Working capital management (WCM) refers to management of a firm’s current assets and current liabilities, which is also a primary function that support firm daily operation such as used to funds its stock, credit sales, and credit purchases. The management of working capital is important in order to maintain its liquidity in day-to-day operation; to ensure it operation is running smoothly and meets its obligation (Eljelly, 2004). A firm without sufficient cash flow will have difficulties to survive in the future as it will be unable to pay its obligations. Therefore, if a firm does not manage their liquidity position well, it will affect firm’s growth, survival and profitability (Shafii, 2010).
The trade-off between profitability and liquidity are essential, however most of the firm’s ultimate objective is to maximise profit, while disregarding the dilemma of liquidity. One objective should not be cost of the other because both of them have their important (Raheman & Nasr, 2007). Jose et al. (1996) also point out this fact saying ‘firms with glowing long term prospects and healthy bottom lines do not remain solvent without good liquidity management’. For these reason WCM should be given proper consideration. However, the management of working capital is complex as it needs to manage a number of different components which are inter-linked to each others. The management needs to concern on account receivables, account payables, inventories and cash, as altering one component will affect the others. Therefore, firms need to identify the optimal level of working capital that can maximise firm’s value (Afza and Nazir, 2007). According to Ganesan (2007), optimization of working capital means minimisation of related costs and maximisation of related income. Efficient WCM will increase firms’ free cash flow, which in turn increases the firms’ growth opportunities and return to shareholders. Consequently, efficient WCM is crucial in order to maintaining firms’ survival, liquidity, solvency and profitability. Thus, WCM has enormous influence to firm’s performance.
Research Question – ‘Does the past evidence showing a relationship between WCM and profitability hold true in Malaysian Listed Companies -manufacturing and services industries.’
The aim of this study is to provide empirical evidence of the relationship between WCM and profitability in a sample of Malaysian listed companies by looking at the manufacturing and services industries. The cash conversion cycle (CCC) will be the indicator of firm’s liquidity which is a comprehensive measure, so that able to identify the most important variable that will affect CCC for two different industries.
1.3 OBJECTIVES OF THIS STUDY
Examine the relationship between the CCC and firm profitability.
Examine the relationship between CCC components which are account receivables, account payable and inventory turnover period with firm’s profitability.
Investigate whether the two industries have the same effect on the relations.
1.4 RATIONAL OF THIS STUDY
Extensive empirical research on WCM has been carried out around the world widely and those researches had given different results on the relationship between WCM and profitability. As the studies on the data undertake from Ernst & Young, 2010 reveals that WCM vary across different industries. The study also gives significant evidence that different firms or sectors adopt different approaches to WCM. So, different firms will use different approaches and strategy to manage their working capital, such as those firms that is less competitive will choose to minimise their receivable in order to increase their cash flow. While for those firms that depends on supplier will maximise their payable account. Therefore, the impact of various working capital mechanisms on firm’s performance from Malaysia perspective might be different due to divergence business environment and culture between other countries.
Besides that, there are few factors that may influence firm working capital such as nature of business, production policy, production cycle, credit policy, and availability of supply (Rama, 2009).
Nature of Business
The nature of business between different industries or firms is different. Thus, working capital requirement needed, also different among different industries or firm. For example, manufacturing is the productions of the product where the inventory can be keep in the warehouse. While services are the services provided to customer which cannot be stored. It also does not have investment in either raw materials, work in progress (WIP) or finished goods. Besides that, it also involves in immediate realization of cash after the services are provided, which means there will be less accounts receivables is exists. In here, it can be believed that services will have lower working capital requirement. [low wc, more risk n return]
This is further proven by John Louie Ramos
The management of hospitality capacity (inventory) is difficult as compared to manufacturing firm due to fluctuating demand pattern. For example, for service industry their inventory is room availability. The number of rooms in a hotel is fixed, once the room is vacant, they will lose the chances of earning money and the inventory during the period is wasted. Meanwhile, the services provided to customer cannot be store. Besides that, if the demand for the room is more than supply, they had to lose the income as they cannot produce the inventory based on demand.
While for the manufacturing firm, they can produce their inventory based on the seasonal demand. They can produce more inventories during the peak demand and less during off-seasons. Then, the firm will have low working capital during off-season. While for those firm that have fixed inventory production policy which means produce the same quantity of inventory to meet the peak demand, then the firm will have large accumulation of inventory during the off-seasons. The large accumulation of inventory will increase the amount of working capital. Thus, the production policy will affect the firm and industry working capital requirement.
The time and process involved in manufacture of goods will also affect firm working capital requirement as more fund is needed to invest, in order for the goods to be completed in time and in good quality.
Credit policy also one of the factors that will affect firm or industry working capital requirements which it determine the firm’s receivables. For services industry, it will have low working capital as it involved cash sales while for manufacturing the working capital requirement will depend on the firm’s credit policy. If the firm offer short credit period, then it will only need low working capital and vice versa.
Availability of supply
The availability of inventory such as raw materials will affect firm working capital requirements. If the availability of raw materials is easily to obtain then firm can maintain low inventory which mean only need low working capital. However, if the level of supply is hard to predict or obtain then the firm had to keep a large amount of inventory in their warehouse in order to avoid the shortage of production. Thus, the firm need large amount of working capital.
Therefore, this study is to examine the differences of the WCM between to the two industries and relationship between liquidity and profitability in Malaysia listed company.
2. LITERATURE REVIEW
2.1 WORKING CAPITAL MANAGEMENT
Working capital represents safety cushion for providers of short term funds of the firm. Without a proper management of working capital, it will have cash shortages and will result in difficulty in paying its obligations, especially in the competitive business worlds nowadays (FPR, 2010). Besides that nowadays, most companies normally do not think of improving liquidity management until them faces financial crisis or becoming on the edge of bankruptcy. In order to make sound decision and survive in the long term, firm must combine strategic planning with comprehensive data by using both financial and non-financial data.
Working capital and liquidity management is important for all businesses either are small, medium or large firm. As cash is the most liquid asset in a firm, therefore efficient liquidity management involves planning and controlling firm’s current assets meets its current liabilities is essential so that firm will not excessive invest in short term finance and avoid risk of inability to meet its short term obligation. Furthermore an efficient WCM enable firm to minimise the need for external financing as the external financing comprises of financial risk. By referring to the risk and return theory (Pettengill et al, 1995), higher risk investments will result in higher returns and vice versa. Hence, firms with low liquidity of working capital may have higher risk then high profitability. Conversely, high liquidity of working capital may face low risk then low profitability. Therefore, firm must take into consideration all the current assets and current liabilities when making financial decision making and try to balance the risk and return. As a result, in addition to profitability, liquidity management is vital for ongoing concern.
Working capital management comprises of inventory management, cash management and credit management. A detailed of those components will be discussed below:
2.1.1 INVENTORY MANAGEMENT
Inventory management is essential for businesses, without proper control and management of the inventory will lead to serious issues facing by the firm. For example, if the inventory does not managed properly or in an efficient manner, it may delay firm’s production process, lost of important customer, customer dissatisfaction, and or result in working capital curtailment (Richard A, 1978). Inventory consists of raw material, WIP and finished goods (Adeyemi, 2010). By referring to (Marilyn, 2006) raw materials are used to make production scheduling easier, to take advantage of price changes and quantity discounts, and to hedge against supply shortages. If raw material inventories were not held, purchases would have to be made continuously at the rate of production. This would not only mean high ordering costs and less quantity discounts, but also production interruptions when raw materials cannot be procured in time. WIP serves to make the production process smoother and more efficient. Besides that, it will provide a buffer between the various production processes. Finished goods have to be held to provide immediate services to customers and to stabilise production by separating production and sales activities. Firm can improve the inventory turnover or shortening the inventory turnover period by speeding up the WIP into finished goods, however it cannot be fully transformed. While for the raw material and finished goods is depend on management decision. Thus, it can be said every firm’s inventory turnover level is significantly different from each other. High inventory holding in a firm will reduce the risk of shortage and decrease the ordering cost. However, hold too much inventories on hand there may be a risk of inventory obsolesces (Van Horne, 1995). Therefore, firm must find a trade-off between those risks by discovery an optimal inventory level. An optimal inventory level can be measured using the economic order quantity (EOQ) as it minimise the annual holding costs and ordering costs (Adeyemi, 2010). The formula for EOQ is as below:
A = Annual demand
Cp = Cost to place an order
Ch = Cost of holding an inventory in a year
Besides that, EOQ can also be explained using graph in the Figure 1. The graph is plotted for total ordering cost, total holding cost and total cost for the quantities ordered. The point at which the line of total ordering cost intersects with the total holding cost is the EOQ. At the point of EOQ, it will show the minimum costs that will incurred when the firm placing the total amount of quantities. The graph also shows that the cost of ordering is decreased when the order quantity is increased. Then, the holding cost will increase when the order quantity is increased. In addition, when the order quantity is increased or decreased, the total cost will increased and decreased as well, where the total cost is the sum of total ordering cost and total holding cost. Hence, the optimal level of inventory cost is at the point of EOQ.
According to Abraham (2005) inventory for services industries consists of two kinds of perishable inventory. One is room availability and the other is food & beverages. The identification of fast and slowing moving of these inventories is within the total inventory is essential in order to avoid insufficient inventory. He also states that an optimal inventory is important in order to have a proper management of the inventory as those unused inventory will lead the firm suffer a lost.
2.1.2 CASH MANAGEMENT
According to Van Horne (1995) cash management is involves managing the monies of the firm in order to maximize cash availability and interest income on any idle funds. Cash management also include the trade receivable of a firm which play an important role in managing working capital. By improving the trade receivable routine more efficient, firm can reached optimal receivables by having adequate credit policy and collection procedure. A credit policy specifies requirements to value the worthiness of customers and a collection procedure provides guidelines to collect unpaid invoices that will reduce delays in outstanding receivables (Richards & Laughlin, 1980). An efficient cash management is essential as it can be an instrumental in preventing losing of cash, maintain sufficient cash to made payment and prevents unnecessary large amounts of cash from being held idle in banks account that produce little or no revenue.
2.1.3 CREDIT MANAGEMENT
Lastly, the optimal payables can be achieved by extending its trade credit from supplier. Simona and Paul (2007) state that trade credit is a substitute financing choice of short term borrowing, where trade credit is ‘free’ while short term borrowing is ‘costly’ as it needs to incur interest cost. For example, when firm extends its credit period from suppliers it will save the cost of short term borrowings. This means that an increased in account payables, will lead to a decrease in the short term borrowing costs. However, by delaying the payments to supplier will damage the firm’s reputation and loss some of the cash discounts offered by supplier for early settlements.
2.2 LIQUIDITY MEASURES
Corporate liquidity is examined from two distinctive dimensions either static or dynamic views (George, 1997; and Lancaster et al., 1999).
2.2.1 CURRENT AND QUICK RATIO
The static view is normally based on traditional measure of current ratio and quick ratio which is calculated based on information at the balance sheet and incorporates no cash flow variables. The underlying behind why these two ratios are well-known in used is due to its simplicity. Current ratio is defined as the relationship between currents assets and current liabilities. It is calculated by dividing the total of the current assets by total of the current liabilities. The current ratio represent margin of safety to the firm’s creditor, an index to the firm stability. While for quick ratio is the ratio of liquid assets to current liabilities. Kamath (1989) argues that the information generated from the ratios is inadequate to measure the liquidity and future cash flow due to their static nature which measures liquidity at a given point of time. George (1997) assert that it will be more appropriate and accurate to evaluate effectiveness of WCM by CCC, rather than the traditional measures of liquidity – current ratio and quick ratio.
2.2.2 CASH CONVERSION CYCLE (CCC)
Whereas dynamic CCC measures ongoing liquidity from the firm’s operation is define as more comprehensive measure of working capital and as a supplement to current ratio and quick ratio (Richards and Laughlin, 1980). CCC shows the time lag between expenditure for the purchases of raw materials and the collection of sales of finished goods (Schilling, 1996). This CCC measures also has been highly recommended by Kamath (1989), and others. CCC is a measure for the efficiency of WCM as it indicates how quickly the current assets are converting into cash. CCC comprise three components of days inventory outstanding (DIO), days sales outstanding (DSO) and days payables outstanding (DPO) [CCC = DIO+DSO-DPO].
DIO is a key figure that measures the average amount of time that a firm hold its inventory. It is calculated by inventory/cost of sales x 365 days. A decrease in the DIO represent an improvement, increase is deterioration (Ross et al, 2005).
DSO is the key figure that measures the average amount of time that a firm hold its account receivables. It formula to calculate is account receivables/sales x 365days. A decrease in DSO represents an improvement, whereas increase represents deterioration (Ross et al, 2005).
DPO is the key figure that measures the average amount of time that a firm hold its trade payables. It is calculated by trade payable/cost of sales x 365days. For DPO, an increase in days represents an improvement, whereas decrease indicates deterioration (Ross et al, 2005).
The traditional view on CCC and profitability highlight that the shorter the CCC, the superior the firm profitability. The firm can shorten their CCC by improving the inventory turnover, collects cash from receivables more quickly and slowing down the payments to suppliers. This will increase the efficiency of firm internal operation and result in greater profitability (Mohammad, 2010). This can be seen in the case of Dell manufacturer in American, which it mainly business is sales of its own brand (Dell) computer and computer accessories through internet and open door sales. Their primary focus is on student market and home user. Richard (2003) had analyse on the Dell’s working capital showing that the increase in inventory turnover and receivable turnover days were affect Dell’s overall profitability. Later in the year 1997, Dell had made some changes on its business operation by only producing those computers when the order is placing by customers and thus, the company able to reduce its CCC to negative working capital due to low inventory turnover. The negative CCC show that Dell able to collect payments from customers before they made payment to their supplier.
On the other hand, shortening the CCC could harm firm’s profitability as reducing the inventory conversion period could increase the shortage cost, reducing the receivable collection periods could makes the company’s lousing it’s good credit customers, and lengthening the payable period could damage the firm’s credit reputation. Therefore, shorter cash conversion cycle associated with high opportunity cost, and longer cash conversion cycle associated with high carrying cost. By achieving the optimal levels of inventory, receivable, and payable will minimize both carrying cost and opportunity cost of inventory, receivable, and payable and maximises sales, and profitability of firms. In this regards, an optimal cash conversion cycle as more accurate and comprehensive measure of working capital management. Schilling (1996) mentions optimum liquidity position, which is minimum level of liquidity necessary to support a given level of business activity. Briefly, he says it is critical to deploy resources between working capital and capital investment, because the return on investment is usually less than the return on capital investment. Therefore, deploying resources on working capital as much as to maintain optimum liquidity position is necessary. Then he sets up the relationship between CCC and minimum liquidity required such that if the CCC lengthens, the minimum liquidity required increases; conversely, that if the CCC shortens, the minimum liquidity required decreases.
2.3 EMPIRICAL EVIDENCE
There are numerous empirical research had done on the relationship between WCM and profitability in different countries and industries by using different variable selection for analysis. Some of the research prove that there is a positive relationship between profitability and CCC such as Dell, however there also had research shows that there are negatively related. Richards and Laughlin (1980) concluded that there is a positive relationship between the current and quick ratios and the cash conversion cycle. Besides that, Chowdhury and Amin (2007) also had found positive correlation between working capital and profitability which examine on the pharmaceutical industry in Bangladesh.
The study done by Lazaridis and Tryfonidis (2006) using the sample of listed company from Athens Stock Exchange for the period 2001-2004 showed that there is a significant relationship between CCC and profitability, which use gross operating profit as a measure of profitability. It same apply for Ganesan (2007), analysis on the WCM efficiency in telecommunication equipment industry, found that there is negative relationship between working capital and profitability. It can be said that management of working capital have significant impact on profitability and liquidity in different countries and industries. Besides that, an empirical research on Pakistani firms done by Raheman and Nasr, (2007) with a sample of 94 firms listed on Karachi Stock Exchange from period 1999-2004, shows that there is a negative relationship between variables of WCM and debt with profitability of the firm. In addition, a study in India’s hospital for the period 2005-2006 by Christopher and Kamalavalli, (2010) the correlations and regression analysis signifying that working capital component namely current ratio, cash turnover ratio, current assets to operating income and leverage negatively influence profitability of the firms. Lastly, the recent study in 2009 by Uyar (2009), he used the ANOVA and Pearson correlation to analyse the relationship between CCC and return on asset for the firm listed in the Istanbul Stock Exchange for the year 2007. The research showed that there is a significant negative correlation between those two variables.
Belt (1985) examined for US companies the trends of cash conversion cycle and its components during the period 1950-1983, for those lines of businesses for which Quarterly Financial Report for Manufacturing, Mining and Trade Corporations (QFR) . He found that retailing and wholesaling firms both had cash conversion cycles shorter than those of manufacturing firms. Mining firms had the shortest cash conversion cycle because this type of industry has the longest payment deferral period of all the major business types. Besley and Meyer (1987) evaluated empirically the interrelationships among the working capital accounts and cash conversion cycle, the firm’s industry classification and the rate of inflation for US companies for the period 1969-1983. Using the Spearman rank correlation coefficient they found that the cash conversion cycle was most correlated with the average age of inventory and least correlated with the age of spontaneous credit. The conclusion suggests that inventory activity is the most important input to the cash conversion cycle. The age of inventory, the average collection period and the age of spontaneous credit proved to be highly correlated. The cash conversion cycle and its components for the examination period differed from industry to industry, but did not vary from year to year.
By looking at the empirical literature on WCM, there is limited research study on the consequences of WCM from Malaysia’s firm perspectives. Irene & Lee (2007) research results show that the Malaysian public listed firms have positive relationship between profitability and working capital to a certain extent. Besides that, the recent study by Mohammad (2010) explores the relation between WCM and firm’s performance. He measures the relationship by selecting 172 listed companies in Bursa Malaysia for the period 2003-2007. Using the Pearson correlation and multiple regression analysis, he found significant negative associations between working capital variables with firm’s market value and profitability. Therefore, he highlights the importance of managing working capital requirements to ensure an improvement in firm’s market value and profitability and must consider the working capital when making company’s strategic.
It can be seen from the above that many studies have done on the WCM, its component and profitability by using different variable to test those relationship. From those studies, different countries, industries and strategies gives different results, some are positively related between WCM and profitability while some are negatively related. Since the previous studies of WCM in Malaysia, is focusing on the relationship between WCM and profitability. Therefore, in studies will further study on the relation of the both variables by making comparison on the two listed industries of manufacturing and services industries in Malaysia.
3. RESEARCH METHODOLOGY
The objective of this study is to look at one parts of financial management which known as WCM with reference to Malaysia. Here, will see the relationship between WCM practices and its effects on profitability of two industries in Malaysia; 16 firms listed on main board of Bursa Malaysia for the period of three years from 2007 to 2009. This section of the study will discuss on the sample selection, variables, and statistical techniques that will be used to examine the relationship between firms’ WCM and profitability.
3.1 DATA SET & SAMPLE
In this study secondary data; firm’s financial statements will be used to examine the research question. Those secondary data will be collected from Bursa Malaysia. A sample of eight companies will be randomly select for both manufacturing and services industries for the period of three years from 2007-2009. The reason for selecting this period was that latest data that will be available for investigation. Manufacturing and services industries are selected for this study because they reveal district difference in term of nature and management of the business. The services industries have a seasonal period and profit as they unable to predict the sales and demand from customers as services industries are people-oriented and people-driven, it is more difficult to effectively automate and control the service costs than in other non-services business sectors. Whereas the inventory for the manufacturing can be stored in the warehouse in order to avoid shortage but for the services industries unable to stored their capacity (inventory) as it will affect their firm’s profitability. Therefore, a comparison of the WCM between the two industries will be look at in this study.
Primary data will not be used as the data that has not been gathered before and the collection of data is time consuming, and high cost. Besides that, the primary data is not able to measure the firm’s financial strength and weaknesses. The measurement of firm’s financial wealth can only be measures and compare by using quantitative data. In addition, this study is to examine the relationship between WCM and profitability which required the quantitative information.
This study had identified key variables that will influence Malaysia firm’s WCM. Choice of variables is influenced by previous study on WCM and also to further study on the previous study on Belgian’s WCM by Deloof.
CCC will be used as a comprehensive measure of WCM which also used as independent variables. CCC is simply DSO plus DIOÂ lessÂ DPO. Profitability is measured by gross operating income (GOI), which is defined as sales minus cost of sales, and divided by total assets minus financial assets. Why it was divided by total assets minus financial assets? As from the list of companies that are randomly selected from Bursa Malaysia, their financial asset is a significant part of its total assets, where financial asset include cash and bank balances, stock and securities that can be readily converted into cash. This also the reason why return on assets is not considered as a measure of profitability in this research, as if firm has mainly financial assets in its balance sheet; its operating activities will contribute little to the overall return on its assets.
Besides that, sales growth ([this year’s sales – previous year’s sales]/previous year’s sales) will be used as control variable in the regression analysis.
3.3 HYPOTHESIS TESTING
As the objectives of this study are:
Examine the relationship between WCM and profitability.
Examine relationship between the DSO, DIO, DPO and firm’s profitability.
Investigate whether the two industries have the same effect on the relations.
The following hypothesis will be formulated and attempt to find statistical evidence for the two industries to support those hypothesis.
The CCC is negatively related to firm’s profitability (ROA) – higher CCC, lower the firm’ profitability and vice versa.
Shortening the DSO will increased firm’s profitability.
Shortening the DIO will increased firm’s profitability.
Lengthening the DPO will increased firm’s profitability.
3.4 ANALYSIS USED IN STUDY
In this study, two types of analysis are performed; there are descriptive and quantitative analyses.
3.4.1 DESCRIPTIVE ANALYSIS
The initial analysis in this study is descriptive statistic, which will provide detailed information of each relevant variable and describe the relevant aspects of cash conversion cycle. All the relevant variables were calculated using balance sheet value, rather than using market value, it is because the firms’ financial statement did not provided market value on the variables that is required in this study. Besides that, the measurement of profitability – GOI could only be based on value in income statement values as there is no way to measure it at so-called market values. In addition, if the market values are used, there will a question on which date the â€˜market values’ are referred to. Thus, in this study the book values of the variables in the firm’s financial statement will be used.
3.4.2 QUANTITATIVE ANALYSIS
Two methods had been applied in quantitative analysis. Firstly, correlation analysis is carried out, which specifically to measure the possible linear relationship between different variables under consideration. Secondly, is regression analysis, which is to estimate the relationship between liquidity, profitability and other selected variables.
We have used Pooled Ordinary Least Squares and Generalized Least Squares (cross section weights) methods for analysis. We used panel data in a pooled regression, where time-series and cross-sectional observations were combined and estimated. In other words, several cross-sectional units were observed over a period of time in a panel data setting. For this purpose of analysis the E – views software was used to analyze financial data and especially in case of pooled data.
4. DATA ANALYSIS AND DISCUSSION
The results of the two types of analysis will be discussed below.
4.1 DESCRIPTIVE ANALYSIS
Initially, descriptive statistics is the first step analysis in this research. It will provide a useful summary of central tendency; mean and median, and variability such as standard deviation, minimum and maximum.
Table 1 and Table 2 presents descriptive statistics for the components of working capital efficiency for eight manufacturing firms and s