Cigarette Factory Ltd (JCF) Nepal Drugs Ltd (ND) Nepal Orind Magnesite Private Ltd (NOMP) Udayapur Cement Industry Ltd (UCI) Total Observation Period 138 METHOD OF ANALYSIS The analysis of secondary data and the estimation of the models are carried out by the application of SPSS and GRETL data analysis software. In the analysis, the study has tried to find out the relationship between operating incomes on the one hand and the measures of working capital management (number of days accounts receivable, inventories, accounts payable, cash conversion cycle, sales, growth, debt and current ratio) on the other. The priori hypothesis in this analysis was that, there was a relationship between gross profit margin and the measures of working capital management in Nepali enterprises. The panel data regression analysis (Fixed Effects Model) is used to investigate the impacts of working capital on corporate profitability. By and large, it is the method of FEM that is used extensively for panel data. 60

9 FEM is a statistical model that represents the observed quantities in terms of explanatory variables that are treated as if the quantities are non-random. In panel data analysis, the term fixed effects estimator (also known as the within estimator) is used to refer to an estimator for the coefficients in the regression model. To estimate the determinants of gross profit margin, it includes 13 enterprises dummies as independent variables. The model used by Marc Deloof in Belgian enterprises (2003) has been used at which fixed effect model regression on panel data is estimated with variables including sales, growth, debt and number of days AR, number of days inventories, number of days AP and cash conversion cycle (Model 1-4). Hence, the models used are: Y (Gross Profit Margin) = a+b 1 RCP+B 2 LnSales+B 3 SG+B 4 DR+B 5 FFAR +B 6 D 1 +B 7 D 2 +B 8 D 3 +B 9 D BnDn+E i... 1 Y (Gross Profit Margin) = a+b 1 PDP+B 2 LnSales+B 3 SG+B 4 DR+B 5 FFAR +B 6 D 1 +B 7 D 2 +B 8 D 3 +B 9 D BnDn+E i 2 Y (Gross Profit Margin) = a+b 1 ICP+B 2 LnSales+B 3 SG+B 4 DR+B 5 FFAR +B 6 D 1 +B 7 D 2 +B 8 D 3 +B 9 D BnDn+E i... 3 Y (Gross Profit Margin) = a+b 1 CCC+B 2 LnSales+B 3 SG+B 4 DR+B 5 FFAR +B 6 D 1 +B 7 D 2 +B 8 D 3 +B 9 D BnDn+E i Y (Gross Profit Margin) = a+b 1 CCC+B 2 CR+B 3 DR+B 4 SG +B 5 D 1 +B 6 D 2 +B 7 D 3 + +BnDn+E i Y (Gross Profit Margin) = a+b 1 RCP+B 2 LnSales+B 3 DR+B 4 FFAR +B 5 D 1 +B 6 D 2 +B 7 D 3 +B 8 D BnDn+E i Y (Gross Profit Margin) = a+b 1 PDP+B 2 LnSales+B 3 DR+B 4 FFAR +B 5 D 1 +B 6 D 2 +B 7 D 3 +B 8 D BnDn+E i Y (Gross Profit Margin) = a+b 1 ICP+B 2 FS+B 3 DR+B 4 FFAR +B 5 D 1 +B 6 D 2 +B 7 D 3 +B 8 D BnDn+E i Y (Gross Profit Margin) = a+b 1 CCC+B 2 LnSales +B 3 DR+B 4 FFAR +B 5 D 1 +B 6 D 2 +B 7 D 3 +B 8 D BnDn+E i 9 Y (ROA) = a + B 1 RCP+B 2 LnSales+B 3 SG+B 4 DR+B 5 CR +B 6 D 1 +B 7 D 2 +B 8 D BnDn+E i. 10 Y (ROA) = a + B 1 PDP+B 2 LnSales+B 3 SG+B 4 DR+B 5 CR +B 6 D 1 +B 7 D 2 +B 8 D BnDn+E i 11 Y (ROA) = a + B 1 ICP+B 2 LnSales+B 3 SG+B 4 DR+B 5 CR +B 6 D 1 +B 7 D 2 +B 8 D BnDn+E i 12 Y (ROA) = a + B 1 CCC+B 2 LnSales+B 3 SG+B 4 DR+B 5 CR +B 6 D 1 +B 7 D 2 +B 8 D BnDn+E i Where, Y= Gross Profit Margin; Ln (sales) = Natural logarithm of sales; SG= Sales Growth; DR= Debt Ratio; RCP= Receivables Conversion Period (Number of Days Account Receivables); PDP= Payables Deferral Period (Number of Days Account Payables); ICP= Inventories Conversion Period (Number of Days Inventories); CCC= Cash Conversion Cycle; FFAR= Fixed Financial Assets Ratio; ROA= Return on Assets; CR= Current Ratio; E i = a random error term The second step of regression (Model 5) includes current ratio, debt ratio, sales growth and cash conversion cycle to determine or measure the effect of relationship between working capital measures and profitability based on that prior hypothesis which was based on the model already tested in large American enterprises by Shin and Soenen (1998). To reach at the conclusion by testing the priori hypothesis that working capital management affects the profitability in Nepali enterprises, different 61

10 variables are added or dropped out as per necessity in the model for final conclusion. As in literature, the effect of receivables conversion period, inventory conversion period, payables deferral period and cash conversion cycles are analyzed individually to see the individual effect of working capital components on profitability. The model used by Gill, Biger and Mathur (2010) in measurement of relationship between working capital management and profitability of American manufacturing enterprises is used to find the consistency of the results obtained through above models. The enterprises size (Firms Size) is measured through sales and FFAR indicates the fixed financial asset ratio (Model-6). The extent to which use of alternatives proxies for working capital management might provide different results as examined by another regression model (Model-7). In this model, the average days of account receivable (RCP) is replaced by the average days of accounts payable (PDP). Similarly, in another regression model, the variable average days of inventory held (ICP) is used instead of RCP or PDP (Model-8). Finally, the model CCC is used as proxy for working capital management (Model-9). The predicted sign for given models are indicated in the given model. Again, in order to gauge profitability, return on asset (ROA) has been used as a measure of profitability irrespective of the percentage of leverage in the capital structure of the company. Hence, the model where return on assets was included as dependent variable as used by Solano and Teruel (2007), Afeef (2011) and Quayyum (2012), has been used in this study (Model, 10-13). RESULTS The relation between working capital management and corporate profitability for sample manufacturing and trading public enterprises in Nepal has been investigated in this study. The number of days accounts receivable, inventories and accounts payable are used as measures of trade credit and inventory policies. The profitability is measured by gross operating profit, which was defined as sales minus cost of goods sold, and it is divided by sales to determine gross margin. In most of the enterprises, net profit is in negative form due to more indirect expenditures in Nepali public manufacturing and trading enterprises which could not provide significant results in the study. So, gross margin is used to measure the profitability of the enterprises. The return on assets is also used as a dependent variable to measure the profitability of the enterprises. The three major components of cash conversion cycle; number of days account receivable, number of days inventory and number of days account payables are used as independent variables. In addition to this, sales, the natural logarithm of sales, sales growth [(this year sales-previous year sales)/previous year s sales], the debt ratio, current ratio, and size are included as control variables in the analysis. First, the results from the descriptive analysis are presented followed by the results from Pearson s correlation analysis to see the association between profitability variables and all independent variables. Finally, the regression analysis, using different models, are used in order to see the impacts of working capital management on performance of overall public manufacturing and trading sector. Table 8 presents Pearson Correlation Coefficient of the variables that has used in the regression model. The return on assets and net profit margin are both positively correlated with the cash conversion cycle. This result is opposite to priori hypothesis that profitability and cash conversion cycle have negative relationship. Whereas, the negative correlation is found between gross profit margin and cash conversion cycle. These results are consistent with the view that the shorter the period between production and sale of products the larger the enterprises profitability (Lazaridis & Tryfonidis, 2006; Quayyum, 2012). The gross margin is negatively correlated with the inventory conversion period thus has indicated that the days of inventories increased has a negative impact on the profitability. 62

11 NPM 1 ROA.880 ** 1 Table 8. Pearson Correlation Coefficients of Selected Public Enterprises NPM ROA GP Ln SALES CR DR SG ICP RCP PDP CCC FFAR GP ** ** 1 Ln SALES CR ** 1 DR **.188 * 1 SG * ICP.984 **.862 ** ** RCP ** PDP ** * 1 CCC.970 **.882 ** ** ** * 1 FAR * ** ** correlation is significant at the 0.01 level (2-tailed) * correlation is significant at the 0.05 level (2-tailed) This analysis has suggested that managers could increase corporate profitability by reducing the number of day s inventories. The net profit margin and return on assets have positive relationship with inventory conversion period. This might be due to different natures and characteristics such as tax effect, interest effect etc., on return on assets and net profit margin. According to priori hypothesis, the growth rate brings positive impacts on profitability. In general, the negative relationship between enterprises profit and cash conversion cycle is expected. In above result, as per the priori hypothesis, the inventory conversion period and cash conversion cycle have negative effects on profitability. In case of net profit margin and return on assets, the positive relationship with cash conversion cycle is found. This means, longer cash conversion cycle might increase profitability of an enterprise because it leads to higher sales. Other relationships are insignificant, thus do not produce significant relationship among the variables. In order to throw more light on the inter-relationship between components of working capital management and profitability of sample enterprises, the regression analysis has been administered. In first step, the model used by Marc Deloof (2003) has been used to investigate the impacts of working capital measures on corporate profitability (Model 1-4). In this first step of regression analysis, the indicators of working capital management and liquidity are regressed against the gross profit margin. The determinants of corporate profitability are estimated with a fixed effects model. The determinants of gross profit margin are estimated using fixed effects estimation and also include 13 enterprises dummies as independent variables. The dummy variables for each individual enterprise have been created to see the individuals impact on working capital management on profitability of the enterprises. A dummy variable is one that takes the values 0 or 1 to indicate the absence or presence of some categorical effect that may be expected to shift the outcome. The enterprises dummies D 1, D 2, D 3, D 4, D 5, D 6, D 7, D 8, D 9, D 10, D 11, and D 12 indicate the dummies for Dairy Development Corporation, Nepal Drugs Ltd., Nepal Orind Magnesite Private Ltd., Janakpur Cigarette Factory Ltd., Hetauda Cement Industry Limited., Herbs Production and Processing Company Ltd., Udayapur Cement Industry Ltd., Agriculture Input Company Ltd., National Seeds Company Ltd., National Trading Corporation Ltd., Nepal Food Corporation Ltd., Nepal Oil Corporation Ltd., and Timber Corporation of Nepal Ltd respectively. The regression result of profitability level on sales, sales growth and other controlling variables debt ratio and fixed financial 63

12 assets ratio have been shown in Table 9. The regression model one is estimated with fixed effects and has included numbers of day accounts receivables as a measure of accounts receivable policy. The coefficient of accounts receivable variable is found positive and highly significant, and does imply that increase in the number of day accounts receivable by one day was associated with an increased gross profit margin by 0.02 percent. It means that higher the days of receivables may indicate higher sales. It may be due to more credit sales. In such case, it might be expected that the amount generated from higher sales was sufficient to cover the expenses and more increase in sales generate the profit of the enterprises. The natural logarithm of sales and fixed financial assets ratio has also found significant negative coefficient in the model. The gross profit margin decreases with firm size and fixed financial assets. The significant negative coefficient is found in the enterprises dummies D 6 and D 9. This means, the gross profit margin is lower for HPPC and NSC. In model two, a significant positive relation is found between gross profit margin and number of days payables. This means, higher the payable deferral period, the enterprises would generate more profit. The other variables in this model are insignificant and the model itself is also not significant. The regression model three has shown a very significant negative relation between gross profit margin and number of day s inventories. DDC, JCF, and NFC had significant negative coefficient. This means, these enterprises have lower the gross profit margin as compared to other public enterprises. The cash conversion cycle is included in model four. The coefficient of cash conversion cycle variable is negative and highly significant. This result is consistent with priori hypothesis that shorter the cash conversion cycle, the longer would be gross profit margin. The model four is found more sensible because, this model includes CCC where as other one, two and three model has used the components of cash conversion cycle as a measure of components of working capital management. The significant positive coefficient of firm s size (natural logarithm of sales) and fixed financial assets ratio indicate the increase in profitability with increase in the sales and fixed financial assets ratio. The estimation had shown that the fixed effects for DDC and NOC had significant negative coefficient whereas HPPC, and NSC had significant positive coefficient. DDC and NOC had lower gross profit margin compared to other enterprises whereas HPPC and NSC had better profit margin. Shin and Soenen (1998) had found a strong negative relationship between the length of the enterprises cash conversion cycle and profitability (priori-hypothesis). The same model is used to analyze the impacts of working capital components on profitability of Nepali public manufacturing and trading enterprises. Table 9. The Determinants of Public Manufacturing and Trading Enterprises Profitability-FEM Estimation The Regression Analysis: Fixed Effects Estimation; Dependent Variable: Gross Profit Margin 13 Non-Financial Public Enterprises ( ), 138 Enterprise-year Observations Variables Model 1 Model 2 Model 3 Model 4 Constant 1.619** (2.317) (-1.488) (-0.764) *** (-4.266) Natural Logarithm of Sales (LnSales) ** (-2.168) (1.394) (1.330) 13.46*** (4.018) Sales Growth (SG) (0.867) (-0.313) (-1.268) (-0.615) Debt Ratio (DR) (0.686) (-0.386) (1.032) (-0.525) Receivable Conversion Period (RCP) *** (4.156) Payable Deferral Period (PDP) 0.030* (1.865) Inventory Conversion Period (ICP) *** (-512.5) 64

13 Cash Conversion Cycle (CCC) *** (-90.33) Fixed Financial Assets Ratio (FFAR) ** (-2.340) (0.499) (-0.399) 8.624* (1.854) DDC (D 1 ) (0.820) (-0.843) ** (-2.222) * (-1.948) ND (D 2 ) (-1.435) (1.267) (0.210) JCF (D 4 ) (0.929) (-0.685) ** (-2.053) (-1.363) HCI (D 5 ) (0.766) (-0.422) (0.698) (-0.769) HPPC (D 6 ) ** (-2.549) (0.959) (1.224) 25.52*** (2.814) AIC (D 8 ) (-0.146) (-0.340) NSC (D 9 ) ** (-2.104) (0.705) (1.025) 25.17** (2.571) NTC (D 10 ) (0.525) (-0.730) (1.536) (-1.615) NFC (D 11 ) (1.373) (-0.357) * (-1.838) (0.063) NOC (D 12 ) (1.635) (-1.154) (-1.290) *** (-3.229) R-Square Adj.R-Square Standard Error F-Statistic 3.809*** *** *** Durbin-Watson Value (DW) *** coefficient is significant at the 0.01 level (2-tailed); ( ) figures in the parenthesis have t-value ** coefficient is significant at 0.05 level (2-tailed) * coefficient is significant at 0.10 level (2-tailed) The model (5) is found significant and the roles of cash conversion cycle become important in Nepali context. The model has shown significant negative relationship between profitability and cash conversion cycle as per prior hypothesis. The analysis has shown significant positive relationship between sales growth and profitability. That means profitability increases as sales increase and decreases with larger cash conversion cycle. Shin and Soenen (1998) conducted same type of study in firms covering the time period of The coefficient of second dummy variable was found negative and significant. This means, ND had lower gross profit margin as compared to other enterprises. The model used by Gill, Biger and Mathur (2010) in measurement of relationship between working capital management and profitability of the American manufacturing enterprises is used to find the consistency of the results obtained through above models (Model-6). The priori hypothesis was that increase in average collection period negatively affects the profitability of the enterprise and when leverage of the enterprise increases, it adversely affects the profitability. The control variable fixed financial assets had been used and that includes cash and bank accounts plus securities and investment accounts that can be readily converted into cash. In this study, only cash and bank are taken as financial assets. The results obtained through the regression analysis are presented in Table

14 Table 10: Impact of Working Capital Management on Performance of Public Manufacturing and Trading Enterprises-FEM Estimation The Regression Analysis using Fixed Effects Model with Dependent Variable: Gross Profit Margin 13 Non-Financial Public Enterprises ( ), 138 Enterprise-years Observations Variables Model 5 Model 6 Model 7 Model 8 Model 9 Constant ** *** (-0.371) Natural Logarithm of Sales (LnSales) Sales Growth (SG) 38.07* (1.943) Debt Ratio (DR) (0.094) Receivable Conversion Period (RCP) Payable Deferral Period (PDP) Inventory Conversion Period (ICP) Cash Conversion Cycle (CCC) *** ( ) Current Ratio (CR) (-1.055) Fixed Financial Assets Ratio (FFAR) (2.229) ** (-2.052) (0.634) 0.000*** (4.095) 66 (-1.550) (1.450) (-0.372) 0.030* (1.874) (-0.011) (0.702) (1.134) *** ( ) (-4.925) *** (4.645) (-0.493) *** (-90.78) ** (-2.487) (0.589) (-0.031) 9.271** (2.054) DDC (D 1 ) (0.673) (0.495) (-0.788) * (-1.837) (-1.875) ND (D 2 ) * (-1.795) (-1.493) (1.153) (0.141) JCF (D 4 ) (1.101) (0.635) (-0.615) (-1.665) (-1.223) HCI (D 5 ) (-0.869) (0.639) (-0.373) (1.015) (-0.667) HPPC (D 6 ) (0.035) ** (-2.408) (0.916) (0.946) 24.12*** (2.760) AIC (D 8 ) (-0.106) (-0.141) (-0.347) (-0.944) NSC (D 9 ) (0.939) (0.205) (0.670) (0.853) 24.27** (2.517) NTC (D 10 ) (0.512) (0.205) (-0.664) 4.037** (2.334) (-1.499) NFC (D 11 ) (0.769) (1.185) (-0.278) (-1.522) (0.263) NOC (D 12 ) (0.425) (1.388) (-1.154) (-0.713) *** (-3.475) R-Square Adj.R-Square Standard Error F-Statistic ** 4.060*** ** ***

15 * * Durbin-Watson Value (DW) *** coefficient is significant at the 0.01 level (2-tailed); ** coefficient is significant at 0.05 level (2-tailed); * coefficient is significant at 0.10 level (2-tailed); and ( ) figures in the parenthesis have t-value The regression analysis in the model (6) has found that the dependent variable gross profit margin is positively related with number of days account receivable. The beta coefficient is found to be negative for control variable fixed financial assets. The positive coefficient of account receivable has revealed that the increase in average collection period significantly affects the profitability of the enterprise. It might be due to more sales in credit. The growth in sales has inverse relationship with profitability. This analysis has revealed that, increase in sales adversely affects the profitability. This result contradicts with the result of Gill, Biger and Mathur (2010) and Deloof (2003). The ratio of fixed financial assets to total assets has negative relation with gross profit margin and significant as per priori hypothesis. Only one enterprise dummy coefficient is found significant. This means, the gross profit margin is lower for Herbs Production and Processing Ltd with respect to decrease in number of days account receivables. In next step regression analysis (Model-7), the average days of account receivable is replaced by the average days of account payable to examine the extent to which use of alternative proxies for working capital management might provide different results. Using the average day s accounts payable in the regression analysis has provided significant positive relationship between average days of payables and gross profit margin. This analysis has revealed that the higher the duration of days of payables, more profitable would be the enterprises. None of the enterprises dummies are turned out to be statistically significant in this model. The model (8) has found that the dependent variable gross profit margin has negative relationship with number of day s inventories. This means, the profit of the enterprises increases with decrease in number of days inventories. This finding is not consistent with priori hypothesis that number of days has positive relationship with gross profit margin. The finding is consistent with theory that the small the number of days inventories, the more profitable would be the enterprises. DDC and NTC have significant relationship with gross profit margin. DDC has lowered the profitability where as NTC has increased the profitability as compared to other enterprises. Finally, cash conversion cycle is used as the proxy of working capital management instead of number of day s receivable, number of days account payable and number of day s inventories (Model-9). The result from regression analysis in the model (9) has shown the negative relationship between cash conversion cycle and gross profit margin. The analysis has found positive relationship in between gross profit margin and natural logarithm of sales and fixed financial assets ratio. Thus, analysis has revealed that the enterprises profitability would increase by decrease in cash conversion cycle and increase in controlling variable fixed financial assets and growth in sales. The findings from dummy coefficient revealed that DDC and NOC have lowered the profitability whereas the profitability was better for HPPC and NSC as compared to other enterprises. Again, in order to gauge profitability, return on asset (ROA) has been used as a measure of profitability irrespective of the percentage of leverage in the capital structure of the company. Hence, return on assets is included in regression analysis (Model, 10-13) as dependent variable as used in study by Solano and Teruel (2007), Afeef (2011) and Quayyum (2012). The indicator of working capital management and liquidity are regressed against the return on assets to investigate the determinants of return on assets for all 138 firm-year observations. The results from the regression analysis using the same model in Nepali context have been presented in Table 11. The regression analysis in model (10) has revealed that the firms size and current ratio have significant positive coefficient. This has indicated the increase in profitability of public trading enterprises and manufacturing enterprises bear increase in sales and current assets (liquidity). This means, more liquid firms are more profitable. The priori hypothesis was that there should be negative relation between liquidity and profitability but the positive relation is found. It means Nepali enterprises are not able to manage liquidity in effective way and the liquidity was 67