THE EFFECT OF CASH CONVERSION CYCLE ON THE PROFITABILITY OF FIRMS LISTED ON THE NAIROBI SECURITIES EXCHANGE ABDUSALAM SALIM MOHAMED D63/80545/2012

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1 THE EFFECT OF CASH CONVERSION CYCLE ON THE PROFITABILITY OF FIRMS LISTED ON THE NAIROBI SECURITIES EXCHANGE ABDUSALAM SALIM MOHAMED D63/80545/2012 A RESEARCH PROJECT SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENT FOR THE AWARD OF MASTER OF SCIENCE FINANCE DEGREE OF THE SCHOOL OF BUSINESS, UNIVERSITY OF NAIROBI NOVEMBER 2013

2 DECLARATION This project is my original work and has not been submitted for a degree to any other University. ABDUSALAM SALIM MOHAMED DATE D63/80545/2012 This research project has been presented for examination with my approval as the University Supervisor. DR. JOSIAH ADUDA DATE CHAIRMAN DEPARTMENT OF FINANCE AND ACCOUNTING ii

3 DEDICATION To my parents, thank you for continuous support and inspiration. To my fiancée, thank you for your motivation. iii

4 ACKNOWLEDGEMENT I first thank God the Almighty, for getting me this far and I thank all those who supported me through my entire studies. Also a big thank you to all my Master of Science, Finance colleagues for their encouragement and for the ideas we shared from their experiences and backgrounds that made my studies a success Several people and institutions have contributed in various ways to the completion of this work. Dr. Josiah Aduda, Chairman of the Department of Finance & Accounting, The University of Nairobi for his guidance and continuous support throughout the entire course and the project, has guided and supported me throughout this study. Apart from his professional guidance, he has been outstanding in terms of reading, reviewing and correcting this work. I thank him for his unfailing assistance, concern and encouragement. Last but not least is to my colleagues for their constructive comments and suggestions and accepting to cover me in my role at different stages of this research project. To all the lecturers at the University of Nairobi who contributed in one way or another in my success throughout this course I am most grateful. To my dear family and friends for their moral and spiritual support throughout the project work I am deeply indebted to you. iv

5 ABSTRACT Cash conversion cycle is a concept that is receiving serious attention all over the world especially with the current financial situations and the state of the world economy. The concern of business owners and managers all over the world is to devise a strategy of managing their day to day operations in order to meet their obligations as they fall due and increase profitability and shareholder s wealth. Cash conversion cycle, in most cases, are considered from the perspective of working capital management as most of the indices used for measuring corporate liquidity are a function of the components of working capital. The purpose of this paper is to investigate the relation between a firm s cash conversion cycle and its profitability. The relation between the firm s cash conversion cycle and its profitability is examined using dynamic panel data analysis for a sample of firms listed on The Nairobi Securities Exchange for the period from 2008 to The analysis is applied at the levels of the full sample and divisions of the sample by industry and by size. A strong negative relation between the length of the firm s cash conversion cycle and its profitability is found in all of the authors study samples except for consumer goods companies and services companies. Our results indicated that there is a significant and negative relationship between the cash conversion cycle and return on asset. The firms with shorter cash conversion cycles are more likely to be profitable than firms with longer cash conversion cycles. A possible explanation to this finding is that when the cash conversion cycle is relatively shorter, the firm may not need external financing, which results in incurring less borrowing cost and interest expense, hence increasing profitability. The operating cash flow ratio can be used to compare companies across a sector, and to look at changes over time. Generally, a higher ratio is preferred, but as with all liquidity ratios, sector norms and the peculiarities of each business need to be taken into account. The power of cash flow analysis is enhanced by comparing ratio results to industry averages or to at least a select group of comparable organizations. Useful insights can also be developed by reviewing year-toyear trends in the ratios of an organization over time. Cash conversion cycle measures the time lag it takes company s investment in raw material to be realised. Management should strive to maintain a very low CCC. v

6 TABLE OF CONTENTS DECLARATION... ii DEDICATION... iii ACKNOWLEDGEMENT... iv ABSTRACT... v LIST OF TABLES... viii LIST OF ABBREVIATIONS... ix CHAPTER ONE:INTRODUCTION Background to the Study Cash Conversion Cycle Profitability Cash Conversion Cycle and Profitability The Nairobi Securities Exchange Research Problem Research Objective Value of the study... 7 CHAPTER TWO:LITERATURE REVIEW Introduction Review of Theories Quantity Theory of Money Keynesian Theory of Money Baumol Model of Cash Management The Pecking Order Theory Determinants of Profitability Review of Empirical Studies Chapter Summary CHAPTER THREE:RESEARCH METHODOLOGY Introduction Research Design Population of the study Sample Selection Data Collection Data Analysis vi

7 3.6.1.Variables Regression model CHAPTER FOUR:DATA ANALYSIS AND PRESENTATION OF FINDINGS Introduction Data presentation Descriptive Analysis Correlation Analysis Regression Analysis Summary and Interpretation of Findings CHAPTER FIVE:SUMMARY, CONCLUSIONS AND RECOMMENDATION Summary of Findings Conclusions Policy Recommendations Limitations of the Study Suggestions for Further Research REFERENCES APPENDICES Appendix 1: Firms Listed on the NSE Appendix 2: Sample Data vii

8 LIST OF TABLES Table 1: Descriptive Table 2: Pearson Correlation Table 3: Model 1 Summary for Components of CCC Table 4: ANOVA for Components of CCC Table 5: Coefficients for Components of CCC Table 6: Model 2 Summary of CCC Table 7: ANOVA for Model 2 CCC Table 8: Model 2 Coefficients CCC viii

9 LIST OF ABBREVIATIONS AAI- Average age of inventory ACP- Average collection period APP- Average payment period CCC- Cash conversion cycle DPO- Days payable outstanding DSO- Days sales outstanding NSE- Nairobi Securities Exchange OC- Operating cycle ROA- Returns on Assets WCM- Working capital management ix

10 CHAPTER ONE INTRODUCTION 1.1. Background to the Study Central to short term financial management is the understanding of a firm s cash conversion cycle. This cycle frames discussion of the management of the firm s current assets and liabilities. This research paper looks at the effects of cash conversion cycle on firm s performance of all the 62 firms listed in Nairobi Securities Exchange (NSE) for a period of 5 years The research studies the effect of different variables of cash conversion cycle (CCC) including the operating cycle (OC) which is composed of average collection period (ACP) and the average age of inventory (AAI), and average payment period (APP) on the net operating profitability of firms listed on NSE, their debt ratio, size of the firm (all these will be measured in terms of natural logarithm of sales) and financial assets to total assets ratio will be used as control variables. Pearson s correlation and regression analysis will be used for our analysis Cash Conversion Cycle CCC is a very important component of working capital management and financial management because it directly affects the liquidity and profitability of the company. It deals with current assets and current liabilities. The traditional link between the cash conversion cycle and the firm's profitability is that shortening the cash conversion cycle increases firm's profitability i.e. you need to collect from debtors faster than you pay suppliers, holding optimal inventory level so as not to tie your cash etc. On the other hand shortening the cash conversion cycle could harm the firm s operations and reduce profitability. This could happen when taking actions to reduce the inventory conversion period, a firm could face inventory shortages; when reducing the receivable collection period a firm could lose its good credit customers; and when lengthening the payable deferral period a firm could harm its own credit reputation. However, identifying optimal levels of inventory, receivables, and payables where total holding and opportunities cost 1

11 are minimized and recalculating the cash conversion cycle according to these optimal points provides more complete and accurate insights into the efficiency of working capital management. In this regard, we suggest an optimal cash conversion cycle as more accurate and comprehensive measure of working capital management. Efficiency of working capital management is based on the principle of speeding up cash collections as quickly as possible and slowing down cash disbursements as slowly as possible. This working capital management principal based on the traditional concepts of operating cycle, cash conversion cycle, weighted cash conversion cycle, and net trade cycle. The operating cycle of a firm is the length of time between the acquisition of raw materials and the collections of receivables associated with the sales of finished goods. Although the operating cycle considers the financial flows comes from receivables and inventory, it ignores the financial flows comes from account payables, in this regards, Richards and Loughlin (1980) suggest the cash conversion cycle that considers all relevant cash flows comes from the operations. The cash conversion cycle can be defined as the length of time between cash payments for purchase of raw materials and the collection of receivable associated with the sale of finished goods. However, the cash conversion cycle focuses only on the length of time financial flows engaged in the cycle and does not consider the amount of fund committed to a product as it moves through the cash conversion cycle. Therefore, Gentry, Vaidyanathan, and Wai (1990) suggest a weighted cash conversion cycle that takes into consideration both the timing of financial flows and the amount of fund committed to each stage of the cycle. The weighted cash conversion cycle can be defined as the weighted number of days funds are committed in receivables, inventories and payables, less the weighted number of days financial flows are deferred to suppliers. In addition to its' complexity, another limitation of the weighted cash conversion cycle is the breakup of inventory into three components of raw materials, work in process, and finished goods is not available for outside investigators; hence, Shin and Soenen (1998) suggest the net trade cycle as an alternative measure for working capital management. They argue that the cash conversion cycle is an additive concept where the denominators for the inventory conversion period, the receivable collection period, and the payable deferral periods are all different, making the addition of the cash conversion cycle components not really useful. They suggest equalizing the denominators of the inventory conversion period, the receivable 2

12 collection period, and the payable deferral periods1. The net trade cycle is basically equal to the cash conversion cycle where the three complaints of the cash conversion cycle (receivables, inventory, and payables) are articulated as a percentage of sales, this makes the net trade cycle easier to calculate and less complex comparing with the cash conversion cycle and the weighted cash conversion cycle. Shin and Soenen (1998) also argue that the net trade cycle is a better working capital efficiency measure comparing with the cash conversion cycle and the weighted cash conversion cycle because it indicates the number of "day sales" the company has to finance its working capital and the working capital manager can easily estimate the financing needs of working capital expressed as the function of the expected sales growth. Although the operating cycle, the cash conversion cycle, the weighted cash conversion cycle, and the net trade cycle are powerful measures of working capital management and firm's liquidity comparing with the static traditional ratios such as the current ratio and the quick ratio that are inadequate and misleading in the evaluation of firm's liquidity, these cycles does not considers the optimal levels of receivables, inventories, and payables. The traditional link between these cycles (the operating cycle, the cash conversion cycle, the weighted cash conversion cycle and the net trade cycle) appears in the existing literatures (see, Shin and Soenen, 1998; Gentry, et al, 1990; Richards and Loughlin, 1980, Deloof, 2003) and firm's profitability, market value and liquidity is that shortening these cycles increases firms profitability, liquidity, and market value. For example; a short cash conversion cycle indicates that the company manage and process inventory more quickly, collects cash from receivables more quickly and slowing down cash payments to suppliers. This increases the efficiency of internal operations of a firm and results on higher profitability, higher net present value of cash flows, and higher market value of a firm (Gentry, et al, 1990).The success of a firm depends ultimately on its ability to generate cash inflows in excess of outflows. The cash flow problems of many businesses are caused by poor financial management and in particular the lack of planning for cash requirements. (Jarvis et al, 1996) 3

13 Profitability Profitability is the ability to make profit from all the business activities of an organization, company, firm, or an enterprise. It measures management efficiency in the use of organisational resources in adding value to the business. Profitability may be regarded as a relative term measurable in terms of profit and its relation with other elements that can directly influence the profit. Profitability is the relationship of income to some balance sheet measure which indicates the relative ability to earn income on assets. Irrespective of the fact that profitability is an important aspect of business, it may be faced with some weakness such window dressing of the financial transactions and the use of different accounting principles. A company should earn profit to survive and grow over a long period of time. Profits are essential, but all management decision should not be profit centered at the expense of the concerns for customers, employees, suppliers or social consequences. Profit is the difference between revenues and expenses over a period of time (usually one year). Profit is the ultimate output of a company, and it will have no future if it fails to make sufficient profits. The profitability ratios are calculated to measure the operating efficiency of the company Cash Conversion Cycle and Profitability Cash conversion cycle of individual firms as well the collective cycle of the industry, highlights how the firms are performing; moreover it also helps to dig out the areas where further improvement is required (Hutchison, 2007). For the business owners, one of the most important tasks is to estimate and evaluate cash flows of the business, to well identify the long run and short run cash inflows and outflows to timely sort out the cash shortages and excess to formulate financing and investing strategies respectively. It also helps in planning the payments to creditors on time to avoid losing reputation and trust of the customers and to avoid potential bankruptcy. Generally cash management is based on cash conversion cycle and is considered as important factors enhancing the performance of companies, since it shows how efficient a firm is in its payments of bills, collection of payments, and selling of inventory. Companies can enhance their profitability by lessening their length of cash conversion cycle through decreasing or lessening the receivables collection period, decreasing or lessening the inventory selling period and increasing or lengthening the credit payment period. 4

14 Since every corporate organization is extremely concerned about how to sustain and improve profitability, hence they have to keep an eye on the factors affecting the profitability. In this regard, liquidity management having its implications on risks and returns of the corporate organizations cannot be overlooked by these organizations and hence cash conversion cycle being indicator of the liquidity management needs to be explored as to how it may affect the profitability of the corporate units. Today due to changing world s economy, advancement of technology and increased global competition among the companies, every company is striving to enhance their profits and for that companies are putting every effort to bring their cash conversion cycle at optimum level to increase profitability The Nairobi Securities Exchange The Nairobi Securities Exchange was constituted as Nairobi Stock Exchange in 1954 as a voluntary association of stockbrokers in the European community registered under the Societies Act. In Kenya, dealing in shares and stocks started in the 1920s when the country was still a British colony. However, the market was not formal as there were no rules and regulations to govern stock broking activities. Trading took place on a gentleman's agreement. Standard commissions were charged with clients being obligated to honour their contractual commitments of making good delivery and settling relevant costs. At that time, stock broking was a sideline business conducted by accountants, auctioneers, estate agents and lawyers who met to exchange prices over a cup of coffee. Because these firms were engaged in other areas of specialisation, the need for association did not arise. In 1951, an estate agent named of Francis Drummond established the first professional stock broking firm. He also approached the then Finance Minister of Kenya, Sir Ernest Vasey, and impressed upon him the idea of setting up a stock exchange in East Africa. The two approached London Stock Exchange officials in July 1953 and the London officials accepted to recognise the setting up of the Nairobi Stock Exchange as an overseas stock exchange. ( 5

15 1.2. Research Problem The ultimate objective of any firm is to maximize the profit. But, preserving liquidity of the firm is an important objective too. Increasing profits at the cost of liquidity can bring serious problems to the firm. Therefore, there must be a tradeoff between these two objectives of the firms. One objective should not be at cost of the other because both have their importance. If we do not care about profit, we cannot survive for a longer period. On the other hand, if we do not care about liquidity, we may face the problem of insolvency or bankruptcy. For these reasons working capital management should be given proper consideration and will ultimately affect the profitability of the firm. Firms may have an optimal level of working capital that maximizes their value. Large inventory and a lenient 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 and (Deloof and Jegers, 1996). 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 cash conversion cycle might increase profitability because it leads to higher sales. However, corporate profitability 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. In Kenya, many studies have been done to establish relationship between working capital management and profitability or liquidity of firms. Agnes (2011) did a study on Relationship between Working Capital Management Financing Policy and Profitability: A Survey of Manufacturing Firms in Kenya and her study concludes that there is need for prudent management of working capital to ensure positive effect on profitability. 6

16 Biwott (2011) The Relationship between Working Capital Management Practices and Profitability of Companies Quoted at the Nairobi Stock Exchange. His study concludes that there is a strong negative relationship between the measures of working capital management including the ACP, inventory turnover in days, APP and the CCC with corporate profitability. Another study conducted by Runyora (2012) also conducted a study on The Impact of Working Capital Management on the Profitability of the Oil Industry in Kenya and her study concludes that there exist relationship between WCM and profitability of retail oil companies in Kenya. This study differs from all above studies as earlier researchers only focus on specific industries/ sectors in the Kenyan market and the focus is not on the publicly listed companies where we expect information to be more accurate and up to date due to high regulatory environment. As to Biwott s study, the difference is that it looks at the whole WCM while the focus of this study is the CCC. Also above studies only focus on one objective; explaining the relationship between WCM and profitability of firms whereas the objectives of this research are as listed below. The problem statement to be analyzed in this study is: Does the CCC management affect the performance of firms listed on the NSE? 1.3. Research Objective The main objective is to establish a relationship between CCC and Financial performance of firms listed on the NSE Value of the study This study on working capital policy and its impact on profitability will be significant or of importance to the following: This work will be useful to policy formulators such as company managers, as to the optimum working capital policy to adopt so as to bring about effective working capital management and enhance profitability and liquidity of the firm. The managers are the agents of the shareholders and are entrusted to make policy decisions. Information on working capital will enable them 7

17 evaluate the key drivers of working capital management and hence be able to come up with strategies on optimal working capital management. External Policy makers and regulators- From recent fall of large companies like Enron, the regulators have become so keen on liquidity of firms. For instance, in Kenya, the Insurance and banking industry regulators are keen on liquidity of the firms in industry that in the banking and insurance forms they are required to disclose admissible assets and liabilities. They also need to file in their forms liquidity ratios of the firms and minimal capital requirements. These reports are audited and signed by the firms external auditors. Therefore, this research will help inform the regulators on the importance of cash conversion cycle consideration on working capital management of the public listed firms on the NSE. Investors/ Investment advisors/ Financial Analysts- The study will provide insights to investors on working capital management practices that influence the business performance. Hence before making investments they will have a clue on how CCC impacts working capital management and the overall effects on profitability and liquidity of a firm. Student/Researchers- It will be beneficial to students and researchers as it will add to the body of existing materials or knowledge which will open way for further research on related subject matters. Research gaps identified help discuss this topic to the finer details hence improve information out in public on the working capital elements of financial management. 8

18 CHAPTER TWO LITERATURE REVIEW 2.1. Introduction In this chapter, the research reviews the existing literature on the link between the length of cash conversion cycle (as a dynamic measure of working capital management) and firm s financial performance. Most of the results of studies that empirically examined the relationship between cash conversion cycle and profitability showed a significant and negative relationship Review of Theories Quantity Theory of Money This is an economic theory which proposes a positive relationship between changes in the money supply and the long-term price of goods. It states that increasing the amount of money in the economy will eventually lead to an equal percentage rise in the prices of products and services. The calculation behind the quantity theory of money is based upon Fisher Equation. According to the quantity theory, money is held only for the purpose of making payments for current transactions. Fishers in 1911 proposed a version of the quantity theory of money that can be explained in terms of the equation below; MV= PT. Where M is the nominal stock of money in circulation, V is the transaction velocity of money. P represents the average price level and T is the number of transactions that take place during the time period. This theory originated in the sixteenth century as European economists noticed higher levels of inflation associated with importing gold or silver from the Americas. According to how the formula is derived, holding the transaction volume and velocity of money constant, any increases in the money supply will yield a proportional increase in the average price level Keynesian Theory of Money The traditional quantity theory of money and the quantity equations do not show how a change in the quantity of money reacts upon the price level. Keynes tries to tackle this aspect of the problem in his General Theory by a restatement of the quantity theory. In doing so, he tried to integrate the theory of money with the theory of employment. To Keynes, the effect of changes 9

19 in the quantity of money on the price level (in turn, the value of money) should be visualized through the inter-related effect on the wage rate, income, investment, employment, etc. Thus, an increase in the quantity of money will have no effect on prices, so long as there is any unemployment, and that employment will increase in exact proportion to any increase in effective demand brought about by the increase in the quantity of money. While, as soon as full employment is reached, wage rate and price will increase in exact proportion to the increase in effective demand. Hence, Keynes enunciated the quantity theory of money as follows: "So long as there is unemployment, employment will change in the same proportion as the quantity of money." The general theory of employment, interest and money identified three reasons why liquidity is important; the speculative motive, the precautions motive and the transaction motive. The speculative motive is the need to hold cash to be able to take advantage. For example, bargain purchase and favorable exchange rates fluctuations in the case of if international firms. For most firms, reserve borrowing ability and marketable securities can be used to satisfy speculative motives. Precautionary motive is the need for a safety supply to act as a financial reserve. The transaction motive is the need to have cash on hand to pay bills. Transaction related needs come from collections activities of the firm. The disbursement of cash includes the payments of wages and salaries, trade debts, taxes etc Baumol Model of Cash Management Baumol model of cash management helps in determining a firm's optimum cash balance under certainty. It is extensively used and highly useful for the purpose of cash management. As per the model, cash and inventory management problems are one and the same. William J. Baumol developed a model (The transactions Demand for Cash: An Inventory Theoretic Approach) which is usually used in Inventory management & cash management. Baumol model of cash management trades off between opportunity cost or carrying cost or holding cost & the transaction cost. As such firm attempts to minimize the sum of the holding cash & the cost of converting marketable securities to cash. At present many companies make an effort to reduce the costs incurred by owning cash. They also strive to spend less money on changing marketable securities to cash. The Baumol model of cash management is useful in this regard. The Baumol model enables companies to find out their 10

20 desirable level of cash balance under certainty. The Baumol model of cash management theory relies on the tradeoff between the liquidity provided by holding money (the ability to carry out transactions) and the interest foregone by holding one's assets in the form of non-interest bearing money. The key variables of the demand for money are then the nominal interest rate, the level of real income which corresponds to the amount of desired transactions and to a fixed cost of transferring one's wealth between liquid money and interest bearing assets The Pecking Order Theory In corporate finance, pecking order theory (or pecking order model) postulates that the cost of financing increases with asymmetric information. Financing comes from three sources, internal funds, debt and new equity. Companies prioritize their sources of financing, first preferring internal financing, and then debt, lastly raising equity as a last resort. Hence: internal financing is used first; when that is depleted, then debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required (equity would mean issuing shares which meant 'bringing external ownership' into the company). Thus, the form of debt a firm chooses can act as a signal of its need for external finance. The pecking order theory is popularized by Myers and Majluf (1984) when he argues that equity is a less preferred means to raise capital because when managers (who are assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think that the firm is overvalued and managers are taking advantage of this overvaluation. As a result, investors will place a lower value to the new equity issuance Determinants of Profitability A profitable firm is better able to withstand negative shocks and contribute to the stability of the financial system. The profitability of a firm is affected by numerous factors. These factors include elements internal to each firm and several important external forces shaping earnings performance. In Kenya, many firms are taking several measures to enhance profitability across the sectors. We have seen firms maximizing revenue growth to enhance profitability while other firms adopt a cost management strategy as revenue growth is not feasible in their industries due to several factors like competition, price regulations etc. It is therefore important to understand 11

21 the determinants of firm s profitability in Kenya. This is essentially important in the light of the above notable changes that always occur in the operating environment of the Kenyan firms. Across all industries, the determinants of profitability are well observed and explored as it is increasingly important to strengthen the foundations of domestic financial system as a way to buildup flexibility for capital flow volatility. In the past, researchers investigated the determinants of profitability of a firm. A good number of researchers considered only the firms characteristics, whereas others included the financial structure and macroeconomic factors as well. In all these studies, contributions had been made in determining the factors that shape the profitability of firms. More recent studies distinguish between managerial (internal) and environmental (external) factors that affect a firm s profitability. Literature has argued that the overall market structure and entry barriers constitute the main external force driving profits. Market structure (represented by regulatory conditions or concentration) is one of the external influences that affect bank profitability; others include trade interdependence, economic growth, inflation, market interest rates and ownership structure. The internal factors according to past studies include capital ratio, credit risk, productivity growth and size of the firm A number of other studies have examined firms profitability in an effort to isolate the factors that account for differences in profitability. Studies have linked firms earnings and various aspects of their operating performance to profitability. A second set of studies focused on the relationship between a firm s earnings performance and balance sheet structure and profitability. A third body of literature examined the impact of regulatory and macroeconomic factors on overall firms profitability. The main conclusion emerging from past studies is that internal factors explain a large proportion of firms profitability; nevertheless external factors have also had an impact on their profitability. Overall, operational efficiency is the major factor in determining performance across industries. Among the internal factors are the management controllable factors which are the firm s specific financial ratios representing cost efficiency, liquidity, asset quality, and capital adequacy. 12

22 2.4. Review of Empirical Studies Many researchers have studied working capital from different views and in different environments. It can therefore be deduced that there exists a significant relationship between performance of firms and working capital management. The following studies were very interesting and useful for this research: Smith and Begemann (1997) emphasized that those who promoted working capital theory shared that profitability and liquidity comprised the salient goals of working capital management. The problem arose because the maximization of the firm's returns could seriously threaten its liquidity, and the pursuit of liquidity had a tendency to dilute returns. This article evaluated the association between traditional and alternative working capital measures and return on investment (ROI), specifically in industrial firms listed on the Johannesburg Stock Exchange (JSE). The problem under investigation was to establish whether the more recently developed alternative working capital concepts showed improved association with return on investment to that of traditional working capital ratios or not. Results indicated that there were no significant differences amongst the years with respect to the independent variables. The results of their stepwise regression corroborated that total current liabilities divided by funds flow accounted for most of the variability in Return on Investment (ROI). The statistical test results showed that a traditional working capital leverage ratio, current liabilities divided by funds flow, displayed the greatest associations with return on investment. Well known liquidity concepts such as the current and quick ratios registered insignificant associations whilst only one of the newer working capital concepts, the comprehensive liquidity index, indicated significant associations with return on investment. All the above studies provide us a solid base and give us idea regarding working capital management and its components. They also give us the results and conclusions of those researches already conducted on the same area for different countries and environment from different aspects. Deloof (2003) discussed that most firms had a large amount of cash invested in working capital. It can therefore be expected that the way in which working capital is managed will have a significant impact on profitability of those firms. Using correlation and regression tests he found a significant negative relationship between gross operating income and the number of days accounts receivable, inventories and accounts payable of Belgian firms. On basis of these results 13

23 he suggested that managers could create value for their shareholders by reducing the number of days accounts receivable and inventories to a reasonable minimum. The negative relationship between accounts payable and profitability is consistent with the view that less profitable firms wait longer to pay their bills. Ghosh and Maji (2003)-in this paper made an attempt to examine the efficiency of working capital management of the Indian cement companies during to For measuring the efficiency of working capital management, performance, utilization, and overall efficiency indices were calculated instead of using some common working capital management ratios. Setting industry norms as target-efficiency levels of the individual firms, this paper also tested the speed of achieving that target level of efficiency by an individual firm during the period of study. Findings of the study indicated that the Indian Cement Industry as a whole did not perform remarkably well during this period. Shin and Soenen (1998) highlighted that efficient Working Capital Management (WCM) was very important for creating value for the shareholders. The way working capital was managed had a significant impact on both profitability and liquidity. The relationship between the length of Net Trading Cycle, corporate profitability and risk adjusted stock return was examined using correlation and regression analysis, by industry and capital intensity. They found a strong negative relationship between lengths of the firm s net trading cycle and its profitability. In addition, shorter net trade cycles were associated with higher risk adjusted stock returns. 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 profitability 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 cash conversion cycle was of more importance as a measure of liquidity than the current ratio that affects profitability. The size variable was found to have significant effect on profitability 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 profitability and liquidity indicators such as 14

24 current ratio and cash gap in the Saudi sample examined. Second, the study also revealed that there was great variation among industries with respect to the significant measure of liquidity. The effect of aggressive working capital policy on financial ratios was examined by Boisjoly (2009), who found that cash flow per share significantly improved due to aggressive management of working capital and that productivity increased. The relationship between profitability and working capital management for firms listed on the Athens Stock Exchange was examined by Lazaridis and Tryfonidis (2006). The results showed significant relationship between operational profitability and the cash conversion cycle, the results also showed that executives can increase profitability of their firms by correctly handling the individual components of working capital to an optimal level Chapter Summary Many financial analysts would speculate about performance of a firm using other measures that are not efficient. It is, however, no secret that to pick a solid performer when the market is slow or under attack takes a little more know-how. The cash conversion cycle can tell you how cash is moving through a company in terms of duration. This ratio is vital because the cycle represents the number of days a firm's cash remains tied up within the operations of the business In taking the time to find the cash conversion cycle, pay attention to the trend of its three general components with special emphasis on the payables processing period. Sometimes shorter processing periods for inventory and/or receivables can be largely offset by increases in the processing period for accounts payables. The processing period for accounts payables will increase if the firm is paying its creditors and suppliers at a slower rate. The main point to remember, however, is that an understanding of each of the three factors in the formula can help pinpoint the trend not only in the cash conversion cycle but also in the individual processing periods themselves, insights that can give both a synopsis of operational efficiency and the justification behind it. 15

25 CHAPTER THREE RESEARCH METHODOLOGY 3.1. Introduction This chapter covered in details the different methods that the researcher used to carry out the research and acquire data. The research design, target population, sample design, data collection procedure and data analysis method Research Design The main purpose of this research was to determine the relationship between firms cash conversion cycle and profitability of firms listed on the NSE. This is an empirical relationship study between cash conversion cycle and its effects on the firms performance of the NSE listed firms. The researcher used descriptive research design. This was deemed appropriate as it involved a depth of study of the relationship between CCC and the financial performance of companies listed in NSE which helped the researcher to describe the state of current affairs and assess the characteristics of the situation. The research was established for a period between This period was considered by the researcher to be adequate for establishing any relationship between CCC and the financial performance of the NSE listed firms Population of the study The population of this study comprised of all firms listed on the NSE. As at September 2013 there were 62 firms listed on the NSE. This statistic was received from NSE and the Capital Markets Authority (CMA) website. This was convenient due to the fact that financial statements of listed firms are readily available and reliable Sample Selection The sample size was at least one company from each of the twelve sectors listed on the NSE (Appendix 1). Convenient sampling technique was used to establish the relationship between CCC and financial performance of firms across all industries/ sector of the NSE and the data was easily accessible and reliable for listed firms. 16

26 3.5. Data Collection The research study mainly used secondary source of data. Data on CCC, WCM and financial performance measures e.g. profitability, quick ratio, debt to equity ratio etc. the secondary data was mainly acquired from NSE and CMA. The period covered by the study was extended to five years, starting from The researcher used mainly the audited statement of financial position and Income statement. The specific data collected during the five year period were the annual profit after tax, sales turnover, current assets, and current liabilities, fixed assets, accounts receivable, inventory and accounts payable as well as the financing aspects including the long term debt and equity for each year of the financial statements of the sampled firms Data Analysis Descriptive analysis was the first step in this analysis; it helped us describe the relevant aspects of CCC and provide detailed information about each relevant variable Variables Choice of variables was influenced by the previous studies on cash conversion cycle and working capital management. All the variables stated below were used to test the hypothesis of this study. They included dependent, independent and control variables. Return on Assets (ROA) of the firm was used as dependent variable. ACP was be used as an independent variable. AAI, APP, the current ratio and the CCC were used as a comprehensive measure of WCM was also used as an independent variable. In addition, size (natural logarithm of sales (LOS), debt ratio and the ratio of Fixed Assets Tangibility (FAT) were included as control variables. All above variables ultimately affect CCC and the WCM. It was expected that there is a negative relationship between ROA and one of the variables of CCC. This was consistent with the conclusions that the time lag between expenditure for the purchases of raw materials and the collection of sales of finished goods can be too long, and that decreasing this time lag increases profitability Regression model This study used panel data regression analysis of cross sectional and time series data. The pooled regression type of panel data analysis was used. The pooled regression is one where both intercepts and slopes are constant, where the cross section firm data and time series data are 17

27 pooled together in a single column assuming that there are no significant cross section temporal effects. The general form of the model was; ROAα= βο + βι X ї + ε, where ROA is Return on Assets at time t, βο, the intercept of equation, βι coefficient of X and X ї, the different independent variables highlighted above, t= time and ε is the error term. The study investigated the effect of cash conversion cycle [CCC] as a whole and also looked into the various components of CCC i.e.; Average Collection Period [ACP], Average Age of Inventory [AAI] and Average Collection Period [APP]. All the two regression models used three control variables namely leverage [LEV], Firm Size [SIZE] and Fixed Asset Structure [FAS] Specifically, when we converted the above general least squares model into our specified variables it became; Model 1 is as follows: ROA = βο + βι (ACP) + β 2 (AAI) + β 3 (APP) + β 4 (LEV) + β 5 (SIZE) + β 6 (FAS) + ε Model 2 is as follows: ROA = βο + βι (CCC) + β 2 (Leverage) + β 3 (LOS) + β 4 (FAS) + ε ROA= Return on Assets ACP= Account receivables *365/Sales AAI= Inventory *365/Cost of Sales APP = Accounts Payables *365/Cost of Sales CCC = AAI +ACP APP LEV = Total Debt / Total Assets FAS = Fixed Assets / Total Assets SIZE = Natural of logarithm of sales ε = Error term 18

28 CHAPTER FOUR DATA ANALYSIS AND PRESENTATION OF FINDINGS 4.1. Introduction This chapter shows the analysis, results and discussion of findings of the study as set out in chapter three. The Statistical Package for Social Sciences software was used and the findings were presented as descriptive statistics, correlation analysis and regression analysis. Data was collected from audited financials reports for the selected companies as set out in the appendices Data presentation Descriptive Analysis Table 1: Descriptive Return on Assets Average Collection Period Average Age of Inventory Average Payment Period Cash Conversion Cycle Leverage Firm Size Fixed Asset Structure Valid N (listwise) N Min Max Mean Std. Dev 45 (0.1923) ( ) Table 1 above shows that the average return on assets for the 45 observation made from 9 companies from the year 2008 to 2012 is 8.04% with a high standard deviation of 8.67% varying from a range of % to a maximum ROA of 27.62%. The average collection period is days (Std Dev. Almost 27 days) with maximum collection of 113 days and minimum of 21 days. The average age of inventory is almost 63 days (Std Dev. Almost 38 days) with maximum collection of days and minimum of almost 11 days. The average payment period is almost 19

29 107.6 days (Std Dev. Almost 78 days) with maximum collection of 323 days and minimum of almost 10 days. The average cash conversion cycle is almost 4.5 days (Std Dev. Almost 84 days) with maximum collection of 102 days and minimum of almost negative days. Leverage has the average of 0.15 (Std. Dev. Almost 0.13) varying from a range of 0 to a maximum of The average firm size as measured by the natural logarithm of sales is with a standard deviation of 1.07 varying from a range of to a maximum of in terms on natural log. Fixed asset structure has the average of 0.61 (Std. Dev. Almost 0.21) varying from a range of 0.13 to a maximum of Correlation Analysis Table 2: Pearson Correlation ROA ACP AAI APP CCC LEV Firm Size Fixed Asset Structure ROA Pearson Correlation *.625 ** ** Sig. (2-tailed) N ACP Pearson Correlation *.396 ** **.258 Sig. (2-tailed) N AAI Pearson Correlation..378 * * **.066 Sig. (2-tailed) N APP Pearson Correlation..625 ** ** ** Sig. (2-tailed) N CCC Pearson Correlation **.322 *.323 * ** * * Sig. (2-tailed) N Leverage Pearson Correlation ** **.592 ** Sig. (2-tailed) N Firm Size Pearson Correlation ** ** * ** ** Fixed Asset Structure Sig. (2-tailed) N Pearson Correlation ** *.592 ** ** 1 Sig. (2-tailed) N **. Correlation is significant at the 0.05 level (2-tailed). *. Correlation is significant at the 0.01 level (2-tailed). 20