Impact of Working Capital Management on firm profitability of cement sector of Pakistan

Introduction

Working Capital is considered as the basic requirement of the Businesses, as they require a regular
amount of cash to make routine payments, to cover unexpected costs and purchase basic materials
used in the production of goods. It is one of the most important components of the corporate
finance. Recently Haq et al. (2011) noted that the firm’s profitability is directly affected by
working capital management. There are two major concepts of working capital. One of the working
capital concept is Gross working capital and is indicates the total current assets of the business. If
current assets are managed efficiently be the business it gives more growth and can increase the
value of the business in the market. The other concept of working capital is the net working capital
which indicates the difference between the current assets and the current liabilities. One of the
fundamental decisions which a finance managers make is the management of working capital.

Working capital is the common measure of liquidity efficiency and overall health of the firm. As
it includes cash, inventory, account receivable, accounts payable, a portion of debt due within one
year and other short term accounts, a company’s working capital reflects company’s activities.
Working Capital Management deals with the management of short term financing and investment
decisions of a firm and a very important component of the corporate finance decisions.

There are two possibilities of working capital, it may be positive or negative as well, Positive
working capital indicates that the business is in a position to pay off its short term liabilities almost
immediately and negative working capital indicates that a business is unable to do so. This is why
it should be managed very carefully. An optimal level of working capital should be maintained by
the finance managers otherwise it may affect the profitability or the liquidity of the firm. Objective
of working capital management is to manage the current assets and liabilities in such a way that
satisfactory level of working capital is maintained.

PANIGRAHI, (2017) working capital management (WCM) involves a risk return trade off: means
not to take an additional risk until and unless it is well accomplished with assure additional returns.
The existence of a firm depends largely on its ability to efficiently and effectively management of
working capital. Working capital management is the heart of every firm’s day to day operations
and also improve the corporate’s profitability. Working capital is considered as the life blood of
the businesses. The interaction between the current assets and current liabilities is, therefore the
main theme of the theory of the working capital management. Working capital efficiency
primarily measured by the cash conversion cycle. Cash conversion cycle basically shows how long
an industry or firm takes to convert its cash outflows into cash inflows (PANIGRAHI, 2017); It
consists of three parts, inventory turnover, payable deferral period, receivable collection period.
Working capital should be at optimal level, if a management team does not keep an organization's
working capital within certain levels, it can have crushing consequences to the organization's
financial health. Working capital management affects either profitability or the liquidity of the
firm, as working capital management is directly affects the profitability as well as the liquidity of
the firm. Therefore, working capital management should be managed efficiently and effectively,
as (BPP learning media, 2010) stated that the efficient working capital means to manage various
components of working capital in such a way that an adequate amount of working capital is
maintained for the smooth running of the firm operations and the fulfillment of the profitability
objective.

There are many factors which can influence the decision of financial managers about the firm’s
current assets and current liabilities, those factors may be internal or external. PANIGRAHI,
(2017) states that generally, there are two basic approaches from where working capital
management is derived: one of them is known as aggressive policy, which indicates low levels of
current assets, mainly low cash balances, a very limited credit grants to its customers and very low
level of inventories stock and large amounts of investments in non-current assets, for the purpose
of generating more profits. Though, this approach pretends a higher level of risk with regard to the
probability of adequate funds for day to day operations and also to pay for current liabilities (Van-
Horne and Wachowicz, (Van-Horne, 2008) 2008). The second approach for working capital
management in known as conservative and is also a flexible approach, this approach suggests to
have large investments in current assets, particularly more cash balances, higher inventory levels
and customer loans, and low amount of investments in the non-current assets, which may create
more value for the firm (Nazir and Afza, (Nazir, “Impact of aggressive working capital
management policy on firms’ profitability”,, (2009)) 2009). Most empirical studies relating to
working capital management and profitability support the fact that efficient management of
working capital enhance a firm’s profitability.

Undoubtedly, profitability of the firm and the working capital management have some relationship
with each other. Much research on the relationship of working capital management and the firm
profitability is available but the selected sector i.e. Cement sector, is not much considered, about
the impact of working capital management. So, much literature is not available in this sector in
Pakistani context. Working capital is very important component of business accomplishments of
any firm. Hence, for the Cement as well, working capital management is of great importance.
Therefore, the aim of this study is to find out “Does efficient working capital management have
any impact on the profitability of firms of Cement sector of Pakistan?”

Literature Review

There is sufficient evidence in existing financial literature that presents the significance of WCM.
Results of empirical analysis show that there is statistical evidence of a strong relationship between
a firm's profitability and its WCM efficiency. However, many earlier studies undertaken on WCM
efficiency reveal that measures of WCM efficiency basically differ across different companies.
Those studies also clearly emphasize significant evidence that issues of WCM are different for
different industries and firms from different industry sectors, as they adopt different approaches to
their working capital management. Firms follow an appropriate working capital management
approach that is quite favorable to them. As the working capital requirement of a manufacturing
sector industry will be different from trading sector and it will have requirements of working
capital different from the service sector industries. Anyhow, the attention of the academicians and
the managers to optimize the working capital is not very new, many have provided a number of
thoughts for the welfare of business over many years. A relationship between the working capital
management efficiency and profitability had found by, (Lazaridis and Tryfonidis (2006)) and many
others before them. Joshi, (Joshi P. , (1995) (1995) has considered the working capital management
a necessary component of the firm’s financial management. The impact on the working capital
management policy due to economic activity was observed by (Lamberson, (Lamberson, (1995))
1995), and to determine this impact he took a sample of 50 small firms from US for a time span
covering 12 years i.e. 1980-1991. By this study he found no effect economic expansion on the
increment of working capital during a specific period. In conclusion, he suggested the existence of
a slight impact on working capital management of any change in economic activity of these firms.

Some other researchers specifically, Jose, Lancaster, and Stevens (Jose, (1996).)(1996) carried out
thorough analysis on the association of financial returns and the cash conversion cycle and found
an inverse association of cash conversion cycle and profitability of firm.

With an aim to establish relationship between the working capital management the profitability of
the firm a number of research studies have been published by different authors in different journals.
Maximum number of the studies published found a relationship between the cash conversion cycle
and profitability of the firm is negative. Cash conversion cycle indicates the length of time between
the outflows of cash for acquisition of raw materials and the cash inflows by selling the goods,
also reflects the decisions on the amount invested in inventory, credit obtained by suppliers and
loans provided t customers. The aggressive approach of working capital management tends to
enhance the profitability of the corporation. (see, Lazaridis and Tryfonidis, (Lazaridis,
(2006))2006; Raheman and Nasr, 2007; and among others).

The impact of different working capital management variables including inventory turnover in
days, average collection period, average payment period and cash conversion cycle on the net
operating profitability of the firms, was studied by Rehman (Rehman A. , 2006) (2006). He
concluded by indication the strong negative relationship between the profitability and these
working capital financial ratios. Furthermore, the study revealed that by reducing the cash
conversion cycle up to an optimal level a positive value for the shareholders can be created by the
firm’s managers.

Strategic working capital management ant its role in corporate strategy development, ultimately
ensuring the survival of the firm was studied by (Chakraborty and Bandopadhyay (Chakraborty P.
B., 2007) 2007). They highlighted the multidimensional impact on the performance of a firm, of
strategic decisions on current assets and current liabilities.

To study the effect of different variables of working capital management on the net operating
profitability, (Raheman and Nasr (Rehman A. N., 2007)(2007)) selected a sample of 94 Pakistani
firms listed on Karachi Stock Exchange for a period of six years from 1999-2004. From the results
of this study, they have proved a negative relationship between variables of working capital
management including the average collection period, inventory turnover (in days), cash conversion
cycle and profitability of the firm. Besides, they have also indicated that size of the firm measured
by natural logarithm of sales has a positive relationship with profitability. Samiloglu and
Demiraunes (Samiloglu, 2008.)(2008) have analyzed the effect of working capital management on
profitability of firms. The study has depicted that the accounts receivable period, inventory period
and leverage affect the profitability of the firm negatively while growth affects the firm's
profitability positively.

The relationship between the working capital management and the profitability of the firm was
also analyzed on pharmaceutical companies of India by (Chakraborty (2008)). And he has also
pointed out that two distinct schools of thought are available there on this issue: one school of
thought among these says that, there is no effect on improvement of profitability on the base of
working capital size, there is possibility of negative relationship between the profitability and the
investment in the working capital. While the second school of thought says, a very important role
is played in the improvement of corporate profitability by the investment in working capital, and
output and sales cannot be maintained unless there is no minimum investment in the working
capital; in fact, the fixed assets are kept inoperative in case of not availability of adequate
investments in working capital.

Another study conducted in US on a large sample of 58987 US firms covering a time span of 20
years 1975-1994 by (Shin and Soenen (1998)). They suggested that for generating greater volume
of wealth for the shareholders of a firm, it is very crucial to manage the working capital of that
firm effectively and in an efficient manner. They also recommended that profitability and net trade
cycle both are inversely related to each other.

Harsh et al., (2017) in meta- analysis of firm profitability and the working capital
management selected 46 research papers that directly studies the relationship between the
profitability of firm and the working capital management, and the result of meta-analysis
supported the traditional view that an aggressive working capital policy leads to higher
profitability and cash conversion cycle is found to be negatively associated with profitability
of the firm.
(Hien Tran, 2017) studied 200 SMEs of Vietnam to test the impact of working capital
management on the profitability from 2010-2012, as the result of this study they indicated
that working capital management is a significant area of financial management; the efficient
working capital management can significantly impact on the profitability and the liquidity
of the business and they found a significant relationship between gross operating income and
the number of days of accounts receivable, accounts inventories and cash conversion cycle.

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