Impact of Working Capital Management on Profitibility of Firms

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Efficient management of working Capital is one of the pre-conditions for the success of an enterprise. Efficient management of working capital means management of various components of working capital in such a way that an adequate amount of working capital is maintained for smooth running of a firm. An optimal working capital management is expected to contribute positively to the creation of firm value.

To reach optimal working capital management firm manager should control the trade off between profitability and liquidity accurately. The purpose of this study is to investigate the relationship between working capital management and firm’s profitability. In this study, we have selected a sample of 4 Indian Oil Drilling and Exploration firms and taken their financial data for a period of 5 years from 2005 – 2009 and studied the effect of different variables of working capital management including the Cash conversion cycle and Current ratio on the profitability of the firms.

The study shows that there is a negative significant relationship between cash conversion cycle & firm profitability and positive relationship between Current Ratio & profitability of firms. This reveals that reducing cash conversion period and increasing the current ratio results into profitability increase. Thus, in purpose to create shareholder value, firm manager should concern on shorten of cash conversion cycle till accomplish optimal level. 1. Introduction The working capital is the life-blood and nerve centre of a business firm. The importance of working capital in any industry needs no special emphasis.

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No business can run effectively without a sufficient quantity of working capital. It is crucial to retain right level of working capital. Working capital management is one of the most important functions of corporate management. A business enterprise with ample working capital is always in a position to avail advantages of any favorable opportunity either to buy raw materials or to implement a special order or to wait for enhanced market status. Working capital can be utilized for the payment of lease, employee’s payroll, and pretty much any other operating costs that are involved in the everyday life of business.

Even very successful business owners may need working capital funds when the unexpected circumstances arise. The overall success of the company depends upon its working capital position. So, it should be handled properly because it shows the efficiency and financial strength of company. Working capital management is highly important in firms as it is used to generate further returns for the stakeholders. When working capital is managed improperly, allocating more than enough of it will render management non-efficient and reduce the benefits of short term investments.

On the other hand, if working capital is too low, the company may miss a lot of profitable investment opportunities or suffer short term liquidity crisis, leading to degradation of company credit, as it cannot respond effectively to temporary capital requirements. Efficient management of working capital means management of various components of working capital in such a way that an adequate amount of working capital is maintained for smooth running of a firm and for fulfillment of objectives of liquidity and profitability.

But, it is very difficult for the management too to estimate working capital properly because, amount of working capital varies across firms over the periods depending upon the nature of the business, nature of raw material used, process technology used, nature of finished goods, degree of competition in the market, scale of operation, credit policy etc. Therefore, a significant amount of fund is required to invest permanently in the form of different current assets. 2. Literature Review Many researchers have studied working capital from different views and in different environments.

The following ones were very interesting and useful for our research: Ghosh and Maji made a study to examine the efficiency of working capital management of the Indian cement companies during 1992 to 2002. For measuring the efficiency of working capital management, performance, utilization, and overall efficiency indices were calculated instead of using some common working capital management ratios. Setting industry norms as target-efficiency levels of the individual firms, this paper also tested the speed of achieving that target level of efficiency by an individual firm during the period of study.

Findings of the study indicated that the Indian Cement Industry as a whole did not perform remarkably well during this period. Dr. D. Mukhopadhyay conducted a research study to examine working capital management practices and the problems faced by the firms in working capital management process particularly in heavy engineering industries. A sick engineering firm named “M/S Heavy Engineering Company Limited” had been selected and data from 1993-94 to 2002-03 had been analyzed.

He reported that, the company has under its possession huge real estate including land and the firm holds legacy of culture and heritage of more than two hundred years of existence in industrial map of the country and as a consequence, it has built up “Goodwill” to a remarkable extent. Thus the company may make revaluation of real estate including land and other assets and make valuation of goodwill and disposal of idle assets and selling off certain percentage of company goodwill can enable the company infuse fresh blood in the form of working capital to run the show.

Jain, Yadav and Surendra made a study on Working capital management practices of public sector enterprises in India. The study was based on an analysis of 13 year period data from 1991 to 2003 of 137 public sector enterprises and stated that, a business organization has to be conscious that inadequate working capital can disrupt its operations leading illiquidity. At the same time excessive working capital is also not desirable since it adversely affects profitability. Shin and Soenen highlighted that efficient Working Capital Management was very important for creating value for the shareholders.

The way working capital was managed had a significant impact on both profitability and liquidity. The relationship between the length of Net Trading Cycle, corporate profitability and risk adjusted stock return was examined using correlation and regression analysis, by industry and capital intensity. They found a strong negative relationship between lengths of the firm’s net trading Cycle and its profitability. In addition, shorter net trade cycles were associated with higher risk adjusted stock returns. All the above studies provide us a solid base and give us idea regarding working capital management and its components.

They also give us the results and conclusions of those researches already conducted on the same area for different countries and environment from different aspects. On basis of these researches done in different countries, we have developed our own methodology for research. 3. Objectives of the Study Keeping in view the pragmatic importance of working capital management in finance, an attempt is made in this study to contribute towards a crucial element in financial management which working capital management. Specific objectives are: To examine a relationship between Working Capital Management and Profitability of the selected firms in Oil Drilling and Exploration industry. ? To establish a relationship between the two objectives of liquidity and profitability of the firm and; ? To find out the relationship between debt used by the firm and its profitability on the firms. 4. Methodology adopted in the study The present study is based on a sample of 4 Oil Drilling and Exploration companies operating in India. These companies constitute a large part of the Oil industry in terms of market sharing within the country.

A brief description about these companies is as below: Gas Authority of India Limited (GAIL): Gas Authority of India Ltd was established on 16th August, 1984. It was incorporated with an objective to create gas sector infrastructure for sustained development of the natural gas sector in the country. It is India’s flagship natural gas company integrating all aspects of the natural gas value chain including exploration and production, processing, transmission, distribution and marketing and related services.

Indraprastha Gas Limited (IGL): IGL incorporated in 1998 and it is a joint venture which is being promoted by the BPCL, Delhi government and GAIL. The IGL has established its monopoly as the supplier of Compressed Natural Gas in the Delhi’s National Capital Region (NCR). Today, the company has crossed 163 CNG stations and 1,22,000 domestic and 300 commercial PNG customers. Indraprastha Gas was awarded Golden Peacock Eco Innovation Award. Oil and Natural Gas Corporation (ONGC): ONGC was incorporated on 23rd June 1993 as an Indian public sector oil and gas company.

It is a Fortune Global 500 company, ranked 152nd and contributes 77% of India’s crude oil production and 81% of India’s natural gas production, it is the highest profit making corporation in India. It was set up as a commission on 14 August 1956. Indian government holds 74. 14% equity stake in this company. ONGC is one of Asia’s largest and most active companies involved in exploration and production of oil. It is involved in exploring for and exploiting hydrocarbons in 26 sedimentary basins of India. It produces about 30% of India’s crude oil requirement.

It owns and operates more than 11,000 kilometers of pipelines in India. Petronet LNG Ltd (PLL): Petronet LNG, one of the fastest growing world class companies in the Indian energy sector was formed in 1998 in a joint venture with the government of India. The company was formed to import LNG and set up LNG terminals in the country. Petronet LNG is one of the leading players in oil and natural gas industry space. The data used in this study was acquired from the internet and web sites of different firms.

Data of companies for the most recent five years formed the basis of our calculations. The period covered by the study extends to five years starting from 2005 to 2009. The reason for restricting to this period was that the latest data for investigation was available for this period. 4. 1 Variables In order to analyze the effects of working capital management on the firm’s profitability, profitability is measured by Return on Total Assets (ROTA), which is defined as profit before interest and tax divided by total assets. Profitability was used as the dependent variable.

With regards to the independent variables, working capital management was measured by cash conversion cycle (CCC) and Current ratio (CR), debt ratio(DR). Sales Growth has been taken as control variable. CCC focuses on the length of time between when a firm makes payment and when firm receives cash inflow. The lower the value is better due to reveal that firm has high liquidity which easily converts its short term investment in current asset to cash. However, longer value of CCC indicate greater investment in current assets, and hence the greater the need for financing of current assets.

CCC is calculated as the number of days required for Average Collection Period (ACP) plus the number of days required for Inventory turnover (ITID) minus the number of days available for accounts payment period (APP). Average Collection Period (ACP) is calculated by dividing account receivable by sales and multiplying the result by 365 (number of days in a year). ACP represents the number of days that a firm takes to collect payments from its customer. Inventory turnover in days (ITID) is calculated by dividing inventory by cost of goods sold and multiplying with 365 days.

This variable reflects the average number of days of stock held by a firm. Longer storage times represent a greater investment in inventory for a particular level of operations. Average Payment Period (APP) is calculated by dividing accounts payable by purchases and multiplying the result by 365. This measure indicates the average time firm takes to pay their suppliers. The higher the value, the longer firms take to settle their payment commitments to their suppliers. In nutshell, we have taken ROTA as dependent variable and CCC, CR, DR and SG as independent variables. 5. RESULTS AND ANALYSIS ) Descriptive Statistics Table 1 Five Year Mean and Standard Deviation for the variables |Company |Statistics |Return On Total|Cash Conversion |Current |Debt Assets |Sales Growth | | | |Assets |Cycle |Ratio |Ratio | | |GAIL |Mean |19. 27 |47. 806 |3. 352 |7. 238 |15. 6575 | |  |Std. Deviation |1. 03187 |7. 87263 |0. 4723029 |2. 10839 |14. 586 | |IGL |Mean |31. 184 |-16. 142 |5. 162 |1. 632 |17. 0925 | |  |Std. Deviation |3. 16318 |38. 9053 |2. 124434 |3. 64926 |2. 6143 | |ONGC |Mean |25. 256 |146. 938 |7. 1 |10. 644 |08. 6625 | |  |Std. Deviation |1. 65687 |6. 60577 |2. 675883 |0. 52691 |6. 7042 | |PLNG L |Mean |16. 858 |23. 64 |2. 64 |42. 334 |47. 1000 | |  |Std. Deviation |5. 88021 |15. 4607 |0. 7602302 |4. 58023 |34. 9364 | |Total |Mean |23. 142 |50. 4915 |4. 5635 |15. 462 |22. 1281 | |  |Std. Deviation |6. 53609 |64. 8311 |2. 4028104 |16. 5071 |22. 9717 | Table 1 gives the descriptive statistics for variables that are used in this study. The average Return on Total Assets (ROTA) for the whole sample is 23. 4% with Indraprastha Gas Limited (IGL) having the highest ROTA of 31. 18% and Petronet LNG Limited with the lowest value i. e. 16. 86%. Indraprastha Gas Limited has the lowest CCCS with -16days and 38. 91 days standard deviation. The combined average current ratio of all selected companies is 4. 56:1 and the lowest current ratio is 2. 64:1 in case of Petronet LNG Limited. Petronet LNG Limited has more than 42% Debt Asset Ratio, while it is least in Indraprastha Gas Limited just as 1. 6%. On average firms sales growth is 22. 13% and the least sale growth by ONGC with only 8. 66%. b) Correlation Analysis

Spearman’s Correlation analysis is used to see the relationship between working capital management and profitability. If efficient working capital management increases profitability, one should expect a negative relationship between the measures of working capital management and profitability variable. Table 2 exhibits result of correlation coefficients and p-values are listed in parenthesis. The result shows a negative relationship between CCCS and ROTA. This means that result support the expectation that a cash conversion cycle (CCC) is negatively associated with higher profitability.

However, the current ratio is positively related to profitability. Generally, traditional liquidity ratios such as current ratio have been understood to have lacked in measuring the efficiency of the firm’s working capital management. Table 2 Correlation Analysis of the variables |Variables |Statistics |Return On |Cash Conversion |Current Ratio |Debt Assets |Sales Growth | | | |Total Assets |Cycle | |Ratio | | |Return On Total |Pearson Correlation |1   |  |  |  | |Assets | | | | | | | |  |Sig. (2-tailed) |  |  |  |  |  | |Cash Conversion |Pearson Correlation |-0. 180 |1 |  |  |  | |Cycle | | | | | | | |  |Sig. (2-tailed) |0. 48 |  |  |  |  | |Current Ratio |Pearson Correlation |0. 441 |0. 534 |1 |  |  | |  |Sig. (2-tailed) |0. 051 |0. 015 |  |  |  | |Debt Assets Ratio |Pearson Correlation |-0. 665** |-0. 066 |-0. 432 |1 |  | |  |Sig. (2-tailed) |0. 002 |0. 781 |0. 057 |  |  | |Sales Growth |Pearson Correlation |-0. 44 |-0. 293 |-0. 290 |0. 664 |1 | |  |Sig. (2-tailed) |0. 192 |0. 271 |0. 275 |0. 005 |  | ** Correlation is significant at the 0. 01 level (2-tailed). * Correlation is significant at the 0. 05 level (2-tailed). c) Regression Analysis To further investigate the impact of working capital management on profitability, the model used for the regressions analysis is expressed in the general form as given in equation below: Profitability = b0 + b1CCCt+ b2 Current Ratiot+ b3Debt Ratiot + b4Sales Growtht (Return on Total Asset)

The above equation measures linear relationship through a simple regression model by taking ROTA as dependent variable and CCC, CR, DR and SG as independent variables. Since the number of firms and years is small therefore, we have assumed that data is free from heteroscedasticity. The regression model results are depicted below: Table 3 Regression for Profitability on Cash Conversion Cycle |Model |R |R Square |Adjusted R Square |Std. Error of the Estimate | |1 |0. 744 |0. 553 |0. 90 |4. 056 | * Predictors: (Constant), SG, Current Ratio, CCC, DR The above table depicts our regression model with R equal to . 74 and R square 0. 553 suggesting that all independent variables are able to explain 56% of the total variation in our dependent variable i. e. profitability. Though, this value is not very high but is not too low as well therefore indicating that model fits reasonably well. Table 4: Anova Table |Model |Sum of Square |df |Mean Square |F |Sign. |1 Regression |223. 758 |4 |55. 940 |3. 401 |0. 048 | | | | | | | | |Residual |180. 923 |11 |16. 448 | | | | | | | | | | |Total |404. 81 |15 | | | | | | | | | | | a. Predictors: (Constant), SG, Current ratio, CCC, DR, Dependent Variable: ROTA The table above exhibits the regression and Residual sum of squares with F statistic 3. 401 and P value 0. 048 which is less than . 05 thus indicating a significant relationship. Table 5 : Coefficient |Model |Un-standardized Coefficients |Standardized |t |Sig. |  | |Coefficients | | | | |B |Std. Error |Beta | | | |1 (Constant) |  |3. 322 | |6. 532 |0. 000 | | |21. 701 | | | | | |CCC |  |0. 020 |-0. 41 |-1. 842 |0. 093 | | |-0. 036 | | | | | |Current Ratio |  |0. 623 |0. 512 |2. 037 |0. 046 | | |1. 268 | | | | | |DR |  |0. 094 |-0. 335 |-1. 116 |0. 288 | | |-0. 05 | | | | | |SG |  |0. 065 |-0. 102 |-0. 355 |0. 729 | | |-0. 023 | | | | | * Dependent Variable: ROTA The above table depicts beta values of various independent variables to identify relative importance of these variables in affecting the profitability (ROTA) of the firms. As is visible from the table, Beta value is highest for current ratio i. . 1. 268 and is found to be significant with P value 0. 046 which is less than . 05. Therefore, we can infer from the results that the most important factor that explains the profitability of the firm is its current ratio. Whereas, beta value for the other independent variables has been found very less and insignificant too with P values greater than . 05. 6. CONCLUSION Working capital management is important part in firm financial management decision. The ability of the firm to continuously operate in longer period is depends on how they deal with investment in working capital management.

The optimal of working capital management could be achieved by firm that manage the trade off between profitability and liquidity. The purpose of this study is to investigate the relationship between working capital management and firm profitability. Cash conversion cycle is used as measure of working capital management. Results of this study found that current ratio is positively associated with profitability whereas cash conversion cycle are significantly negative associated to the firm profitability. Thus, firm manger should concern on reduction of cash conversion period in purpose of creation shareholder wealth.

The primary aim of this study is to investigate the relationship between working capital management and firm’s profitability in Oil Drilling and Exploration sector in India. Since our study focused exclusively on the 4 Oil Drilling and Exploration firms for the 5 years, therefore, there is much to be explored about working capital management & its relationship with profitability with respect to Indian firms from other industries as well . We suggest that further research may be conducted on the same issue with more companies covering diverse industries and more number of years in the sample.

The scope of further research may also be extended to other components of working capital management such as cash, marketable securities, receivables and inventory management. REFERENCES ? Deloof, M. (2003). Does Working Capital Management Affect Profitability of Belgian Firms? Journal of Business Finance & Accounting, 30(3&4), 573-587. ? Eljelly, A. 2004. “Liquidity-Profitability Tradeoff: An empirical Investigation in An Emerging Market”, International Journal of Commerce & Management, 14(2), 48 – 61 ? Filbeck, G. , & Krueger, T. M. (2005).

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