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The Empirical Economics Letters, 13(1): (January 2014) ISSN 1681 8997

Working Capital Management and Corporate Profitability

College of Business Administration, Abu Dhabi University

Abu Dhabi, UAE

Email: nobanee@gmail.com

Ayman E. Haddad

College of Business and Economics, The American University of Kuwait

Safat13034, Kuwait

Email: ahaddad@auk.edu.kw

Abstract: This study examines the relationship between working capital management,

profitability, firm size and industry type for firms in Japan. The study sample consists

of 2123 Japanese non-financial firms listed at the Tokyo Stock Exchange for the period

1990-2004. We observe that the cash conversion cycle and return on investment

relationships are commonly significant and negative, suggesting that the shortening of

the cash conversion cycle enhances the profitability of Japanese firms. We also

observe that all types of Japanese firms included in this study can increase their

profitability by shortening the receivable collection period and shortening the

inventory conversion periods. However, the slowing of payment to suppliers improves

the profitability for service firms only.

Keywords: Working Capital Management; Cash Conversion Cycle; Receivable

Collection Period; Inventory Conversion Period; Payable Deferral

Period; Return on Investment

JEL Classification Number: G30; G39

1. Introduction

Maximization of the owner’s wealth is the basic financial goal in the management of

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Working capital management is about managing current assets and current liabilities. It is

an essential component of corporate finance since it affects the firm’s liquidity,

profitability, cash flow and market value (Alshattarat et al. 2010;Deloof, 2003; Mathuva,

2010; Nobanee et al. 2011; and Raheman and Nasr, 2007). Firms with inadequate cash

and inventory levels may incur shortages that could disturb the firm’s operations

(Appuhami, 2008). Among comprehensive performance measures for assessing how well

a company manages its current assets and current liabilities is the cash conversion cycle

suggested by Richards and Laughlin (1980). Stewart (1995) defines the cash conversion

cycle as “a composite metric describing the average days required to turn a dollar invested

in raw materials into a dollar collected from a customer”. Besley and Brigham (2005)

describe the cash conversion cycle as “the length of time from the payment for the

purchase of raw materials to manufacture a product until the collection of accounts

receivable associated with the sale of the product”. The short cash conversion cycle

indicates that the firm is collecting the receivables as quickly as possible and delaying the

payments to suppliers as much as possible. This cycle is expected to increase the value of

the firm,its profitability, cash flow, and liquidity (Deloof, 2003; Gentry et al. 1990;

Mathuva, 2010; Nobanee et al. 2011; and Raheman and Nasr, 2007).

A great deal of research in the area of the efficiency of working capital management and

its impact on the firm’s profitability, liquidity, cash flow and market value has been

carried out worldwide (Afza and Nazir, 2007; Alshattarat et al. 2010; Chowdhury and

Amin, 2007; Christopher and Kamalavalli, 2009; Deloof, 2003; Ganesan, 2007; Lazaridis

and Tryfonidis, 2006; Mathuva, 2010; Mohamad and Saad, 2010; Narware, 2004;

Padachi,2006; Raheman and Nasr, 2007; Sayuddzaman, 2006; Shin and Soenen, 1998;

and Uyar, 2009). This study contributes to prior studies by examining not only the

relationship between the firm’s profitability and the overall cash conversion cycle but also

its components. This study breaks the cash conversion cycle (CCC) into its components

(receivable collection period, inventory conversion period and payable deferral period).

The impact of different working capital management practices on the profitability of

Japanese firms might be different from that of other countries due to the unique Japanese

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The Empirical Economics Letters, 13(1): (January 2014) 41

government. Realizing the fact that the business environment in Japan is different from

that of the rest of the world, it would be interesting to examine the working capital

management including the cash conversion cycle with its components and firm’s

profitability in Japan.

The rest of the paper is organized as follows: Section two presents the data and the

methodology used. Section three documents the analysis and the results of the study.

Finally, section four concludes the paper.

2. Data and Methodology

The data set in this study was retrieved from Data Stream. It includes all non-financial

firms listed on the Tokyo Stock Exchange. Some firms with missing data are excluded

from the sample. The final sample contains 2123 companies covering the period between

1990 and 2004. Profitability is measured by return on investment computed as net income

divided by total capital invested. The receivable collection period measures the amount of

time that it takes for a business to receive the cash payment from its customers or clients

as a result of sales goods (or services).It is measured as [(account receivable/sales) *365].

The inventory conversion period is the amount of time between the acquisition of raw

materials (or merchandise) and the sale of merchandise. Inventory conversion period is

measured as [(inventory/cost of goods sold)*365]. The payable deferral period is the

length of time between the purchase of goods and the payments of cash made for them. It

is calculated as [(account payable/cost of goods sold)* 365]. The cash conversion cycle is

an additive function calculated as [receivable collection period + inventory conversion

period — payable deferral period].

To test the effect of the cash conversion cycle and its components on profitability, we

apply a robust regression. Robust regression is used when residuals do not have a normal

distribution, there is a case of suspicion about heteroskedasticity and there are outliers. We

regress the cash conversion cycle, the receivable collection period, the inventory

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The results show that the coefficients of the receivable collection period for all companies,

small companies, and service companies are negative and significant. This indicates that

reducing the receivable collection period increases the profitability of such companies.

The results also show that the inventory conversion period is significantly and negatively

related to profitability for all companies, small companies, medium companies, general

industries, service companies, and information technology companies. The negative and

significant relationship of the inventory conversion period is consistent with the view that

companies with low inventory levels reduce the holding inventory cost that leads to high

profitability. However, the relationship between the payable deferral period and

profitability is significant and positive for service companies only. This indicates that

delaying payments to suppliers saves some cash that could be reinvested in the service