Cash Conversion Cycle with Firm Size and Profitability

This study examines the relationship of cash conversion cycle with the size and profitability of the firms in the four specific manufacturing sectors listed at Karachi Stock Exchange named Automobile and Parts, Cement, Chemical, and Food Producers Hence, the results are not generaliseable to non-listed companies but do present valid benchmarks of CCC turnover days for firms in the industrial sectors studied. The data is gathered from the annual reports of 31 sampled firms out of the total firms in the related sectors i.e. 143 covering the period of 2006-2010. The statistical tests which were used in the study for empirical investigation are One-Way ANOVA and Pearson correlation analysis. The lowest mean value of the CCC length is found in the cement industry, with an average of -52.38 days, and the highest mean value of the CCC is found in the Automobiles industry, with an average of 73.72 days. As was expected there is a significant negative correlation between the CCC and the firm size in terms of total assets, and appears a negative correlation between CCC and profitability in terms of return on total assets with the values of -0.415 and -0.131 respectively. The paper is one of the rare studies about the subject conducted in developing countries, and also in Turkey. Secondly, the paper presents industry benchmarks to the firms to evaluate their CCC performance. The study has several implications and is supposed to be very beneficial for the industries, academics and analysts, as it describes the cash management performance of the selected sectors and its findings can help in setting some useful benchmarks in the related sectors.

Key words: – Working Capital Management, liquidity, Profitability, Cash conversion cycle, ANOVA, Pearson Correlation.

Introduction

Working capital management (WCM) and liquidity management hold a significant position among the financial decisions because these affect the firm’s profitability, risk and its market value. Researchers have studied working capital management in different areas and in different ways, as several studies have been conducted on the relationships among the inventory management, account receivables, accounts payable and the cash conversion cycle. Cash conversion cycle ( CCC ) have three main components receivable conversion period, payment deferral period and the inventory conversion period. The firms always attempt to works to seek the most suitable combination of these variables so that the firm’s liquidity is kept intact as well as the firm’s profitability is also ensured at its optimal level. The CCC length relates to the number of days the cash resources are tied up in the working capital components. A larger CCC turnover definitely results in the unprofitable use of the firm’s resources and eventually it can hurt the firm’s profitability. The firms usually set appropriate policies of collection and discounts of the accounts receivables and resultantly these policies have much to do with the firm’s profitability. The firms have to make a very appropriate choice between the CCC length and offering discounts to their customer. On the other side of the credit payments, the firms have to ensure their adequate solvency as well as to delay the time period for the payment towards their creditors and the suppliers for the items and materials purchased on credit.

Liquidity management, which refers to management of current assets and liabilities, plays an important role in the successful management of a firm. If a firm does not manage its liquidity position well, its current assets may not meet its current liabilities. Hence, the firm may have to find external financing due to having difficulty in paying its short term debts. Unfortunately, every firm is not able to find external financing easily, especially as it is in small firm case. In addition, although firms are able find external financing, the cost of borrowing may be expensive, resulting in poorer bottom line. Liquidity of firms can be gauged by cash conversion cycle (CCC) measuring the time lag between cash payments for purchases and collection of accounts and debts receivables from clients. The working capital ratios such as current ratio and quick ratio are useful liquidity indicators of firms; they focus on static balance sheet values (Moss and Stine, 1993) whereas, CCC is a dynamic measure of ongoing liquidity management, as it considers related elements of both balance sheet and income statement along the time dimension (Jose et al., 1996). Measuring an individual firm’s CCC length is vital for its liquidity analysis and improvements, whereas the industry benchmarks are vital for comparative evaluation of its overall CCC performance and explore the viable opportunities for growth in the related sector(Hutchison et al., 2007). Cash or finance is really considered the lifeblood of business and a proper cash management and the firm’s liquid resources is vital to the firm’s profitability, survival and the ultimate growth. One can never expect a smooth working of any business unit unless and until its precious resources are used in an optimal way. The firms which face the WCM management problems and liquidity shortages always find it extremely difficult to cope with the issues relating to their survival and eventual growth. So investigating the optimal combination of the components of WCM is of paramount academic as well as practical importance, and that especially in the context of the developing countries and the small and medium sized enterprises ( SMEs). The meager resources on the disposal of the SMEs compel them to seek external financial assistance and that too is not always available in the required magnitude as the financial markets in the developing countries are not well developed and the lenders as well as the financial institutions are usually found hesitant to finance their needs. So the topic of liquidity management is of great importance in the context of the developing countries like Pakistan.

Defining Cash Conversion Cycle

The CCC measure is basically related to working capital management (Keown et al., 2003; and Bodie and Merton, 2000). It 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 (Padachi, 2006). The management of a firm’s short term assets and liabilities is vital to the survival and ultimate growth of firms without which it long term prospects and healthy bottom lines can’t be guaranteed (Jose et al., 1996). The CCC length in days can be simply described in an equation as follows:

CCC length = Stock turnover days + receivables turnover days – payables turnover days

So we can easily understand that managing the cash both on the receivables side and the payable side is very important for the efficient utilization and ensured performance of the firms.

Figure 1: The cash conversion cycle

Adapted from Jordan (2003)

Cash conversion cycle (CCC) can be negative or positive. A positive CCC shows the number of days a firm must arrange/borrow or tie up its working capital/current assets before it receives payment from its customer(s). Whereas a negative CCC can be seen as highly favorable as it means that the firm has already received cash from sales/accounts receivables before has to discharge its current obligations towards its creditors (Hutchison et al., 2007; Uyar, 2009). It can be argued that the firm must try to make or keep the CCC days as minimum or preferably in negative as it can ultimately relieve the firm owners/managers from many worries of cash bottlenecks and liquidity problems. Managing a minimum CCC days or keeping it in negative invariably demands an efficient working capital management on the part of the firm owners. It has been argued that the firm may have to adopt all or any one of the following strategies to maintain an efficient level of CCC days (Bodie and Merton, 2000; Uyar, 2009):

• Minimizing the firm’s inventory turnover days: The firm must adopt efficient inventory management methods/processes of ordering, handling and utilization in the production and ensure that the inventory turnover days are kept as minimum as possible. The firm must also ensure an effective approach like that of Quick Response Supply (QRS) or the Just In Time (JIT) with respect to its inventory management to ensure a timely receiving and replenishment of stocks and supplies.

• Quick collection of the firm receivables/debts: The firm must adopt an efficient and quick method of collection of its accounts so that its funds are not tied up unproductively for overdue time periods.

• Slow payment of current obligations, utility bills etc. It is better and highly advisable that the firm must maintain an intact record of its payment of current obligations in such a way that it is able to avail as much days from its suppliers and creditors as possible before it has to actually discharge its obligations. The firm’s ability to generate cash receipts well in advance and in excess of disbursements is vital to its success and growth (Padachi, 2006).

The management of working capital means the management of current assets and current liabilities and financing of the current assets. Liquidity management pertains to how the company manages its current assets and its liabilities. It is very helpful and plays a significant role on the successful management of the firm. The efficient working capital management is the most crucial factor for maintaining liquidity, survival, solvency and profitability of business (Mukhopadhyay, 2004). Efficiency of working capital management is based on the principle of speeding up collections as much as possible and slowing down disbursements as much as possible. The cash conversion cycle primarily focuses on the number of days funds are tied up in receivables, inventories and payables. It could have a negative relationship with profitability when the firm tries to shorten their cash conversion cycle period in such a way that by reducing average age of inventory a firm could face the situation of stock out, by trying to reduce average collection period they could lose their good creditors and by delaying payments a firm could lose their reputation. So, the purpose of this study is to find the optimal relationship between the cash conversion cycle and profitability and also the relationship between cash conversion cycle and the size of firm.

Problem Statement The statement of the problem to be analyzed is:

Are the firm size and profitability affected by the cash conversion cycle time period?

Purpose of the Study

There are many researches regarding working capital management and its impact on the profitability of firms but very few researches have been conducted in Pakistan regarding working capital management and still a little is found regarding the cash conversion cycle relationship with the firm size and profitability. So the purpose of this study is to analyze the impact of cash conversion cycle on the profitability as well as on the size of the firms from four industrial sectors of Pakistan. The primary objective of the study is to examine the relationship between:

the length of the CCC and the size of the firms, and

the length of the CCC and profitability of the firms.

The study concentrates on anticipating the consequences of cash conversion cycle in terms of the size and profitability of Pakistani sectors (Automobile and parts, Cement, Chemical and Food producers). Section three provides literature review about the CCC. Section four presents research methodology and design of the study. Section five analyzes findings of the study, and the sixth section provides the concluding remarks of study.

Literature Review

Liquidity management is best if based on the principle of collecting cash from accounts receivables as early as possible and delaying the payments of current obligations as much as possible. When a business is not able to manage its liquidity position it will face difficulty in paying its short term debts and therefore the business move towards external financing to clear its short term debts. Management of working capital was found to have a significant impact on both the profitability and liquidity in previous studies in the context of different countries (Uyar, 2009). Uyar, (2009) examined the sample of 166 corporations from seven industries of merchandising and manufacturing sector listed in Istanbul Stock Exchange and concluded that the larger the firm size, the shorter the CCC or the smaller the firm size, the longer the CCC and the firms with shorter CCC are more likely to be more profitable than the firms with longer CCC.

It can be safely argued that every firm whether micro, small of large, must maintain and ensure an efficient cash management record in order to get maximum return on its highly precious capital invested in the business. Conversely, a poor cash management may well land the firm into troubles as it couldn’t be able to pay its current obligations on time and eventually the firm may have to face the technical insolvency in the short run, or even the ultimate bankruptcy if such state of poor cash management persists and remains unresolved for excessively long period of time. So it can be established that liquidity management is important to maintain adequate profitability as well as the survival of the firm (Uyar, 2009).

The Corporate liquidity can be assessed in the context of two different aspects: static or dynamic (Lancaster et al., 1999; Farris and Hutchison, 2002; Moss and Stine, 1993and Uyar, 2009). The first static aspect based view relates to the use of conventional ratios like working capital ratios and liquidity ratios. These various ratios are deployed to gauge or measure the liquidity of the firm at a specific point in time whereas the dynamic view takes into account the firm’s ongoing or concurrent liquidity position based on firm’s operations. So the CCC days is the very outcome of this dynamic view of cash management on the part of the firm. Moss and Stine (1993) found firm size to be an important factor towards the CCC days. They showed that the larger the size of the firms; the shorter is the CCC turnover in days. They also found a significant a positive relationship of the CCC when compared to the working capital ratios. The previous researchers have found a significant and negative relationship between profitability and the length of CCC (Jose et al., 1996; Eljelly, 2004; Uyar 2009).

Deloof (2003) investigated the effect of working capital management on corporate profitability of Belgian firms using the sample of 1,009 large Belgian non-financial firms for the tenure of 1992-1996. Trade credit and inventory policies are measured by average collection period, average age of inventory and payable deferral period. Working capital management is measured through cash conversion cycle. Their findings suggest that managers can increase corporate profitability by reducing the average collection period and average age of inventory and by increasing the period to pay their obligations.

Samiloglu and Demirgunes (2008) analyzed the effect of working capital management on the firms profitability of the Turkey manufacturing firms listed in the Istanbul Stock Exchange (ISE) for the period of 1998-2007 using the multi regression model for the analysis. Empirical findings showed the results that receivable conversion period, inventory conversion period and leverage affects negatively on the firm profitability, while growth in sales affects firm profitability positively.

Karaduman, Akbas, Ozsozgun and Durer (2010) studied the effect of working capital management on profitability using the panel data study for the period of 2005-2008 of the companies listed in Istanbul Stock Exchange and said that working capital management is the most fundamental driver of firms market value because it directly affects profitability and is also very crucial from the firms point of sustainability. So the firms should develop the well balance between the profitability and risk when it comes to working capital management.

Zarivawati and et al (2009) analyzed the WCM and corporate performance of the six different economic sectors listed in Bursa Malaysia using a panel data of 1628 firm for the year of 1996-2006 and reported a strong negative relationship between cash conversion cycle and firm profitability.

Wongthatsanekorn (2010) investigated the CCC management of 13 listed private hospitals in Thailand by regular and panel data regression analyses for the period of 2002 to 2008 and suggested that corporate profitability could be enhanced by decreasing accounts receivable and accounts payable.

Lyroudi and Lazaridis (2000) examined the cash conversion cycle and liquidity analysis of the food industry in Greece. And reported that there is a significant positive relationship between CCC and the traditional liquidity measures of current and quick ratios. Koumanakos (2008) analyzed the effect of inventory management on firm performance for the period of 2000-2002 using the ICAP database containing financial information on all firms from three sectors. The findings indicated that high level of inventories was associated with the lower rate of return. Padachi, (2006) analyzed the WCM trends and their impact on firm performance for a sample of 58 small manufacturing firms using panel data for regression analysis for the period of 1998-2003. He reported a significant negative relationship between the inventory levels and the profitability.

Singh and Pandey (2008) studied the relationship between the WCM and performance of Hindalco Industries for the period of 1990 to 2007 and found a strong relationship between the WCM ratios and firm performance. Lazaridis and Tryfonidis (2006) also studied the relationship between the WCM and performance of listed firms in Athens for the period of 2001 to 2004 and found a strong relationship between the WCM ratios and firm performance and their results from regression analysis showed strong association between profitability (gross operating profit) and CCC. They also concluded that an efficient and optimal CCC management was vital for the increase in the value of stake of shareholders in the firm.

Falope and Ajilore used a sample of 50 Nigerian quoted firms and found an indirect relationship between net operating profits and WCM. The research by Eljelly, (2004) also found a strong negative association between the WCM measures and the firm performance.

Gill and Biger and Mathur, (2010) also observed and reported a very significant association between slow collection of accounts receivables and low profitability. Mathuva (2009) studied the influence of WCM on profitability using a sample of 30 firms listed on the Nairobi Stock Exchange (NSE) using the regression models and concluded that there exists a strong association between average collection period (ACP) and profitability, a strong association between the stock turnover period and profitability, and a strong association between average payment period (APP) and profitability.

Dong and Su (2010) examined the relationship of working capital management with the profitability based on a secondary data collected from listed firms in Vietnam stock market for the period of 2006-2008 and reported strong association between CCC length and low profitability. In their study relating to a sample of 22,000 public companies, Hutchison et al. (2007) also showed an association between shorter CCC and higher profitability for over ¾ th of the sampled industrial units. Schilling (1996) has coined the concept of optimum liquidity position as the minimum necessity to support any particular business volume. According to him, the decision to segregate the capital employed between the current assets and fixed assets s very vital to the performance of the business. Both the returns on investment in current assets and fixed assets are to be considered. Since the return on total capital employed turns out to be lesser than the return on fixed assets, investment in current assets must be done very cautiously maintaining a minimum of liquidity. He further establishes that if the CCC turnover days are increased, the minimum liquidity required increases; and conversely, if the CCC turnover decreases, there also occurs a fall in the volume of cash needed by the business.

In Pakistan’s context Raheman and Nasr, (2007) analyzed the effect of WCM componenets on liquidity and profitability by selecting a sample of 94 Pakistani firms listed on Karachi Stock Exchange for a period of 6 years from 1999 – 2004. They reported a significantly negative correlation between WCM components and profitability, and between liquidity and profitability.

Afza and Nazir (2009) studied relationship between WCM policies and a firm’s profitability by taking 204 non-financial companies listed on Karachi Stock Exchange (KSE) for the time span of 1998-2005. They used regression analysis and found a strong positive association of low profitability and aggressive WCM and recommended a conservative approach towards WCM and related financing policies.

Noreen, Khan and Abbas, (2009) examined the international WCM of MNCs in Pakistan. They studied three major areas namely the international cash management operations, international sales and foreign exchange activities of one hundred and fifty companies of the banking, telecommunication, and related service providers. Their is study is envisaged to be helpful to the policy makers and decision making authorities to better consider and adopt efficient ways of WCM practices.

Research Methodology

This is basically a study which envisage the analysis through correlation analysis and One-Way ANOVA Testing. The correlation analysis is to be used for seeking the exact relationships among the CCC length, profitability and the firm’s size. The One-Way ANOVA Testing is to be used for analyzing any of the differences across the industries studied in terms of the CCC turnover days.

Hypotheses

Since the aim of the study is to examine the relationship of the cash conversion cycle with the firm size and profitability so following hypothesis have been developed for empirical test.

H01: There is no relationship between cash conversion cycle and firm size.

H11: There exists a relationship between cash conversion cycle and the firm size.

H02: There is no relationship between cash conversion cycle and profitability.

H12: There is exists a relationship between CCC and profitability of the firm.

The Study Design-Methods and Procedures

Sampling

The sample contains four industries (i.e. cement, food, sugar and auto-mobiles) and ten companies are randomly taken from each industry. The data used for analysis is for the period 2006 to 2010. Service firms are considered beyond the scope of this study and thus not sampled. For the purpose of the study, firm size is measured by total assets and sales revenue, and profitability is measured by return on assets and return on equity.

Data Collection

The data of Cement and Food Industry for the years 2006 to 2010 used in this study had been taken from secondary sources. The necessary secondary data have been collected from the financial statements published in the Annual Reports and financial statements were downloaded from the companies’ official websites.

Variables

The CCC length is measured by calculating accounts receivable, inventory and accounts payable. Firm size is measured in terms of values of total assets and total sales. Profitability is measured in terms of return on assets and return on equity.

Data Analysis

One-Way ANOVA analysis is to be conducted to investigate significant difference among industries in terms of length of CCC.

Pearson correlation analysis is envisaged to demonstrate the relationship of CCC with the firm size and profitability of the firm.

5 . Analysis of findings

Analysis of Means

The lowest mean value of the CCC is found in the cement industry, with an average of -52.38 days, and the highest mean value of the CCC is found in the Automobiles industry, with an average of 73.72 days.

Table 1

Mean values, by industry

Industry Code

Cash Conversion Cycle Days

Return on Equity Share %

Return on Assets %

Total Assets

Total Sales

Sugar

Mean

21.02

.215614

.078264

3280385947.42

6093547162.22

N

50

50

50

50

50

Std. Deviation

60.236

.3917544

.1000480

3842043368.221

9537925547.885

Cement

Mean

-52.38

.030669

.019841

24692689724.14

8758739551.72

N

29

29

29

29

29

Std. Deviation

35.350

.2101461

.0806435

13245293347.060

6557414501.160

Chemical

Mean

33.12

.221522

.139162

16244525882.72

14853858149.80

N

50

50

50

50

50

Std. Deviation

34.202

.2308085

.1523157

12900992848.633

14196706098.093

Auto Mobiles and Parts

Mean

73.72

.239096

.084428

6556255418.16

14301051575.16

N

25

25

25

25

25

Std. Deviation

27.032

.1773378

.0597593

7069415281.887

16455726127.703

Total

Mean

19.68

.186517

.088035

12053506356.89

10772077934.94

N

154

154

154

154

154

Std. Deviation

58.318

.2914784

.1189753

12809609975.131

12626549474.308

In order to investigate whether there is a significant difference among industries in terms of the CCC, one-way ANOVA analysis with Duncan test from Post-Hoc tests was conducted (see Table 3 and 2). The results show a highly significant F-value of 40.453 with respect to the CCC length across the industries. Thus we reject the null hypothesis that the means are equal across the industries studied and can conclude that there appear significant differences among the industries in terms of the CCC length.

Table 2 One-way ANOVA Analysis

Cash Conversion Cycle Days

Sum of Squares

df

Mean Square

F

Sig.

Between Groups

232713.282

3

77571.094

40.453

.000

Within Groups

287636.128

150

1917.574

Total

520349.409

153

Table 3 Duncan a, b test Industry N Subset for alpha =.05

Cash Conversion Cycle Days

Industry Code

N

Subset for alpha = .05

1

2

3

Cement

29

-52.38

Sugar

50

21.02

Chemical

50

33.12

Auto Mobiles and Parts

25

73.72

Sig.

1.000

.250

1.000

Means for groups in homogeneous subsets are displayed.

a Uses Harmonic Mean Sample Size = 34.940.

b The group sizes are unequal. The harmonic mean of the group sizes is used. Type I error levels are not guaranteed.

Correlation analysis

CCC and Firm size Correlation

To analyze the association among the different variables of interest relating to the working capital management, Pearson correlation analysis was conducted (see Table 4). There is a significant negative correlation between the CCC and the firm size in terms of total assets (-0.415). This means the larger the firm size, the shorter is the CCC turnover period in terms of days. As it is common finding that the smaller firms are usually confronted with the problems in the areas of WC management and the liquidity management. The smaller firms may well be cautioned to manage their inventory and receivable turnover in terms of days.

Table 4 Correlation Matrix

CCC

Total_Assets

Total_SALES

ROE

ROA

CCC

Pearson Correlation

1

-.418(**)

-.131

.109

.296(**)

Sig. (2-tailed)

.

.000

.104

.179

.000

Total_Assets

Pearson Correlation

-.418(**)

1

.568(**)

-.029

-.105

Sig. (2-tailed)

.000

.

.000

.725

.194

Total_SALES

Pearson Correlation

-.131

.568(**)

1

.289(**)

.105

Sig. (2-tailed)

.104

.000

.

.000

.196

ROE

Pearson Correlation

.109

-.029

.289(**)

1

.548(**)

Sig. (2-tailed)

.179

.725

.000

.

.000

ROA

Pearson Correlation

.296(**)

-.105

.105

.548(**)

1

Sig. (2-tailed)

.000

.194

.196

.000

.

N

154

154

154

154

154

Notes: * Correlation is significant at the 0.05 level (2-tailed).

**Correlation is significant at the 0.01 level (2-tailed).

CCC and Profitability Correlation

Interestingly, here appears a significant positive relationship between the length of CCC and the profitability of firms in terms of return on total assets giving a strong indication to the firm managers/owners that longer the CCC turnover in days, lesser capital will be deployed in current assets and eventually there will be more capital investment leading towards a higher profitability of the firm. This rationale is also supported by the concept of optimum liquidity position promulgated by Schilling (1996). The cash conversion cycle in terms of days and profitability in terms of return on equity appears to be negatively correlated with the firm’s profitability (-0.131) revealing and supporting the previous research finding that the companies with shorter CCC turnover days are more profitable than the firms with longer CCC. This might be due to the fact that the firms having more investment blocked in current assets may have to resort to the alternate, but rather costly external sources of financing. So it appears that the firms which are not efficient in managing their working assets and the crucially important liquid assets are facing the high cost of financing as a result of which their profitability is decreased.

6. Conclusion

This study conducted on listed companies in the Karachi Stock Exchange, presents the mean values CCC for various industries comparatively. Moreover, the finding indicated a significant negative correlation between the length of CCC and the firm size, in terms of total assets. So the larger firms seem to manage their CCC turnover days efficiently whereas their smaller counterparts happen to be struggling with their cash management issues. This finding is in line with that of Moss and Stine (1993) and cautions the smaller firms to better manage their CCC turnover days.

Interestingly, here appears a significant positive relationship between the length of CCC and the profitability of firms in terms of return on total assets giving a strong indication to the firm managers/owners that longer the CCC turnover in days, lesser capital will b