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WORKING CAPITAL MANAGEMENT AND FIRM’S PROFITABILITY: AN INTERACTION OF CORPORATE GOVERNANCE MECHANISM

Nurazleena Ismail1; Norazida Mohamed2 & Wan Nazihah Wan Mohamed3

1Faculty of Business Management, Universiti Teknologi MARA Kelantan 2Faculty of Accountancy, Universiti Teknologi MARA Kelantan

3Academy of Language Studies, Universiti Teknologi MARA Kelantan

1azleena@kelantan.uitm.edu.my ; 2azida767@kelantan.uitm.edu.my; 3wnazihah@kelantan.uitm.edu.my

ABSTRACT

Efficient working capital management is necessary to achieve both profitability and liquidity of a company. Working capital management involves managing the firm’s current assets and current liabilities by optimizing financing its net working capital needs from the difference between current assets and current liabilities (Duggal & C.Budden, 2012). This paper aims to conceptualize corporate governance mechanism as an interaction between working capital management practices and firm’s profitability. Six built hypothesis testing are used to achieve the paper’s objectives. This paper uses empirical studies from the previous researches that are relevant to the hypothesis testing. In this paper, the variables of working capital management are accounts receivable, inventories, accounts payable and cash conversion cycle. In terms of profitability, the firms need to use return on assets to measure their profit position and efficiency. Subsequently, the interaction of corporate governance has to consider the board size and CEO tenure. Keyword: Working Capital Management; Profitability; Corporate Governance

1. INTRODUCTION Profitability is important to ensure the firm’s stability and sustainability. The firm can maximize the shareholder’s value when it maximizes the profit. In order to maximize the shareholder’s return, the firm should efficiently manage the working capital by managing the assets and liabilities of the firm. The importance of working capital management of a corporation in the globalization era is shown in the significant decline of corporate performance during the late 1990s financial crisis. This is due to the reason that working capital management has profitability and liquidity implications of the firms. Efficient working capital management is necessary to achieve both profitability and liquidity of a company. In other words, the working capital management involves managing the firm’s current assets and current liabilities by optimizing financing its net working capital needs from the difference between current assets and current liabilities (Duggal & C.Budden, 2012). As mentioned by Riaz, Ahmad and Iqbal (2014), working capital management involves planning and controlling of current assets and current liabilities in order to eliminate risks for short term obligations and avoid excessive investment in assets. Working capital management is also concerned with efficient utilization of current assets to generate sufficient amount to pay current liabilities. The management of working capital consists of managing inventories, accounts receivable, account payable and cash, and cash equivalents. The ability of managing working capital can maximize shareholder’s wealth and it can be achieved when

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the company earns sufficient profits. Besides that, the profitability of the firm can be measured on return of total asset (Bose, 2013; Kaddumi & Ramadan, 2012). Furthermore, corporate governance also gives an impact towards working capital management efficiency. Bose (2013) investigated the impact of corporate governance towards the efficiency of working capital management in American manufacturing firms. The study found a small number of researches that quantitatively tested working capital management and firm’s profitability. There are also limited researches found on quantitative testing in Malaysia. Darun (2012) however worked on consumer product industry using the qualitative studies. In contrast, only a few number of research examined the efficiency of corporate governance as interacting effect between working capital management and firm’s profitability in Malaysia. Malaysian corporate governance is realized on the shareholder’s value and taken into account the stakeholder’s interest. In relation to this, this paper aims to conceptualize the corporate governance mechanism as an interaction between working capital management practices and firm’s profitability. Six built hypothesis testing are used to achieve the paper’s objectives. This paper uses empirical studies from the previous researches (Ramachandran & Janakiraman, 2009; Guest, 2009; Wu et al., 2009; Nwankwo & Osho, 2010; Kaddumi & Ramadan, 2012; Naser, et al., 2013; Gill & Biger, 2013; Riaz et al., 2014) that are relevant to the hypothesis testing. 2. WORKING CAPITAL MANAGEMENT The uses of funds are categorized into two parts namely long-term funds and short-term funds. A major part of long-term funds is invested in fixed assets that need to retain in the business to earn profits during its life. But, the short-term funds are also required to run the business operations known as working capital. Guthmann (1953) defined working capital as “the portion of a firm’s current assets which are financed from long-term funds.” There are two concepts of working capital which are balance sheet concept and operating cycle concept (Deivikaran, 2007). The balance sheet concept has two interpretations which are gross or total of current assets and excess of current assets over current liabilities. Excess of current assets over current liabilities are called the net working capital or net current assets. The net working capital represents the amount of current assets which would remain if all current liabilities were paid. Additionally, the operating cycle concept consists of three primary activities such as purchasing resources, producing the product and distributing (selling) the product. These activities create funds flows that are both unsynchronized (cash disbursement usually take place before cash receipts) and uncertain (future sales and cost which generate the respective receipts and disbursement, cannot be forecasted with complete accuracy). Genestenbreg defined it as “the circulating capital means current assets of company that are changed in the ordinary course of business from one form to another as for example from cash to inventories, inventories to receivable and receivable to cash.” Hence, the management of current assets, current liabilities and the inter-relationship between them is termed as working capital management. Practically, there is usually a distinction between the investment decisions concerning current assets and the financing of working capital. 3. WORKING CAPITAL MANAGEMENT THEORY Working capital management is a very important aspect of corporate finance. It has to do with using the money that is needed to run the day-to-day operations of an organization efficiently in order to achieve the aims and objectives of the organization. The elements of working capital are current

Comment [U1]: State the LR OR NAME OF COUNTRIES

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assets (cash, accounts receivable, inventories) and current liabilities (bank overdraft, trade creditors and accrued expenses). The importance of cash as an indicator of continuing financial health should not be a surprise in view of its crucial role within the business (Nwanko & Osho, 2010). The interaction between current assets and current liabilities is the main theme on the theory of working capital management. Thus, as stated by Duggal and C.Budden (2012), the theory of working capital management emphasizes on minimizing company’s cash conversion cycle (CCC) defined as the time interval between cash payments and cash receipts. CCC is estimated as below:

CCC = Average Age of Inventory (AAI) + Average Collection Period (ACP) –Average Payment Period (APP)

AAI measures the holding inventory period from producing finished goods until sales of finished goods. The second term is ACP which is the measure of how fast a firm collects debt from the customers. The equal value of AAI and ACP indicates a higher value of AAI and ACP; and the higher the firm’s investment in its net working capital. APP is the last term that measures vendor financing in which the higher the value of APP denotes a greater amount of vendor financing. A firm that minimizes its CCC also minimizes its needs for net working capital and will affect the firm’s cost of capital. Thus, the CCC is the actual time between cash outflows and cash inflows. An increase in the CCC would indicate a worsening of the firms’ liquidity, and a decrease would indicate an improvement in the firms’ liquidity. Hence, the improvement of company’s liquidity will lead to the profitability of the firm. 4. WORKING CAPITAL MANAGEMENT AND PERFORMANCE OF FIRMS The existence, survival, growth and stability of any corporate body are highly dependent on the efficiency and effectiveness of its management. In the past, it showed that a lot of corporate organizations failed to achieve their objectives because of inefficiency of management in its working capital (Nwankwo & Osho, 2010). The working capital management is a branch of total quality management that focuses on decision making. The decision making which is the basis of working capital management encompasses the following:

i) Decision on the company’s level of current asset in investment ii) Decision on the level of investment in each type of current asset iii) Decision on the specific sources and mix of short-term credit the company should

use iv) Decision on the level of short-term and long-term debts the company uses for

financing activities.

Hence, the evidences derived from previous researches have tested the relationship between working capital management and the firm’s profitability and liquidity (Riaz, Ahmad & Iqbal, 2014; Bose, 2013; Ahmad, Azim & Rehman, 2013; Rehn, 2012; Raheman & Nasr, 2007). Ahmad et al. (2013) found that tight credit policy, investment management efficiency, delayed payment policy and overall efficiency of working capital management give significant positive effect on operational liquidity position. Apart from that, results of previous study found a strong negative relationship between working capital management and profitability of firm (Raheman & Nasr, 2007; Bose, 2013). On the other hand, it also showed a significant effect between working capital management and profitability of firms (Kaddumi & Ramadan, 2012) that has a basic role in maximizing the shareholders’ wealth by making the firm more profitable through shorting the cash conversion cycle and net trading cycle.

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Furthermore, Abuzayed (2012) used robust estimation technique to examine the effect of working capital management on firm’s profitability. It found that profitability affected positively with the cash conversion cycle and financial markets tailed to penalize managers for inefficient working capital management in emerging markets. Moreover, Duggal and C.Budden (2012) investigated whether the US business revised their policies in the upshots of the recession causing the cash cycle to change. It showed no significant change between pre- and post-recession values in average of cash conversion cycle where firms retained more cash and short-term investment in 2010 than 2007. In Pakistan, most of the Pakistani firms have large amount of cash invested in working capital (Riaz, Ahmad & Iqbal; 2014). It found that the working capital had a significant impact on profitability of firms and played a key role in value creation for shareholder as longer cash conversion cycle had a negative impact on operating profitability of firms. This result was also supported by Raheman and Nasr (2007) in which they found that the increase of cash conversion cycle will lead to a decrease of profitability of the firms. Performance of firm is resulting from its profitability either it is high or low. Profitability can be measured on gross profit margin, operating profit margin, net profit margin, return on asset and return on equity. Bose (2013) examined the profitability of firms by using the return on total assets (ROTA). It found that cash position ratio had a positive influence on ROTA and the other ratios namely working capital turnover ratio, net current assets to total assets ratio, inventory turnover and current ratio has a negative influence on ROTA. Moreover, ROTA is negatively associated with day of working capital and it is insignificant. In addition, Kaddumi and Ramadan (2012) used two alternative measures of profitability as proxy for the performance which were (ROTA) and net operating profit (NOP). It found that the firm’s profitability measured by ROTA was affected by average collection period, cash conversion cycle and net trading cycle. Furthermore, profitability of firms measured by NOP was affected by average collection period, average age of inventory, average payment period, cash conversion cycle and net trading cycle. These results were consistent with the traditional theory of working capital management in which conservative policy was expected to reduce profitability in order to maintain high liquidity. In contrast, Riaz et al. (2014) used gross operating profit as a proxy variable to measure profitability. The significant negative relationship had been found between profitability and the average collection period, average age of inventory, average payment period and cash conversion cycle among Pakistani firms listed in Karachi stock exchange. 5. CORPORATE GOVERNANCE Corporate governance comprises of two mechanisms which are internal and external corporate governance (Wu, Lin, Lin & Lai; 2009). The internal corporate governance gives priority to shareholders’ interest and operates on the board of directors to monitor top management. In contrast, external corporate governance monitors and controls managers’ behaviors through external regulations and forces that involved suppliers, stakeholders, accountant, lawyers, providers of credit rating and professional institutions. In Malaysia, financial regulator had formularized and introduced The Capital Market Master-plan to eradicate governance woes which were viewed to be the culprit to the 1997 crisis. According to Ghazali and Manab (2013), despite the Master-plan, Malaysian Code on Corporate Governance 2000 (MCCG 2000) was introduced where risk management for the first time was clearly stated and viewed as one of the principal responsibilities of the board of directors. Moreover, MCCG 2007 strives to strengthen the role of audit committees by requiring the committees to comprise fully of non-executive directors and it is mandatory to

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include the internal auditing committee in risk management team. In addition, Ghazali and Manab (2013) highlighted whether the implementation of MCCG 2000 and 2007 gives an impact to companies’ performances. It found that both MCCGs did not improve the company’s performance where the firms’ value had declined since the code implementation. Moreover, the board of directors and the CEO were responsible to formulate policies regarding cash management, accounts receivable, inventory purchases and maintenance, accounts payable and all other policies in the organization. Marn and Romuald (2012), Shakir (2008), and Haniffa and Hudaib (2006) investigated the relationship between corporate governance and company performance for public listed companies in Malaysia. Haniffa and Hudaib (2006) investigated the relationship between the corporate governance structure and performance of companies listed in the Kuala Lumpur Stock Exchange (KLSE). Two measurements of corporate performance namely Tobin’s Q and return on assets were considered as proxies for market return and accounting return respectively. The six corporate governance structures were board size, proportion of non-executive directors, CEO duality, proportion of directors on the board with multiple directorships, shareholdings held by the top five largest shareholders and directors’ shareholdings. The study found that board size and top five substantial shareholdings were significantly associated with both market and accounting performance measures. Furthermore, CEO duality and managerial shareholdings were significantly associated with accounting performance. Shakir (2008) examined the relationship between board composition and performance of property companies. The result showed that board size had a consistent negative relationship with Tobin’s Q in all regressions. In contrast, Marn and Romuald (2012) identified five main corporate governance namely board size, board composition, audit committee, CEO status and ownership structure were analyzed in terms of their relative impact on the firm’s performance as defined by earnings per share. The results showed board size and ownership structure had significant effects on the firm’s performance. Other variables like board composition, audit committee and CEO status did not show any significance effect on the firm’s performance. Besides Malaysian firms, large public companies in the United State also examined the relationship between corporate governance and firms’ stock performance (Kaplan & Minton; 2012). The result showed that greater CEO turnover was associated with higher stock return. In addition, American manufacturing firms showed that corporate governance improved the efficiency of working capital management (Gill & Biger; 2013). They emphasized on the relationship between characteristics of corporate governance such as CEO tenure, CEO duality, board size and audit committee on various characteristics of working capital components and measures of efficiency. Apart from that Dikolli, Mayew and Nanda (2014) found a negative relation between CEO turnover and the firm’s performance as its continuance declined in CEO tenure. In the United Kingdom, Guest (2009) examined the impact of board size on firm performance for UK listed firms. The findings showed a strong evidence of negative relation between board size and three different firm performance measures namely profitability, Tobin’s Q and share return. Besides that Wu, Lin, Lin and Lai (2009) examined the impact of corporate governance mechanism on firm’s performance among listed and over-the-counter firms in Taiwan. The performance of firm is measured by using return on assets, stock return and Tobin’s Q. The results showed that firm performance had negative and significant relations to board size, CEO duality, stock pledge ratio and deviation between voting right and cash flow right. Further results indicate that firm’s performance had positive and significant relations to board independence and insider ownership.

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Mamo (2013) discussed how corporate governance practices can be applied to improve working capital management and business success. The key lessons for the corporate governance professional are strategic focus, working capital improvements; minimize business risk, underpinning human capital, building relationships with customers, suppliers and employees and financial end result (lean working capital, improved profitability and optimum capital structure).

6. PROPOSITION OF HYPOTHESES The relationship between working capital management and profitability of firms has already been tested by the previous researchers and the effect of corporate governance towards the efficiency of working capital has also been examined. Therefore, this study intends to propose the new body of knowledge by focusing on the interaction of corporate governance efficiency that affects the relationship of working capital management and firm’s profitability. The variables for working capital management are accounts receivable, inventories, accounts payable and cash conversion cycle. In addition, profitability of firms will be measured using return on assets while the efficiency of corporate governance will consider the board size and CEO tenure. Hence, this study will identify the six propositions supported by the past researches. Nwankwo and Osho (2010) found that inefficiency of working capital management will lead to failure to achieve the objectives among the corporate organizations. In addition, Kaddumi and Ramadan (2012) also showed significant effect between working capital management and profitability of firms that has a basic role in maximizing the shareholders’ wealth. Therefore, proposition 1 is: Ha : Working capital management has a significant relationship with profitability of firms For the next proposition, Riaz et al. (2014) showed a negative relationship between net operating profitability and average collection period. It means that tight credit policy will give a significant effect on the company’s performance (Ahmad et al., 2013). Kaddumi and Ramadan (2012) also resulted a negative relationship between average collection periods with profitability that implied a shortening collection period will increase the profitability of firms. Hence, proposition 2 is: Ha : Accounts receivable management has a significant relationship with profitability of firms With regard to the impact of inventory cycle on the EBIT of the firms, the regression results disclosed that inventory days have negative relationship with EBIT (Ramachandran & Janakiraman, 2009) which was consistent with Kaddumi and Ramadan (2012). It means that the shortening of holding inventories will lead to a better performance of the firm. Thus, proposition 3 is: Ha : Inventory management has a significant relationship with profitability of firms The positive relationship between average payment period and profitability implies that extending payment period will increase the profitability of firms (Kaddumi & Ramadan, 2012). Riaz et al. (2014) also found that inter-item matrix correlation between accounts payable with profitability shows a positive relationship. The next proposition 4 is: Ha : Accounts payable management has a significant relationship with profitability of firms

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Cash is the most liquid asset of any firm. Naser et al. (2013) have identified cash management as the process of ensuring that enough cash is available to meet the running expenses. It also aims to reduce the cost of cash holding. Therefore, proposition 5 is: Ha : Cash management has a significant relationship with profitability of firms According to Gill and Biger (2013), corporate governance can improve the efficiency of working capital management. Apart from that, corporate governance showed a significant effect between profitability and market return (Guest, 2009; Wu et al., 2009). Hence, proposition 6 is: Ha : Corporate governance mechanisms has an interaction effect on working capital management and profitability of firms. 7. PROPOSED FRAMEWORK The identification of variables will develop the above proposition of hypotheses which is presented in the proposed framework as in figure 1:

Figure 1: Proposed Framework 8. CONCLUSION As a conclusion, working capital management is important to achieve the firm’s performance and efficiency. Therefore, the firms can sustain their business through efficient management of the working capital. This is because most of the firms that did not properly manage their working capital had to shut down the business. Corporate governance is also important either internal or external in order to make sure the firms smoothly run the business in ensuring their shareholders’ and stakeholders’ wealth. Due to that, I would recommend the investigation of the companies listed in Bursa Malaysia from different industries for future research toward their working capital management. It also has to look at how the mechanism of corporate governance has an interaction effect on working capital management and profitability of firms. The researcher also has to consider the variables of working

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capital management which are accounts receivable, inventories, accounts payable and cash conversion cycle. In terms of profitability, the firms need to use return on assets to measure their profit position and efficiency. Lastly, the interaction of corporate governance has to consider the board size and CEO tenure. REFERENCES Abuzayed, B. (2012). Working capital management and firm performance in emerging markets: The case of Jordan. International Journal of Managerial Finance , 155-179.

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