Optimal working capital for the company and impact of the management of the cash flows

Аisholpan Bekenova

Scientific director: Asem Zhakipova, Master of Finance, ACCA, Professional accountant KZ, Auditor KZ.

Kazakh Humanities and Law University (KAZGUU)

Introduction

Management of working capital refers to management of current assets and current liabilities. Firms may have an optimal level of working capital that maximizes their value. Prior evidence

This study examined the impact of working capital management on firms‟ performance by using audited financial statements “Maikuben West Holding” corporation and “Ugol dvor” LLP in Kazakhstan for the period of 2014 to 2016. The performance was measured in terms of profitability by return on total assets, and return on investment capital as dependent financial performance (profitability) variables. The working capital was determined by the Cash conversion period, Accounts receivable period, inventory conversion period and accounts payable period are used as independent working capital variables. Moreover, the traditional measures, current ratio are used as liquidity indicators, firm size as measured by logarithm of sales, firm growth rate as measured by change in annual sales and financial leverage as control variables.

A few numbers of research hypothesis can be made in view of the impact of working capital management on firms’ performance. In light of the research objective the following discussion will covers the hypotheses that this study will attempt to test.

H1: cash conversion cycle is significant related to financial performance of the firm.

H2: Inventory management (holding periods) have significant impact on firms’ financial performance.

H3: The way how receivables are managed has significant effect on the financial performance of firms

H4: Accounts payable periods has significant impact on the financial performance of firms.

The expected results increase the firms' profitability by improving the efficiency of management of working capital components.

Acronyms

Working capital management (WGM)

Cash Conversion Cycle (CCC)

The return on assets (ROA)

Small and medium enterprises (SMEs)

Financial management (FM)

Objective of working capital management (WGM)

According to Gitman (2009) the objective of Working Capital Management (WCM) is to minimise the Cash Conversion Cycle (CCC) the amount of capital tied up in the firm’s current assets. It focuses on controlling account receivables and their collection process, and managing the investment in inventory. Working capital management is vital for all business survival, sustainability and its direct impact on performance.

Working capital management is an important area of financial management in every business function. WCM deals with the administration of the liquidity components of firms’ short-term current assets and current liabilities (Gitman, 2009). The most important current assets are cash, debtors or account receivables, stock or inventory and current liabilities consisting of creditors or account payables, accrued expenses, taxation liabilities, short-term debt such as commercial bills, and provisions for current liabilities such as dividends declared but not yet paid (Birt et al., 2011).

Cash conversion cycle

Both liquidity and profitability are the core concern of the company’s management. Also, profitability is expected to have significant impact on company’s cash conversion cycle. Cash conversion cycle might have both positive and negative effect on the company profitability, for instance, while a company with long cash conversion cycle might have higher sales because of long credit term given to trade credit customers, high cost of investment in working capital might decrease profitability as well (Deloof, 2003). Lazaridis and Tryfonidis (2006) find the negative relationship between cash conversion cycle and profitability measured by gross operating profit. The researchers explain this negative result as shorter cash conversion cycle will generate more profit for a company. Nimalathasan (2010) found that, cash conversion cycle and return on assets are negatively correlated also he stated that when cash conversion cycle increases that cause for decrease return on assets. He pointed in his study that an increase in number of days in cash conversion cycle even by one day that is associated with a decrease by 5.03% in return on assets of selected listed manufacturing companies in Sri Lanka. Also he has suggested that to managers of selected companies to his study, they can increase their company’s profitability by reducing the number of days on inventories conversion cycle and accounts receivable, through his results. Izadi Niya and Taaki (2010) selected a sample composed of the big and small Iranian firms to find empirical evidences about the impact of working capital management on the profitability. The regression results indicated that the cash conversion cycle and return on asset are significantly and inversely related. Additionally, they showed that investment of huge amounts in inventories and accounts receivables decreases the profits. Eljelly (2004) also reports significant negative relationship between the liquidity level and profitability in companies with long cash conversion. Base on the prior empirical studies, the researcher expect profitable company to have effective working capital management which results in the shorter cash conversion cycle.

Hypothesis is formulated as follows:

H1: cash conversion cycle is significant related to financial performance of the firm.

In contrary, Jeng-Ren, et al. (2006) find the significant positive relation between the net liquid balance as a measure of working capital management and firm performance measured by return on assets. They find that high profit companies tend to have more working capital balance as a result from using conservative policy. In addition, the result with another measurement, working capital requirement, point out the positive relation which suggest that companies have inefficient working capital management which leads to high account receivable and inventory balance.

Average number of days inventory

An economic evaluation of a firm’s performance to provides financiers an inspiration of how lengthy it gets a business to revolve its stock into sales. Usually, the lesser the number of day’s the good for firm. However, it is essential to keep in mind that the average inventory is change according to firm to firm and industry to industry. Lazaridis and Tryfonidis (2006) find the negative relationship between number of day’s inventories and gross operating profit but it is not in significant level. Samiloglu and Demirgunes (2008) conduct the study to examine the effect of working capital management on company profitability of listed manufacturing companies in Istanbul Stock Exchange for the period from 2010 to 2016. Cash conversion cycle, accounts receivable period and inventory period are used to measure the effects of working capital management; return on assets is used as a profitability measure. Results from regression analysis show that profitability has a significant negative relation inventory period. Deloof (2003) found a significant negative relation between gross operating income and number of day’s inventories. This explains that an increase of the inventories is an affect from a decrease in sales which leads to lower profit for the companies. Another research by Boisjoly (2009) found an increase of inventory turnover over a period of fifteen years that indicates that companies have improved their inventory management. To manage inventory, there are several manufacturing operating managements to apply, such as; just-in-time procedures, make-to-order procedures, lean manufacturing initiatives to improve their operating processes, quality programs to reduce number of parts and supplier rationalization to reduce number of suppliers (Boisjoly, 2009). Şamiloğlu and Demirgüneş (2008) findings of the study show that inventory period affect firm profitability negatively. García-Teruel and Martínez-Solano (2007) the return on assets (ROA) is used as a measure of profitability, and the number of days accounts receivable, number of days inventories, number of days accounts payable and cash conversion cycle are used to measure working capital management. The correlation matrixes demonstrate that the return on assets has the significant negative relationship with number of day’s inventory. With the advantage from inventories, companies tend to perform better in managing their working capital and have the shorter inventory conversion period.

Hypothesis 2 is formulated as follows:

H2: Inventory management (holding periods) have significant impact on firms’ financial performance.

Average number of day’s receivable

Sales are made on credit and recovery of the payments of these sales in the period is called number of day’s receivable. The accomplishments of business greatly depend lying on the capability of financial managers to control cash conversion cycle (Filbeck and krueger, 2005). Organization can minimize firm’s debt cost and raise the capital for obtainable ventures through reducing the amount of short term resources. If the firm have more current assets so that it directly affect the profitability. Lazaridis and Tryfonidis (2006) find the negative relationship between number of day’s accounts receivables and profitability measured by gross operating profit. This negative result demonstrated that companies can increase their profitability by decreasing credit term giving to their customers. Deloof (2003) find the significant negative relation between the average number of days accounts receivable and gross operating income as a measure of profitability. Boisjoly (2009) provide the evidence that companies have focused on improving the management of accounts receivable as their accounts receivable turnover increase over the 15 year time period for 1990-2004. Several techniques can be applied such as strengthen their collection procedures, offer cash discount and trade credit, and use receivables factoring (Boisjoly, 2009). Samiloglu and Demirgunes (2008) conduct the study to examine the effect of working capital management on company profitability of listed manufacturing companies in Istanbul Stock Exchange for the period from 2010 to 2016. Cash conversion cycle, accounts receivable period and inventory period are used to measure the effects of working capital management; return on assets is used as a profitability measure. Results from regression analysis show that profitability has a significant negative relation with accounts receivable period. García-Teruel and Martínez-Solano (2007) examine effects of working capital management on profitability of 8,872 small and medium enterprises (SMEs) in Spain for the period from 1996 to 2002. The return on assets (ROA) is used as a measure of profitability, and the number of days accounts receivable, number of days inventories, number of days accounts payable and cash conversion cycle are used to measure working capital management. The correlation matrixes demonstrate that the return on assets has the significant negative relationship with number of day’s accounts receivable.

Raheman and Nasr (2007) the results report that profitability has significant negative relation with accounts receivable as a measure of liquidity. Furthermore, there is a negative relationship between average collection period and profitability found by Alipour (2011). Also Şamiloğlu and Demirgüneş (2008) findings of the study show that accounts receivables period affect firm profitability negatively. Base on the prior studies and discussion, hypothesis 3 is proposed as follows:

H3: The way how receivables are managed has significant effect on the financial performance of firms

Average account payable

Arnold (2008 pp.479-482) described that account payable is the cheapest and simplest way of financing an organization. Accounts payable are generated when a company purchases some products for which payment has to be made no later than a specified date in the future. Accounts payable are a part of all the businesses and have some advantages associated with it e.g. it is available to all the companies regardless of the size of the company and earlier payment can bring cash discount with it. Companies not only need to manage their account payables in a good way but they should also have the ability to generate enough cash to pay the mature account payables. García-Teruel and Martínez-Solano (2007) examine effects of working capital management on profitability of 8,872 small and medium enterprises (SMEs) in Spain for the period from 1996 to 2002. The return on assets (ROA) is used as a measure of profitability, and the number of days accounts receivable, number of days inventories, number of days accounts payable and cash conversion cycle are used to measure working capital management. The correlation matrixes demonstrate that the return on assets has the significant negative relationship with number of day’s accounts payable. The study of Deloof (2003) shows a negative relation between average number of day’s accounts payable and profitability which indicates that profitability has an effect on accounts payable policy as a company with less profit takes longer payment period. In the case for Belgian companies, suppliers offer their customers substantial discount for the cash payment customer which lead to increasing profit of the company (Deloof, 2003). In the study of Boisjoly (2009), the result shows an increase in account payable turnover over the 15 year time period which is contrary to expectation as large companies have extended their payment period to suppliers from 45 to 60 days or 60 to 90 days. The explanations are that only few companies succeeded in increasing their payment terms, increasing in amount of accounts payable or decreasing in fund for working capital (Boisjoly, 2009). Nuru Mohammed (2011) there is a negative relationship between accounts payable period and profitability measures; however, except for operating profit margin this relationship is not statistically significant.

Therefore, more number of day’s accounts payable is considered better for shorter cash conversion period (Lantz, 2008, p. 116) , hypothesis 4 can be stated as follows:.

H4: Accounts payable periods has significant impact on the financial performance of firms.

In contrary, Lazaridis and Tryfonidis (2006) explain significant positive relationship between gross operating profit as a measure of profitability and number of day’s accounts payable. The researcher explain this positive significant result as a company delays its payment which affects the higher level of working capital and use to increase its profitability which less-profit companies would make use of this to delay their payment.

We believe that for optimization of working capital, profitable and liquidity measure need to be controlled, and cash management must be regulated by the Miller-Orr and Baumol model.

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