City University Research Journal Fayaz et al.

Volume 03 Number 01 June 2012 Article XX

Impact of Working Capital Management on Profitability: tries to generate positive cash flows. Because the positive cash flows consider just like
A Case of Pakistan Textile Industry. blood in human body. Laughim (1998) found that cash conversion cycle is the prime tool
used to measure the financial performance of the companies. Besley (2005) explained that
Fayaz Ali Shah and Wajid Khan cash conversion cycle is the time involved from purchasing the raw material, convert them
ABSTRACT into finished goods and receiving the cash from credit sales.
To be successful in short run, management of working capital was significantly important The company's success and cash management depend on the creditors trust on the business
for firms. Improper management of working capital negatively affects the firm profitability. because the creditor are the prime loan provider to the business. It is in the best interest of
Optimum level of working capital can maximize firm value and ultimately profits. The the company to deal skillfully with both of the company suppliers and creditors. Delay
current study was taken to examine the impact of working capital and its components on payment can cause the firm to lose its credit worthiness. Companies try to maximize the
return the assets of Pakistan Textile Industry. Return on assets was used as a proxy for firm sale figure and to ensure not to tie the scarce funds in inventories. Often the wholesalers
profitability. For this purpose annual data of 46 listed companies were taken from textile enjoy the credit sale to know about the product feature and benefit before paying for it
industry as a sample for a period of (2003 -2009). (Jegers & Deloof, 1996). The delaying of payment seriously harms profitability and
For the quantification relationship of return on assets was taken as a dependant variable reduces the potential discount benefit. There is direct relationship between the cash
and number of day's account receivable, number of day's inventory, number of day's conversion cycle and profitability. The shorter the collection period, the higher will be
account payable and cash conversion cycle were taken as independent variables. The data company profitability. Further, it reduces risk of default. Often firms employ lenient credit
was in panel form therefore, the ordinary least square method was used. The results revel policy to increase the sale which ultimately cause to decrease the days of receivables
that all the independent variables, number of day's account receivable, number of day's conversion into cash. Therefore, companies try to reduce the cash conversion cycle to
inventory, number of day's account payable and cash conversion cycle negatively affected increase the overall profitability.
the dependant variable return on assets. Thus, it was concluded that shorten the period Financial management literature primarily focuses on capital investment and efficient
from sales to cash receipt, high the firm's ability to generate profits. utilization of resources in the context of risk return trade off. Investments in current assets
are carefully examined by firm's corporate body due to the fact that it directly affects
Key Words: Working capital, Textile industry, Profitability, Panel data, Regrission, operations. The current study aims to examine the impact of working capital components
OLS method, Optimum level and Correlation. on profitability of textile firms. This study will assist the investors in their investment
decision in the textile industry. Further, it will also assist corporate managers in capital
INTRODUCTION structure decisions and to quantify and analyze the impact of various investor combinations
Working capital management is concerned with the firm current assets management of financial resources on return on assets.
decision. The shareholders hire professional personnel to determine the resource allocation
to working capital. The current assets consist of inventories, cash and cash equivalent.
OBJECTIVE OF THE STUDY
Firms are struggling to compete for scarce resources in short run. They need huge amount to
?To know about the changes in cash conversion cycle and its impact on firm’s
invest in working capital. To avail the short term benefits associated with timely decline in
profitability of Pakistan textile industry.
the raw materials prices and to undertake other investment opportunities available in the
?To help investors to effectively manage their financial resources in short run.
capital market. The corporate finance literature outline the importance of working capital
and explained that working capital and liquidity are directly related with firm
LITERATURE REVIEW
profitability.(Nasir, 2007) examined the equity market of Pakistan and found out that firms
(Delop M, 2003) found a significant negative relationship between operating income and
having more liquid investments were more profitable than those having less liquid
investments. Their finding confirmed that current assets consist of about three fourth of all number of days account receivables , number of days inventory and number of days account
the firm’s assets. On the other hand, firms that have low liquidity facing high risk. The payable by studying 1009 Belgium firms for a period of (1992-1996). (Nasir, 2007)
stakeholders receive dividend and retain profit for speculative and precautionary motives. examined the profitability of Pakistani firms in short run. According to their study most of
If working capital is not managed properly then firm will not only lose their economic the company's investments are in current assets. Because working capital has a direct
resources in short run but also their long run success become uncertain and probably no impact on overall profitability of Pakistani firms. Using the panel data and employing the
dividend payments to stockholders. Therefore, firm's value is directly related with optimal Ordinary Least Square methods, they found a negative relationship between profitability
and efficient use of working capital. The managers are trying to bring the trade off between and cash conversion cycle, receivables turnover, inventory turnover and number of days
the liquidity and profitability for effective unitization of working capital. Every business account payable. Further, they explained that managers can create value for their

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Impact of working capital management Fayaz et al.

shareholders by reducing the receivables turnover, inventory turnover and cash conversion Sample Size:
cycle. The negative relationship between accounts payable and profitability indicates that A sample size 46 firms was taken from 187 listed textile firms. Textile industry is one of the
delaying payments reduces firm’s value. The studies of Schwartz (1974) and Deloop &
paramount revenue generating sector and also provides thousands of job opportunities to a
Jegers (1996) explained that high profits increase firm’s ability to lend more money to its
customers and low profitability reduces allocation of cash to account receivables. Pedro, skillful labor of our country (15 million workers were employed by the textile sector. It
(2007) examined that working capital is highly important for low capital companies. Short contributes 8.5% to GDP. The textile sector contributes about 53% of our total exports in
term investments are the prime source of generating profits for companies that have low 2010. The companies that were selected as sample have significant contribution to the
capitalization. They further explained that working capital components directly affect the industry and all relevant financial information is available for the seven years. The present
return on assets. They concluded that timely investment in current assets increases firm's study was carried to assist the investors to know the financial performance of textile
profitability. Loannis, (2006) examined gross profit and cash conversion cycle of different industry and quantitatively make their investment decisions. For the last few decades a lot
firms. The study confirmed that corporate body is interested in firms operating profit and
of research has been done in the same area with the objective to provide such a plate-form
found a significant negative relationship between operating profit and cash conversion
cycle. It was added that managers can further enhance the overall value of the firm by that enables investors to earn maximum returns, while lowers their risks associated with
keeping the cash conversion cycle and its components at optimal level. Afza, (2008) their investment. Pakistan remained fourth among the top eight textile exporting countries
examined 268 public limited companies listed in Karachi Stock Exchange. Employing the of the world and a member of a world club of textile exporters. Pakistan textile exports
regression analysis and descriptive statistics, their findings conclude that there is reached to US$ 10 billion in fiscal year 2009. Some of the big players from Pakistan which
significant difference in industries investment in current assets and financing decisions. are also a part of the sample used in the study play a major role in the export of textile
The same effect remained constant for six year by using the rank order correlation. products to all part of the world including Europe, Far East, Gulf Countries and America.
RESEARCH METHODOLOGY
They are Indus Dying and Manufacturing Company, Ata Textile Mills Limited, Fazal
This section provides deep inside to the sample, variable and methodology applied to
outline the finding of the study. Textile Mills, J A Textile Mills, Nishat Textile and Sppining Mills, J K. Spinning Mills,
Generally most of the working capital management theories predict negative or positive Artistic Denim Mills and Sapphire Textile Mills.
relationship between cash conversion cycle and its components which conclude that when Regression Model:
the probability becomes high returns and risk of the financial distress are also high. The Regression is used to predict the values of quantitative outcome variable using several other
current study was carried to test empirically the impact of working capital on return of predicative variables. Simple regression shows the collective effect of independent
assets of Pakistan Textile Industry. For this purpose 46 listed companies were taken from variables on the dependent variable.
textile industry as a sample for the period of (2003 -2009). Annual data was used in this
study. Data were collected from karachi Stock Exchange and annual financial statements of ROA it =b o+b 1 NODAR it +b 3 NO DIit +b 2 NO DAP it +b4 CCCit +e
it

the companies i.e. balance sheet analysis published by State Bank of Pakistan. W he re
B o= I nte rce pt
Table 1. Variable, Abbreviation and Measurement B i = Co-e ffic ie nts of Pr edictor s
th th
ROA it = Return on a sset of the i f ir m for the t time period
Variables Abbreviations Measurement NODAR it = Number of da y’ s a ccount receiva ble of the i th f ir m for the t th time perio d
th th
NODIit = Number of da y’s inventor y of the i fir m for the t time period
Return on assets ROA Return on assets was calculated earnings
NODAP it = Number of da y’ s a ccount paya ble of the i th f irm fo r the t th time period
before taxes as percentage of total th th
CCC it = Ca sh c onversion c yc le of the i f ir m for the t time period
assets .
eit = Error term.
Number of day’s account NODAR. Account receivable in days was
receivable calculated by receivables divided b y RESULTS AND DISCUSSION
credit sales and m ultiplyin g by 365
This section explained the impact and magnitude of working capital management on return
days .
Number of day’s invento ry NODI. Average inventory was divided by cost on assets of textile industry in Pakistan.
of goods sold and multiplying by 365
days . Descriptive Statistics:
Number of day’s account NODAP To calculate, NODAP, the account The empirically analysis of textile sector consists of, means, standard deviation, skewness
payable payable was divided by purchase and
and kurtosis of all variables. The results confirmed that there is abnormal variation between
multiplying by 365 days.
. means and standard deviation of all variables used in this study. The following table 2
Cash conversion cycle CCC The cash conversion cycle was indicates the Descriptive statistics:
calculated by account receiv ables in
days plus inventor y turnover in days
minus account payable in days.

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Impact of working capital management Fayaz et al.

Table 2. Descriptive Statistics Significance of the coefficients:

Mean St andard
The t-statistics shows the individual coefficient is significance and p value shows the exact
Statis tics Minim um Maxi mum Count level of significance if individual slop coefficient significance. The t-value of number of
Devi at ion
days account receivable is -.869 and p value is .000 show that of number of days account
ROA. 61.4289 385.43656 -100.00 2597.10 322
receivable is statistically significant and negative sign explains that one time decrease in
322 number of days account receivable bring a .869 increase in the dependent variable i.e. return
NODAR. 37.4652 74.26198 .00 1235.10
on assets . The t-value of number of days inventory is -.468 and p value is .051 which show
NODI. -2.8488 40.49511 -333.30 212.20 322 that number of days inventory is significant and indicating that shortening the inventory
322 turnover increases firm is profitability. The t-value of number of days account payable is -
NODAP. 23.2503 111.29283 -70.67 607.00
3.982 and p value is .000 shows that the variable is statistically insignificant and indicating
CCC . 107.4773 149.27986 .70 870.50 322 that delaying payments increase firm profitability. The t-value of cash conversion cycle is -
.278 and p-value is .000 show that the cash flow ratio is statistically significant. The above
The mean value of ROA is 61.42, and standard deviation of 385.43 the difference is significance negative slop coefficients confirm the findings of (Delop, 2003).
abnormal. The difference between the means and standard deviation of NODAR is 36.79
which is also abnormal. The mean of NODI is -2.84 and standard deviation is 40.49 Diagnostics of Regression model:
showing a difference of 38.01 which is abnormal. Also the mean of NODAP is 23.25 and Table 5. Key results of diagnostic statistics
standard deviation is 111.29 which is also abnormal. Means and standard deviation of CCC
Statis tics V alues
is 107.47, 149.27 respectively, which show a difference of 41.80 which is also abnormal.
R-sq uared. .9 2 0
Correlation Matrix: The correlation is presented in the following table. Ad ju sted R -sq uared . .9 1 8
Table 3. Correlation Matrix Pro b (F-s tatistic). 0.0 00
ROA NODAR NODI NODAP CCC. O bserv ati on . 3 22
ROA 1.000
NODAR -.087 1.000
Diagnostics statistics confirmed the correlation coefficient results. The empirical finding
NODI -.028 -.036 1.000 showed that all the independent variables are responsible for the overall change of 92.0% in
NODAP -.490 -.084 .075 1.000 the dependant variable i.e. Return on assets. The significance of F-statistics value confirms
that model is good predicator of explaining the impact of all independent variables on
CCC. -.094 -.089 .070 -.011 1.000 dependent variable.
CONCLUSION
The relationship among variables was checked through pair-wise correlation. The From the results we conclude that working capital management represents a firm is financial
coefficient value of less than 0.80 shows that variables was not strongly correlated and no position in terms of liquidity and profitability. We conclude that proper allocation of firms
multicollinearity was found. current resources positively affect the company growth. Conversely low investment in
current assets responds negatively to company value creation and also raise the demand for
Regression Results: The detailed results of estimated parameters and other relevant credit. From the empirical finding we conclude that all the independent variables (cash
information are shown in the following table. conversion cycle, receivables turnover, inventory turnover, payable in days) have
Table 4. Results of Regression significant negative impact on dependent variable i.e. return on assets.
Variables Coefficient Std. Error t-Statistic Prob. The analysis also confirmed that cash conversion cycle has negatively associated with return
Intercept 8.978 12.469 .720 .472 on assets which means that the company have timely availability of cash and cash equivalent
NODAR -.869 .104 -8.391 .000 and can achieve the benefits of discount by making early payments. Our findings is with
NODI -.468 .238 -1.962 .051 perfect conformity with the finding of (Shine et al,1998) they studied the American firms
NODAP -3.982 .082 -48.800 .000 for a period of 1975-1994 and found a significant negative relationship between cash
CCC -.278 .069 -4.051 .000 conversion cycle and firm profitability. The finding suggests that the managers should run
the business carefully and properly manage current resources. We found that if shorten the

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Impact of working capital management Fayaz et al.

period, to receive payments from customers on due dates, receivables turnover can Shin, H.H., and L. Soenen, (1998). “Efficiency of Working Capital and Corporate
positively contributes in overall firms value maximization. If the company is not able to Profitability”, Financial Practice and Education 8 (2), 37-45
receive payment on due date, then it harms its effectiveness and efficiency because they will
wait for a longer period of time to pay its bills. Also they will not be able to take the
advantage of discount on early payments. Negative significant relationship between Fayaz Ali Shah: Lecturer at the Department of Management Studies, University of
Malakand. Ph.D Scholar at the University of Technology Malaysia. Area of interest:
inventory turnover in days and return on assets indicating that lesser the time involve in Human Resource Management.
turning of inventory into sales, high the earning before interest and payments. e-mail:

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