Impact of Working Capital Management on Profitability of Textile

Sector of Pakistan

Sumaira Tufail Bilal Javaria Khan

Hailey College of Commerce Hailey College of Commerce University of Central Punjab,
University of the Punjab, University of the Punjab, Lahore, Pakistan
Lahore, Pakistan Lahore, Pakistan
[email protected] [email protected] [email protected]

Abstract
Working capital can be considered as source of existence for a financial body and
management of working capital is regarded as one of the most essential part of business
management. This study aims to find out the impact of working capital policies on
profitability. Return on assets is used as a measure of profitability. Current assets to
total assets ratio is used to compute the investment policy of working capital
management and to determine financing policy of working capital management current
liabilities to total assets ratio is used. Other variables that are used in this study are
quick ratio, debt to equity ratio and size of the firms. Secondary data of 117 textile firms
listed on Karachi stock exchange is taken for a period of six years i.e. 2005-2010 to
calculate all these variables. Results of the regression analysis show that aggressiveness
of working capital management policies is negatively associated with profitability.
Moreover liquidity and size of the firm have positive relation profitability whereas debt
to equity ratio is negatively correlated with profitability. Textile sector is one of the
majors sectors of Pakistan. It needs due consideration regarding the management of
assets and liabilities. So, the aim of this study is to provide some useful
recommendations for the people responsible for the management of this sector. This
study also establishes the basis for future research in this area of business.
Key Terms: Working Capital Management, Profitability, Textile Sector, Pakistan
Introduction
Working Capital mainly represents the current assets of a firm which is the
portion of financial resources of business that changes from one type of resources to
another during the day-to-day execution of business (Gitman, 2002). Current assets
mainly comprise of cash, prepaid expenses, short-term investments, accounts
receivable, inventory and other current assets. Net working capital can be measured by
deducting current liabilities of a firm from its current assets. If the value of current
assets is less than that of current liabilities then net working capital would have a
negative value showing a deficit working capital. When a business entity takes the
decisions regarding its current assets and current liabilities then it can be termed as
working capital management. The management of working capital can be defined as an
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accounting approach that emphasize on maintaining proper levels of both current assets
and current liabilities. It provides enough cash to meet the short-term obligations of a
firm.
Profitability can also be termed as the rate of return on investment. If there will be
an unjustifiable over investment in current assets then this would negatively affect the
rate of return on investment (Vishnani & Shah, 2007). The basic purpose of managing
working capital is controlling of current financial resources of a firm in such a way that
a balance is created between profitability of the firm and risk associated with that
profitability (Ricci & Vito, 2000).
Every business requires working capital for its survival. Working capital is a vital
part of business investment which is essential for continuous business operations. It is
required by a firm to maintain its liquidity, solvency and profitability (Mukhopadhyay,
2004). The importance of managing working capital of a business efficiently cannot be
denied (Filbeck & Krueger, 2005). Working Capital management explicitly impacts
both the profitability and level of desired liquidity of a business (Raheman & Nasr,
2007). If a firm will invest heavily in working capital i.e. more than its needs, then the
profits which can be generated by investing these resources in fixed or long term assets
will be diminished. Moreover the firm will have to endure the cost of storing inventory
for longer periods as well as the cost of handling excessive inventory (Arnold, 2008).
On the other hand, if a firm will invest heavily in fixed assets to generate profits
by neglecting its short-term capital needs then it is quite possible that it may have to
face bankruptcy because of insufficient funds. The profitability as well as adequate level
of liquidity is required to be maintained for the survival of a business, so if a firm will
not pay sufficient attention to its working capital management, then it is quite possible
that the firm would have to face bankruptcy (Kargar & Blumenthal, 1994). Shortage of
working capital is normally attributed as a major cause of failure of many small
businesses in various developing and developed countries (Rafuse, 1996).Effective
management of working capital consists of two steps which are planning for resources
and controlling them. Both of these are required to facilitate the firm in meeting its short
term obligations and also to let the firm avoid wastage of resources by over investment
in current assets (Eljelly, 2004). Effective management of working capital decreases the
need for lending funds to pay back the short term debts of the firm.
There are different approaches for the management of working capital. Two basic
policies of working capital management are namely aggressive working capital
management policy and conservative working capital management policy. An
aggressive investment policy with high levels of fixed assets and low investment in
current assets may generate more profits for a firm. On the other hand it also
accompanies a risk of insufficient funds for daily operations and for payment of short
term debts. A conservative investment policy is opposite to it with less investment in
fixed assets and more in current assets. For financing of working capital aggressive
policy implies that current liabilities are maintained in a greater portion as compared to
long-term debts. High level of current liabilities requires more resources to be in liquid
form to pay back debts earlier. But current payouts bear less rate of interest and hence
can cause more savings. In conservative working capital financing policy a greater
portion of long-term debts is used in contrast to current liabilities.

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Working capital management and profitability certainly have some relation with
each other. Much research work is available on this relationship but the selected sector
i.e. Textile Sector has not been under much consideration before this in Pakistan,
regarding the significance of working capital management. So, much literature is not
available in this sector in Pakistani context. Working capital is very important part of
business activities of any firm. For the Textile sector as well, working capital
management is of crucial value. So, the aim of this study is to find out “Does efficient
working capital management have any impact on the profitability of firms of Textile
sector of Pakistan?”
The remaining study is based on an analysis of previous literature which provides
the theoretical background for the study, research methodology which includes
description of all variables included in the study and sample size.Chapter 4 comprises of
the empirical analysis and regression results of the study. Chapter 5 provides the
conclusion on all above.
Review of Literature
Working capital management can be considered as an important source of
profitability of a firm. Many researchers investigated the impact of working capital
management on profitability. This past research demonstrated that efficient working
capital management leads to greater profitability.Smith (1980) conducted a study on
Profitability and Liquidity and suggested that working capital management directly
influence risk and profitability of a firm. Hence it can be inferred that effective working
capital management can increase the financial strength of a business.Soenen (1993) also
performed an analysis of working capital management and its relationship with financial
performance. His study was based on US firms and after the study he suggested that if
the length of net trade cycle increases then it affects the return on investment negatively.
The Working Capital management is regarded as an essential part of financial
management of a firm (Joshi, 1995). Lamberson (1995) observed the impact of
economic activity on the Working Capital Management Policy. For this he took a
sample of 50 small firms of US for a time period of 12 years i.e. 1980-1991. He found
that economic expansion do not cause an increase in the investment of working capital
during a specific period. Finally he suggested that there exists a slight impact of any
change in economic activity on working capital management of these firms.
Some other researchers namely, Jose, Lancaster, and Stevens (1996) carried out a
detailed analysis on the association of cash conversion cycle and financial returns. They
located an inverse association of profitability with cash conversion cycle.
Shin and Soenen (1998) conducted an expanded study by taking a large sample of
58985 firms of US. Their study was based on a longer time phase of 1975-1994. They
suggested that for generating greater volume of wealth for the shareholders of a firm, it
is very crucial to manage the working capital of that firm effectively and in an efficient
manner. They also recommended that profitability and net trade cycle both are inversely
related to each other.
Lyroudi and Lazaridis (2000) investigated the relationship of liquidity and cash
conversion cycle for the food industry of Greece. They concluded that a considerable
positive relationship exists among Cash Conversion Cycle and current ratio, average
age of inventory and average collection period. Also they located an inverse relationship

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between CCC and average payment period. They concluded that there was no
statistically significant relationship between variables used for liquidity measurement
and that used for profitability measurement. Also they suggested that cash conversion
cycle had no significant relationship with debt ratio.
Working capital management and profitability relationship has been explored by
many other researchers as well. Deloof (2003) analyzed 1009 non-financial firms of
Belgium. He found that gross operating profit of a firm is negatively related to
inventory turnover and average collection period. Hence, he recommended that financial
managers can try to improve profitability by enhancing average payment period and by
curbing inventory turnover and average collection period. He also recommended that
profitability is strongly related to working capital management of a business.Through a
study on Saudi Arabian companies, Eljelly (2004) discovered that the profitability and
cash gap have a significant negative relationship with each other. Mallik, Sur, and
Rakshit (2005) evaluated Indian pharmaceutical industry. They discovered that
profitability and liquidity do not have any significant relationship for these firms.
Chiou, Cheng, and Wu (2006) studied the different components which influence
the management of working capital by considering a sample of companies of Taiwan.
They collected the data of these companies for a period of six years i.e. 1998-2004.
From their study they draw a conclusion that for working capital management decisions
internal and external factors both are important. However inside factors are more
important for this decision. These factors include size of the company, profitability, debt
ratio and operating cash flow.
Lazaridis and Tryfonidis (2006) conducted an analysis on 131 firms of Athens.
Their study was based on a time span of four years starting from 2001 and ending on
2004. The rationale of their study was to evaluate working capital management and its
effect on profitability of these firms. To measure profitability they used gross operating
profit. They used cash conversion cycle, debt ratio, fixed assets and size of the
company. They found that curbing the length of Cash Conversion Cycle causes
profitability improvement.
Two researchers namely Meszek and Polewski (2006)analyzed the construction
sector. Their work targeted mainly the strategies which should be used for the working
capital management in construction sector. They have not worked to evaluate the
overall working capital management effectiveness and financial performance of
construction sector.
The study of S.M.Amir Shah and Sana (2006) was based on a period of five years
i.e. 2001-2005. They used working capital ratios to determine the effect of working
capital management on financial performance. These working capital ratios include
inventory turnover, current ratio, quick ratio, average collection period and average
payment period. They used correlation analysis and OLS method to reach the results.
Finally they revealed that Gross profit is negatively associated with all working capital
ratios except number of days payable.
In a study on small manufacturing firms, Padachi (2006) analyzed working capital
management and its relation with profitability by examining a sample of manufacturing
firm of Mauritius. Period of the study was six years i.e. 1998-2003. He used days of
receivables, inventory turnover, cash conversion cycle and days of payables as
explanatory variables, and return on total assets (ROA) as dependent variable. They

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used regression analysis to find out the results. They found that paper and printing
industry showed greater scores for different working capital components amongst the
overall manufacturing industry. These greater scores affect the profitability of this
industry positively. Finally they concluded that if a firm will invest heavily in its
inventory and accounts receivables then the profitability of that firm would be lower.
Vishnani and Shah (2007) from their study on Indian consumer electronic
industry discovered that profitability for the overall industry had no recognized
relationship with liquidity, but majority of the companies belonging to this industry
showed a positive association for profitability and liquidity. Ganesan (2007) conducted
a study on Telecommunication & equipment industry by taking 349 firms of this sector.
The time period of this study was 7 years i.e. 2001-2007. He declared that in this
industry effective working capital management and financial performance do not have
any significant inverse relationship with each other. He also indicated that there exists a
strong and inverse association between financial performance and liquidity.
Raheman and Nasr (2007) performed an analysis on 94 firms listed at KSE, based
on a time span of 6 years from 1999 to 2004. They have taken different working capital
ratios such as Net Operating Profitability, Debt ratio, current assets to total assets ratio,
cash conversion cycle, average collection period, inventory turnover, average payment
period, current ratio and natural logarithm of sales. They suggested that profitability and
working capital management are negatively related to each other.
García-Teruel and Martínez-Solano (2007) also investigated the profitability and
working capital management relationship by their study on small and medium
enterprises of Spain. For this they used data of 8,872 small and medium enterprises
(SMEs) from1996 to 2002. They used return on assets (ROA) to evaluate the
profitability as dependent variable. On the other hand, inventory turnover, collection
period and payment period were used as independent variables to compute the
effectiveness of working capital management for these companies, whereas sales
growth, debt ratio and firm’s size was used as control variables for the study. They
recommended that profitability is inversely related to average age of inventory and
average collection period. These results are similar to the results of other studies i.e.
reducing the cash conversion cycle have a positive impact on profitability. It is inferred
from these results that profitability can be increased by decreasing the length of cash
conversion cycle which could be possible by decreasing inventories and average
collection period.
Afza and Nazir (2007) studied 263 firms of Pakistan for a time phase of six years
i.e. 1998-2003. They stated that adopting inefficient working capital management
policies affects the profitability negatively.
Afza and Nazir (2008) reviewed their pervious study to estimate the impact of
different types of working capital management policies on financial performance of
firms in different sectors. For this they used a sample of 263 non-financial firms
belonging to 17 different sectors listed at KSE from1998 to 2003. The secondary data
was collected from the financial reports of selected companies and also from the
publications of State Bank of Pakistan. There are two types of working capital
management policies namely aggressive working capital management policy and
conservative working capital management policy. In aggressive working capital
management policy a firm places less amount of capital in current assets to earn more

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profit from fixed assets, whereas in conservative working capital management policy
firms use more capital as current assets. For the measurement of the degree of
aggressiveness they used current liabilities to total assets ratio (CLTAR) and current
assets to total assets ratios (CATAR). To locate the impact of these policies on the
performance of firms they used Return on Equity (ROE) and Return on Assets (ROA).
Results were found by using regression analysis. They found an inverse relationship
between degree of aggressiveness of these policies and profitability.
Uyar (2009) took a sample of 166 Turkish companies to predict the nature of
relationship of profitability and size of the firms with Cash Conversion cycle. The result
demonstrated that profitability and size of the firms both are negatively related with
Cash Conversion Cycle.
The study of Binti Mohamad and Mohd Saad (2010) was based on secondary data
of 172 firms of Malaysia. They evaluated the impact of various components of working
capital on profitability and market value of the firms. The study covered a time span of
five years from 2003 to 2007. For this purpose they used different working capital
components namely cash conversion cycles (CCC), debt ratio (DR), current assets to
total assets ratio (CATAR), current liabilities to total assets ratio (CLTAR)and current
ratio (CR),. To see the effect of these working capital components on financial
performance they used Tobin’s Q (TQ), return on invested capital (ROIC) and return on
assets (ROA) as a measurement of financial performance of the selected firms. To
deduce the results they used correlations and multiple regression analysis. The results
showed that there exists an inverse relationship between different working capital
components and performance of firms.
Raheman, Afza, Qayyum, and Bodla (2010) studied 204 manufacturing firms of
Pakistan to explore the impact of working capital management on the performance of a
firm. The study was based on 10 years i.e. 1998-2007. They took average age of
inventory, average payment period, average collection period, current ratio (CR),
current liabilities to total assets ratio (CLTAR), gross working capital turnover ratio
(GWCTR), current assets to total assets ratio (CATAR), sales growth (SG), size of the
firm as natural logarithm of sales (LOS) and debt ratio (DR)as independent variables. In
contrast, Net Operating Profitability (NOP) was taken as a dependent variable. Results
of their study demonstrated that performance of firms is significantly related to cash
conversion cycle and average age of inventory. They also described that Pakistani firms
normally follow conservative policy for management of working capital i.e. they prefer
to place more capital in liquid assets to avoid the risks of less availability of funds for
daily operations. Finally they suggested that these firms need effective management and
proper financing as well.
Another researcher Danuletiu (2010)conducted an analysis on 20 companies of
Alba country. He assessed the effect of working capital management efficiency on the
financial performance of these companies for a period of five years i.e. 2004 to 2008.
For his analysis he used net working capital (NWC) as a measure of long-term financial
balance, working capital necessary (WCN) as a measure of short-term financial balance
and net treasury (NT) a difference of both NWC and WCN. Return on Assets (ROA),
Return on Sales (RS) and Return on equity (ROE) were used to measure the
profitability. To find the results, Pearson correlation analysis was used. The study

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concluded that profitability has an inverse relationship with working capital

management components.
Gill, Biger, and Mathur (2010) extended the work of Lazaridis and Tryfonidis
(2006) by studying 88 companies of Newyork. The time span of the study was 3 years
i.e. 2005 to 2007. To elaborate the relationship of profitability with working capital
management, they took Accounts receivables, Accounts payables, Cash conversion
cycle, Inventory, natural log of sales as a proxy of size of the firm, fixed assets ratio and
debt ratio as independent variables while dependent variable was Gross Operating
Profit. The regression analysis was used to find out the results. They stated that if the
collection period of accounts receivable is greater, then there would be less profitability.
So, they suggested that managers should try to reduce the credit period in order to
improve the profitability. They also recommended that cash conversion cycle is
positively related with financial performance.
The importance of working capital for the management of short-term liquidity of
firms was also discovered by Bhunia and Brahma (2011). For this they have taken the
data of four steel companies of India for a period of 10 years i.e. 1997-2006. They used
different variables to measure the liquidity such as Current Ratio (CR), Debt-Equity
ratio (DER), Liquid Ratio (LR), Absolute Liquid Ratio (ALR), Average Age of
Inventory (AOI), Average collection period (ACC) and Average payment period (APP).
To measure profitability they used Return on Capital Employed. The relationship of
these variables with each other is figured out by using multiple correlations and
regression analysis. They concluded that liquidity and profitability are strongly related
to each other.
Ikram ul Haq, Sohail, Zaman, and Alam (2011)also carried out a study using data
of 14 companies from cement sector of Pakistan. The study was based on six years i.e.
2004-2009. They used Current Ratio (CR), Current assets to total assets ratio (CATAR),
Liquid Ratio (LR), Inventory Turnover ratio (ITR), Age of Debtors (AOD), Current
assets to total sales ratio (CTSR) and Age of Creditors (AOC) as predictors and Return
on investment (ROI) as dependent variable for this purpose. To produce the results they
used statistical techniques of regression and correlation analysis. They realized that a
moderate relationship exists between financial performance and working capital
management.
To propose working capital management’s effect on liquidity and solvency of
small and medium size enterprises (SMEs), James Sunday (2011) worked on Nigerian
companies. He reported that small firms have weak financial positions so they highly
depend on credit for smooth running of their operations.
Ching, Novazzi, and Gerab (2011) performed a twofold study in which they made
a comparison of two samples of two different types of companies. The two types were
fixed capital intensive companies and working capital intensive companies. The purpose
of this study was to discover difference between these two types of companies regarding
the profitability and working capital management. They took two samples each having
16 companies listed on Brazilian stock exchange. Their study was based on five years
i.e. 2005 to 2009. They used Days of working capital (DWC), Cash Conversion
Efficiency (CCE), Debt Ratio (DR), days of accounts receivables (DAR) and days of
inventory (DI) as independent variables and to measure profitability they used Return
on Sales (ROS), Return on Asset (ROA) and Return on Equity (ROE) as dependent

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variables. Results were found using multiple linear regressions. They stated that
effective working capital management is evenly important for both kinds of companies
regardless of their intensiveness.
Singh and Asress (2011) also examined the effect of working capital solvency
level on profitability by their study on a sample of 449 Indian manufacturing firms. The
study was based on a period of ten years i.e. 1999-2008. For this purpose, working
capital requirement (WCR) was selected as dependent variable and Total Operating
Cost (TOC), cycles (N) and Operational breakeven point (OBEP) as independent
variables. To find out the results they used One-way ANOVA test, multiple means
comparison test (Bonferroni, Scheffe and Sidak) and Independent t-test. Results of these
tests showed that if a firm will have adequate amount of capital for its current
operations than its performance will be better as compared to the firms having lower
amount of working capital. So, they suggested that availability of sufficient amount of
working capital have positive impacts on the profitability of a firm as it enables a firm
to manage all the current operating activities without any interruption.
Overall from this review of literature, it is concluded that a lot of work is available
on manufacturing sector of Pakistan regarding working capital management and
profitability. But there is no research work available specifically on textile sector of
Pakistan. Textile sector contributes a lot in exports of Pakistan. Pakistan is regarded as
8th biggest exporter in Asia for exports of textile products. Textile sector can play a
major role in the future growth of economy of Pakistan. So, this sector requires
considerable attention. This study aims to fill this gape of non-availability of research
work on textile sector of Pakistan.
Data and Methodology
To determine working capital management’s impact on profitability of textile
sector, secondary data of these firms is used. The data for the study is collected from the
publications of State Bank of Pakistan as well as from the publications of Karachi stock
exchange. The required data is also gathered from the official websites of the companies
incorporated in the study. The data is taken from the balance sheets of the companies of
textile sector.
A simple random sample of 117 companies is selected out of 164 textile
companies of Pakistan. The firms with missing or inaccessible data were eliminated
from the study. As well as the companies which are originated or liquidated during the
selected time period are also excluded from the study. Random sampling is a quite
useful technique as it avoids sampling error by giving equal chance of selection to each
company (Castillo, 2009).The study period is five years starting from 2005 to 2010.
Methodology
As the data selected for the study consists of observations in a time series manner
so, panel data methodology is used in this study. Panel data methodology has specific
benefits such as it assumes that different firms are heterogeneous in nature i.e. have
widely dissimilar elements, it also considers the variability in data, it provides more
instructive data and more degree of freedom, hence it provides more efficiency than
cross-sectional data methodology (Baltagi, 2001). Panel data also provides a solution
for the unobserved heterogeneity which is a general problem in cross-sectional data and
panel data can easily handle large number of observations (Dougherty, 2011).

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Panel data includes observations having both dimensions, cross-sectional and

time-series. So, it is quite possible that there may be present cross sectional effect for
some of the observations. To deal with this kind of problems, several techniques can be
used. The two main techniques for this is fixed effect model and random effect model.
Dougherty (2011) has provided a decision making criteria for using these two
techniques as illustrated in the figure below:

Figure 1: Choice of regression model for panel data.

Source: Adapted from Dougherty (2011)

If the observations are based on a random sample then both random effect model
and fixed effect model are applicable to it. To check that which of these models should
be used, Housman’s specification test is applied. This test uses the null hypothesis that
“there is not a systematic difference in coefficients”. If this hypothesis is not accepted
then fixed effect model is used otherwise random effect model is preferred. In case of
acceptance of the above said null hypothesis, validity of random effect model is further
checked by using Breusch Pagan Langrange multiplier test. If this test rejects the null
hypothesis developed here i.e. “there are no random effects” then random effect model
is employed otherwise pooled ordinary least square regression is used.

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Both fixed and random effect models that can be used in this study are given
below.
Fixed effect model:
ROA it= β0i+ β1(CATARit) + β2(CLTAR it) + β3(QRit) + β4(LOSit) + β5(DERit) +uit

Random effect model:

ROA it= β0+ β1(CATARit) + β2(CLTAR it) + β3(QRit) + β4(LOSit)+ β5(DERit) + uit+ ε it

Where:
ROA= Return on Assets, CATAR= Current Assets to Total Assets Ratio,
CLTAR= Current Liabilities to Total Assets Ratio, DER= Debt to equity Ratio, QR=
Quick Ratio and LOS= natural logarithm of Sales.
Return on assets (ROA) is included in the study as a dependent variable as a
measure of profitability of the firms. Current assets to total assets ratio (CATAR) is
included in the study as an independent variable to measure the investment policy of
working capital adopted by the textile sector of Pakistan. Current liabilities to total
assets ratio (CLTAR) is also included as an independent variable to determine the
working capital financing policy of the selected firms. These two ratios have been used
by many researchers to know the investing and financing policy of working capital such
as Afza and Nazir (2008), Raheman et al. (2010), Ikram ul Haq et al. (2011), Raheman
and Nasr (2007) and Mohamad and Saad (2010). Quick ratio (QR) is used as a control
variable to find the impact of intense liquidity on profitability. Quick ratio (QR) is also
used by many researchers as a control variable to determine working capital
management and profitability relationship, for example, Bhunia and Brahma (2011) and
S.M.A. Shah and Sana (2005) has used this ratio in their study. Size of the firms is also
included in the study as a control variable. Natural log of sales is used by many
researchers as a proxy to demonstrate size of the firms i.e. Raheman and Nasr (2007),
Raheman et al. (2010) and Padachi (2006).To show leverage, debt to equity ratio (DER)
is used as a control variable. This ratio is used by Mohamad and Saad (2010), Gill et al.
(2010), Raheman and Nasr (2007), Ching et al. (2011) and Raheman et al. (2010) as
well in the past research.
Variables
The study attempts to elaborate the effect of various policies used for working
capital management on financial performance. To achieve this aim variables are
selected by analysis of previous studies discussed in the section of literature. All the
selected variables are used for developing and testing the hypothesis. These variables
include dependent, independent and control variables.
Dependent Variable
Return on assets (ROA) is used as a dependent variable. ROA is a ratio which
explains how efficiently a firm is utilizing its existing resources for the maximization of
profits. Increase in ROA normally shows an increase in profitability (Gitman, 2002).
ROA= (Earnings available to common shareholders/ Total Assets) × 100

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It is used by many researchers as dependent variable for the measurement of

profitability such as Afza and Nazir (2008), Mohamad and Saad (2010), Danuletiu
(2010), Padachi (2006) and Ching et al. (2011).
Independent Variables
Current Assets to Total Assets Ratio (CATAR)is used as an independent variable.
This ratio is used to find out the investment policy of working capital adopted by the
firms under consideration. This investment policy can be of two types, first is the
aggressive policy and second is the conservative policy. In aggressive investment policy
of working capital, less investment is made in current assets as compared to fixed assets
to get more returns. On the other hand, in conservative investment policy of working
capital, more investment is placed in current assets as compared to fixed assets.
Aggressive investment policy allows getting more profits through investing major
portion of resources in fixed assets. Conservative investment policy helps to circumvent
the risk of bankruptcy.
It can be measured by using following formula.
CATAR = Total current assets / Total assets
Here, CATAR = Current assets to total assets ratio
A lesser value of Current assets to total assets ratio demonstrates more aggressive
policy.
Mohamad and Saad (2010), Afza and Nazir (2008), Raheman et al. (2010), Ikram
ul Haq et al. (2011) and Raheman and Nasr (2007) have used this ratio as an
independent variable to find the impact of working capital management on profitability.
They all suggested that this ratio has a positive relationship with profitability. So, in this
study as well a positive relation is expected between profitability and current assets to
total assets ratio.
Current Liabilities to Total Assets Ratio (CLTAR)is included to discover the
working capital financing policy. It can also be of two types, aggressive financing
policy and conservative financing policy. In aggressive financing policy a greater
portion of current liabilities is used than long-term debts. In conservative financing
policy, more long-term debts are used than current liabilities. This ratio can be
measured as follows:
CLTAR = Current liabilities / Total Assets ratio
Where, CLTAR = current liabilities to total assets ratio.
Mohamad and Saad (2010), Afza and Nazir (2008) andRaheman et al. (2010)
have found an inverse relation between current liabilities to total assets ratio and
profitability. So, the expected relation between this ratio and profitability is negative.
Quick Ratio (QR) is used as a control variable. Quick ratio shows the credit
worthiness of a firm. If the value of this ratio is higher, then it shows that the firm can
pay its debts earlier. Quick ratio can be calculated as given below:
Quick Ratio = Quick assets / Current liabilities
Previous work of different researchers shows a negative relation between quick
ratio and profitability i.e. S.M.A. Shah and Sana (2005); (S.M.Amir Shah & Sana,
2006),Mohamad and Saad (2010), Bhunia and Brahma (2011), Raheman and Nasr

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(2007), Afza and Nazir (2008) and IkramHaq, Sohail, Zaman, and Alam (2011). So, the
expected relation of quick ratio and profitability is also negative.
To show the firm size, natural logarithm of sales (LOS) is used as a control
variable. Sales volume has a positive relation with profitability. Raheman and Nasr
(2007), Padachi (2006); Raheman et al. (2010) and Raheman et al. (2010) have used
natural logarithm of sales in their study. They all found a positive relation between sales
and profitability.
Debt to Equity Ratio (DER) is also used as a control variable. Debt Ratio
estimates that how much portion of total assets of a firm is financed by its creditors. It
represents the leverage of a firm. Higher value of debt ratio shows that the firm has
greater indebtedness and more financial leverage. Greater leverage shows that the cost
of financing working capital would be higher. Debt ratio can be calculated by using the
following formula:
Debt ratio = (Total Liabilities / Total equity) × 100 (Gitman, 2002)
Many researcher have discovered an inverse relationship between debt ratio and
financial performance such as Mohamad and Saad (2010), Gill et al. (2010), Raheman
and Nasr (2007), Ching et al. (2011) and Raheman et al. (2010). So, an inverse
relationship is expected between debt to equity ratio and profitability in this study as
well.
Results and Discussion
This section provides the details of the model and findings of the study. Before
moving towards formal discussion of results, an analysis of descriptive statistics is
presented.
Descriptive Statistics
Table 1 provides the descriptive statistics for all the variables. It shows the
number of observations of all variables, their average values and their standard
deviation. It shows the minimum and maximum values as well which can be attained by
these variables.
The descriptive statistics show that all the variables have 465 observations. The
dependent variable return on assets has the average value of 0.8220. It has a minimum
value of -26.21and a maximum value of 160.97. The standard deviation for return on
assets is 10.4774.
To check the working capital investment policy of these companies, current assets
to total assets ratio (CATAR) is included, it has an average value of 0.3385with a
standard deviation of 0.09412. Minimum value of CATAR is 0.0667 and its maximum
value is 0.49949.
To check the financing policy adopted by the selected firms for the management
of working capital and its relationship with profitability, current liabilities to total assets
ratio (CLTAR) is used. It has an average value of 0.48673while the standard deviation
of0.23546. The minimum value for CLTAR is 0.10964 and the maximum value for it is
2.5460.

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The independent variable quick ratio (QR) has a maximum value of1.01and a
minimum value of zero. It has an average value of 0.21264 while standard deviation of
0.1631.
To determine the firm size and its impact on working capital management, natural
logarithm of sales volume is included. Average value of this variable is 6.0783.The
maximum value for log of sales is 7.4988 and the minimum value for this is 3.4704.It
has a standard deviation of 0.50016.
To check the leverage of these firms, debt to equity ratio (DER) is used. It has the
average value of -1.0717 while standard deviation of 93.8627. The minimum value is -
2001.88for debt to equity ratio and its maximum value is 236.66.

Table 1 Descriptive Statistics

Pearson’s correlation coefficient analysis

Correlation coefficient explains the relationship between two variables. It shows
change in one variable because of any change in other variable (Kohler, 1994). Table 2
shows the matrix of Pearson’s correlation coefficient analysis. This analysis helps to
locate the relationship that exists among the independent or explanatory variables. It
signifies the presence of muti-colinearity among the independent variables. Multi-
colinearity can influence the results, so a good model should not have any multi-
colinearity among the predictors.
First of all correlation between dependent variable which is return on assets
(ROA) and independent variable current assets to total assets ratio (CATAR), is
analyzed. The results of correlation analysis show a positive correlation between them
having a value of 0.1091. This correlation indicates that these two variables have a
positive relationship with each other i.e. if there will be an increase in current assets to
total assets ratio then the dependent variable return on assets will also increase and vice
versa. P-value for this correlation is 0.0186 which shows the significance of this

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relationship. This correlation is significant at 5% level of significance. Return on assets

(ROA) has a negative correlation with independent variable current liabilities to total
assets ratio (CLTAR). The value of this correlation is -0.1400 having p-value of 0.0025.
The p-value shows the significance of the relationship between return on assets and
current assets to total assets ratio at 5% level of significance. This correlation is good
for the study as it shows a significant relationship between independent variable current
assets to total assets ratio and dependent variable return on assets.
The correlation outcomes for current assets to total assets ratio (CATAR) and
current liabilities to total assets ratio (CLTAR) show that they have a positive
correlation of 0.0816 with each other. This means that an increase in the value of
independent variable current assets to total assets ratio will cause an increase in current
liabilities to total assets ratio and vice versa. But this correlation is not statistically
significant at 5% level of significance as its p-value is 0.078.
The correlation of current assets to total assets ratio is 0.3315with quick ratio and
p-value for this is 0.00. This correlation has a positive value so this relationship is also
positive as the previous one.
Current assets to total assets ratio has a correlation value of 0.2659 with log of
sales, a variable included to measure the size of firms. It has a p-value of 0.00. The
correlation results for current assets to total assets ratio and log of sales show a positive
relationship between them.
Current assets to total assets ratio has a positive relationship with debt to equity
ratio. The value of correlation coefficient between them is 0.0978 having a p-value of
0.0350.Thiscorrelation signifies that a raise in current assets to total assets ratio is
accompanied by an increase in debt to equity ratio and vice versa.
Pearson’s correlation demonstrates a negative relation between current liabilities
to total assets ratio and quick ratio. Correlation coefficient for these is -0.3688and its p-
value is 0.00. Negative relation shows that an increase in current liabilities to total
assets ratio subsequently causes a decrease in quick ratio.
Current liabilities to total assets ratio also have an inverse relationship with log of
sales which is included to measure the size of the selected firms. Correlation coefficient
for this is -0.2360having a p-value of 0.00, showing a negative and insignificant
relationship between these two variables.
Correlation coefficient of current liabilities to total assets ratio with debt to equity
ratio is 0.0450 having a p-value is 0.3334.
Quick ratio has an insignificant but positive relationship with both debt to equity
ratio and log of sales. It has a correlation coefficient of 0.1542 and 0.0247 respectively
for log of sales and debt to equity ratio. Its p-values for debt to equity ratio and log of
sales are 0.5945 and 0.0009 respectively. Log of sales have a coefficient of correlation
of 0.0554 for debt to equity ratio with a p-value of 0.2328.
From table 2 it is quite clear that all the independent variables have correlation
coefficient values less than 1. The cut-point show the multi-colinearity is 0.6. All the
correlation coefficients of independent variables have values less than 0.6, which
demonstrates no multi-colinearity among the independent variables. So, there is no
problem of multi-colinearity in this analysis.

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Table 2 Pearson’s correlation coefficient matrix

The values in parenthesis show P-values.

Regression analysis and results
The working capital management and profitability relationship is analyzed by
using panel data techniques of fixed effects regression and random effects regression.
The results of both of these techniques are illustrated in table 4.3 and table 4.5.
Fixed effect model
Table 3 demonstrates the results of fixed effect model. At 5% level of
significance, current assets to total assets ratio appears to be significant in this model.
Current liabilities to total assets ratio is also significant in this model but its significance
level is 1%.All of the three control variables i.e. quick ratio, debt to equity ratio and log
of sales are insignificant in the fixed effect model. They do not cause any significant
change in the independent variable. The significance of current assets to total assets
ratio shows its correlation with the independent variable, return on assets. In the same
way, current liabilities to total assets ratio also have a strong correlation with return on
assets. Both of these predictors affect the independent variable. A change in any of them
will definitely cause some change in dependent variable.
The β-coefficient of current assets to total assets ratio is 19.2848, which shows
that if there is an increase of 1 unit in CATAR then it causes an increase of 19.2848
units in ROA. So, there is positive relationship between them.
Similarly the β-coefficient of current liabilities to total assets ratio is -14.5197.
This coefficient with negative sign shows an inverse relationship of CLTAR with the
independent variable. This can be interpreted as an increase of 1 unit in CLTAR will
lead to a decrease of 14.5197 units in ROA.
Quick ratio has β-coefficient of 2.4176, which demonstrates a positive relation
between QR and ROA. But this relationship is not significant. Coefficient of log of
sales having a value of 1.2813 signifies an affirmative relationship between firm size
and return on assets. Here again the relationship is not significant because of its p-value
of 0.633, showing insignificance even at 10% level of significance. Debt to equity ratio
has an inverse and insignificant relationship with return on assets with coefficient -
0.0033.

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The value of R-square for fixed effect model between variables is 7.68%. R-
square with variables is 6.91% and overall R-square for this model is 4.33%. This
model is good fit as F-statistics is significant.

Table 3 Fixed effect models

R-square within = 0.0691, between = 0.0768 and overall = 0.0433, F-statistics = 5.39, and Prob. > F =
0.0001. Variable is significant at *1, **5 and ***10% level of significance (Two tailed).
Table 4 represents the results of fixed effect model with robust standard error. The
robust test standardizes the standard errors. In this test, the values of coefficients for the
variables remain same as the previous results with simple standard errors. So, the
relationship that exists among dependent and explanatory variables remains same. In
this test, current assets to total assets ratio (CATAR) is significant at 1% level of
significance and current liabilities to total assets ratio (CLTAR) is significant at 5%
level of significance. Moreover, debt to equity ratio (DER) which was insignificant
previously has become significant now and its level of significance is 1%. So, these
results are more favorable as compared to the previous one.

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Table4 Fixed effect model with robust standard error

R-square within = 0.0691, between = 0.0768 and overall = 0.0433, F-statistics = 11.28, and Prob. > F =
0.0000. Variable is significant at *1, **5 and ***10% level of significance (Two tailed).
Random effect model
In random effect model current assets to total assets ratio and current liabilities to
total assets ratio, both are insignificant because their p-value is insignificant even at
10% level of significance. So, they do not cause any definite change in return on assets,
the dependent variable. Quick ratio and log of sales both are significant at 1% level of
significance. Debt to equity ratio is insignificant in random effect model as well. Table
5 shows the results of random effect model.
Current assets to total assets ratio has β-coefficient value of 2.5775. This shows
that 1 unit increase in CATAR will cause an increase of 2.5775 units in ROA, but this
effect is not significant. Current liabilities to total assets ratio has an inverse and
insignificant relationship with return on assets. Its β-coefficient is -2.3027.
Quick ratio, log of sales and debt to equity ratio have an affirmative relation with
return on assets in random effect model. Their coefficients are 9.0504, 3.3999 and
0.0002 respectively.
Value of R-square for random effect model is 3.66% within variables and 22.53%
between the variables. Overall R-square for this model is 6.99%.Thismodel is good fit
with significant value of Wald Chi2 test.

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Table 5 Random effect model

R-square within = 0.0366, between = 0.2253 and overall = 0.0699, Wald Chi2 = 34.47, and Prob. >Chi2 =
0.0000. Variable is significant at *1, **5 and ***10% level of significance (Two tailed).
Table 6 represents the results of random effect model with robust standard errors.
The results of random effect model are not changed in robust standard error test. Quick
ratio (QR) and log of sales (LOS) are significant again in this model as the previous one
at 1% level of significance.

Table 6 Random effect model with robust standard errors

R-square within = 0.0366, between = 0.2253 and overall = 0.0699, Wald Chi2 = 23.15, and Prob. >Chi2 =
0.0003. Variable is significant at *1, **5 and ***10% level of significance (Two tailed).

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Comparison of fixed and random effect models

Table 7 presents a comparison of fixed and random effect model where model I
includes the results of fixed effect and random effect with simple standard errors and
model II represents the results of these two models with robust standard errors. In fixed
effect model with robust standard errors maximum number of variables has significant
relationship with dependent variable. So, the results of fixed effect model with robust
standard errors are most favorable.

Table 7 Comparison of fixed and random effect models

Model I Model II
Variables

Fixed effect Random effect Fixed effect Random effect

Coefficient Coefficient Coefficient Coefficient
P>t P>z P>t P>z
s s s s
CATARit 19.28488 0.038** 2.57755 0.652 19.28488 0.004* 2.57755 0.738

CLTARit -14.5197 0.000* -2.30271 0.317 -14.5197 0.019** -2.30271 0.363

QRit 2.417611 0.591 9.050446 0.007* 2.417648 0.576 9.050446 0.000*

LOSit 1.281314 0.633 3.399958 0.001* 1.281354 0.583 0.399958 0.000*

DERit -.0033507 0.530 0.0002797 0.956 -.0033507 0.000* 0.0002797 0.750

Constant -6.945533 0.678 -21.51995 0.001 -6.945533 0.661 -21.51995 0.001

Variable is significant at *1, **5 and ***10% level of significance (Two tailed).

Hausman’s specification test

The values of R-squares are higher in random effect model as compared to the R-
square values in fixed effect model. Hausman’s specification test is applied for checking
the suitability of the model i.e. either fixed effect model should be used or random
effect model. It has the value of Ch2 statistics equal to 26.18 significant at 1% level of
significance. This rejects the null hypothesis developed in hausman’s specification test
that there is no systematic difference in coefficients. So, these results show that fixed
effect model is more suitable for this study as compared to random effect model. Table
8 presents the results of this test.

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Table 8 Hausman Test

Chi2 = 26.18, and Prob. >Chi2 = 0.0001

Discussion
The β-coefficient of current assets to total assets ratio (CATAR) is 19.2848. The
positive value of this coefficient shows a positive relationship between independent
variable current assets to total assets ratio and dependent variable return on assets.
Moreover the significance of its p-value shows a statistically significant relationship
between them. Return on assets is included here to demonstrate profitability. So,
consequently there is a positive relation between current assets to total assets ratio and
profitability. A higher value of this ratio escorts towards more profitability.
A greater value of current assets to total assets ratio shows less aggressive
investment policy of working capital (Afza & Nazir, 2008). From this, it can be
concluded that a less aggressive working capital investment policy leads to more
profitability. If a firm invests more in fixed assets then it can generate more profits. If a
firm uses more of its resources as current assets then it will lead to wastage of resources.
These results are similar to the findings of Afza and Nazir (2008), Ikram ul Haq et al.
(2011), Raheman and Nasr (2007), Raheman et al. (2010) and Mohamad and Saad
(2010).
The β-coefficient for current liabilities to total assets ratio (CLTAR) is -14.5197.
Negative value of this coefficient demonstrates a negative relationship between current
liabilities to total assets ratio and return on assets i.e. profitability. An increase in
current liabilities to total assets ratio leads to less profitability.
A higher value of current assets to total assets ratio shows a comparatively more
aggressive working capital financing policy, that means more investment in current
liabilities as compared to long-term debts. An aggressive financing policy results in less
profitability. These results are in accordance to the findings of Mohamad and Saad
(2010), Afza and Nazir (2008) and Raheman et al. (2010).
The value of β-coefficient is 2.4176. It shows a positive relationship between debt
to equity ratio and profitability of a firm. These results are contradictory to the findings

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of Mohamad and Saad (2010), Gill et al. (2010), Raheman and Nasr (2007) and Ching
et al. (2011).
Size of the firm is positively related with Profitability. Natural logarithm of sales
is used as a proxy of firm size. The value of β-coefficient for this relation is 1.2813.
Positive relation shows that an increase in size of the firm enhances the profitability. A
firm with greater size will also have greater profitability. These findings are consistent
with that of Raheman and Nasr (2007), Raheman et al. (2010) and Padachi (2006).
Debt to equity ratio is used as proxy of leverage. The value of β-coefficient for
this is -0.00335. A negative sign exhibits the presence of a negative relation between
leverage of a firm and its profitability. When leverage increases, then it negatively
affects the profitability. Some previous researchers have also reported the same results
such asRaheman and Nasr (2007), Mohamad and Saad (2010), Gill et al. (2010) and
Ching et al. (2011).
Discussion and Conclusion
The management of working capital is one of the most important financial
decisions of a firm. Efficient level of working capital should be present for smooth
running of business regardless of the nature of business. From this study, it is concluded
that maintaining efficient level of working capital is very important for textile sector as
well like all other sectors of business.
The present study includes 117 textile firms of Pakistan for a time span of six
years from 2005 to 2010. It explores the role of efficient working capital management in
generating profitability through two main policies of managing working capital namely
working capital investing policy and working capital financing policy. Investing policy
is regarding the management of current assets of the business and financing policy is
concerned about the management of current liabilities mainly. In aggressive working
capital investing policy more resources are invested in fixed assets than current assets to
gain more profits. A conservative working capital investment policy is opposite to it. In
aggressive working capital financing policy more current liabilities are used than long-
term debts and vice versa for conservative financing policy. The results of this study
show that conservative investing policy of working capital leads to more profitability
similarly conservative financing policy also results in more profitability. Moreover, the
results show a positive correlation between investing policy and financing policy of
working capital. This positive relation demonstrates that the firms which follow
aggressive working capital investing policy, they also go for aggressive financing
policy. Similarly the firms pursuing conservative investing policy also prefer
conservative financing policy for the management of working capital.
Regarding the hypothesis, it is found in the study that the alternative hypothesis
(H11) which illustrates, there is a significant relationship between
aggressive/conservative working capital investment policy and profitability is accepted,
so null hypothesis (H01) is rejected. A positive and significant relation is found between
degree of conservatism of investment policy of working capital and profitability of
textile sector of Pakistan. The second alternative hypothesis (H12) that there is a
significant relationship between aggressive/conservative working capital financing
policy and profitability is also accepted. So, null hypothesis (H02) is rejected. The
findings show a negative and significant relationship of profitability with degree of
aggressiveness of working capital financing policy. The third null hypothesis (H03) is

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also rejected that there is no relationship between liquidity and profitability and
alternative hypothesis (H13) is accepted showing a significant relation between liquidity
and profitability. In the same way, fourth alternative hypothesis (H14) is accepted that
there is a considerable positive relationship between the firm size and profitability,
hence null hypothesis (H04) is rejected. Fifth null hypothesis (H05) is also rejected and
alternative hypothesis (H15) that there is a considerable negative relationship between
total debts utilized by the textile firms of Pakistan and their profitability; is accepted.
These findings are similar to the results of some previous researchers such as Raheman
and Nasr (2007), Afza and Nazir (2008) and Padachi (2006).
The findings of this study are helpful for the financial managers of the textile
sector as these provide the information regarding the management of short-term capital
and also inform them about the management policies used by their peers. This
information is useful for maintaining a healthy competition and improving own
organization. Eventually it is recommended that the managers should try to create good
synchronization between the assets and liabilities of the firm.
The relationship between working capital management and profitability can be
examined using many variables and covering many dimensions. In this study, an
attempt is made to cover as many important dimensions as possible. But to cover all the
dimensions and to include all the variables is just not possible. So, the results estimated
from this study should be evaluated keeping in mind that there could be many other
variables as well besides the variables mentioned above, that can explain working
capital management and profitability correlation and this study is limited only to the
effect of selected variables in measuring the efficiency of working capital management.
Another limitation of the proposed study is that the data used of only 6 years due to the
limitation of lack of availability of data. This study has the implication for textile sector
only.
This study can be extended in terms of empirical model such as some other
variables can be also be included in the model used in this study. These other variables
can be cash conversion cycle, current assets, return on equity and gross profit etc.
Moreover this study can be extended in terms of number years as well.
Textile sector is selected for this study; future research can also be done for other
sectors as well such as cement sector, telecommunication sector etc. Research can also
be made on financial sector which unexplored with respect to working capital
management.
This study concludes that aggressiveness of working capital management policies
is inversely related to profitability. This implies that the financial managers of textile
sector should follow conservative investment policy and conservative financing policy
of working capital management i.e. they should invest more of their financial resources
in current assets as compared to fixed assets and they should use more long term debts
as compared to current liabilities.

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