Working capital management and profitability during the business cycles

IntroductionThis study is aimed to investigate the effect of working capital management on profitability during business cycles (boom and bust). If capital structure and long-term investment decisions are foundation of firm, proper management of working capital likes blood in the firms’ veins provides financial health and continuity possibility. One of the most important functions of every organization is the efficient management of working capital. Obviously, the uncertainty associated with macro-economic factors plays an important role in changing the product demand and firms financing. So that Kvrazyk & Levi (2003) believe firms determine the timing for debt issuing based on economic conditions. The main source of working capital financing, is retained earnings so it can be argued that business cycles affect the firm financing through its impact on economic growth, product demand and subsequently sales. For example, when sales of firm decline its profit is reduced and an important source of working capital financing is affected. In this situation, management will have to use external funds that are expensive. Regardless of the kind of industry in which the firm operates, the macroeconomic conditions affect all industries. For example, the recession declines the general level of demand, decreases sales and liquidity and imposes increasingly pressures on firms business. Lending limitations of financial institutions have led to cash becomes the scarce resource. Hence, the importance of working capital management is more than ever before. Therefore, this study investigated the effects of working capital management on profitability in different business cycles. In this study, for the first time, the effects of working capital and the profitability are examined taking into account the business cycles in both fixed and variable sample. Fixed sample includes companies that listed in the stock exchange continuously for the whole sample period. However variable sample includes companies that also have been listed during the research period (every year new companies listed in Tehran Stock Exchange). This study is aimed to investigate the relationship between business cycles, working capital management and profitability.
The study hypothesis includes:Hypothesis 1: There is a relationship between profitability and cash conversion cycle (separated by boom and bust).
Hypothesis 2: There is a relationship between profitability and commitment payment period (separated by boom and bust).
Hypothesis 3: There is a relationship between profitability and average collection period (separated by boom and bust).
Hypothesis 4: There is a relationship between profitability and average inventory turnover period (separated by boom and bust).
MethodologyThe effect of working capital management on the profitability during business cycles is examined by panel data regression using annual data. The diagnosis tests to determine the model (panel or pool regression) including F Limer and Hausman tests are fitted. It should be mentioned that profitability is calculated through two measures including return on assets (ROA) and gross operating profit. To evaluate the effect of business cycles on the relationship between working capital management and profitability, we must first identify business cycles. For this purpose the filter Hodrick –Perescot is used. The study consisted of both fixed and variable samples with 143 and 251 companies in Tehran Stock Exchange for 2001 to 2013 respectively.
Results & DiscussionThe results of the two fixed and variable samples are shown in the below table.
Business cycles Variable Expected Sign ROA (dependent variable) GOI (dependent variable)
Example(251) Example(143) Example(251) Example(143)
Boom Ccc1 - Negative and insignificant positive and insignificant Negative and insignificant positive and insignificant
Ccc*D1 positive and significant positive and insignificant positive and insignificant Negative and insignificant
Bust Ccc - positive and insignificant positive and insignificant positive and insignificant Negative and insignificant
Ccc*D2 - negative and significant Negative and insignificant Negative and insignificant positive and insignificant
Boom AP negative and significant negative and significant negative and significant negative and significant
AP*D1 - negative and significant negative and significant Negative and insignificant Negative and insignificant
Bust AP negative and significant negative and significant negative and significant Negative and insignificant
AP*D2 positive and significant positive and significant positive and insignificant positive and insignificant
Boom AR - negative and significant negative and significant negative and significant negative and significant
AR*D1 negative and significant Negative and insignificant negative and significant Negative and insignificant
Bust AR - negative and significant negative and significant negative and significant negative and significant
AR*D2 - positive and significant positive and insignificant positive and significant positive and insignificant
Boom INV - negative and significant Negative and insignificant Negative and insignificant Negative and insignificant
INV*D1 positive and significant positive and insignificant positive and insignificant positive and insignificant
Bust INV - positive and insignificant Negative and insignificant Negative and insignificant Negative and insignificant
INV*D2 - negative and significant Negative and insignificant Negative and insignificant positive and insignificant
CCC: Cash Conversion Cycle, AP: Accounts Payable, AR: Accounts Receivable, INV: Inventory Conversion Period
As it can be seen there is a significant negative relationship between the profitability and collection period and this finding is supported by the expectations. In other words, this result has not been changed despite of balanced and unbalanced sample. There is negative relation between collection period and profitability during the boom that is reversed during the recession relative to the boom. The results indicated significant negative relationship between the profitability and commitment payment period. According to the results, as long as the economic downturn prevails, the commitment period has a positive relationship with profitability while the mentioned relationship is reversed in the boom period. Sensitivity analysis indicates that no change in the findings has been achieved with balanced sample.
Conclusions & SuggestionsThe results indicate that as long as the return on assets (ROA) is used as a profitability measure, the relationship between profitability with the commitment payment period and the collection period is negative during the boom and there is a positive significant relationship between profitability and the cash conversion period and average inventory turnover. These relationships are reverse in recession. While if the gross operating earnings is used as second measure of profitability, it cannot find any significant relationship between profitability with the cash conversion period, average inventory turnover and commitment payment period neither during boom nor bust. There is negative (positive) significant relationship between gross operating profit and the average collection period in boom (recession). So, the results of this research are affected by the profitability measures. The results of the study are always true in variable and constant samples. Findings sensitivity analysis shows that the main results of this research are not influenced by variable sample and is established also for constant sample.