Impact of Working Capital Management on Profitability: A Case Study of Trading Companies

*Rafathunnisa Syeda*

## **Abstract**

The success of any business depends on its profitability, liquidity, and solvency. Liquidity plays an important role in the successful running of a business. Many prior studies have been conducted to measure the relationship between working capital and profitability. The results showed that the high investment in inventories and receivables is associated with lower financial performance. They found a negative relationship between Return on Assets and Inventory turnover and Cash conversion cycle the present study is designed to know the direct impact of working capital on profitability by choosing the days of collection, days of payment, days inventory converts to sales and finally the cash conversion cycle. This study examines the association between the profitability and working capital using the data of 15 US trading companies for the period of 2015 to 2019. The key points in this study are firstly there exists a negative relationship between the profitability and the average collection period, the lower the average collection period higher will be the profitability, indicating that a decrease in the number of days a firm receives payment from sales affects the profitability of the firm positively. Secondly there is a highly significant positive relationship between average payment period and profitability. This implies that the longer a firm makes the payment to its creditors, the more profitable it is. Thirdly the cash conversion cycle decreases it will lead to an increase in profitability of the firm, and managers can create a positive value for the shareholders which indicates that it has been maintained. The regression analysis showed the value for the R-squared in the model is 0.584, i.e., 58.4% of the variation in the dependent variable Net Profitability is explained by the independent variables.

**Keywords:** net profitability, trading companies, working capital management, average collection period, average payment period, inventory turnover days, cash conversion cycle

#### **1. Introduction**

An attempt has been made in this empirical study to know the impact of working capital management on profitability, both the factors are important concerns of management. If working capital is not managed perfectly it will reduce the liquidity of the company and ultimately effects profitability.

The working capital should be maintained at a desired level depending upon the size of the firm, excessive working capital leads to the unnecessary accumulation of inventories causing losses and wastages. The large debtors indicate the defective credit policy which might lead to bad debts. On the other hand, with the inadequate working capital, the firm will not be in a position to pay short-term liabilities. The firm may not be able to pay its day-to-day expenses which creates inefficiencies and reduces profits.

The success of any business depends on its profitability, liquidity, and solvency. Liquidity plays an important role in the successful running of a business. The crucial functions of financial managers to ensure the liquidity of a firm, that it must be in a position to meet its short-term obligation without which it cannot survive. The working capital which consists of current assets and current liabilities which measure the liquidity has been chosen as the main independent variable to study its relationship with the profitability. The collection period, payment period, inventory days and cash conversion cycle has been used as a measure of working capital.

Many prior studies have been conducted to measure the relationship between working capital and profitability as examined by Azhar [1]. The impact of liquidity and management efficiency on the profitability of select power sectors using different ratios as independent variables, where debtor turnover ratio, collection efficiency, and interest coverage showed a significant impact. Rathiranee and Sangeetha [2] examine the impact of working capital on financial performance in select trading firms where the regression analysis results showed that the high investment in inventories and receivables is associated with lower financial performance i.e., Return on Assets (ROA). They found a negative relationship between Return on Assets and Inventory turnover and Cash conversion cycle for the trading firms listed in Colombo Stock Exchange. Mansoori and Muhammad [3] have studied the same picture with the evidence from Singapore found that Management performance would be improved by managing working capital efficiently. Their results demonstrate that firm's profitability is increased by decreasing in receivable conversion period and inventory conversion period. Saradhadevi found in her study that there exists a highly significant negative relationship between the profitability and cash conversion cycle and a highly significant positive relationship between the time it takes the firm to pay its (Average payment period) which implies the longer a firm takes to pay its creditors the more profitable it is.

Keeping in view the above scenario the present study is designed to know the direct impact of working capital on profitability by choosing the days of collection, days of payment, days inventory converts to sales and finally the cash conversion cycle.

Many studies have been conducted for manufacturing companies, cement and textile companies, oil and gas companies only a few have been focused on trading companies. Hence the present study has its focus on working capital management and its impact on profitability in relation to trading sector.

#### **2. Review of literature**

1.Working capital management and profitability [4]: This study aims to find out the impact of working capital management on profitability. Return on assets, Current ratio, debt to equity ratio, operating profit to debt ratio, and inventory turnover ratios of the firms are the variables that are used in this study carried out for electrical equipment firms listed on Karachi stock exchange 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. T-test is applied to see for individual variable significance, it tells that each variable is significant. It is concluded that working capital management has positive significant impact on profitability of the firms.


years from 2001 to 2010. The study uses Regression analysis. The findings indicate that there exists a significant negative linear relationship between inventory conversion period and profitability. It was also found that when profitability increases with the decrease in the financial debt ratio. Further, it showed a positive relationship between profitability and firm size, as the profitability increases with an increase in firm size. Lastly, the relationship between the current ratio and profitability was negative.


*Impact of Working Capital Management on Profitability: A Case Study of Trading Companies DOI: http://dx.doi.org/10.5772/intechopen.99912*

focusing on real estates and construction companies from the Abu Dhabi market. The finding of this study presented that there is a negative relationship between cash conversion cycle and profitability; longer the CCC, the profitability decreases. Another finding showed that the amount of payable days is negatively related to profitability.


#### **3. Research question**

The main objective of any business is to earn profit and manage the funds efficiently and effectively which has direct impact on profits. So, working capital is the major constituent to measure liquidity. This study examines the association between the profitability and working capital using the data of 15 US trading companies for the period of 2015 to 2019.

#### **4. Hypotheses development**

Working capital is an important issue during financial decision making. The crucial part in managing working capital is required to maintain its liquidity in dayto-day operation for the smooth running of business and meeting its obligations in time. Thus, working capital is selected as one of the independent variables to know that how it effects profitability.

H1: There is a significant relationship between Working Capital Management and profitability.

H2: Working capital management has strong impact on profitability.

Keeping in view the above studies the following objectives have been outlined for the present study.

#### **5. Objectives of the study**



**Table 1.**

*Showing the key research variables.*

## **6. Methods**

The choice of the variables for the present study is influenced by the previous studies on working capital management. They include dependent, independent and some control variables. The profitability in terms of Return on assets, Gross profit ratio, Operating profit and Net income are taken as dependent variable in previous studies.

The dependent variable is the one which is affected during the experiment, for the present study profitability is taken as dependent variable i.e., in terms of Net Income. The independent variable is the one which effects the dependent variable. Average collection period, cash conversion cycle, average payment period, inventory turnover ratio, current ratio, liquid ratio, etc. were taken as independent variables in previous studies. For this study the independent variables are the average collection period, average payment period, inventory turnover days and cash conversion cycle. The study aims at to find out the association between the variables through different statistical analysis (**Table 1**).

The following equation is used to estimate the impact of working capital on profitability.

*NI it ACP it APP it ITD it CCC it* ( ) =+ + + + â0 â1 â2 â3 â4 ( ) ( ) ( ) ( )

NI (it) = profitability of the firms at time 5 years, i = 15 firms. β0 = the intercept of an equation. β = coefficients of independent variables. T = time 5 years 2015–2019. Average collection period ACP. Average payment period APP. Inventory turnover days ITD. Cash conversion cycle CCC.

In the above general equation, the Profitability is the dependent variable, and it is influenced by the independent variables i.e., ACP, APP, ITD and CCC.

#### **7. Sample and data collection**

The main source of data is the S&P Capital IQ website. Many studies have been conducted to examine the relationship between the financial performance and working capital management. These studies have been done relating to the cement companies, trading companies, manufacturing companies, pharmaceutical *Impact of Working Capital Management on Profitability: A Case Study of Trading Companies DOI: http://dx.doi.org/10.5772/intechopen.99912*

companies and only a few have been carried out about trading companies. So for the present study sample is taken from trading companies.

The present study aims at to provide some empirical evidence of impact of working capital management on profitability for a sample of 15 trading companies for the period of five years from 2015 to 2019. These companies are randomly selected from all listed companies in the New York Stock Exchange (NYSE). The sample companies includes: 1) Applied Industrial Technologies Inc. (AIT), 2) DXP Enterprises Inc., 3) Eco Shift Power Corp. (ECOP), 4) EVI Industries Corp., 5) General Finance Corp. (GFN), 6) Gypsum Management and Supply Corp. (GMS), 7) W.W. Grainger (GWW), 8) H&E Equipment Inc. (HEES), 9) HD Supply Inc. (HDS) 10) Houston Wire and Cable Company (HWCC), 11) Huttig Building Products Inc. (HBP) 12) Kaman Corporation (KAMN), 13) MRC Global Inc., 14) MSC Industrial Direct Co. Inc. (MSM), 15) ProShares Ultra Health Care (RXL).

The Net Profitability is taken as the dependent variable and the average collection period (ACP), average payment period (APP), inventory days converted to sales (ITD) ad cash conversion cycle (CCC) are considered as independent variables.

#### **8. Results**

The analysis of data is done using descriptive statistics, correlation matrix and regression analysis.

The following observations are made from the above **Table 2** compiled with five years data for 15 trading companies:



#### **Table 2.**

*Descriptive statistics of 15 companies for the years from 2014 to 2019.*

## **9. Correlation analysis**

Correlation analysis is used to measure the degree of association between different variables under consideration. Correlation matrix of all variables included in the analysis is presented in **Table 3** which is calculated based on data of 15 trading companies for a period of five years 2015 and 2019.

An attempt has been made to find the relationship between profitability and WC, for this purpose Pearson's coefficient of correlation analysis is done. As indicated in the above studies there exist a negative correlation between the profitability and the collection period, the lower the average collection period higher will be the profitability. The correlation between average payment period and profitability is 0.127 which shows a positive relationship if there is an increase in payment period it leads to an increase in profitability. There exist a negative correlation between profitability and the cash conversion cycle is −0.271 which indicates an increase in collection period leads to increase in CCC and vice versa and ultimately effects profitability The correlation between inventory conversion days and profitability is positive which is beyond expectation. There exists a negative correlation between cash conversion cycle and average payment period.

It is recommended that the companies should avoid an increasing cash conversion cycle because it means that the business is becoming more operating inefficient, locking more and more cash into its processes. They should maintain a lowest cash conversion cycle compared to their peers, or at least a decreasing one. A decreasing CCC represents a more efficient company that converts its inventories faster as well as gets paid faster and probably is paying its suppliers later thus, holding cash for more time (**Table 4**).


#### **Table 3.**

*Correlation matrix of 15 companies for the year 2015 and 2019.*


#### **Table 4.**

*Regression results of 15 companies for the year 2015 to 2019.*

*Impact of Working Capital Management on Profitability: A Case Study of Trading Companies DOI: http://dx.doi.org/10.5772/intechopen.99912*

### **10. Regression analysis**

The regression analysis showed the value for the R-squared in the model is 0.584, i.e., 58.4% of the variation in the dependent variable (NI) is explained by the independent variables working capital of the model, which is represented by CCC, APP, ACP, and ITD and 42% is affected by other factors.

#### **11. Summary and conclusions**

The study is carried out for a sample of 15 trading companies for the period of five years from 2015 to 2019. These companies are randomly selected from all listed companies in the New York Stock Exchange (NYSE).

This study examined the relationship between Net Profitability and several variables of working capital management such as average collection period, average inventory turnover in days, average payment period and cash conversion cycle. The results showed that there exist a negative relationship between the profitability and the average collection period, the lower the average collection period higher will be the profitability. The correlation between average payment period and profitability is 0.127 which shows a positive relationship if there is an increase in payment period it leads to an increase in profitability. It is found that the cash conversion cycle decreases it will lead to an increase in profitability of the firm, and managers can create a positive value for the shareholders which indicates that it has been maintained.

The results of this study show that there is a strong relationship between the working capital and profitability of the firms. It means if the financial managers keep an eye on the liquidity it will lead to profitability. So, it is recommended that Companies should always maintain a sound collection policy and it is further suggested that managers can create value for their shareholders by reducing the number of days accounts receivable, increasing the number of days accounts payable and inventories to a reasonable minimum.

The hypotheses is accepted for working capital management that it has strong impact on profitability. There is a significance relationship between Working Capital Management and profitability. The study has examined the impact in terms of average collection period, average payment period, inventory turnover days and cash conversion cycle on profitability.

Furthermore, On the basis of the above analysis the results can be further strengthened if the firms manage their working capital in more efficient ways. Management of Working capital means the management of current assets and current liabilities. If these firms efficiently manage their cash, accounts receivables, accounts payables, and inventories, this will ultimately increase profitability of these companies.

### **12. Limitations of the study**


*Accounting and Finance Innovations*

## **Author details**

Rafathunnisa Syeda Northeastern Illinois University, Chicago, IL, USA

\*Address all correspondence to: srafathunnisa@gmail.com

© 2021 The Author(s). Licensee IntechOpen. This chapter is distributed under the terms of the Creative Commons Attribution License (http://creativecommons.org/licenses/ by/3.0), which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.

*Impact of Working Capital Management on Profitability: A Case Study of Trading Companies DOI: http://dx.doi.org/10.5772/intechopen.99912*

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## Section 8
