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Working Capital Management and Profitability

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 Mediterranean Journal of Basic and Applied Sciences (MJBAS)
Volume 2, Issue 2, Pages 117-125, April-June 2018

Working Capital Management and Profitability

Rimsha Khalid1, Tehreem Saif2, Abdul Rehman Gondal3 and Hamza Sarfraz4
1
Student at Limkokwing University of Creative Technology.
2
Student at University of Central Punjab, Lahore.
3
Student at National University of Modern Languages, Islamabad
4
Student at Limkokwing University of Creative Technology.

Article Received: 30 January 2018 Article Accepted: 27 March 2018 Article Published: 10 June 2018

ABSTRACT

This study aims to find out the impact of working capital management on profitability. Return on assets is used as a proxy of profitability. Other
variables that are used in this study are Current ratio, debt to equity ratio, operating profit to debt ratio, and inventory turnover ratios of the firms.
Secondary data of electrical equipment firms listed on Karachi stock exchange was taken for a period of six years i.e. 2007-2012. Regression analysis
was applied to the data. Normality and linearity test was also applied. Results showed significant positive results. It is concluded that working capital
management has positive significant impact on profitability of the firms.
Keywords: Working Capital, Return on Assets, Profitability.

1. INTRODUCTION
The primary objective of any financial manager is to maximize the shareholders wealth. In this regard he has to
make optimize decisions about maintaining of assets and liability level. Working capital simple means the current
assets of the company that can be change from one type to other type during day to day operations of the firm
(Gitman, 2002). Current assets are usually cash, prepaid expenses, short term investment, account receivables,
inventory etc. Another term is used in this regard is Net working capital which is difference of current assets and
current liabilities. It can be calculated by deducting the current assets from current liabilities. Net working capital
may have positive or negative value. A financial manager takes decisions regarding the current assets and current
liabilities this is called working capital management. While making decisions he must consider the fact that a
certain level of current assets is necessary to meet the short term liabilities and liquidity. On the other hand Current
assets also play a role to freeze the capital of a company. As a result of which profitability affected. Profitability or
rate of return on investment is suffered by the decision of management about working capital. Profitability can also
termed as the rate of return for particular investment. Imbalance of current assets and liabilities can negatively
affect the rate of return (Vshnani & Shah, 2007). This is the basic purpose of managing working capital so that to
control the current financial resources of a firm in such a way that a balance is created between profitability of the
firm and risk of insolvency (Ricci & Vito, 2000).

Every business needs working capital for long term survival. Business cannot be carried out without Working
capital. Working capital of the firm helps to maintain its liquidity, solvency and profitability (Mukhopadhyay,
2004). The significance of managing working capital of a firm cannot be denied (Filbeck & Krueger, 2005).It has
direct impact on both the profitability and level of desired liquidity of a business (Rehman & Nasr, 2007). If a
company invests heavily in working capital more than its needs, then the profits which can be generated by
investing these resources in fixed or long term assets will be decrease. Moreover the firm will have to breathe cost
of inventory for longer periods as well as the cost of handling the stock (Arnold, 2008).

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 Mediterranean Journal of Basic and Applied Sciences (MJBAS)
Volume 2, Issue 2, Pages 117-125, April-June 2018

In nut shell, if a company invests in fixed assets to generate profits by ignoring its short-term capital needs then it is
possible that it may have to face technical insolvency because of insufficient funds. If a company not pays proper
attention to its working capital management, then it is quite possible that the firm would have to face bankruptcy
(Kargar & Bluementhal, 1994). Here are two different theories to manage the working capital one of which is
aggressive working capital management policy and the second one is conservative working capital management
policy. An aggressive investment policy allows us to maintain high level fixed assets which generate the more
profits. One the other end conservative managing policy is opposite to it with less investment in fixed assets and
more in current assets. For working capital aggressive policy implies that current liabilities are maintained in a
greater portion as compared to long-term debts. Working capital management and profitability definitely have
relation with each other. Previous research is available on this relationship but the sector i.e. Electrical and
machinery equipment sector. Working capital is important part of business activities of a firm. For the electrical
machinery sector as well, working capital management is of crucial part. So, the objective of this study is to find out
“Does efficient working capital management have any impact on the profitability of firms of electrical and
machinery equipment sector of Pakistan?”

1.1 Statement of Problem

Working capital management is important area of finance because without proper management of working capital
it is difficult for organization to run its operations smoothly. In order to explain the relationship between working
capital management and profitability different researches had been carried out in different parts of the world
especially in developing countries. Despite the importance this issue failed to attract the attention of researchers in
Electrical Equipment Sector of KSE Pakistan. Thus no research work is found while surfing on internet, browsing
through the books and journals, on this topic In Pakistan. So by keeping in view the study is conducted to find out
the relationship between working capital management and profitability of the Pakistani Electrical Equipment
Sector, and will also try to meet the gap between existing literatures.

1.2 Research Objectives

1.2.1 General objectives
The main objective of the study is to evaluate the relationship of working capital and profitability of Electrical
machinery and apparatus sector of KSE listed companies of Pakistan.

1.2.2 Specific Objectives

General objectives are further divided in to specific objectives which are as follow
 To determine whether there is significant relationship between Inventory turnover ratio and profitability
of the firm
 To examine the significant relationship between current ratio and firms profitability
 To evaluate the significant relationship between debt to equity ratio and profitability of the firm
 To ascertain if there is significant impact of operating cash flow to debt ratio on profitability of the firm.

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 Mediterranean Journal of Basic and Applied Sciences (MJBAS)
Volume 2, Issue 2, Pages 117-125, April-June 2018

1.3 Research Hypotheses

 H0: There is no significant relationship between Inventory turnover ratio and profitability of the firm
 H1: There is significant relationship between Inventory turnover ratio and profitability of the firm
 H0: There is no significant relationship between debt to equity ratio and firms profitability
 H1: There is significant relationship between debt to equity ratio and firms profitability
 H0: There is no significant relationship between Current ratio and profitability of the firm
 H1: There is no significant relationship between Current ratio and profitability of the firm
 H0: There is no significant impact of operating cash flow to debt ratio on profitability of the firm
 H1: There is significant impact of operating cash flow to debt ratio on profitability of the firm

1.4 Theoretical Framework

 Topic of study is the impact of working capital management on profitability of the electrical machinery
apparatus sector of KSE listed sector of Pakistan
 Return on assets, asset test ratio, current ratio, inventory turnover ratio, operating cash flow to debt ratio are
the variables used in this study.
 Working capital means current assets of the firm. We have to maintain the current assets to meet the short
term obligations as well as to run the operating activities. But this is observed that maintaining the high
level of working capital may harmful for the profitability of the company because high level of current
assets means high level of investment freeze. On the basis of this logic research is attempt to explore the
effect of working capital on profitability of electrical machinery sector of Pakistan.

2. LITERATURE REVIEW
(Afza & Nasir, 2010) Found a relationship significant and positive between working capital management and
profitability. (Uyar, 2009) Also worked on it and conclude that there is significant positive relationship between
WCM and Profitability but one of the variable that was cash conversion cycle showed negative association with
WCM.

(Lue, Lee, & Hwang, 2009) conclude that if a firms value enhanced the cash conversion cycle will decreased. (Gill,
Biger, & Mathur, 2010) draw a conclusion by using pearson correlation model that if account receivable,
inventory, account payable are maintained at optimal level then the firm may generate maximum profits.

(Dong & Su, 2010) observed the significant positive association of cash conversion cycle with the return on assets
of the firms. (Kumar & Sharma, 2011) observed that in India cash conversion cycle has positive significant
relationship with profitability of the firm. (Johnson & Templar, 2011) Stated that there is passively significant
impact of current assets on the return on capital employed. (Gul, B., Rehman, Khan, & Khan, 2013) Observed the
influence of working capital management (WCM) on performance of small medium enterprises (SMEs) in
Pakistan. Independent variables were Number of Days Account Receivable (ACP), Number of Day’s Inventory

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 Mediterranean Journal of Basic and Applied Sciences (MJBAS)
Volume 2, Issue 2, Pages 117-125, April-June 2018

(INV), Cash Conversion Cycle (CCC) and Number of Days Account Payable (APP). The data used in this study
was taken from SMEDA, Karachi Stock Exchange, tax offices, company itself and Bloom burgee business week. In
addition to these variables some other variables were used which included Firm Size (SIZE), Debit Ratio (DR) and
Growth (GROWTH).

(Oladipupu & Okafor, 2013) Examined the firm’s working capital management practice on its profitability and
dividend payout ratio. Using both the Pearson product moment correlation technique and ordinary least square
(OLS) regression technique, they conclude that shorter net trade cycle and debt ratio promotes high corporate
profitability. The study focused on the extent of the effects of working capital management on the Profitability and
Dividend Payout Ratio. Financial data were obtained from 12 manufacturing companies quoted on the Nigeria
Stock Exchange over 5 years period (2002 to 2006).

(Almazari, 2013)Conclude the relationship between the working capital management (WCM) and the firms’
profitability for the Saudi cement manufacturing firm. The results showed that Saudi cement industry’s current
ratio was important liquidity indicator which effected profitability, the cement firms must choose a trade-off
between these two objectives so that, neither the liquidity nor profitability suffers. The sample was taken 8 Saudi
cement manufacturing companies listed in the Saudi Stock Exchange for period of 5 years from 2008-2012.

(Nyabwanga, Lumumba, Odondo, & Otineo, 2012) examined the impact of working capital management on
performance of SSEs in Kisi South District, the findings of the study were that, working capital management
practices were low among SSEs as majority had not adopted formal working capital management routines and their
performance was on a low side.

(Mehmood., Jan., & Ullah., 2010)Concluded that to improve profitability of a firm and sufficient liquidity to meet
short term liabilities asit fall due are two objects of working capital management WCM initiative release capital and
increase profitability that can be used for investments or to reduce the debt. It also works for to improve efficiency
in the areas of receivables, inventories and payables.

(Ahmad, Azeem, & Rehman, 2013) Investigated the effect of working capital management on the operating
liquidity of manufacturing companies listed on Karachi Stock Exchange, Pakistan. The study concluded that
operational liquidity of manufacturing firms can be improved by using proper policies and strategies of working
capital management.

(Afeef, 2011) in his paper on investigating the effect of WCM on Profitability of SME’s in Pakistan based on a
sample of 40 Pakistani small and medium enterprises (SME’s) listed in Karachi Stock Exchange for a period of six
years from 2003 to 2008 leading to a total of 240 observations. The Correlation matrix of the pooled data of firms
observed, significant negative relationship of the Inventory Conversion Period and the Receivable Collection

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 Mediterranean Journal of Basic and Applied Sciences (MJBAS)
Volume 2, Issue 2, Pages 117-125, April-June 2018

Period with the Operating Profit to Sales was observed. .However, no significant relationship was found between
the profitability and the Payable Deferral Period, Cash Conversion Cycle & Current Ratio.

(Al-Mwalla, 2012)Investigated the impact of working capital management on the firms’ profitability and examined
in a sample of 57 companies on Amman Stocks market for the period of 2001 to 2009. This was concluded a
conservative policy of investment has a positive impact on the company’ profitability.

(Napompech, 2012)Argued that working capital is needed for day-to-day operations of a firm. The regression
analysis was based on a panel sample of 255 companies listed on the Stock Exchange of Thailand from 2007
through 2009.The result showed significant negative relationship between gross operating profits and inventory
conversion period and the receivables collection period.

3. METHODOLOGY
3.1 Variables
3.1.1 Inventory Turnover (ITR)
Ratio that shows how many times firm inventory is sold and replaced over a particular period. The days in the
period can be divided by the inventory turnover formula to calculate the days it takes to sell the inventory on hand
or "inventory turnover days."

3.1.2 Current Ratio(CAR)

Firms Ability to pay short term debt is called current asset ratio.
It can be measured, current asset divided by current liabilities.

Current Assets
Current Ratio =
Current Liabilities

3.1.3 Debt to equity Ratio (DER)

The ratio of total liabilities of the company to its stockholders equity. It is a leverage ratio and measures the degree
to which the assets of the business are financed by the debts and the shareholders' equity of a business.

3.1.4 Operating cash flow to debt ratio(OCDR)

This ratio compares a firm's operating cash flows to its total debt. This ratio provides an information of a firm's
ability to cover its debt with yearly cash flow from operations.

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 Mediterranean Journal of Basic and Applied Sciences (MJBAS)
Volume 2, Issue 2, Pages 117-125, April-June 2018

3.1.5 Return on assets (ROA)

The return on assets (ROA) percentage shows how profitable firms’ assets are in generating revenue.

3.2 Data Source

This research is conducted on the area of electrical machinery apparatus sector of KSE listed companies. Cross
sectional data is taken from the official site of State Bank of Pakistan from the year 2006 to 2011.

3.2.1 Model
Ordinary least square regression is applied in this study because research is conducted to view the dependence of
some variables on other.
Y=βo + β1.X1+β2.X2

4. RESULT AND ANALYSIS

4.1 Descriptive Statistics

Std.
Mean Deviation N
ROA 5.5000 4.73340 6
CAR 1.1850 .05244 6
DER 2.1883 .21217 6
ITR 4.8650 .91666 6
OCDR -.0083 .04535 6

4.2 Correlations
ROA CAR DER ITR OCDR
Pearson Correlation ROA 1.000 .311 .519 .941 -.196
CAR .311 1.000 -.515 .145 -.433
DER .519 -.515 1.000 .495 -.018
ITR .941 .145 .495 1.000 -.201
OCDR -.196 -.433 -.018 -.201 1.000

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 Mediterranean Journal of Basic and Applied Sciences (MJBAS)
Volume 2, Issue 2, Pages 117-125, April-June 2018

If we look at the table for correlation Return on asset is correlated with current ratio about 31 percent, with debt
equity ratio 50 percent, with inventory turnover ratio almost 94 percent, and operating cash flow to debt ratio is
negatively correlated with R.O.A.

4.3 Coefficients (a)

Unstandardized 95% Confidence Interval Collinearity

t Sig.
Coefficients for B Statistics
Model
Std. Lower Upper Std.
B Tolerance VIF B
Error Bound Bound Error
1 (Constant) 29.390 .691 -130.199 .005 -98.742 12.183
CAR 47.494 .461 103.038 .006 41.637 21.351 .400 2.497
DER 10.262 .118 86.598 .007 8.756 11.767 .370 2.702
ITR 3.469 .023 151.842 .004 3.179 3.760 .533 1.875
OCDR
18.243 .395 46.169 .014 13.222 7.264 .729 1.372

Dependent Variable: ROA

T-test is applied to see for individual variable significance, the results shows that t-test value of each variable is less
than .05. it tells us that each variable is significant. Another test that is V.I.f also applied to check multicolinearity
between the variables, and the results showed current ratio shads problem of multicolinearaity.
Y=βo + β1.X1+β2.X2+β3.X3+ β4.X4+ ε
ROA= 29.390 + 47.494 CAR +10.262 DER + 3.469 ITR + 18.243 OCDR

5. CONCLUSION
This study was aimed to detect the impact of working capital management on profitability of electrical equipment
sector of KSE listed companies of Pakistan. For this purpose regression model was applied and different
assumption test was also applied for the model fitness. As discussed above all independent variables shows
significant positive impact on dependent variable i.e. profitability of the firms.

REFERENCES
[1] Afeef, M. (2011). Relationship of Working Capital Management With Firms Profitability During the
Period of Global Slowdown. Intenational Management Institution New Dehli.
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Profitability. The IUP Journal of Applied Finance , 20-30.
[3] Ahmad, N., Azeem, P., & Rehman, J. u. (2013). Does Working Capital Management Affect the
Operational Liquidity Position of Firms? Jounal of Global Economy .

123 | P a g e ISSN (Online): 2581-5059 Website: www.mjbas.com

 Mediterranean Journal of Basic and Applied Sciences (MJBAS)
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[4] Almazari, A. A. (2013). The Relationship between Working Capital Management and Profitability: An
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 Mediterranean Journal of Basic and Applied Sciences (MJBAS)
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[23] Uyar, A. (2009). The Relationship of Cash Conversion Cycle with Firm Size and Profitability: An
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