European Journal of Economics, Finance and Administrative Sciences ISSN 1450-2275 Issue 32 (2011) EuroJournals, Inc. 2011 http://www.eurojournals.

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Impact of Working Capital Management on Profitability and Market Valuation of Pakistani Firms
Hassan Mobeen Alam Corresponding Author, Assistant Professor at Hailey College of Commerce University of the Punjab, Lahore Pakistan E-mail: hassanmobeen.hcc.pu.edu.pk@gmail.com Liaqat Ali Principal, Hailey College of Commerce, Dear Faculty of Commerce University of the Punjab, Lahore Pakistan Ch. Abdul Rehman Rector, Superior University, Lahore Pakistan Muhammad Akram Lecturer at Hailey College of Commerce University of the Punjab, Lahore Pakistan Abstract Study Objectives: A firms sustainability is usually linked with its profit making ability but this misconception has been cleared since the outbreak of present liquidity crises. Liquidity is regaining the lost significance in the literature of finance. Objective of our study is to find out impact of working capital management on the profitability of the firm without compromising for the liquidity of the firm. Furthermore we also tried to explore the impact of efficient working capital management, proxy for financial performance, on market value of the firm. Methodology: In this paper we use secondary data, of sixty five companies randomly selected from Karachi Stock Exchange. The five years panel data, from 2005 to 2009, is extracted from publicly available sources, financial statements and other web sources, is used. Because of difference in nature of operations, financial and service sector firms are not included in the analysis. Tobins Q; proxy used for determining the market value of the firm. Whereas return on assets & return on invested capital; were used to measure financial performance of the firm. Five financial ratios, Cash Conversion Cycle; Current Ratio; Current asset to total asset ratio; Current liabilities to total asset ratio and Debt to asset ratio, were used as variables against which changes in dependent variables measured by applying correlation and multiple regression technique using SPSS. Findings: Significant correlations exist between WC components with market value and firms profitability. Therefore it seems that Pakistani firms heavily rely upon the current assets for generation of profits. Thus they have to invest in current assets in addition to meet the short term maturities resultantly decline in profitability. Hence this study confirms the findings of previous studies. This study also reveals the continuation of existing trend. Research limitations / Implications:

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European Journal of Economics, Finance And Administrative Sciences - Issue 32 (2011) Originality /Value: This study will contribute towards the body of knowledge as no such study has been done in Pakistan for this period of time. Limitations Despite the theoretical significance, findings are subject to serious practical limitations. Cross sectional studies indicate changes in working capital requirements across the time and industry. Further research should focus the needs of each firm and industry at a particular moment of time. Keywords: Working capital management, Profitability, Market valuation, Pakistan.

1. Introduction
Current liquidity crisis has highlighted the significance of working capital management. As without efficient management in this area no company can survive. Working capital is linked with, both, liquidity and profitability of a firm. Working capital ascertains the firms ability to continue its operation without endangering the liquidity. Working capital management is comprised of many important decision makings. Management of accounts receivables, accounts payables, inventories which include policy decisions in the areas of credit policy and terms of sales etc. What are the appropriate levels of working capital for firms in variety of industries? This question is dealt by almost all the managers and researchers in financial studies. (Lamberson1995). (Horne & Wachowicz, 2000). The answer lies in the objective of a firm, maximization of profits. So each firm will try to develop the model for itself. Maximizing profits, no doubt, is one of the main objectives of a firm but it must not be at the expense of liquidity, the life of the firm. So each manager is required to have a trade off between the two essentials of a firms life.(Raheman* and Nasr,2007). Aggressive sales campaign may include liberal credit policy and high inventory levels, to avoid inventory shortage but it will inflate the account receivables and demand for more WC. On the other hand important component of working capital is accounts payables, and if payments are delayed to the vendors, it will be difficult for a firm to continue its operation market value of the firm will also suffer. Extensive research has been conducted, worldwide and in Pakistan, exploring the various aspects of working capital management (WCM).However no attempt has been made to explore the effect of efficient WCM on the market Valuation of a firm. Although empirical study in the developed economies has established that efficient WCM improves market value of a firm and consequently positive impact upon shareholders value. However less academic evidence has been provided for emerging economies. Hence it becomes highly suggestive to find the evidence from Pakistani perspective. This study will not only contribute that it will add to the body of existing knowledge but it will also have policy implications upon regulatory bodies and financial institutions, such as, SECP; banks & DFIs. Studies in corporate finance is, customarily, considered as the study of long term financial decisions, provision of long term assets and share & dividend policies. However topics of short term finance are not less significant in developing an efficient corporate financial strategy. Among short term strategies working capital management plays vital role in increasing the shareholders value of a firm. Working capital management is the name of striking balance between two objectives of a firm, i.e. profitability & liquidity.(Rehman & Nasar2007)The company strives for maximization of profits without loosing its credit standing & liquidity. To maximize the profits it puts the productive resources (owned & borrowed) in the operation. Managerial decision about borrowing; generating own resources or marinating the current level of business operation determines the working capital needs of the firm.(Deloof, M. 2003) Thus research questions are:

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European Journal of Economics, Finance And Administrative Sciences - Issue 32 (2011) a. Does working capital management have relationship with the profitability of firms in Pakistan? b. Does efficient working capital management affect the market valuation of a firm in Pakistan?

2. Literature Review
Studies in working capital are as old as the study of economics is. (Fazzari & Petersen, 2007) Adam Smith (1771) made clear distinction between fixed and circulating capitals. Dewing, (1941), mentions the existence of two distinct terms in the balance sheet of Society of Royal Mines, prepared in 1571, fixed and current capital. What makes working capital distinct from fixed capital? Dewing, (1941), a leading researcher in financial studies, finds the Liquidity as key difference. A survey conducted in 1911 by Pindyck reveals a shift in emphasis, irreversibility of fixed capital, reversibility of working capital. (Fazzari & Petersen, 2007) An optimal level of working capital is the need of firm, even though firm is using some technique like Six Sigma. (Filbeck & Krueger, 2005). Researchers in WCM have explained the concept in a variety of ways as it is efficient management of liquid assets and liabilities. (Eljelly, 2004) He used current ratio & cash gap to measure the profitability and liquidity of the companies in Saudi Arabia by applying correlation and regression analysis. The research found that cash conversion cycle in more relevant determinant of liquidity than liquid ratio. Literature of financial studies depicts that financial ratios used to be considered for decision making in working capital management in earlier stages but a very few of the researchers discussed WCM as a policy.(Filbeck and Krueger, 2005).However some studies pointed out that average of financial ratios tend to vary across the industry and the time..(Filbeck and Krueger, 2005). Gupta (1969) and Gupta and Huefner (1972).Conclusions were further confirmed that average mean of profitability, leverage and liquidity ratios tend to vary across the industries. (Johnson (1970 & Pinches et al.1973) Extending the discussion, (Maness and Zietlow, 2002, 51, 496) suggest models for value creation incorporating short term factors in their model. However they did not consider situational difference, inter industry & intra industry. Cross sectional analyses of industries show the significant relationship between WCM and firms profitability. Ganesan, (2007), analyzed impact of working capital management upon the performance of firms in Telecom industry. The variables used were, days sales outstanding, number of days for payment to vendors, average days inventory held, cash conversion efficiency, revenue to total assets, revenue to total sales, etc. Findings reveal negative & insignificant relationship between profitability and daily working capital requirement in the said industry.

3. Research Design
In this paper we use secondary data, of sixty five companies randomly selected from Karachi Stock Exchange. The five years panel data, from 2005 to 2009, is extracted from publicly available sources, financial statements and other web sources, is used. Because of difference in nature of operations financial and service industry firms are not included in the analysis. Dependent variables Tobin Q: It is used to measure the market value of the firm as proxy. ROA: Return on Assets, used as proxy for financial performance. ROI: Return in Invested Capital, used as proxy for financial performance.

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Independent Variables CCC: Cash Conversion Cycle CR: Current Ratio. CATAR Current asset to total asset ratio CLTAR Current liabilities to total asset ratio DTAR Debt to asset ratio Research Hypotheses Hypothesis (A): There exists a relation between Market value (Tobin Q ) and Working Capital components. Hypothesis: (B). There exists a relation between financial performance (Return on Asset) and Working Capital components. Hypothesis (C). There exists a relation between financial performance (Return on Invested Capital) and Working Capital components. Regression Model
TQ it = _0+ _1 CCC it + _2 CACLR it+ _3 CATARit + _4 CLTAR it+ _5 DTAR it + ROA it = _0+ _1 CCC it + _2 CACLR it+ _3 CATARit + _4 CLTAR it+ _5 DTAR it + ROIC it = _0+ _1 CCC it + _2 CACLR it+ _3 CATARit + _4 CLTAR it+ _5 DTAR it + (1) (2)

(3)

Where, TQ it = market value of firm i for time period t ROA it = return on assets of firm i for time period t ROIC it = return on invested capital of firm i for time period t CCC it = cash conversion cycle of firm i for time period t CACLR it = current asset to current liabilities ratio of firm i for time period t CATAR it = current assets to total assets ratio of firm i for time period t CLTARit = current liabilities to total asset ratio of firm i for time period t DTAR it = total debt to total assets ratio of firm i for time period t = error term of the model

4. Results and Interpretations

Correlation Analysis Table2 shows the extent of relationship between the variables. Results having low values thus depict absence of multicollinearity among variables. As values exceeding 0.80 are regarded as indicator of multicollinearity. Correlation for Tobin Q indicate positive coefficient with CATAR, CLTAR and DTAR all at 1% significant level, but positive insignificant with CACLR, while, negative coefficient with CCC at 5% significant level. As for ROA, results demonstrate positive coefficient with CACLR and CATAR at 1% level, whilst, negative significant coefficient at 1% level with CCC, CLTAR and DTAR The correlations between ROIC with ACLR, CATAR, and CLTAR also indicating positive significant coefficient at 10%, 1% and 1% level respectively whereas viewing negative significant coefficient with CCC, at 1% level and DTAR at 10% level. Overall the correlations results indicates both alternate hypotheses A, B and C can be accepted implying a significant correlations exist between WC components with market value and firms profitability. Regression Analysis However, examining simple bi-variate correlation in a conventional matrix does not take into account of each variables correlation with all other explanatory variables. To test the effects of working capital on firm value and profitability, a regression analysis are given using 860 firm-years observations and

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the results is presented in table 3. According to Table 3, CCC has a negative association with Tobin Q, ROA and ROIC at 1% significant level. The result for ROA verify the study done by Uyar (2009), The results are also in line with the findings of Martnez-Solano and Garca-Teruel,(2006), However did not find any published study in term of CCC with Tobins Q and ROIC. Findings of this study, suggest that that any increase in TobinQ, ROA and ROIC can be explained by a reduction in CCC and this may infer that, most of the, profitable firms have a shorter CCC. Firms with shorter CCC will be less dependent upon borrowed financing thus less financial costs and thus enhanced profitability. Therefore a discrete management of components of CCC accounts receivables, accounts payables & inventories, will lead to enhanced profitability and growth of the firm. The result of CACLR, at 1% confidence, is negatively related with ROA and ROIC but negatively insignificant with Tobins Q. This can be explained that an incremental change in ROA and ROIC can be explained owing to a reduction in CACLR but not for Tobins Q that, supports our hypothesis B and C, as the effect of CR is negatively significant with ROA and ROIC. Therefore we can conclude that profits maximization can be achieved by reducing the CACLR,. ratio. Our research upholds the findings of Christopher and Kamalavalli (2009) and Shin and Soenen (1998).A further and exhaustive investigation is imperative upon because some other researchers,(Sayuddzaman, (2006) who found positive association with performance. The regression results for CATAR at 1% confidence level show positive relation with Tobins Q, ROIC & ROA shows that an incremental change in Tobins Q, ROA and ROIC would be result of an incremental change in CATAR thus endorse hypotheses 1, 2 and 3. Nazir, (2009), Afza & Nazir, (2007) drew same results for Tobin Q and ROA. Christopher and Kamalavalli (2009) and Narware (2004)ported the similar findings for ROIC. Empirical results provide sufficient evidence that there is strong tendency for Pakistani firms to depend upon current assets for generation of profits. Thus they have to invest in current assets in addition to meet the short term maturities resultantly decline in profitability. The analysis of results, regarding CLTAR, the analysis reveals negative relation with Tobins Q and ROIC both at 10% confidence level while 1% negatively significant with ROA. This point out that the lowering the ratio will increase the profitability of the firm that confirm all the three hypotheses, as the changes in dependent variables can be predicted by the changes in CLTAR. The results for ROA confirm ``the study by Nazir, (2009) and Afza & Nazir, (2007) while Tobins Q contradict to Afza & Nazir, (2007) and Nazir, (2009). As regard to firms performance, Debt to asset ratio (DTAR) indicated mixed results; it indicated a positive relation with Tobins Q at 1% significant level and reverse with ROA at significant level. However the results for return on invested capital (ROIC) indicates a negative but insignificant relation with DTAR. This implies that the increase or decrease of debt level will significantly affect the firms performance, which means that reducing the debt level will significantly increase the ROA and reducing the TobinQ. (Binti Mohamad & Binti Mohd Saad, 2010) The findings ratify our Hypothesis A and B, that market valuation (Tobins Q )and return on assets (ROA) are dependent on good WCM but not Hypothesis C where a change in Tobins Q and ROA can be explained by the change in DTAR but changes in DTAR cannot explain the changes in ROIC. These findings are consistent with the findings of Shin and Soenen (1998), Padachi (2006) and Christopher and Kamalavalli (2009)

5. Conclusions
Empirical results of our research provide sufficient evidence that there is strong tendency for Pakistani firms to depend upon current assets for generation of profits. Thus they have to invest in current assets in addition to meet the short term maturities resultantly decline in profitability. We appreciate that there is ample room for the companies to improve in respect of efficient WCM. Such measures will enable the Pakistani firms to curtail the costs and / thus compete globally for their products.

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Empirical results support the findings of studies (Rehman & Nasar, 2007) and others. It is found that current ratio is most significant having impact upon profitability. Results also approve Hypothesis A that a significant relationship exists between WCM and market valuation of firm. It could be stimulating impact upon the management of the firms for efficient management of resources. More is to be done for further research in the area as it is the initial level of enquiry. Further research areas should be including: a) Study should focus on each segment of the economy rather than random selection; because studies, having significant evidence that working capital ratios tend to vary across the industries. b) Each component of working capital be focused separately for its role in the firm, industry and economy. This effort will lead to formulation of some sort of theory. c) It must be noted that significance of such studies is constrained by time, as varios surveys revealed that ratios tend to vary across the time.

References
1] Abdul Raheman & Mohamed Nasr.(2007). Working capital management and profitability case of Pakistani firms. International Review of Business Research Papers, Vol.3 (2), pp. 275 296. Afza T., & Nazir, M.S. (2007). Is it better to be aggressive or conservative in managing working capital?, Paper presented at Singapore Economic Review Conference (SERC) on August 02-04, Singapore Ashiq Ali,1994, The incremental information content of earnings, working capital from operations, and cash flows Journal of Accounting Research,pp61 Christopher, S. B., and Kamalavalli, A. L. (2009). Sensitivity of profitability to working capital management in Indian corporate hospitals. [Online] Available: http://ssrn.com/abstract=1331500 Deloof, M and Jegers, M. 1996. Trade credit, product Quality, and Intra Group Trade:Some European Evidence, Financial Management, Vol 25 No 3 pp. 33-43 Deloof, M. 2003. Does Working Capital Management Affects Profitability of Belgian Firms?, Journal of Business Finance & Accounting, Vol 30 No 3 & 4 pp. 573 587 Eljelly, A. (2004). Liquidity-profitability tradeoff: an empirical investigation in an emerging market.International Journal of Commerce and Management, Vol.14 (2), pp. 48- 61. Fink, R. 2001. The 2001 working capital survey: Forget the float? CFO 17 (9):54-64. Greg Filbeck and Thomas M. Krueger (2005)An Analysis of Working Capital Management Results Across Industries Mid-American Journal of Business, Vol. 20, No. 2 Ganesan, Vedavinayagam. 2007. An analysis of working capital management efficiency in telecommunication equipment. Industryrivier Academic Journal, 3, No. 2, Fall. Hyun-Han Shin & Luc Soenen. (1998). Efficiency of working capital management and corporate profitability, Journal of Financial Practice and Education, Vol.8 (2), pp. 37 - 45. Kesseven Padachi,2006, International Review of Business Research Papers, Vo.2 No. 2. October 2006, Pp. 45 -58 Maness, T. and J. Zietlow. 2004. Short-term Financial Management. Australia: Southwestern Press. Nazir, M.S. (2009). Impact of working capital aggressiveness on firms profitability. IABR & TLC Conference Proceedings, San Antonio, Texas, USA. Raheman, Abdul & Mohamed Nasr. (2007). Working capital management and profitabilitycase of Pakistani firms. International Review of Business Research Paper, 3.1,pp.279-300. Uyar, Ali. (2009). The relationship of cash conversion cycle with firm size and profitability: an empirical investigation in Turkey. International Research Journal of Finance and Economics, ISSN 1450-2887 Issue 24, EuroJournals Publishing, Inc.

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Appendix
Table 1: Notations and measures used for all variables in the study
Notation TQ ROA ROIC CCC Description (market value of equity + book value of liability)/ total assets earning before interest tax/ total asset net income/ total capital days sales in inventory (DSI) + days sales outstanding (DSO) -days payables outstanding (DPO); *DSI= inventories/ (COGS/days in year) *DSO= receivables/ (sales/days in year) *DPO= payables/ (COGS/days in year) current asset/ current liabilities current asset/ total asset current liability / total asset total debt/ total asset

Variable Name Dependents Variables; 1. Tobin-Q 2.Return on Asset 3. Return on Invested Capital Independents Variables; 3. Cash Conversion Cycle

4. Current Asset to Current Liability Ratio 5.Current Asset To Total Asset Ratio 6.Current Liability to Total Asset Ratio 7. Total Debt to Total Asset Ratio

CACLR CATAR CLTAR DTAR

Table 2:

The Pearson Correlations Matrix

TobinQ 1 .308***.000 .398***.000 -.086**.012 .011.737 .172***.000 .103***.002 .107***.002 ROA .308***.000 1 .631***.000 -.154***.000 .183***.000 .293***.000 -.078**.023 -.247***.000 ROIC .398***.000 .631***.000 1 -.135***.000 .064*.061 .379***.000 .203***.000 -.063*.066 CCC -.086**.012 -.154***.000 -.135***.000 1 .089***.009 .179***.000 .018.602 -.067**.050 CACLR .011.737 .183***.000 .064*.061 .089***.009 1 .333***.000 -.280***.000 -.358***.000 CATAR .172***.000 .293***.000 .379***.000 .179***.000 .333***.000 1 .530***.000 -.151***.000 CLTAR .103***.002 -.078**.023 .203***.000 .018.602 -.280***.000 .530***.000 1 .251***.000 DTAR .107***.002 -.247***.000 -.063*.066 -.067**.050 -.358***.000 -.151***.000 .251***.000 1

VARIABLES TobinQ ROA ROIC CCC CACLR CATAR CLTAR DTAR

*** Significant at 1% level ** Significant at 5% level * Significant at 10% level

Table 3:

Linear multiple regression coefficients with dependent variables; Tobin Q (TQ), return on asset (ROA) and return on invested capital (ROIC)
Eq.3 ROIC t p -6.812*** .000 -2.809*** .005 10.595*** .000 -1.785* .075 -634 .526 .440 0.194 41.089*** 0.000

Eq.1 TOBINQ Eq.2 RAO t p t p -3.564*** .000 -8.024*** .000 -1.014 .311 -3.454*** .001 5.568*** .000 12.340*** .000 -1.883* .060 -8.391*** .000 4.057*** .000 -3.988*** .000 0.254 0.489 0.064 0.239 11.761*** 53.606*** 0.000 0.000 Significant at 1% level Significant at 5% level Significant at 10% level

Dependent Variable Independent Variable CCC CACLR CATAR CLTAR DTAR R R Square F-Value