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Working Capital Management
Working Capital Management
Research Report
Working
Capital
Management
Course: Financial Management
May 6
2015
Mayank Singh
ACKNOWLEDGEMENT
The same was the case with me. I faced many problems when I started
the work on report but we are greatly thankful to Almighty god for enabling
us to get successfully through my responsibilities.
Very warm and special thanks to my respected teacher whose real
dedication and devotion kindled in me hope and light. Sir I thank your ability
of extracting the very best out of me, for your patience and perseverance, and
also for acknowledging the efforts made by me during the whole semester.
Thank you
Abstract
Working capital is current assets (cash, receivables, inventory, etc.) minus current
liabilities (debt obligations due within one year). Working capital may also be
viewed as the amount of a business's current assets provided (financed) by longterm debt and/or equity.
If, for example, a business has no current liabilities, working capital equals current
assets. In the situation just described, 100% of current assets are provided
(financed) through long-term debt and/or equity. If, in contrast, a business has
exactly $0 working capital, current assets equals current liabilities. Or, in other
words, 100% of current assets are provided (financed) with short- term debt
(current liabilities).
A business that has no working capital or very little working capital will likely
have difficulty in paying short-term debt obligations from operational sources of
cash in sustained or sudden declines in sales. Therefore, the importance of
maintaining an appropriate level of working capital and its contribution to business
survival is a concept that small business managers should understand. Managers
should develop a working capital philosophy that they can apply and monitor
carefully.
The importance of working capital is quite often overlooked by both the borrower
and the lender. Working capital may be viewed as the amount of a business's
current assets financed by long-term debt and/or equity. A business that has little
or no working capital is likely going to have difficulty in paying or refinancing
short-term debt during times of business declines which may be accompanied by a
tightening of business credit.
INTRODUCTION:
Methodology:
The primary aim of this paper is to investigate the impact of WCM on corporate
profitability of Mauritian small manufacturing firms. This is achieved by
developing a similar empirical framework first used by Shin and Soenen (1998)
and the subsequent work of Deloof (2003). We extend our study by also analysing
the trends in working capital need of firms and to examine the possible causes for
any significant differences between the industries.
Our study focuses exclusively on the small manufacturing firms operating in five
major industry groups which are both registered and organised as
proprietary/private companies. This restriction places a limit on the number of
firms qualifying for the study and is further narrowed down following the revised
Companies Act of 2001 which requires firms with a given turnover threshold to
file only an aggregated financial statements.
Thus the empirical study is based on a sample of 58 small manufacturing
companies. The data has been collected from the financial statements of the sample
firms having a legal entity and have filed their annual return to the Registrar of
Companies. The sample was drawn from the directory of Small Medium Industrial
Development Organisation (SMIDO), a database for registered manufacturing
firms operating in diverse activities and for which data was available for a 6 years
period, covering the accounting period 1997-98 to 2002-03. The companies
qualified for the above two conditions are further grouped into industries based on
the classification as listed in the 2003 directory. Thus the data set covers 58 firms
from five industry subsectors: food and beverages, leather garments, paper
products, prefabricated metal products and wood furniture. This has given a
balanced panel data set of 348 firm-year observations for a sample of 58 firms.
For the purpose of this study, profitability is measured by Return on Total Assets
(ROTA), which is defined as profit before interest and tax divided by total assets.
The operating income measure of profitability used in the study of Deloof (2003) is
not appropriate for this study. The SMEs is characterised by a low fixed assets
base and relied to a large extent on accounts payable to fund its gross working
capital. Thus a comprehensive measure of profitability is best captured by
computing the return on total assets which is equal to the total liabilities of the
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firms, made up mainly of equity capital and current liabilities. Some firms have
significant fixed financial assets and were thus excluded from the calculation of
ROTA.
Working Capital Analysis
The major components of gross working capital include stocks (raw materials,
work-in-progress and finished goods), debtors, cash and bank balances. The
composition of working capital depends on a multiple of factors, such as operating
level, level of operational efficiency, inventory policies, book debt policies,
technology used and nature of the industry. While inter- industry variation is
expected to be high, the degree of variation is expected to be low for firms within
the industry.
Control variables
In order to account for firms size and the other variables that may influence
profits, sales a proxy for size (the natural logarithm of sales), the gearing ratio
(financial debt/total assets), the gross working capital turnover ratio (sales/current
assets) and the ratio of current assets to total assets are included as control
variables in the regressions. The regressions also include the ratio of current
liabilities to total assets to measure the degree of aggressive financing policy, with
a high ratio being relatively more aggressive.
The explanatory variables
The efficiency ratios, namely accounts receivable, inventory and accounts payable
have been computed, using the formulas as listed in Appendix 1. The Cash
Conversion Cycle (CCC) 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. The longer the cycle, the larger the
funds blocked in working capital. The return on assets is a better measure since it
relates the profitability of the business to the asset base.
Findings:
In the first part of data analysis, profile of the respondents and results of open
ended questions is being discussed. A total of 190 responses were received
comprising 83% response rate. These responses represent four broad industries
mainly service sector (covering banks and financial institutes, petroleum gas,
telecommunication and service providers). During the last decade, service industry
particularly banking and telecommunication sectors has shown a tremendous
growth in Pakistan. The overall consensus of industry analysts is that Pakistan is
one of the countries with a huge untapped potential for telecommunication growth
and an attractive investment environment that is the main reason why researcher
has tried to gather data from these firms. (Bhatti, 2006).
When analyzed the total respondent pool about the working capital decision
making, it was revealed that 65.8 % of the respondents confirmed it at the
corporate level. This result is closer to the Ricci and Vito study who had reported it
as 57.3%. The regional level value was 32.1% and only 1.6% of the respondents
were taking decisions at local level. Overall, it may be concluded that most of the
firms tend to make it at corporate level which shows the centralized approach for
making working capital decisions.
Response rate was 76.3% when inquired about the firms percentage of overseas
sales, it was discovered that 71% of the respondents replied it between 1-50%.
However 29% of the respondents answered that it was between 51-100%. About
relationship with foreign banks, the results of the survey indicate that almost
68.7% of the firms have relationship with 1-20 foreign banks. This result is quite
parallel with Ricci and Vito study which show that 74.1% of the firms have
relationship with 1-25 foreign banks. Response rate for this question was 77.3%.
71% of the respondents claimed that overseas demand deposit account were
between 1-20. More surprisingly it was revealed that 3.2% firms confirmed
between the numbers 10,000-50,000.
Next section discusses about international cash management, international sales
and foreign exchange activities.
Wire Transfers
CHIPS (Clearing Ho se Interbank Payment System) and SWIFT (Society for
Worldwide Interbank Financial Telecommunications) are two computerized
systems of international wire transfers A primary benefit offered by SWIFT lies in
the standardization of the transfer process, which significantly reduces errors by
providing a singular means of communication between correspondent banks. In
addition, "SWIFT has evolved into one of the least costly, securest, most rapid
means of transmitting . . . instructions" (Aggarwal and Baker, 1991).
The results of the survey shown in table 1 indicate that 59.5% of the respondents
use wire transfers often, while 6.8% never use them. These results are somewhat
similar to Ricci & Vito study, which says that 68% of the respondents often used
wire transfers, whereas 7.2% never used it. So it may be inferred that wire transfers
being less costly instrument, is being used as international cash management
operations.
Electronic Funds Transfers
Wire Transfer is transferring credits from your Bank Account to the Weapons
factory or Research. With using Wire Transfer you do not have to have wealth.
Wire transfers cost 30% more then
purchasing by Wealth. Online electronic funds transfer is much more secure than
traditional wire transfers. There are no unexpected agent fees, and no need for the
recipient to carry large amounts of cash. Table 1 reveals that 53.7% of the
respondents often use it and 12.6% said that they never did. The result is quite
similar to the Ricci and Vito study which confirm that 61% of the respondents
often use it.
Cash Pooling
Summary statistics in table 1 show that 28.4% of firms were often use cash pooling
as one of the cash management techniques whereas 27.4% were using it
sometimes. There has been found a significant difference when compared this
result with Ricci and Vito study which says that 52.0% often use cash pooling
whereas 28.0% has never used it. The reason could be the major disadvantage
attached to
pooling which is that the firm's subsidiaries have less control over their cash flows
since all cash not needed for transaction purposes is transferred to the pool.(Ricci
et al, 1996)
Payments Netting
The payoff from multilateral netting systems can be large relative to their expense.
For instance, "many companies find they can eliminate 50% or more of their
intercompany transactions through multilateral netting, with annual savings in
foreign exchange transaction costs and bank transfer charges that average about
1.5% per dollar netted" (Shapiro, 1992).
As may be seen in table 1 only 20% of the respondents say that they often use it
while 21.6% say that they have never used it. If one looks at the Ricci and Vito
study, it was found that results are more or less similar which says that 23.2% of
respondents often use it and 27.3% say they never used it. One reason of the low
usage can be explained by the fact that payment netting is a relatively new
phenomenon.
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Value Dating
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About value dating, the results in table 2 clearly demonstrate that 33.2% of the
respondents never used it whereas only 15.8% have often used it. These results are
similar to Ricci study which shows that 42% of the respondents never use value
dating. Reason for the lack of value dating may be that it "makes international
funds transfers potentially more expensive than domestic transfers" (Hill and
Sartoris, 1992), due to the high opportunity cost of delayed funds. Clearly, value
dating as a form of compensation can present significant cash management
challenges (Seeman, 1992)
Letters of Credit
A letter of credit is a document issued mostly by a financial institution which
usually provides an irrevocable payment undertaking (it can also be revocable,
confirmed, unconfirmed, transferable or others e.g. back to back: revolving but is
most commonly irrevocable/confirmed) to a beneficiary against complying
documents as stated in the credit.
Documentary Collections
Documentary collection is a good method of payment when the buyer and seller
know each other well and there is minimal country risk involved. (Stroh, 1994)
The documentary collections method is in essence a time draft (discussed below),
with documents required before payment is made. In the documentary collections
process, the banking system serves as the transfer agent.
Cash in Advance
This mode of payment offers the greatest protection at the end of exporters because
no credit extension is required. The primary disadvantage of cash in advance is
that it can limit the exporter's sales potential. Importers are often unwilling or
unable to meet cash in advance terms for several reasons. First, the buyer must rely
upon the integrity of the seller, who simultaneously controls both the goods and the
funds. Second, the importer has the least amount of flexibility with cash in advance
terms.
Factoring
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Currency Swaps
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Conclusion:
Working capital, being the lifeblood of any organization has a broad spectrum of
importance in running the short term objectives such as cash management on one
hand and decisions pertaining to foreign exchange activities on the other. Different
analyses in this study have produced several conclusions. First, the process of
internationalization has not increased significantly as it is evident from degree of
internationalization. Only 29% of the respondents have overseas sales between 51100%. Also decisions are still being taken at the corporate level as opposed to local
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and regional levels which show the higher degree of centralization for decisions
about working capital management. Wire transfers and electronic funds transfer
were the most popular International cash management vehicles. The reason can be
explained by the fact that these vehicles are speedy and cost effective.
Open accounts, letter of credit and documentary collections were mostly used by
the respondents when asked about the mode of payment for international sales.
Surprisingly, the usage of letter of credit was significantly higher as compared to
the Ricci and Vito survey. The explanation of this finding can be that both the
exporters and importers have benefits which outweigh the cost involved.
About the foreign exchange activities, spot market and forward market was the
most widely used vehicle. Interestingly, Ricci and Vito survey also show the wide
use of these two vehicles at the top among the usage of foreign exchange activities
vehicles despite the fact that there was a difference of almost 8 years between these
two researches. To conclude all this, it can be generalized that firms have shifted
their concerns towards low cost and efficient methods related to international
working capital management decisions and there was found no significant
difference when analyzed with respect to different sectors. Like any other study,
this survey is not without limitations. First, the scale used was just taken as teacher
made instrument and was not without loop wholes. For example, some of the
questions were answered by the respondents based on their own understanding.
Second, some concepts specially related to foreign exchange activities are
relatively novel and the respondents had not enough knowledge about it. Third,
response rate was somewhat low for open ended questions which might reflect in
generalizing the results. Last, but not least there is a lack of fundamental research
in the area of working capital so enough literature was not available which could
provide a strong foundation for proper research design. Future researchers may
take this study as a baseline for conducting the longitudinal research.
Also focus groups with industrialists and professionals can be done to improve the
tool.
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