Actors Influencing Corporate Working Capital Management Essay Example

Actors Influencing Corporate Working Capital Management Essay The main purpose of this study is to explore factors that influence working capital management by non-financial companies listed on Abu Dhabi Securities Exchange. The cash conversion cycle is used to proxy working capital management where short cycle implies effective management. Six factors frequently employed in previous research were used to explain variations in cash conversion cycle. The factors included industry type, sales growth, operating cash flows, return on equity, leverage and size. The latest annual reports for all non-financial companies listed on Abu Dhabi Securities Exchange and operate in the UAE were used to achieve the purpose of the study. The result of the analysis revealed that the effectiveness of working capital management of the companies covered in the study are influenced by sales growth, size and the level of corporate leverage. INTRODUCTION Working capital is a financial measure used to assess corporate liquidity. Reasonable working capital should be available to any firm to ensure that it has sufficient funds to cover its short-term obligations and to pay for future operating expenses. This guarantees the continuity of the firm’s operations. In fact, it is possible to see a profitable firm forced out of business due to inability to meet its short- term obligations when they fall due. It is therefore vital for any firm to manage its working capital successfully to ensure continuity. We will write a custom essay sample on Actors Influencing Corporate Working Capital Management specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on Actors Influencing Corporate Working Capital Management specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on Actors Influencing Corporate Working Capital Management specifically for you FOR ONLY $16.38 $13.9/page Hire Writer In the last few years, several studies have been undertaken to investigate factors affecting corporate working capital. Most of the studies examined the relationship between corporate working capital and profitability (see for example: Hayajneh and Yassine, 2011; Sabri, 2012; Gill et al. , 2010; Dong and Su, 2010; Boisjoly, 2009; Falope and Ajilore, 2009; Mathuva, 2009; SEN and ORUC, 2009; Uyar, 2009; Samilogu and Demirgunes, 2008; Teruel and Solano, 2007; Raheman and Nasr, 2007; Lazaridis and Tryfonidis, 2006; Padachi, 2006; Eljelly, 2004; Deloof, 2003; Shin and Soenen, 1998; Jose et al. 1996). Other studies, attempted to establish a relationship between the efficiency of working capital management and a number of corporate attributes. In this respect, Charlton et al. (2002) examined the relationship between the industry type and liquidity of the corporation and working capital management. Jeng-Ren et al. (2006) studied the relationship between working capital management and a numbe r of firm’s attributes such as size, industry type, leverage position and growth. Moss and Stine (1993) explored the relationship between firm’s working capital management and its size. It is evident that the focus of most of previous studies undertaken to examine factors that influence working capital was on profitability with few studies employing corporate attributes such as size, growth, leverage and industry type to explain level of efficiency of working capital management. In the current study, an attempt will be made to test all these ? Any views or opinions expressed in this manuscript are those of the authors and do not necessarily reflect the position of their employers, the editor or the publisher 1 Financial and Economic Advisor- Kuwait Fund. 2 Freelance Financial Analyst 3 Economic Advisor- Kuwait Fund 2 4 Freelance Financial Analyst 2011. Sales growth was calculated between the fiscal years 2010 and 2011 except Data covered the fiscal year 3 Economic Advisor- Kuwait Fund Copyright  © 2012 Journal of Contemporary Issues in Business Research (JCIBR) All Rights Reserve Page No. 1 Journal of Contemporary Issues in Business Research factors. So far, no attempt has been made to examine the relationship between working capital management and firm’s attributes of companies listed on Abu Dhabi Securities Exchange (ADX). ADX was established in 15th November 2000 to trade shares of companies operating in the United Arab Emirates (UAE). Hence, ADX is considered to be one of the youngest stock exchanges in the r egion. At the end of 2011, the number of listed companies on the KSE reached 69. On 6 September 2011, market capitalization of the companies listed on the market reached AED 212. 4 billion (USD $58. 20 billion). Examining the relationship between working capital management and profitability of companies listed on ADX is, therefore, important and expected to add a new dimension to the literature, since most of the companies operating in UAE do not face liquidity problems. In previous research, the focus of working capital management was on how to secure enough liquidity to meet forms of short-term obligations. In a small country, like the UAE with large oil revenues, the focus of working capital management will be on how to make use of the surplus of liquidity. The remainder of the paper is organized as follows. The following section will provide a brief explanation to working capital management. Section three reviews recent studies about the relationship between corporate working capital management and firm’s attributes. Study methodology is explained in section four. The findings are discussed in section five, with the conclusion offered in the last section. WORKING CAPITAL MANAGEMENT Working capital is the difference between current assets and current liabilities. Working capital management involves managing cash, receivables, inventories and payables. In cash management, the firm ensures that cash is available to meet its running expenses and reduces the cost of cash holding. Receivables management involves adopting proper credit policy to the firm’s customers. Proper credit policy is expected to attract customers and boost sales. Although such a policy would have a positive impact on profit and return on capital, it affects the firm’s cash flows. Hence, corporate management needs to strike a balance between boosting sales and securing necessary cash flows. Inventories management is achieved by maintaining a certain level of inventory that allows the flow of production and reduces the cost of raw materials. This is expected to minimize ordering costs, lower time lead in production and work in progress, keep finished goods at the lowest level possible and avoid over production and storage costs. All of this would result in an increase in cash flow. On the other hand, firms manage payables though identifying a proper source of financing. Inventories are ideally financed by credit secured from suppliers. In some cases, the firm might need to secure a bank loan to pay for inventories by using overdrafts or by factoring receivables through converting them into cash. Related Studies and Hypotheses Development Different variables have been employed in the literature to explain the efficiency of working capital management. However, most of the studies attempted to establish a relationship between working capital management measured by cash conversion cycle (CCC) and profitability by using various measures. Other studies employed firm’s attributes such as size, industry type, operating cash flow, sales growth, and debt ratio. Studies employed any of these variables will be reviewed. Profitability. As mentioned earlier, most of the studies used to explain the level of efficiency of working capital management focused on profitability as an important factor. It is argued that efficient working capital management results in low CCC and this would lead to speedy availability of cash flows and, hence, better profitability. In this respect, Jose et al. 1996) Copyright  © 2012 Journal of Contemporary Issues in Business Research (JCIBR) All Rights Reserve Page No. 12 Journal of Contemporary Issues in Business Research looked at the relationship between profitability and working capital management by using return on assets (ROA) and return on equity (ROE) as proxies of profitability and CCC as a proxy of working capital management. The researchers conducted the analysis according to the industry type of the corporations. They reported a negative relationship between CCC and ROA across all industries. That is to say, high profitability results in low cash conversion cycle. However, a negative relationship was reported between CCC and ROE only in the services and retail/ whole sale industries. The researchers indicated that other factors such as corporate competitive position, capital intensity, production process, product durability and marketing channels might determine the relationship between CCC and ROE. Shin and Soenen (1998) tested the relationship between the firm’s efficiency of working capital measured by the net trade cycle and profitability measured by ROA and return on sales (ROS). They found a negative significant relationship between the efficiency of working capital management and profitability. Similarly, Yung-Jang (2002) collected data from Japan and Taiwan and employed CCC as an indicator on working capital management and ROA and ROE as measures of profitability (performance). He concluded that the relationship between CCC and each of ROA and ROE is commonly negative and sensitive to the type of the industry for Japanese and Taiwanese companies included in his study. In the same way, Deloof (2003) examined the relationship between working capital management measured by CCC and profitability measured by gross operating income. He reported negative and significant relationships between the number of days of each of the components of the CCC (receivables, inventories and payable) and profitability. However, a negative but not significant relationship between CCC and profitability was identified in the sample companies. He, therefore, concluded that profitability can be improved by reducing the number of days f collecting receivables and number of days of holding inventories. In a similar line of research, Eljelly (2004) looked at the relationship between working capital management and profitability in a sample of Saudi companies operating in three sectors of the economy (agriculture, manufacturing and services). He used the current ratio and CCC as measures of liquidity and used net operating income plus depreciation divided by net sales as a measur e of corporate profitability. He noticed variations in CCC among industries covered in the study. He also noticed that corporate size, represented by net sales and total assets, together with CCC affect the profitability of capital-intensive (agricultural and industrial companies) more than the profitability of labor-intensive (services companies). He concluded that shorter CCC is related to higher profitability. He also observed that the relationship between working capital management and profitability was stable over the period of study. Lazaridis and Tryfonidis (2006) looked into the relationship between working capital management and profitability in a sample of companies listed on Athens Stock Exchange. They related each of the CCC components with corporate profitability measured by gross operating profit [(sales cost of sales)/ (total assets financial assets)]. They noticed a negative significant relationship exists between corporate profitability and receivables, payables and CCC days. The relation was also negative with inventories days but insignificant. They explained the negative relation between the holding period for accounts payable and profitability on the grounds that less profitable firms may take advantage of credit period granted by suppliers and wait longer before paying their bills. They also reveal a positive relationship between corporate size measured by sales and profitability and corporate profitability decreases as the financial debt ratio increases. They concluded that managers are likely to improve their profit by efficiently handling their CCC through maintaining receivables, inventories and payables days at an optimal level. Teruel and Solano (2007) also tested the relationship between corporate working capital management measured by number of days receivables, inventories, payables and CCC Copyright  © 2012 Journal of Contemporary Issues in Business Research (JCIBR) All Rights Reserve Page No. 3 Journal of Contemporary Issues in Business Research and profit measured by ROA in a sample of small and medium sized Spanish companies. They observed a negative significant relationship between profitability and each of the working capital management variables. They concluded that managers can create value by speeding up collection of receivables and reduci ng the days of holding inventories. They also concluded that shortening the cash conversion cycle improves corporate profitability. Raheman and Naser (2007) conducted similar research on a sample of Pakistani companies. The working capital management variables used by Teruel and Solano (2007) were employed and they replaced ROA with net operating profit as a proxy of profitability. They reported a strong negative relationship between variables of the working capital management and corporate profitability and managers can create a positive value for the shareholders by reducing the cash conversion cycle to a minimum level. They also reported a positive relationship between corporate size and its profitability and a significant negative relationship between corporate debt and its profitability. Samilogu and Demirgunes (2008) investigated the effect of working capital management measured by CCC and its components and corporate profitability measured by ROA in a sample of companies listed on Istanbul Stock Exchange. They observed that while receivables period, inventories period, and leverage negatively affect corporate profitability, corporate growth measured by growth in sales positively affect profitability. SEN and ORUC (2009) attempted to determine the relationship between the efficiency of corporate working capital management and profitability in a sample of companies listed on Istanbul Stock Exchange. The researcher employed several variables to proxy working capital management: CCC, net liquid balance, current ratio, receivables period and inventory periods. He used return on assets as a measure of profitability. He reported negative significant relationship between all variables used to proxy working capital management and profitability. The result was consistent among all companies included in the study and across sectors. Uyar (2009) considered the relationship between corporate CCC and profitability measured by ROA and ROE in a sample of companies listed on Istanbul Stock Exchange. He found significant negative relation between the two variables. Dong and Su (2010) studied the relationship between working capital management measured through CCC and its components and profitability measured by gross operating profit in a sample of companies listed on Vietnam Stock Exchange. They presented negative significant relationship between the two variables. Gill et al. (2010) examined the relationship between working capital management measured by CCC and profitability measured by gross operating profit in a sample of American companies listed on New York Exchange. They concluded that management can create profit by correctly handling CCC and maintaining receivables at an optimal level. Rimo and Panbunyuen (2010) looked into corporate characteristics that affect working capital management in a sample of companies listed on NASDAQ OMX Stockholm Exchange. They reported that corporate profitability is affected by CCC. On the other hand, Rimo and Panbunyuen (2010) reported positive relationship between CCC and profitability measured by ROA in a sample of companies listed on NASDAQ OMX Stockholm Exchange. The researchers concluded that the surveyed companies have â€Å"less effective working capital management†. Hayajneh and Yassine (2011) investigated the relationship between working capital efficiency and profitability in a sample of 53 manufacturing companies listed on Amman Exchange Market. They reported a negative and significant relationship between profitability and each of average receivable collection period, average conversion inventory period and average payment period, and cash conversion cycle. Copyright  © 2012 Journal of Contemporary Issues in Business Research (JCIBR) All Rights Reserve Page No. 14 Journal of Contemporary Issues in Business Research Al-Mwalla (2012) examined the impact of working capital management policies on the firms’ profitability and value in a sample of 57 industrial companies on Amman Stocks Market for the period of 2001 to 2009. The researcher concluded a conservative investment policy has a positive impact on the sampled companies profitability. It is therefore hypothesized that: ? Hypothesis 1: Working capital management is related to firm’s profitability. Size. Few studies were undertaken to examine the relationship between corporate working capital management and corporate size. It is argued that corporate size influences corporate working capital management since large size companies have more bargaining power over customers (receivables) and suppliers (payables) than small size companies. A large company can negotiate with its supplier credit terms including large quantity discounts and long time payment terms. In addition, large firms are usually well established and have higher inventory turnover than small firms. In this respect, Moss and Stine (1993) studied the relationship between corporate size, measured by net sales and total assets, and CCC in a sample of retail companies. They noticed that large size companies tend to have shorter CCC than small size companies. They also noticed that small size companies have longer receivables, inventories and payable periods than small size companies. This led them to conclude that large size firms have better working capital management than small firms. They advised small size companies to improve their working capital management by handling their receivables and inventories. In a similar line of research, Jose et al. (1996) looked at the relationship between corporate working capital management measured by CCC and its size measured by sales. They reported negative relationship between the two variables in five out seven sectors covered in their study. However, Jeng-Ren et al. (2006) explored the relationship between net liquid balance and corporate size. They observed positive relationship between the two variables. The outcome of their study implied that large size companies tend to produce more net liquid balance than small size companies. Uyar (2010) examined the relationship between working capital management measured by CCC and corporate size in a sample of companies listed on Istanbul Stock Exchange. He observed a negative significant relation between working capital management and corporate size. Rimo and Panbunyuen (2010) explored the relationship between CCC and corporate size measured by total assets. They a reported negative relationship between the two variables. They concluded that working capital management is more effective with the large size companies surveyed in their study. It is therefore hypothesized that: ? Hypothesis 2: Working capital management is related to firm’s size. Industry. Companies operating in different sectors tend to have different capital structures, different operations, different products, different markets, different customers and different credit policies. All of these factors impact corporate working capital management. Therefore, it is fair to say that working capital management is influenced by industry type. This relation has been empirically tested by Jose et al. 1996) who compared the CCC among seven sectors and noticed that construction companies tend to have the highest CCC, while manufacturing companies reported the lowest CCC. Hyun-Han and Soenen (1998) examined the relationship between working capital management and industry type in a sample of companies operating in eight sectors. They found the agricultural companies to have short receivable periods and the oil and gas extraction, and communication companies to have a short inventory periods Copyright  © 2012 Journal of Contemporary Issues in Business Research (JCIBR) All Rights Reserve Page No. 15 Journal of Contemporary Issues in Business Research due to low levels of inventory that they maintain over the time. Lancaster and Stevens (1999) looked into the relationship between earnings and cash flows under different industries. They concluded that industry impacts the relationship between cash flows. Charlton et al. (2002) noticed high investment sensitivity to cash flows in three out of seven industries covered in the study (construction, natural resources and retail/ whole sales industries). Yung-Jang (2002) explored variations in the CCC of Japanese and Taiwanese companies among different industries. He observed that while Japanese companies operating in food industry have on average the shortest CCC, services companies showed the longest CCC. On the Taiwanese side, transportation companies achieved in average the shortest CCC, while construction companies have the longest CCC. In the same token, Teruel and Solano (2007) classified small and medium sized companies into eight industries and examined their CCC. They showed that the services companies have the shortest CCC, while the manufacturing and agricultural companies have the longest CCC. Rimo and Panbunyuen (2010) revealed significant positive relationship between CCC and industry type in four out of the eight industries covered in their survey. It is therefore hypothesized that: ? Hypothesis 3: Working capital management is related to the industry type of the firm. Operating cash flows. A limited number of studies investigated the relationship between cash flows and working capital management. Operating cash flows give indication about corporate ability to generate working capital through management policies in handling receivables, inventories and payables. Since short CCC is expected to result in positive operating cash flows, this gives indication about working capital management. In this regards, Moss and Stein (1993) reported negative relationship between CCC and cash flows measured by cash flows/ total assets. This indicates that companies with short CCC tend to have more cash flows than companies with long CCC. Jeng-Ren et al. (2006) studied the relationship between working capital management measured by net liquid balance and operating cash flow and found significant relationship between them. This implies that companies reporting high operating cash flows have high net liquid balance. This can be viewed as indication on working capital management. Rimo and Panbunyuen (2010) examined the relationship between CCC and operating cash flow in a sample of Swedish companies. They observed inverse relationship between the two variables indicating efficient working capital management of the surveyed companies. It is therefore hypothesized that: ? Hypothesis 4: Working capital management is related to firm’s cash flows. Sales growth. Sales growth is the percentage change in sales from one year to another. Companies experiencing high sales growth rate need to have efficient working capital management to finance such growth. In this context, Kim et al. (1998) showed positive significant relationship between corporate growth rate and liquidity in a sample of American industrial companies. They concluded that companies with potential future growth tend to produce and maintain a certain level of liquidity. Likewise, Opler et al. (1999) demonstrated that companies experiencing growth opportunities and have risky cash flows tend to maintain high cash holdings (cash/ non-cash asset). On the other hand, Jeng-Ren et al. 2006) studies the relationship between corporate age, as a proxy of corporate growth, and net liquid balance and pointed to a positive significant relationship between them. They explained their results on the grounds that well established companies with moderate growth opportunities tend to Copyright  © 2012 Journal of Contemporary Issues in Business Research (JCIBR) All Rig hts Reserve Page No. 16 Journal of Contemporary Issues in Business Research generate more working capital than newly established companies. Rimo and Panbunyuen (2010) tested the relationship between CCC and sales growth in a sample of Swedish companies. They noticed a negative relationship between the two variables. They concluded that the surveyed companies are efficient in managing their working capital. It is therefore hypothesized that: ? Hypothesis 5: Working capital management is related to the firm’s sales growth. Leverage/ Gearing. The leverage/gearing ratio reflects the percentage of corporate assets financed by liabilities. Low leverage ratio may indicate that the company generates high cash flows to finance future expansion (expansion can be also financed by additional shares issues). Contrary to this, a company reporting high leverage ratio may indicate that this companies generates low cash flows to finance its expansion. Hence, it relies on outside borrowings. In this frame, Jeng-Ren et al. (2006) reported a negative significant relationship between debt ratio and working capital management measured by net liquid balance. The result implies that when a company has low net working capital, it looks for external sources of funds to finance its activities. This would result in high leverage ratio. Rimo and Panbunyuen (2010) looked into the relationship between CCC and debt ratio. The result of their analysis pointed to a positive relationship between CCC and debt ratio. The result indicates that increase in CCC period results in increase in the debt ratio. It is therefore hypothesized that: ? Hypothesis 6: Working capital management is negatively related to firm’s level of leverage. Data collection and study approach. To provide testing for the hypotheses developed above, the annual reports of companies listed on Abu Dhabi Securities Exchange were used. The website of ADX contains detailed information about all listed companies. On 31 December 2011, 69 companies were listed on ADX. By excluding two non-national companies, Qatar Telecom and Sudan Telecommunication Co. Ltd. , number of companies will be reduced to 67. These companies are divided into the following sectors: Insurance- 17, Banks- 14, manufacturing13, services- 7, consumer staples- 5, Investment and financial services- 6, real estate- 4, energy- 2, and telecommunications- 1. Since it was difficult to identify working capital components of companies operating in the banking, insurance and investment and financial services sectors, these sectors were excluded from the current study. Details of sectors and companies covered in the current study are summarized in table 1. The annual reports for the fiscal years 2010- 2011 of all these companies were used in the current study4. List of the companies’ names, symbol, industry type, incorporation and listing dates are given in Table 2. The data were entered into an SPSS file in order to identify the relationship between working capital management represented by the cash conversion cycle and firms profitability, size, industry, cash flows, sales growth and leverage. The relationship between working capital management and firm’s attributes are presented in the following regression model. CCCx = ? 0 + ? 1PROF + ? 2SIZE + ? 3INDS + ? 4OCFL + ? 5SGRW + ? 6LEVE + ? 4 Data covered the fiscal year 2011. Sales growth was calculated between the fiscal years 2010 and 2011 except for Eshraq properties Co. where income statement data were not available for 2011. Hence, 2010 data were used. Copyright  © 2012 Journal of Contemporary Issues in Business Research (JCIBR) All Rights Reserve Page No. 17 Journal of Contemporary Issues in Business Research Where: CCCx = Cash Conversion Cycle = Inventory days + Accounts Receivables days – Accounts Payable days ? 0 = Intercept PROF = profit measured by return on equity (Net profit/ Equity) SIZE = Size measure by total assets INDS = Industry type: 1 Services, 2 Manufacturing, 3 Consumer Stables, 4 Real Estates, 5 Energy, 6 Communication. OCFL = Operating cash flows and operating cash flows to total assets ratio SGRW = Sales growth = Sales(x) – Sales(x-1)/ Sales(x-1) LEVE = Leverage = [Total Liabilities- Accounts Payable]/ Total Assets ? Standard Error ? 1- ? 6 = Parameters of the model [Tables 1 and 2 about here] FINDINGS Descriptive Statistics As discussed in the regression model, six explanatory variables heavily documented in the literature were used to explain working capital management in all non-financial companies listed on Abu Dhabi Securities Exchange. Table 3 provides descriptive statistics about the independent a nd explanatory variables employed in the current study. [Table 3 about here] It can be observed from table 3 that the cash conversion cycle of the companies covered in the study varies among companies. This is reflected by the mean, standard deviation and the minimum and maximum amounts. Similarly, sales growth varied from being negative in few cases to become more than double in other cases. The standard deviation of the sales growth variable points to great variation across the companies. The same thing can be clearly seen in the return on equity variable. This indicates that companies’ performance varied between positive and negative. As for the companies’ size measured by total assets, the table showed the size varied from as small as AED 257 million to exceed AED 11 billion. The highly reported standard deviation of the total assets implies that there is big difference in the size of the companies covered in the current study. In this study two operating cash flows variables were used. While, in the first one, the total operating cash flows was used, in the second the total operating cash flows was compared to total assets. Once again, both variables pointed to large difference in the amount of operating cash flows and the ratio of cash flows to total assets of the companies covered in the study. Several companies reported negative operating cash flow, whereas others reported high positive figures. The highly reported standard deviation reflects variations in the reported amount among the companies. An important point to notice in table 3 is that the companies covered in the current study are not heavily leveraged as represented by the mean and the median. To have a close look at the effect of the industry type on the variables covered in the current study, descriptive statistics were calculated and reported in table 4. Table 4 about here] Table 4 showed that the manufacturing companies report the longest cash conversion cycle, whereas the lowest cash conversion cycle is achieved by the telecommunication and Copyright  © 2012 Journal of Contemporary Issues in Business Research (JCIBR) All Rights Reserve Page No. 18 Journal of Contemporary Issues in Business Research the real estate companies. This result is utterly justified since the manufacturing companies go through a l ong process of ordering materials and converting it into finished goods. The table also showed that all companies operating in he services, real estate, energy and communication sectors achieved positive sales growth. This result is also justified on the grounds that these companies are limited in number and the UAE economy is a fast growing one. The fast growing demand for services, real estate, energy and telecommunication makes sales growth inevitable. This has also affected the profitability of the companies operating in these sectors. It is evident from the table that none of the companies operating in these sectors reported negative return on equity as documented by the minimum and maximum value of return on equity for each industry. Similarly, the table revealed that the largest companies measured by their total assets belong to sectors such as communication, energy, real estate and services. The table further showed that, on average, only companies operating in the energy sector were heavily leveraged. The leverage ratio of most of the companies belong to other sectors was around 25%. This reflects the religious nature of the UAE society that avoids dealing with interest. Interest is prohibited by the Islamic Sharia’h principles. Another important point noticeable in table 4 is all companies operating in the communication, energy, and real estate industries reported positive operating cash flows. Correlation To identify the level of association between the explanatory variables used to estimate the regression model, Pearson coefficient of correlations was executed and reported in table 5. High level o