Electronic copy available at: http://ssrn.

com/abstract=2105638
Relationship Between Working Capital Management and Firm Profitability
Manufacturing Sector of Pakistan
Muhammad Safdar Sial
Lecturer ,Department of Management Sciences, COMSATS Institute of Information
Technologv
E-mail: MuhammadsaIdarciitvehari.edu.pk
Aqsa Chaudhry
Admin OIIicer, United Nations Children`s Eund (UNICEE)
E-mail: AchaudhryuniceI.org
Electronic copy available at: http://ssrn.com/abstract=2105638
ABSTRACT:
PURPOSE:
The goal oI the study is to measure the relationship between working capital management
and Iirm proIitability in the manuIacturing sector oI Pakistan.
DATA & METHODOLOGY: We have selected the sample oI 100 Pakistani
manuIacturing listed companies on Karachi Stock Exchange Ior the time period oI 10
year Irom 1999-2008. The data used in this study was acquired Irom Karachi Stock
Exchange (K.S.E) and Irom the Balance Sheet Analysis oI Joint Stock Companies by
State Bank oI Pakistan. We have studied the eIIect oI diIIerent variables oI working
capital management including the Average collection period, Inventory turnover in days,
Average payment period and cash conversion cycle. Current ratio, Size and debt ratio
used as control variables. Pearson Correlation and Regression Analysis (Ordinary Least
Square and Eixed EIIect Model) are used.
FINDINGS: The results show that there is a strong negative relationship between
variables oI the working capital management and proIitability oI the Iirm. It means that
as the cash conversion cycle increases it will lead to decreasing proIitability oI the Iirm,
and managers can create a positive value Ior the shareholders by reducing the cash
conversion cycle to a possible minimum level. We Iind that there is a signiIicant negative
relationship between liquidity and proIitability. We also Iind that there is a positive
relationship between size oI the Iirm and its proIitability. There is also a signiIicant
negative relationship between debt used by the Iirm and its proIitability.
RESEARCH LIMITATIONS: The sample size consisting oI 100 manuIacturing
companies is relatively small as compared to 650 companies listed on the Karachi Stock
Exchange as on August 2009 which slightly limits the generalizability oI the Iindings.
ORIGINALITY VALUE: To the best oI the researcher`s knowledge this study is a
unique study oI its kind in the Non- Einancial Sector that studies the impact oI working
capital management on Iirm proIitability oI manuIacturing sector.
KEYWORDS: Working Capital Management, Karachi Stock Exchange, Eirm
ProIitability
PAPER TYPE: Research Paper
INTRODUCTION:
Working capital management is one oI the most important areas in Iinancial management
oI a Iirm. Managers spend much time on day-to-day problems that involve working
capital decisions. Management oI working capital generally means managing current
assets and current liabilities (Garcia-Teruel PJ, Martinez-Solano PM, 2007). It is
important Ior manuIacturing Iirms because current assets oI these manuIacturing Iirms
account Ior almost halI oI the total assets (Raheman A, Nasr, 2007). EIIicient working
capital management involves planning and controlling oI current assets and current
liabilities in such a way that eliminates the risk oI inability to meet short term obligations
on the one hand and avoid too much investment in these assets on the other hand.
The supervision oI working capital (WCM) by managing the proportion oI the WCM
components is essentials to the Iinancial health oI businesses Irom all industries. To
reduce accounts receivable a Iirm may have harsh collections policies and lesser sales
credits would lead to lost sales thus reducing the proIit. Maximizing account payable by
having longer credits Irom the supplier also has the chance oI getting poor quality
materials Irom supplier that would ultimately aIIect the proIitability. Minimizing
inventory may lead to lost sales by stocks-outs. The working capital management should
aim at having balanced optimal proportion oI the WCM components to achieve
maximum proIit and cash conversion cycle is used as a broad measure oI working capital
management actually cash conversion cycle is a time interval between payment Ior the
purchase oI raw material and collection oI sales oI Iinancial goods.
Working capital is considered as the liIe-blood Ior the business. II a business has some
Iavorable amount oI working capital then it`s always getting the return on any Iavorable
opportunity. Working capital can be utilized to pay the payroll oI the employees and
petty expenses. Every successIul business owners may be maintaining the right amount
oI working capital Iunds to meet the unanticipated situation. Every Iirm tries to
competently handle the working capital because it shows the eIIiciency and strength oI
the business and working capital is also used to create the extra return Ior the
stakeholders. II working capital is too low then Iirm may loose the proIitable
opportunities and may Iace the short term liquidity crisis. Amount oI working capital
depends upon the many Iactors like nature oI the business, technology used in the
business, scale oI operations, nature oI Iinished goods, nature oI raw material,
competition and credit policy.
The critical objective oI any Iirm is to maximize the proIit. But, preserving that liquidity
oI the Iirm is an also important objective. The problem is that increasing the proIits at the
cost oI liquidity can bring serious problems to the Iirm .ThereIore ,there must be trade oII
between these two objectives because both have their own importance .II we don`t care
about proIit, we can not stay alive Ior a longer period. On the other hand, iI we don`t care
about liquidity, we may Iace the problem oI bankruptcy. Eor these reasons working
capital management should be given proper consideration and will Iinally aIIect the
proIitability oI the Iirm.
LITERATURE REVIEW:
DelooI (2003) explored the study oI large Belgian non-Iinancial Iirms Ior the period oI
1992-1996 and concluded a negative association oI proIitability with number oI day`s
accounts receivable, inventories and accounts payable. ThereIore study suggested that
shareholder value can be enhanced by reducing the number oI day`s accounts receivable
and inventories to a reasonable minimum.
Raheman, A., and M. Nasr (2007) examined the study on Pakistani Iirms and Iind out
that liquidity put the negative impact on Iirm proIitability which proved that liquidity and
proIitability has inverse relationship. Eurther they indicated that debt ratio has a negative
association with the proIitability, which means when leverage increased then Iirm proIit
adversely aIIected. Size oI the Iirm and proIitability oI Iirm has a positive relationship.
Size oI Iirm is measured in term oI log oI sales. It means less proIitable Iirms wait longer
to pay their bills. They also Iound inverse relationship between cash conversion cycle,
average collection period, inventory turnover in days with the proIitability
Eljelly (2004) and Jose (1996) Iindings recommended that managers can create value by
reducing their inventories and the number oI days Ior which their accounts are
outstanding. Similarly, shortening the cash conversion cycle also improves the Iirm`s
proIitability.
Hutchison (2007) indicated a straight link between smaller Cash Conversion Cycle and
higher proIitability. Ali Uyar (2009) investigated that signiIicant negative association
between the cash conversion cycle and return on assets it mean shorter cash conversion
cycle increase the proIitability and vice versa.
Kamath (1989) investigated the study on retailing Iirms and concluded that there was
inverse association between cash conversion cycle and proIitability. It means proIitability
enhanced by decreasing the cash conversion cycle.
Wang (2002) examined the relationship between working capital management and Iirm
proIitability and Iound that lesser the investment in working capital which leads to
increase the proIitability oI the Iirm. Khan, S.U, et al (2006) conducted the study on 30
listed Pakistani non-Iinancial Iirms to investigated the relationship between working
capital management and corporate proIitability oI non- Iinancial Iirms. ThereIore,
suggested that there was a negative relationship between Iirms` gross proIit and the
number oI day`s inventories, account payable and cash conversion cycle.
On the basis oI literature review we develop these Hypotheses.
H1: There is negative relationship between Average Collection Period and ROA.
H2: There is negative relationship between Inventory turnover in days and ROA.
H3: There is negative relationship between Average Payment Period and ROA.
H4: There is negative relationship between Cash Conversion Cycle and Return on Asset
H5: There is positive relationship between Size and Return on Asset
H6: There is positive relationship between Debt Ratio and Return on Asset
H7: There is negative relationship between Current Ratio and Return on Asset
RESEARCH METHODOLOGY AND ANALYSIS:
The Sample consisted oI 100 manuIacturing companies listed on Karachi Stock
Exchange. Include those companies in the sample which the complete data was available
according to variables. The data was acquired Irom the Balance sheet analysis oI Joint
Stock Companies by State Bank oI Pakistan. Some Iinancial Iigures were getting Irom
the annual reports oI the companies downloaded Irom the websites oI the companies. The
period covered was 1999 to 2008. The sample includes companies Irom diIIerent sector
oI the economy.
TABLE 3.1: Number of Companies selected From Different Sectors of Pakistan
Industry Sample () age
Cement 14
Chemical 29
Sugar 35
Euel & Energy 19
Tobacco 03
Total 100
The explanatory variables and their relationship with proIitability can be traced Irom the
early literature oI Iinance such as Jose (1996), Shin & Soenen (1998), and DelooI (2003).
This study examines the explanatory power oI seven variables Ior return on assets. The
independent variables Ior the study was as size, debt ratio (DR), current ratio (CR),
average collection period (ACP), inventory turnover in days (ITID), average payment
period (APP), and cash conversion cycle (CCC). The relationship oI these variables with
return on assets oI 100 manuIacturing companies Ior the period oI 1999-2008 was
examined. Size (Natural logarithm oI Sales) (LOS)), Debt Ratio (DR) and Current Ratio
(CR) included as control variables.
The Iollowing equations used to estimate the impact oI working capital management on
the proIitability measures
ROA
it
0
1
(ACP
it
)
2
(ITID
it
)
3
(APP
it
)
4
(CCC
it
)
5
(Size
it
)
6
(DR
it
)
7
(CR
it
) c (Equation-3.0)
The Model was re-written Ior each component oI working capital variables as Iollow
ROA
it
0
1
(ACP
it
)
2
(Size
it
)
3
(CR
it
)
4
(DR
it
) c (Equation-3.1)
Where
ROA
it.
Return on Assets oI Iirm i at time t , i 1,2,..,100 Iirms.

0
. The intercept of equation

i
: CoeIIicients oI Independent variables
X it : The diIIerent independent variables Ior working capital Management oI Iirm i at
Time t
t : Time 1, 2,..,10 years.
c: The error term
ROA: Return on Assets
ACP : Average Collection Period
ITID: Inventory Turnover in Days
APP: Average Payment Period
CCC: Cash Conversion Cycle
CR: Current Ratio
DR: Debt Ratio
Size: Natural logarithm oI Sales
Analysis of Data:
We have perIormed two types oI analysis, descriptive and quantitative. The results oI
these two types oI analysis are discussed in this section.
Descriptive analysis presents the average and standard deviation oI the diIIerent variables
which was used in the study. Descriptive analysis also present the Minimum and
Maximum values oI the variables which help in getting a picture about the maximum and
minimum values a variable can achieve.
Table 4.1 presents` descriptive statistics Ior 100 Pakistani manuIacturing Iirms Ior a
period oI ten years Irom 1999-2008 and Ior a total 1000 Iirms year observations. The
mean value oI the average collection period was 89 days and standard deviation was 56
days. Minimum time taken by a company to collect receivables was 2 day while the
maximum time Ior this purpose was 297 days. It takes an average 94 days to sell
inventory with standard deviation oI 57 days. Here, maximum time taken by a company
was 365 days, which was a very large time period to convert inventory into sales. Eirms
wait an average 154 days to pay their purchases with standard deviation oI 107 days.
Here, minimum time taken by a company was 2 days and maximum time taken Ior this
purpose was 449 days. The cash conversion cycle used as a proxy to check the eIIiciency
in managing working capital was on average 30 days and standard deviation was 19 days.
Here the minimum value was 2 days and maximum value Ior this purpose was 213 days.
To check the size oI the Iirm and its relationship with proIitability, natural logarithm oI
sales was used as a control variable. The mean value oI log oI sales was 6.82 while the
standard deviation was 1.59.The maximum value oI log oI sales Ior a company in a year
was 10.08 and the minimum was 1.58.To check the debt Iinancing and its relationship
with the proIitability the debt ratio was used as a control variable .The results oI
descriptive statistics show that the average debt ratio Ior the Pakistani manuIacturing
companies was 26 with a standard deviation oI 21 . The mean value oI current ratio
was 54.It mean 54 oI the total assets are in current Iorm. The mean value oI Return
on assets was 23.9 and standard deviation was 12.65.
TABLE 4.1: Descriptive Statistics of 100 Companies for the period of 1999-2008
N Minimum Maximum Mean Std.Deviation
ACP(Days) 1000 2.30 297.22 89.36 56.56
ITID(Days) 1000 7.30 365.00 94.65 57.67
APP(Days) 1000 2.08 449.31 154.79 107.90
CCC(Days) 1000 2 213.25 30.35 19.92
SIZE (LOS) 1000 1.58 10.08 6.82 1.59
DR () 1000 10 79.60 26.73 21.36
CR () 1000 10.80 94.90 54.25 18.59
ROA () 1000 -44.60 50.70 2.39 12.65
Pearson`s Correlation analysis:
Pearsons correlation analysis was used Ior data to see the relationship between variables
such as those between working capital management and proIitability.
Table 4.1 presents Pearson correlation coeIIicients Ior all variables considered.
We have started our analysis oI correlation results between the average collection Period
and Return on assets. The results oI correlation analysis show a negative coeIIicient -
.912, with P-Value oI (.000). It mean results are highly signiIicant at u 1 and iI
average collection period was decreased then that put the positive impact on return on
assets. Correlation results between inventory turnover in days and return on assets also
show the same type oI results and signiIicant at u 1 .It mean iI Iirm take the more
time to selling the inventory, it will negatively eIIect the proIitability oI the Iirm.
Correlation results between average payment period and return on assets also show the
same trend and signiIicant at u 1.It mean less proIitable Iirms wait longer to pay their
bills. The cash conversion cycle which was a comprehensive measure oI working capital
management also has a negative coeIIicient -.678 and p value was (.000) and it was
signiIicant at u 1 .It means that iI the Iirm was able to decrease this period, It can
increase its proIitability .Erom the above results I conclude that iI Iirm reduce these time
period then Iirm was eIIicient managing working capital and this eIIiciency will lead to
increase proIitability. Correlation between size (measured LOS) and return on assets
indicate the positive relationship and the coeIIicient was positive .920, with p-value oI
(.000) signiIicant at u 1 .It mean proIitability was increased when size oI the Iirm was
increased .Correlation between debt ratio and return on assets was also negative and
signiIicant at u 1.In this analysis the current ratio has a signiIicant negative
relationship with proIitability (measured by return on assets). The coeIIicient was -.246
and p-value oI (.000) the result was signiIicant at u 1.
Common Effect Regression Model:
Common EIIect Model was used to estimate the explanatory power oI various variables
Ior return on assets Ior the sample period 1999-2008.The explanatory variables were
average collection period, inventory turnover in days, average payment period, cash
conversion cycle, size, debt ratio and current ratio were tested through a multiple
regression model.
Table 4.2 indicate that coeIIicient oI size was positive and signiIicant at u 1.It means
that bigger Iirm size have more proIitability as compared to Iirms oI smaller size. I used
the debt ratio as proxy Ior leverage. Debt ratio show the signiIicant negative relationship
with return on asset. It mean when leverage in the Iirm increased it will adversely eIIect
on return on asset. Average collection period (ACP) has also negative relationship with
return on asset. P-value oI ACP (.001) and it was signiIicant at u 1.It mean when
average collection period was decreased then that put the positive impact on return on
assets. The coeIIicient oI Inventory Turnover In days (ITID) was negative and signiIicant
at u 1 .It means the increase or decrease the inventory turnover signiIicantly eIIect the
proIitability oI the Iirms. It mean iI inventory take the more time to sell then that
negatively eIIect the proIitability oI the Iirm. CoeIIicient oI average payment period
(APP) was negative and highly signiIicant at u 1.It mean increase or decrease the
average payment period signiIicantly aIIects the proIitability oI the Iirm. The negative
relationship between average payment period and return on asset indicate that less
proIitable Iirms wait longer to pay their bills. the result indicate that cash conversion
cycle have negative relationship with return on assets and signiIicant at u 1 In this
case Adjusted R
2
was .864.It mean 86 independent variables explained the return on
assets. Overall the model was signiIicant at E-SigniIicant (.000)
The Fixed Effects or Least-Sequre Dummy Variables (LSDV) Regression Model
Eixed eIIect regression model is used to capture the industry eIIect as well as time eIIect.
Table 4.3 shows the industry eIIect and Table 4.4 show the time eIIect.
DISCUSSION:
This study presents evidence that variables oI working capital management can be used
in explaining the return on assets. This study examine the relationship between return on
assets and several variables oI working capital management such as size, current ratio,
debt ratio, average collection period, average inventory turnover in days, average
payment period and cash conversion cycle in Iive sectors oI Pakistani manuIacturing
Iirms. Sectors studied include cement, chemical, sugar, Iuel & energy and tobacco. This
study has endeavored to credence to this theory on the basis on 100 manuIacturing Iirms
oI Pakistan Ior the period oI 1999-2008. Regression analysis Iollows and return on assets
was taken as dependent variable upon the main working capital management variables by
using Ordinary Least square (OLS) and Eixed EIIect Regression Model. Results report
the presence oI a positive relationship between size and return on assets and negative
relationship was Iound between average collection period ,inventory turnover in days,
average payment period, cash conversion cycle, current ratio and debt ratio. In this study
size, average collection period, inventory turnover in days, average payment period ,cash
conversion cycle ,current ratio and debt ratio results consistently signiIicant role in
predicting return on assets. Empirical results oI the study suggest that positive
relationship between size and return on assets which mean larger Iirm size have more
proIitability as compared to smaller Iirm. Debt ratio show the negative relationship with
return on assets which mean when leverage oI the Iirm increased it will adversely eIIect
the proIitability oI the Iirm. Current ratio which was traditional measure oI liquidity also
show the negative relationship with return on assets which conIirm our hypothesis that
liquidity and proIitability has inverse relationship. Average collection period show the
negative relationship with return on asset which mean increase or decrease the account
receivable signiIicantly eIIect the return on assets. Inventory turnover in days show the
negative relationship with return on assets which mean iI inventory take the more time to
sell it will adversely aIIect the return on assets. The study show the negative relationship
between average payment period and return on assets which mean less proIitable Iirm
wait longer to pay their bills. Cash conversion cycle also show the negative relationship
with return on asset. It mean increase or decrease the cash conversion cycle also
signiIicantly put the eIIect on return on assets. Industry eIIect and time eIIect in panal
data was examined Ior Iive sectors Ior the time period 1999-2008. In estimating industry
eIIect size, debt ratio, average collection period, inventory turnover in days, average
payment period, indicate the signiIicant explanatory power oI the model. CoeIIicients oI
chemical, sugar, Iuel & energy are diIIerent Irom cement sector. Study also report that
behavior oI the return on asset was diIIerent with the passage oI time.
REEERENCES
AIza, T. & M. S. Nazir, (2007). Working Capital Management Policies oI Eirms:
Empirical Evidence Irom Pakistan. ConIerence Proceedings oI 9th South Asian
Management Eorum (SAME) on Eebruary 24-25, North South University, Dhaka,
Bangladesh. p. 1-15.
DelooI, 2003. 'Does Working Capital Management AIIects ProIitability oI Belgian
Eirms? Journal oI Business Einance & Accounting, Vol 30 No 3 & 4 pp. 573 587
Bhayani, S,. (2004).working capital and proIitability relationship: A case study oI Gujarat
Ambuja Cements Ltd SCMS Journal oI Indian Management April-June 2004.
Eljelly, A. (2004) Liquidity-ProIitability TradeoII: An empirical Investigation in an
Emerging Market, International Journal oI Commerce & Management, Vol 14 No 2
pp.48 61
Hutchison, P. D., Earris II, M. T. and Anders, S. B., (2007) Cash-to-cash analysis and
management, The CPA Journal, Vol. 77 No. 8, pp. 42-47.
Jose, M. L., Lancaster, C. & Stevens, J. L., (1996) Corporate returns and cash conversion
cycles, Journal oI Economics and Einance, Vol. 20 No.1, pp. 33-46.
Kamath, R. (1989) How useIul are common liquidity measures? J .Cash Manage, 9:24-
28.
Uyar, A. (2009) The Relationship oI Cash Conversion Cycle with Eirm Size and
ProIitability: An Empirical Investigation in Turkey. International Research Journal oI
Einance and Economics. 24.
Wang, Y.J. (2002) Liquidity Management, Operating PerIormance, and Corporate Value:
Evidence Irom Japan and Taiwan. Journal oI Multinational Einancial Management. 12,
159-169
Table 4.1
Pearson Correlation
Dependent Variable: ROA
100 Pakistani Non -Financial Firms, 1999-2008, 1000 Firms -Year Observations
ACP ITID APP CCC SIZE DR CR ROA
ACP Pearson Correlation
Sig.(2-tailed)
1 .998
.000
.989
.000
.824
.000
-.980
.000
.963
.000
.125
.000
.912
.000
ITID Pearson Correlation
Sig.(2-tailed)
.998
.000
1 .983
.000
.849
.000
-.977
.000
.953
.000
.119
.000
-.901
.000
APP Pearson Correlation
Sig.(2-tailed)
.989
.000
.983
.000
1 .749
.000
-.956
.000
.952
.000
.067
.035
-.909
.000
CCC Pearson Correlation
Sig.(2-tailed)
.824
.000
.849
.000
.749
.000
1 -.818
.000
.760
.000
.105
.001
-.678
.000
SIZE Pearson Correlation
Sig.(2-tailed)
.980
.000
-.977
.000
-.956
.000
-.818
.000
1 -.951
.000
-.253
.000
.920
.000
DR Pearson Correlation
Sig.(2-tailed)
.963
.000
.953
.000
.952
.000
.760
.000
-.951
.000
1 .121
.000
-.910
.000
CR Pearson Correlation
Sig.(2-tailed)
.125
.000
.119
.000
.067
.035
.105
.001
-.253
.000
.121
.000
1 -.246
.000
ROA Pearson Correlation
Sig.(2-tailed)
-.912
.000
-.901
.000
-.909
.000
-.678
.000
.920
.000
-.910
.000
-.246
.000
1
Correlation is signiIicant at the 0.01 level (2-tailed)
Correlation is signiIicant at the 0.05 level (2-tailed)
Table 4.2
Dependent Variable: Return on Asset Common Effect: Ordinary Least Square
(OLS)
CoeIIicients T-value P-value
Intercept 4.52 .735 .462
Size 1.95 3.131 .002
DR -.244 -9.334 .000
CR -.069 -6.447 .000
ACP -.058 -3.232 .001
ITID -.09 -5.90 .000
APP -.055 -9.111 .000
CCC -.123 -9.560 .000
E-SigniIicance .000
Adjusted R
2
.864
TABLE: 4.3
Dependent Variable: Return on Asset Industry Effect: Fixed Effect Model
(F.E.M)
CoeIIicient T-Value P-Value
Intercept(Cement) 13.21 4.291 .000
Size 1.314 1.970 .049
DR -.219 -6.713 .000
CR -.033 -2.956 .003
ACP -.091 -4.241 .000
ITID -.028 -1.663 .097
APP -.113 -4.241 .000
CCC -.092 -4.241 .000
D2(Chemical) -6.124 -2.024 .043
D3(Sugar) -4.055 -1.337 .181
D4(E & E) 1.445 .475 .635
D5(Tobacco) 12.173 3.942 .000
E-SigniIicance .000
Adjusted R
2
.890
TABLE: 4.4
Dependent Variable: Return on Asset Time Effect: Fixed Effect Model (F.E.M)
CoeIIicient T-Value P-Value
Intercept(1999) 4.506 .727 .468
Size 1.961 3.122 .002
DR -.244 -9.281 .000
CR -.069 -.6.414 .000
ACP -.058 -3.214 .001
ITID -.09 -1.663 .097
APP -.055 -9.072 .000
CCC -.123 -9.530 .000
D1(2000) .147 .224 .823
D2(2001) .073 .111 .911
D3(2002) -.033 -.049 .961
D4(2003) -.097 -.147 .883
D5(2004) -.147 -.223 .823
D6(2005) -.043 -.066 .948
D7(2006) -.105 -.159 .873
D8(2007) -.163 -.247 .805
D9(2008) .260 .395 .693
E-SigniIicance .000
Adjusted R
2
.863