EFFECTS OF WORKING CAPITAL MANAGEMENT ON SMES PROFITABILITY: EVIDENCE FROM BANGLADESH

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1 EFFECTS OF WORKING CAPITAL MANAGEMENT ON SMES PROFITABILITY: EVIDENCE FROM BANGLADESH G. M. Wali Ullah, M. Nazmul Islam, Lecturer, Department of Finance, R&D Officer, School of Business, School of Business, Independent University, Independent University, Bangladesh (IUB) Bangladesh (IUB) Irfan Bin Khair Graduate, School of Business, Independent University, Bangladesh (IUB) Abstract Working capital management (WCM) has great impact on firm s profitability. Due to the lack of access in long term capital market, small medium enterprise (SMEs) gives more emphasis on effective use of working capital management to ensure profitability. Bangladeshi SMEs are also highly depended on WCM. In this regards this paper aims to examine the between working capital management and profitability of SMEs from Bangladesh. 10 SMEs were selected for the period of The effects of various variable of working capital management including Accounts Receivables (AR), Accounts Payables (AP), Inventory (INV), Cash Conversion Cycle (CCC), Size, Current Ratio, Financial Debt Ratio (FD), Asset Turnover were studied. This study indicated that AR, AP and CCC had no with Gross Operating Profit (GOP) and Return on Asset (). There was a between INV and but no with GOP. LnS or size of the firm and FD were found as with both GOP and. CR had a with GOP but not the. In case of A-TURN, there was strong with both and GOP. Significant finding of this study was that some factors working on firms WCM in other countries also works similarly in Bangladesh. Keywords Working Capital Management, Profitability, SME, Bangladesh. I. INTRODUCTION Working capital is an important component of corporate financial management because it directly affects the profitability of the firms (Raheman & Nasr, 2007). Management of working capital refers to management of current assets and of current liabilities (Teruel &Solano, 2007). It is more important for small business to balance between liquidity and profitability while conducting its day to day operations. In a country like Bangladesh Small Medium-Sized Enterprises (SMEs) have occupied a central place in the Bangladeshi economy. With limited access to the long-term capital markets, these firms tend to rely more heavily on owner financing, trade credit and 9

2 short-term bank loans to finance their needed investment in cash, accounts receivable and inventory (Chittenden, 1998; Saccurato, 1994). II. PROBLEM STATEMENT This study aims to measure and analyze the between working capital management and profitability of small firms and its results are expected to contribute to the existing literature on working capital and SMEs. So the problem statement of the study is to test the influence of working capital management and some other related determinants on the profitability of the firms in Bangladesh. With that statement in focus, this study looks to examine the working capital management of the sample firms demonstrating how different determinants of working capital management and other related determinants can affect the profitability of the firms based on 3 years data ( ) from financial statements for 10 sample firms. III. LITERATURE REVIEW Working capital management is important for creating value for shareholders (Shin & Soenen, 1998). Moreover working capital management is important because of its effects on the firms profitability and risk (Smith, 1980). Practices of working capital management vary from industry to industry. According to Filbeck and Krueger (2005) differences exist among industries in working capital practices overtime. However, limited access in the long term capital market force small medium size enterprise (SMEs) to depends highly on WCM (Chittenden, 1998; Saccurato, 1994). Many research works has been done before on effects of working capital management on SMEs. The largest number of empirical studies relating to WCM and profitability support the fact that aggressive working capital policies enhance profitability. Mobeen Alam et al. (2011) investigate 65 Pakistani companies for the time period between and have found correlation between the components of working capital with market value and profitability of the company. Similarly Eljelly (2004) empirically examined the between profitability and liquidity of 929 joint stock companies in Saudi Arabia and has found effect on profitability at the industry level. Deloof (2003) has also explored between working capital management and profitability and recommended that profitability is strongly related to working capital management of a business. In contrast with that Raheman and Nasr (2007) conducted a study to observe the between WCM and Profitability in case of Pakistani Firms reveals that there is a strong negative between variables of WCM and profitability of the firm. Similarly, Teruel and Solano (2007) also found negative between WCM and SME s profitability after analyzing small and medium sized Spanish firms. IV. RESERCH QUESTION AND HYPOTHESES A. Research Question Is there any between various determinants of Working Capital Management and Profitability? B. Hypotheses H1: There is a between AR and H2: There is a between AP and H3: There is a between INV and H4: There is a between CCC and H5: There is a between CR and 10

3 H6: There is a between FD and H7: There is a between LnS and H8: There is a between A- TURN and V. METHODOLOGY A. Data Collection The study was based on secondary data and it investigated 10 firms (private limited company or sole proprietorship) selected under SME. All the data collected and used from the financial statements for the period of Panel data methodology have used. Panel data involves the pooling of observations on a cross-section of units over several times. B. Research Model and Variables Based on the review of previous studies with respect to the main determinants of Working Capital Management and Profitability, the following two models are formulated to state the hypothesized : GOP=a+B1AR+B2AP+B3INV+B4CCC+B5CR+B6F D+B7LnS+B8A-TURN =a+b1ar+b2ap+b3inv+b4ccc+b5cr+b6f D+B7LnS+B8A-TURN Where- GOP is the Gross Operating Profit as a measurement of profitability. is the Return on Total Asset also as a measurement of Profitability AR is the No. of Days A/R = (Accounts Receivables/Sales) x 365 AP is the No. of Days A/P = (Accounts Payables/Cost of Goods Sold) x 365 INV is the No. of Days Inventory = (Inventory/Cost of Goods Sold) x 365 CCC is the Cash Conversion Cycle = (No. of Days A/R + No. of Days Inventory) No. of Days A/P LnS is the Firm Size = Natural Logarithm of Sales FD is the Financial Debt Ratio = (Short-Term Loans + Long-Term Loans)/Total Assets CR is the current ratio = (Current Asset/Current Liabilities) A-TURN is the asset turnover = (Sales/Total Asset) C. Findings 1) Descriptive Analysis: This study conducted descriptive statistics to describe the basic features of the data in sample. Through a statistical tool this study was able to find out the number of variable in sample, their minimum value, maximum value, their mean and standard deviation. TABLE 1 MEA MEDI MAXI MINI SD N AN MUM MUM GO P 67 RO A AR AP INV CC C LnS 5.90E +08 FD E+ 2.41E+ 1.01E+ 6.41E CR A- TU RN

4 As shown under Table 1, the mean of the ratio of was % which was lower than the GOP ratio ( %). Again GOP ratio reflected the higher standard deviation ( %) than the standard deviation of ratio which is % exactly. But the maximum values of GOP (40.23%) and (40.32%) are almost similar. In addition, it was found that the mean of AR was days with SD of days. AP showed 21.5 days as mean, % as standard deviation and a maximum value of 297 days. INV and CCC indicated their mean value of days and days with SD of and respectively. And the mean of FD and CR were % and respectively. The maximum values for the both were and 1.06 with the standard deviations of and accordingly. Adding to that A- TURN which indicates asset turnover had a mean value of , maximum value of 0.42 and the standard deviation of ) Regression Analysis: From EViews mentioned under Table 2, we got the following regression equation considering GOP as dependent variable. (Taking 3 digits after decimal): in accounts payables have a negative relation with GOP highlighting the fact that having high payables with suppliers adversely affects the profitability for these SMEs. Combined together, these affects the cash conversion cash in a negative manner to their GOP, as leaving cash outside the hands of SMEs leads to a profitable output. Also, contrary to the literature on capital structure, higher debt and current asset holdings also negatively impacts the GOP for these SMEs. More the SMEs use their own funds and lesser the debt, higher their profitability is as demonstrated with these findings. The coefficient of LnS or size of the firms suggests an opposite with GOP. Here, the value of R-Square is which means that the independent variables explain GOP or gross operating profit by 86.7%. TABLE II GOP = *AR *INV *AP *CCC *LnS *FD *CR *A-TURN According to the result, the symbols of the coefficients for each variables show their with the dependent variable, Gross Operating Profit. As visible, days in accounts receivables have a positive relation with GOP. This is very much contradictory to the usual practice, as it implies that these SMEs have more profit when they sell in receivables basis. However, it would make sense since most businesses in Bangladesh are conducted in credit due to the unavailability of monetary resources. Similarly, days 12 From EViews mentioned under Table 3, we got the following regression equation considering as dependent variable. (Taking 3 digits after decimal):\ = *AR+7.608*INV+0.549*CR *A-TURN *AP *CCC *LnS *FD

5 TABLE III Similar findings are demonstrated after considering as the dependent variable here, as the between AP, AR, INV and CCC remain quite similar with profitability. According to the result, if AR increases by 1%, there will be an increase of 1.508% in or return on assets. The coefficient of INV is which mean that 1% change in INV leads to a positive change of 7.608% in. The coefficients of CR and A-TURN also show positive which imply that 1% change in CR and A-TURN will lead to an increase in of 0.549% and 3.151%. There is an opposite between the ratio of AP and reflected by the negative coefficient of AP and it suggests that the ratio will be decreased by 4.698% if AP of the firms rises by 1%. The coefficient value of CCC is which implies that 1% increase in the ratio of CCC causes 0.012% decrease in the ratio of. The coefficient of size of the firm or LnS is which suggests a negative with. Here, the value of R-Square is which means that the independent variables explain or return on asset ratio by 70.2%. 3) P- Value Test: Considering the significance level 15%, if p 0.15, null hypotheses (H0) will be rejected and alternate one will be considered. The value has been shown under Table 4 and Table 5- TABLE IV H0 H1-8 P- Value Decision There is no There is a Accepted null between AR between AR and There is no There is a Accepted null between AP between AP and There is no There is a Accepted null between INV between INV and GOP and GOP There is no There is a Accepted null between CCC between CCC and GOP and GOP There is no There is a Rejected null between LnS between LnS and There is no There is a Rejected null between FD between FD and There is no There is a Rejected null between CR between CR and There is no There is a Rejected null between A- between A- TURN and TURN and GOP GOP 13

6 TABLE V H0 H1-8 P- Value Decision There is no There is a Accepted null between AR and between AR and There is no There is a Accepted null between AP and between AP and There is no There is a Rejected null between INV between INV and and There is no There is a Accepted null between CCC between CCC and and There is no There is a Rejected null between LnS and between LnS and There is no There is a Rejected null between FD and between FD and There is no There is a Accepted null between CR and between CR and There is no There is a Rejected null between A- between A- TURN and TURN and Throughout the study, the objective was to investigate the significance of determining factors of Working Capital Management on Profitability in the context of local firms under SME in Bangladesh. In order to achieve the goal, this study gathered secondary data of 3 years ( ) of 10 private and sole proprietorship firms and Panel data methodology was used to analyze different information. This study indicated that AR, AP and CCC had no with GOP and. There was a between INV and but no with GOP. LnS or size of the firm and FD were found as with both GOP and. CR had a with GOP but not the. In case of A-TURN, there was strong with both and GOP which is An important finding of this study was that some factors working on firms Working Capital Management in other countries also work in a similar fashion in Bangladesh. However, some results were not consistent with the previous studies. VII) SIGNIFICANCE OF THE STUDY AND CONCLUDING NOTES This study conducts an analysis of the influence of Working Capital Management on Profitability based on ten local SME firm. Even though the analysis has been built on known research methods and models used in several similar studies also in many countries, but very rare in the context of Bangladesh. This study will help to understand the general practices of working capital management in Bangladesh in terms of This will also act as a guide for the managers to design their working capital structure and manage it efficiently to maximize the market value of the firm. Finally, the limitations revealed through the study can open the door to conduct further research on Working Capital Management determinants which will surely lead to new insight 14

7 Working capital management is particularly important in the case of small and medium-sized companies. Most of these companies assets are in the form of current assets. Also, current liabilities are one of their main sources of external finance. The objective of the current research has been to provide empirical evidence about the effects of working capital management on the profitability of a sample of small and medium-sized firms. However, we could not confirm a between an SME s profitability and the number of days accounts receivable and days of payable. But we did find that number of days of inventories affects a SME s profitability. However, this study had some limitations such as mix results with regards to traditional findings on corporations compared to the SMEs of our sample. Further research is needed to improve this study and make it more robust. VIII) REFERENCES 1) Abuzar, M. A. Elijelly,(2004). Liquidity profitability tradeoff: An empirical investigation in an emerging market. International journal of commerce and management, 14(2), ) Deloof, M. (2003). Does working capital management affect profitability of Belgian firms? Journal of business finance & Accounting, 30(3 4), ) Filbeck, G. & Krueger.T.M. (2005). An Analysis of Working Capital Management results across industries.mid-american [20]. Journal of Business, 20 (2), ) Mobeen Alam, H., Ali, L., Abdul Rehman, Ch., & Akram, M. (2011). Impact of Working Capital Management on Profitability and Market Valuation of Pakistani Firms. European Journal of Economics, Finance and Administrative Sciences,32, pp ) Narita, M., Shimizu, S., Ito, T., Chittenden, T., Lutz, R. J., Matsuda, H., & Tsujimoto, Y. (1998). Bax interacts with the permeability transition pore to induce permeability transition and cytochrome c release in isolated mitochondria. Proceedings of the National Academy of Sciences, 95(25), ) Raheman, A., & Nasr, M. (2007). Working capital management and profitability case of Pakistani firms. International review of business research papers, 3(1), ) Saccurato, F. (1994). The study of working capital. Business Credit, 96(1), ) Shin, H. H., & Soenen, L. (1998). Efficiency of working capital management and corporate profitability. Financial practice and education, 8, ) Smith, K. (1980), Profitability versus Liquidity Tradeoffs in Working Capital Management. Readings on the Management of Working Capital, West Publishing Company, New York, St. Pau. 10) Teruel, P.J.G. & Solano, P.M. (2007), Effects of Working Capital Management on SME Profitability, International Journal of Managerial Finance, Vol. 3 No.2, pp Lazaridis, I., & Tryfonidis, D. (2006). Relationship between working capital management and profitability of listed companies in the Athens stock exchange. Journal of financial management and analysis, 19(1). 15