Research report on Working Capital Management

14,596
-1

Published on

Research Report on Working Capital Management related to Finance students.

Published in: Economy & Finance, Business
0 Comments
5 Likes
Statistics
Notes
  • Be the first to comment

No Downloads
Views
Total Views
14,596
On Slideshare
0
From Embeds
0
Number of Embeds
0
Actions
Shares
0
Downloads
655
Comments
0
Likes
5
Embeds 0
No embeds

No notes for slide

Research report on Working Capital Management

  1. 1. Working Capital Management July 20 2012 Course: Financial Management M. Shaharya Saeed SP10-BB-0039 Mohammad Ali Jinnah University Research Report Submitted to: Sir Umair Baig
  2. 2. Working Capital Management 2 ACKNOWLEDGEMENT “The hardest steel goes through the hottest furnace.” The same was the case with me. I faced many problems when I started the work on report but we are greatly thankful to Almighty Allah for enabling us to get successfully through my responsibilities. Very warm and special thanks to my respected teacher Sir Umair Baig, whose real dedication and devotion kindled in me hope and light. Sir I thank your ability of extracting the very best out of me, for your patience and perseverance, and also for acknowledging the efforts made by me during the whole semester. Thank you From: M. Shaharyar Saeed
  3. 3. Working Capital Management 3 Abstract Working capital management is important part in firm financial management decision. Improper management of Working capital, that is, too much or too low working capital may suffer firms, so an optimum level of working capital is the key to a smooth inflow of profit. In this paper we investigate the relationship between profitability and working capital management. We used a sample of 60 textile companies listed at Karachi Stock Exchange (KSE) for the period of 2001- 2006 and the firms observations are 360. The purpose of this study is to establish a relationship that is of statistical significant between profitability, the cash conversion cycle and its components (Number of days Accounts receivables, Number of days Accounts payables and Number of days Inventory). The results of our research showed that there is statistically negative significance between profitability, measured through Return on Asset, and the cash conversion cycle. Moreover managers can create profits for their companies by handling correctly the cash conversion cycle and keeping Number of days Accounts receivables, Number of days Accounts payables and Number of days Inventory to an optimum level. Keywords: Working Capital Management ; Profitability: Evidance From Pakistan Firms.
  4. 4. Working Capital Management 4 Relevence of Working Capital Management: Working capital is current assets (cash, receivables, inventory, etc.) minus current liabilities (debt obligations due within one year). Working capital may also be viewed as the amount of a business's current assets provided (financed) by long- term debt and/or equity. If, for example, a business has no current liabilities, working capital equals current assets. In the situation just described, 100% of current assets are provided (financed) through long-term debt and/or equity. If, in contrast, a business has exactly $0 working capital, current assets equals current liabilities. Or, in other words, 100% of current assets are provided (financed) with short- term debt (current liabilities). A business that has no working capital or very little working capital will likely have difficulty in paying short-term debt obligations from operational sources of cash in sustained or sudden declines in sales. Therefore, the importance of maintaining an appropriate level of working capital and its contribution to business survival is a concept that small business managers should understand. Managers should develop a working capital philosophy that they can apply and monitor carefully. The importance of working capital is quite often overlooked by both the borrower and the lender. Working capital may be viewed as the amount of a business's current assets financed by long-term debt and/or equity. A business that has little or no working capital is likely going to have difficulty in paying or refinancing short-term debt during times of business declines which may be accompanied by a tightening of business credit.
  5. 5. Working Capital Management 5 INTRODUCTION: Working capital management is important part in firm financial management decision. Working Capital refers to a company’s Current Assets. Current Assets are Cash and Equivalents, Accounts Receivable, and Inventory. Working Capital Management is applying Investment and Financing Decisions to Current Assets. Working capital management is a very important component of corporate finance because it directly affects the liquidity and profitability of the firm Referring to theory of risk and return, investment with more risk will result to more return. Thus, firms with high liquidity of working capital may have low risk then low profitability. Conversely, firm that has low liquidity of working capital, facing high risk results to high profitability. The issue here is in managing working capital, firm must take into consideration all the items in both accounts and try to balance the risk and return. 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 Liquidity (Ability to pay bills, keep sales coming in, keep customers happy, play it safe ) and Profitability (Size of earnings after taxes) accurately. Working capital management is the lifeblood of business and every manager's primary task is to help keep it flowing and to use the cash flow to generate profits. Creditors are a vital part of effective cash management and should be managed carefully to enhance the cash position. There is an old saying in business that if you can buy well then you can sell well. Management of your creditors and suppliers is just as important as the management of your debtors. Slow payment can be inexpensive and flexible source of financing but it can cost the firm when discount is offered for an early payment and may create ill-feeling that can signal that your company is inefficient or in trouble. Large inventory and a generous trade credit policy may lead to high sales. Large inventory reduces the risk of a stock- out. Trade credit may stimulate sales because it allows customer to assess product quality before paying (long, Maltiz and Ravid, 1993 and Deloof and Jegers, 1996) on the other hand, late payment of invoices can be very costly if the firm is offered a discount for early payment.
  6. 6. Working Capital Management 6 Methodology: The primary aim of this paper is to investigate the impact of WCM on corporate profitability of Mauritian small manufacturing firms. This is achieved by developing a similar empirical framework first used by Shin and Soenen (1998) and the subsequent work of Deloof (2003). We extend our study by also analysing the trends in working capital need of firms and to examine the possible causes for any significant differences between the industries. Our study focuses exclusively on the small manufacturing firms operating in five major industry groups which are both registered and organised as proprietary/private companies. This restriction places a limit on the number of firms qualifying for the study and is further narrowed down following the revised Companies Act of 2001 which requires firms with a given turnover threshold to file only an aggregated financial statements. Thus the empirical study is based on a sample of 58 small manufacturing companies. The data has been collected from the financial statements of the sample firms having a legal entity and have filed their annual return to the Registrar of Companies. The sample was drawn from the directory of Small Medium Industrial Development Organisation (SMIDO), a database for registered manufacturing firms operating in diverse activities and for which data was available for a 6 years’ period, covering the accounting period 1997-98 to 2002-03. The companies qualified for the above two conditions are further grouped into industries based on the classification as listed in the 2003 directory. Thus the data set covers 58 firms from five industry subsectors: food and beverages, leather garments, paper products, prefabricated metal products and wood furniture. This has given a balanced panel data set of 348 firm-year observations for a sample of 58 firms. For the purpose of this study, profitability is measured by Return on Total Assets (ROTA), which is defined as profit before interest and tax divided by total assets. The operating income measure of profitability used in the study of Deloof (2003) is not appropriate for this study. The SMEs is characterised by a low fixed assets
  7. 7. Working Capital Management 7 base and relied to a large extent on accounts payable to fund its gross working capital. Thus a comprehensive measure of profitability is best captured by computing the return on total assets which is equal to the total liabilities of the firms, made up mainly of equity capital and current liabilities. Some firms have significant fixed financial assets and were thus excluded from the calculation of ROTA. Working Capital Analysis The major components of gross working capital include stocks (raw materials, work-in-progress and finished goods), debtors, cash and bank balances. The composition of working capital depends on a multiple of factors, such as operating level, level of operational efficiency, inventory policies, book debt policies, technology used and nature of the industry. While inter- industry variation is expected to be high, the degree of variation is expected to be low for firms within the industry. Control variables In order to account for firm’s size and the other variables that may influence profits, sales a proxy for size (the natural logarithm of sales), the gearing ratio (financial debt/total assets), the gross working capital turnover ratio (sales/current assets) and the ratio of current assets to total assets are included as control variables in the regressions. The regressions also include the ratio of current liabilities to total assets to measure the degree of aggressive financing policy, with a high ratio being relatively more aggressive. The explanatory variables The efficiency ratios, namely accounts receivable, inventory and accounts payable have been computed, using the formulas as listed in Appendix 1. The Cash Conversion Cycle (CCC) is used as a comprehensive measure of working capital as it shows the time lag between expenditure for the purchases of raw materials and the collection of sales of finished goods. The longer the cycle, the larger the funds blocked in working capital. The return on assets is a better measure since it relates the profitability of the business to the asset base.
  8. 8. Working Capital Management 8 Findings: In the first part of data analysis, profile of the respondents and results of open ended questions is being discussed. A total of 190 responses were received comprising 83% response rate. These responses represent four broad industries mainly service sector (covering banks and financial institutes, petroleum gas, telecommunication and service providers). During the last decade, service industry particularly banking and telecommunication sectors has shown a tremendous growth in Pakistan. The overall consensus of industry analysts is that Pakistan is one of the countries with a huge untapped potential for telecommunication growth and an attractive investment environment that is the main reason why researcher has tried to gather data from these firms. (Bhatti, 2006). When analyzed the total respondent pool about the working capital decision making, it was revealed that 65.8 % of the respondents confirmed it at the corporate level. This result is closer to the Ricci and Vito study who had reported it as 57.3%. The regional level value was 32.1% and only 1.6% of the respondents were taking decisions at local level. Overall, it may be concluded that most of the firms tend to make it at corporate level which shows the centralized approach for making working capital decisions. Response rate was 76.3% when inquired about the firm’s percentage of overseas sales, it was discovered that 71% of the respondents replied it between 1-50%. However 29% of the respondents answered that it was between 51-100%. About relationship with foreign banks, the results of the survey indicate that almost 68.7% of the firms have relationship with 1-20 foreign banks. This result is quite parallel with Ricci and Vito study which show that 74.1% of the firms have relationship with 1-25 foreign banks. Response rate for this question was 77.3%. 71% of the respondents claimed that overseas demand deposit account were between 1-20. More surprisingly it was revealed that 3.2% firms confirmed between the numbers 10,000-50,000. Next section discusses about international cash management, international sales and foreign exchange activities.
  9. 9. Working Capital Management 9 i) International Cash Management A brief summary and comparison of usage with UK firms of international cash management techniques. Wire Transfers CHIPS (Clearing Ho se Interbank Payment System) and SWIFT (Society for Worldwide Interbank Financial Telecommunications) are two computerized systems of international wire transfers A primary benefit offered by SWIFT lies in the standardization of the transfer process, which significantly reduces errors by providing a singular means of communication between correspondent banks. In addition, "SWIFT has evolved into one of the least costly, securest, most rapid means of transmitting . . . instructions" (Aggarwal and Baker, 1991). The results of the survey shown in table 1 indicate that 59.5% of the respondents use wire transfers often, while 6.8% never use them. These results are somewhat similar to Ricci & Vito study, which says that 68% of the respondents often used wire transfers, whereas 7.2% never used it. So it may be inferred that wire transfers being less costly instrument, is being used as international cash management operations. Electronic Funds Transfers Wire Transfer is transferring credits from your Bank Account to the Weapons factory or Research. With using Wire Transfer you do not have to have wealth. Wire transfers cost 30% more then purchasing by Wealth. Online electronic funds transfer is much more secure than traditional wire transfers. There are no unexpected agent fees, and no need for the recipient to carry large amounts of cash. Table 1 reveals that 53.7% of the respondents often use it and 12.6% said that they never did. The result is quite similar to the Ricci and Vito study which confirm that 61% of the respondents often use it.
  10. 10. Working Capital Management 10 Cash Pooling Summary statistics in table 1 show that 28.4% of firms were often use cash pooling as one of the cash management techniques whereas 27.4% were using it sometimes. There has been found a significant difference when compared this result with Ricci and Vito study which says that 52.0% often use cash pooling whereas 28.0% has never used it. The reason could be the major disadvantage attached to pooling which is that the firm's subsidiaries have less control over their cash flows since all cash not needed for transaction purposes is transferred to the pool.(Ricci et al, 1996) Payments Netting The payoff from multilateral netting systems can be large relative to their expense. For instance, "many companies find they can eliminate 50% or more of their intercompany transactions through multilateral netting, with annual savings in foreign exchange transaction costs and bank transfer charges that average about 1.5% per dollar netted" (Shapiro, 1992). As may be seen in table 1 only 20% of the respondents say that they often use it while 21.6% say that they have never used it. If one looks at the Ricci and Vito study, it was found that results are more or less similar which says that 23.2% of respondents often use it and 27.3% say they never used it. One reason of the low usage can be explained by the fact that payment netting is a relatively new phenomenon.
  11. 11. Working Capital Management 11 ii) International Sales A brief summary and comparison of usage with UK firms of international cash management techniques Open Accounts Importers prefer open account terms over many other methods of payment because open account sales offer simplified, flexible purchase procedures. In addition, open account sales cost less for importerswhen compared to other methods such as letters of credit. Moreover, the open account method of payment is the most secure method for importers since they have power over both the goods and the funds. For exporters, sales on open account have both benefits and costs. Since importers prefer purchases on open account, selling on open account may improve an exporter's competitiveness. Another benefit of open account sales is that coordination with banks is not required; therefore, bank charges are saved. (Ricci et al, 1996). Summary statistics shown in table 2 clearly indicate that 40.5% of the respondents often use open accounts whereas 15.3% never used it. These results are close to Ricci & Vito study which shows that 41.1% of the respondents often use it whereas 10.1% never used it. Reason could be that it is the most secure method of international sales operations. Lockboxes Companies use the lockbox system in order to reduce the time float. Domestic and International lockbox are same the only difference is that in international lockbox companies employ banks located in foreign countries to collect their payments. Table 2 show that 21.1% of the respondents often use lockboxes, whereas 39.5% has never used it. These results are closer the results of Ricci and Vito study, the reason cited could be the increased use of online banking in recent years which has eliminated float to its minimum. It has been estimated that the savings from lockbox float gains declined approximately 60% from 1984 to 1994 (Hinton, 1994).
  12. 12. Working Capital Management 12 Value Dating About value dating, the results in table 2 clearly demonstrate that 33.2% of the respondents never used it whereas only 15.8% have often used it. These results are similar to Ricci study which shows that 42% of the respondents never use value dating. Reason for the lack of value dating may be that it "makes international funds transfers potentially more expensive than domestic transfers" (Hill and Sartoris, 1992), due to the high opportunity cost of delayed funds. Clearly, value dating as a form of compensation can present significant cash management challenges (Seeman, 1992) Letters of Credit A letter of credit is a document issued mostly by a financial institution which usually provides an irrevocable payment undertaking (it can also be revocable, confirmed, unconfirmed, transferable or others e.g. back to back: revolving but is most commonly irrevocable/confirmed) to a beneficiary against complying documents as stated in the credit. Documentary Collections Documentary collection is a good method of payment when the buyer and seller know each other well and there is minimal country risk involved. (Stroh, 1994) The documentary collections method is in essence a time draft (discussed below), with documents required before payment is made. In the documentary collections process, the banking system serves as the transfer agent. Cash in Advance This mode of payment offers the greatest protection at the end of exporters because no credit extension is required. The primary disadvantage of cash in advance is that it can limit the exporter's sales potential. Importers are often unwilling or unable to meet cash in advance terms for several reasons. First, the buyer must rely upon the integrity of the seller, who simultaneously controls both the goods and the funds. Second, the importer has the least amount of flexibility with cash in advance terms.
  13. 13. Working Capital Management 13 Factoring The selling of receivables to a financial institution, the factor, usually “without recourse”. The sale is usually “without course” meaning that the selling firm would not be liable for any receivables not collected by the factor. Factoring arrangements are governed by a contract between the factor and the client. The contract is frequently for one year with an automatic provision for renewal and can be cancelled only with the prior notice of 30-60 days. Its principal shortcoming is that it can often be expensive but at the same time factor often relieves the firm of credit checking, the cost of processing receivables, collection expenses, and bad-debt expenses. Sight or Time Drafts Sight and time drafts are employed as the basis for payment in many export transactions. They are drawn by the seller on the buyer and are generally forwarded by the seller through his/her bank to the buyer’s bank for collection. A sight draft calls for payment when it is presented to the buyer, whereas time draft calls for payment within a period of time after a date is established by “sight” “arrival” or “date”. Sight or time draft is less secure than the letter of credit. Unlike a letter of credit transaction, a sight or time draft is not supported by the credit of a bank. (Reif et al, 1997) GIRO Payments A giro (from the Latin “gyre”: turn, transfer) is a payment mechanism that allows the direct transfer of funds between giro bank account holders. Corporations use giro payments in the areas of receivables management, small cross-border transfers, and payroll services (Oosthoek, 1985). The advantages of giro payments include decreased collection float and low cost. The major disadvantage for the seller is that he or she must wait for the buyer to initiate the giro payment. As it can be seen from table 2 only 20.5% of the respondents are using giro payments whereas 35.3% never used it. Ricci & Vito study show that only 11% use giro payments and 45.1% have never used it. These results show congruency in terms of usage of this vehicle. Similar patterns of results are showing that firms are still reluctant to use giro payments since it calls to wait for the buyer for initiation.
  14. 14. Working Capital Management 14 iii) Foreign Exchange Activities A brief summary and comparison of usage with UK firms of foreign exchange activities Spot Market The most common type of foreign exchange transaction is for immediate exchange, at the spot rate. The market where these transactions occur is known as the spot market. (Madura, 2006). 43.2 % of the respondents often use spot market and 17.9% never used it. Ricci and Vito survey shows that 71.2% of the respondents often use it whereas 2.9% never used it. These results are comparable but show different percentages. Forward Market & Futures Contract The derivative securities introduced in 1971 first time are being widely used as forward and futures contracts for hedging to reduce the foreign currency risk. Both forwards and futures are agreements that bind two parties to exchange currencies at a fixed exchange rate at a future date. Essentially, both contracts offer the benefit of securing cash flows on imminent transactions. Where, futures contracts are standardized, forward contracts are tailored to individual needs. Currency Options An option which gives the owner the right to buy or sell the indicated amount of foreign currency at a specified price before a specific date. Results of this survey shown in table 3 shows that 23.7% of the respondents often use it whereas 26.3% has never used it. Comparison with Ricci and Vito study indicate that 12.6% often use it and 24.3% have never used it. Reason for this could be that currency options might be too sophisticated and immediate to most of the firms residing in Pakistan. Leading and Lagging When a perfect hedge is not available or is too expensive, to eliminate transaction exposure, the firm should consider the methods to at least reduce exposure. One of the methods being used is leading and lagging.
  15. 15. Working Capital Management 15 Currency Swaps An arrangement in which two parties exchange specific amounts of different currencies initially, and a series of interest payments on the initial cash flows are exchanged. Often, one party will pay a fixed interest rate, while another will pay a floating exchange rate (though there may also be fixed-fixed and floating-floating arrangements). At the maturity of the swap, the principal amounts are exchanged back. Unlike an interest rate swap, the principal and interest are both exchanged in full in a currency swap. Results of the survey shown in table 3 indicate that 20.0% of the respondents often use this vehicle whereas 33.2% has never used it. In contrast, Ricci and Vito study reflect that 6.8% of the respondents often use it whereas 73.8% never used it. Limitations of the study: 1.All the data presented for the working capital management. 2.The information provided to the researcher may be over simplifications of facts over generalization from insufficient data. 3.Working capital analysis does not measure the qualitative aspects of the business. It does not show the skills, technical know how and the efficiency of its employees and managers. 4.The working capital management does not reveal the over all financial position of the company.The working capital management does not explain about profitability. Conclusion: Working capital, being the lifeblood of any organization has a broad spectrum of importance in running the short term objectives such as cash management on one hand and decisions pertaining to foreign exchange activities on the other. Different analyses in this study have produced several conclusions. First, the process of internationalization has not increased significantly as it is evident from degree of internationalization. Only 29% of the respondents have overseas sales between 51-
  16. 16. Working Capital Management 16 100%. Also decisions are still being taken at the corporate level as opposed to local and regional levels which show the higher degree of centralization for decisions about working capital management. Wire transfers and electronic funds transfer were the most popular International cash management vehicles. The reason can be explained by the fact that these vehicles are speedy and cost effective. Open accounts, letter of credit and documentary collections were mostly used by the respondents when asked about the mode of payment for international sales. Surprisingly, the usage of letter of credit was significantly higher as compared to the Ricci and Vito survey. The explanation of this finding can be that both the exporters and importers have benefits which outweigh the cost involved. About the foreign exchange activities, spot market and forward market was the most widely used vehicle. Interestingly, Ricci and Vito survey also show the wide use of these two vehicles at the top among the usage of foreign exchange activities vehicles despite the fact that there was a difference of almost 8 years between these two researches. To conclude all this, it can be generalized that firms have shifted their concerns towards low cost and efficient methods related to international working capital management decisions and there was found no significant difference when analyzed with respect to different sectors. Like any other study, this survey is not without limitations. First, the scale used was just taken as teacher made instrument and was not without loop wholes. For example, some of the questions were answered by the respondents based on their own understanding. Second, some concepts specially related to foreign exchange activities are relatively novel and the respondents had not enough knowledge about it. Third, response rate was somewhat low for open ended questions which might reflect in generalizing the results. Last, but not least there is a lack of fundamental research in the area of working capital so enough literature was not available which could provide a strong foundation for proper research design. Future researchers may take this study as a baseline for conducting the longitudinal research. Also focus groups with industrialists and professionals can be done to improve the tool.

×