Impact of Working Capital Management Policy on Market ...This research study investigated the impact...
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Global Journal of Contemporary Research in Accounting, Auditing and Business Ethics (GJCRA)
An Online International Research Journal (ISSN: 2311-3162)
2015 Vol: 1 Issue 2
354 www.globalbizresearch.org
Impact of Working Capital Management Policy on
Market Value Addition
R.M.S. Bandara,
Department of Accountancy,
University of Kelaniya, Colombo, Sri Lanka.
Email: [email protected]
_______________________________________________________________________________________________________
Abstract
Working Capital Management (WCM) includes maintaining appropriate levels of current
assets and current liabilities required by a firm. Management of short-term assets and
liabilities needs a careful investigation since it plays an important role in deciding the firm’s
profitability, risk as well as its value.
This research study investigated the impact of Working Capital Management Policy (WCMP)
on firm value in Sri Lankan Companies. Data were gathered from 74 companies listed in the
Colombo Stock Exchange (CSE) covering seven business sectors for the sample period of
2009/10 to 2013/14 which comprises 370 firm year observations.
Descriptive statistics, correlation and panel regression analysis were employed as measures
of analysis. Firms’ Working Capital Investment Policy (WCIP) and Working Capital
Financing Policy (WCFP) were used as independent variables. Firm value was measured in
terms of Market Value Addition (MVA) as dependent variable in the study.
According to the overall panel regression model, WCIP and WCFP both recorded a negative
relationship to MVA proving the individual model results. The results showed significant
negative relationship between the firms’ degree of aggressiveness of WCIP and MVA of the
companies in Sri Lanka. It provided evidence that the minimum level of investment in current
assets leads to have higher MVA of the firms in Sri Lanka. Further results do not provide
statistically significant results to prove the negative relationship between WCFP and MVA.
___________________________________________________________________________
Key words: Working Capital Management Policy, Firm Value, Market Value Added, Sri
Lanka
Global Journal of Contemporary Research in Accounting, Auditing and Business Ethics (GJCRA)
An Online International Research Journal (ISSN: 2311-3162)
2015 Vol: 1 Issue 2
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1. Introduction
Corporate financial officers identify Working Capital Management (WCM) as being
important to their firms’ value. Management of short-term assets and liabilities needs a
careful investigation since the WCM plays an important role in the determination of the
profitability, liquidity and risk as well as the ultimate objective of firm’s value (Smith, 1980).
The greater the investment in current assets lead for the lower risk due to ability of settling
short term obligation, but also the lower the profitability obtained, because of the inability to
invest in the profitable long term investments. Efficient management of working capital is a
fundamental part of the overall corporate strategy to create shareholders’ value. Firms try to
keep an optimal level of working capital that maximizes the value of the firms (Howorth and
Westhead, 2003; Deloof, 2003 and Afza and Nazir, 2007 & 2008).
The main objective of WCM is to maintain an optimal balance between each of the
working capital components. Business success heavily depends on the ability of financial
executives to effectively manage the working capital component of receivables, inventory,
and payables (Filbeck and Krueger, 2005). Firms can reduce their financing costs and/or
increase the funds available for expansion projects by minimizing the amount of investment
tied up in current assets while arising a higher level of liquidity risk.
Working Capital Management Policy (WCMP) is the firm’s way of making investment in
their current assets which is known as working capital investment policy and use short-term
liabilities to finance firms’ assets which is known as working capital financing policy.
Theoretically, a firm can adopt different working capital management practices as aggressive
working capital management policy, moderate working capital management policy and
conservative working capital management policy based on its investment and financing
policies. Those different policies and practices are affecting the profitability, liquidity, risk as
well as finally the value of the firm in different ways.
The Firm Value is the present value of the expected future flows discounted at the rate of
return required by investors (Robert, Mark and Rabhi, 2008). Any investment in working
capital larger than this optimum would increase the firm’s assets without a proportionate
increase in its returns and thus lowering the rate of return on investment. Weston and
Copeland (1992) suggested that, given the optimum, increasing the cash holding which is one
of the working capital components of the company, negatively affects the shareholder value.
Peter Drucker (1998) has stated that until a business earns a profit that is greater than its cost
of capital, it operates at a loss, means firm is not operating as a value creator, it destroy the
value. While most of the studies suggest that firms which minimize their investment in net
operating capital leading for an aggressive working capital management policy, will
Global Journal of Contemporary Research in Accounting, Auditing and Business Ethics (GJCRA)
An Online International Research Journal (ISSN: 2311-3162)
2015 Vol: 1 Issue 2
356 www.globalbizresearch.org
maximize their profitability and thereby maximize firm value, this inference does not
necessarily follow.
In the current research work, a deep attention was given to the financial statements of
listed companies in Sri Lanka. Based on the financial figures extracted from the annual
reports, researcher observed that organizations are having different levels of current assets
and liabilities. Further, some organizations adopt aggressive working capital policy while
some are running with conservative and moderate level of policies. Therefore, researcher is
interested to carry out a study, to identify the impact of working capital policy on firm value
of the listed companies in Sri Lanka.
1.1 Problem statement
How does Working Capital Management Policy impact on Firm Value in Sri Lanka?
The problem is to identify the relationship between working capital management policy
and value of the Sri Lankan companies listed in the Colombo Stock Exchange (CSE).
1.2 Research Question
What is the relationship between Working Capital Management Policy (WCMP) and
Firm Value?
It is argued that the failure of WCM is mainly due to inability of reflecting the
characteristics and challenges of contemporary organizational settings that has led to a loss of
relevance and give rise to the need for a conceptual framework explaining current WCMP.
Having identified working capital management Investment Policy (IP) and Financing Policy
(FP) of the firms, backed by the literature and theoretical domain, researcher examined the
relationship to value of the firms which is measured by the Market Value Added (MVA).
With the answer of this research question, researcher elaborates the behaviour of the WCM in
an organization and how it leads to create firm value in Sri Lankan organizations.
1.3 Research objective
The researcher expects to achieve following objective at the completion of the study.
To determine the relationship between Working Capital Management Policy & Firm
Value in Sri Lanka.
1.4 Significance of study
In the today’s dynamic business environment, survival of the organization is more
uncertain even though the companies are earning profit, unless they can’t meet the short term
obligations. Corporate finance basically deals with three decisions such as capital structure
decisions, capital budgeting decisions, and working capital management decisions. Among
these, working capital management is a very important component of corporate finance since
it affects the profitability and liquidity of a company and finally to its value. Efficient WCM
involves planning and controlling current assets and current liabilities in a manner that
eliminates the risk of inability to meet short term obligations on one hand and avoids
Global Journal of Contemporary Research in Accounting, Auditing and Business Ethics (GJCRA)
An Online International Research Journal (ISSN: 2311-3162)
2015 Vol: 1 Issue 2
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excessive investment (Eljelly, 2004). Therefore, it is deemed that there is a need of studying
the role of working capital management policies on firm value in the Sri Lankan context.
Further, a profitable company may fail, if it does not have adequate cash flow to meet its
liabilities as they fall due. On the other hand, one of the main objectives of a firm is to
maximize its value. Therefore, it is important to study how firms should keep the proper
investments in current assets and maintain proper level of current liabilities in an enterprise
with maximizing its’ value. Moreover Firm value is more important to have sustainable
growth rate for a business leading to attract prospective investors. Because value of the firm is
the form that investors motivate to invest in the business and increase of value will benefit the
firms’ prestige by increasing future growth. Further, firm value is also important since it
affects to achieve the desired performance and long term survival of the enterprises.
Therefore with the current study, researcher attempted to support for the organizations to keep
a healthy WCMP in such a way to maximize firm value.
If the management of working capital policy is satisfactory, there is high performance in
the organization, possibly leading to create its value. Theory explains that the lower degree of
aggressiveness is leading for low level of liquidity, high level risk and high level of
profitability; it does not explain the ultimate impact to the value creation of an organization.
And also it varies according to the Investment policy and the financing policy of the firm. It is
evidenced by the inconclusive results generated by the researchers in the literature as
mentioned earlier paragraphs. Further, Wadsworth and Bryan (1974) pointed out that
sometime managers’ decisions relating to the working capital management will increase
earnings but it destroy value of the firm while some decisions increase the value but no profit
is added to the firm. Therefore, researcher expects to study the behavior of working capital
management policy adopted by the Sri Lankan organizations and how it leads to create value
to the firm. Further, it will contribute to fill the knowledge gap in the existing literature.
According to the literature available, very few researches have been carried out in the area
of WCM in Sri Lanka and less researches have been carried out relating to the WCMP and the
firm value in specific in the Sri Lankan context. Therefore the researcher expected to study
the behavior and stability of working capital management in different business sectors and the
impact of those on the firm value. While the propose study enhances the WCMP ensuring the
maximum utilization of current assets and current liabilities in Sri Lankan enterprises to
achieve ultimate objective of value creation, it will lead to fill the empirical gap exists.
2. Literature Review
A wide-ranging literature review was conducted to identify the direction of this study and to
understand the broader perspectives of Working Capital Management (WCM) and its impact
to the value of the firm.
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WCM is important because of its impact on the firm’s profitability and risk, and
consequently its value (Smith, 1980). Excessive levels of current assets may have a negative
effect on the firm’s profitability whereas a low level of current assets may lead to lower level
of liquidity and stock-outs resulting in difficulties in maintaining smooth operations (Van
Horne & Wachowicz, 2004). Accordingly, greater the investment in current assets, the lower
the risk, but also the lower the profitability obtained. Filbeck and Krueger (2005) highlighted
the importance of efficient WCM by analyzing the WCMP of 32 non-financial industries in
USA. According to their findings significant differences exist between industries in working
capital practices over time. WCM literature presents a long debate on the risk/return tradeoff
among different WCMP (Brigham and Ehrhardt, 2004; Gitman, 2005; Moyer et. al., 2005 &
Pinches, 1991). Accordingly, it is worth to notice that more aggressive working capital
policies are associated with higher return and higher risk while conservative working capital
policies are concerned with the lower risk and return (Carpenter and Johnson, 1983; Gardner
et al., 1986 & Weinraub and Visscher, 1998). It further explain, when a company is
continuing with the aggressive working capital management policy will lead to have higher
level of return, lower level of liquidity and higher level of risk which is not healthy every
time. However, effective management of working capital policy has been receiving little
attention and yielding more significant results. More aggressive working capital policies are
associated with higher return and higher risk while conservative working capital policies are
concerned with the lower risk and return (Gardner et al., 1986 & Weinraub & Visscher,
1998).
Salawu R.O. (2006) investigated fifteen diverse industrial groups over an extended period
to establish the relationship between aggressive and conservative working capital practices.
The results strongly explained that the industries had significantly different current asset
management policies. Additionally, the relative industry ranking of the aggressive or
conservative asset policies exhibited remarkable stability over time. It is evident that there is a
significant negative correlation between industry asset and liability policies. Relatively
aggressive working capital asset management seems balanced by relatively conservative
working capital financial management. Furthermore he explains that a firm in deciding its
working capital policies should consider the policies adopted in that particular industry in
which it operates and a firm pursing aggressive working capital investment policy should
match it with a conservative working capital financing policy. This is important to mitigate
the risk being faced under aggressive working capital investment policies by safety involved
under conservative working capital financing policy.
However, Weinraub and Visscher (1998) have discussed the issue of aggressive and
conservative working capital management policies by using quarterly data for a period of
1984 to 1993 of US firms. The researchers have examined ten diverse industry groups to
Global Journal of Contemporary Research in Accounting, Auditing and Business Ethics (GJCRA)
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study the relative relationship between their aggressive/conservative working capital policies
and they have concluded that the industries had distinctive and significantly different working
capital management policies over the time. Moreover, the relative nature of the working
capital management policies exhibited remarkable stability over the ten-year study period.
The study showed a significant negative correlation between industry asset and liability
policies. It is important to notice that they also generated similar results and additionally they
concluded that relatively aggressive working capital asset policies (working capital
investment policy) are followed and balanced by relatively conservative working capital
financial policies confirming the Salawu’s (2006) similar findings in Nigerian context.
Further, Afza and Nazir (2007) investigated the relationship between the aggressive and
conservative working capital policies for seventeen industrial groups and a large sample of
263 public limited companies listed at Karachi Stock Exchange for a period of 1998-2003.
Using ANOVA and LSD test, the study found significant differences among their working
capital investment and financing policies across different industries. Moreover, rank order
correlation confirmed that these significant differences were remarkably stable over the
period of six years of study. Finally, ordinary least regression analysis found a negative
relationship between the profitability measures of firms and degree of aggressiveness of
working capital investment and financing policies.
Another important study which confirms the results of Afza and Nazir (2007), conducted
by Mian S. and Talaf (2009) have shown that the negative relationship between the
profitability measures of the firm and the degree of aggressiveness of working capital
management policies by analyzing the 204 Pakistan firms listed under sixteen industrial
groups in the Karachchi Stock Exchange (KSE). The data was analyzed for the period of
1998-2005.
Theoretically, greater the investment in current assets, the lower the risk, but also the
lower the profitability obtained. In contradiction, Carpenter & Johnson (1983) provided
empirical evidence that there is no linear relationship between the level of current assets and
revenue systematic risk of US firms; however, some indications of a possible non-linear
relationship were found which were not highly statistically significant. So, the link between
WCM and firm value is not simple as the link between WCM and firm profitability discussed.
Turning to the empirical literature on WCM policy and the firm value, researcher could
not find any published study of the relationship between WCMP and firm value in specific.
Hall, J. (2001); Ruback and Sesia (2000) and Smith (1980) stated that efficient level of
WCM is one of the driver for value creation. Deloof (2003); Garcia-Teruel and Martinez-
Solano (2007); Soenen (1993) and Shin and Soenen (1998) all showed that the profitability
of a firm, measured by either return on assets or return on equity, is improved as the firm
improves its management of its working capital. While most of such studies suggest that firms
Global Journal of Contemporary Research in Accounting, Auditing and Business Ethics (GJCRA)
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that minimize their investment in net operating capital will maximize their profitability and
thereby maximize firm value, this inference does not necessarily follow (Robert, Mark &
Rabhi, 2008).
The study available relating to the Sri Lankan context is the research done by Pandey and
Perera (1997), providing an empirical evidence of WCMP and practices of the private sector
manufacturing companies in Sri Lanka. The information and data for the study were gathered
through questionnaires and interviews with chief financial officers of a sample of
manufacturing companies listed on the Colombo Stock Exchange. They found that most
companies in Sri Lanka have informal working capital policy and company size has an
influence on the overall working capital policy (formal or informal) and approach
(conservative, moderate or aggressive). And also, company profitability has an influence on
the methods of working capital planning and control. According to the study conducted by S.
Morawakage and Lakshan A.M.I (2009) with the companies registered in Colombo Stock
Exchange, results suggest that managers can increase corporate profitability by reducing the
number of inventory turn over days and increasing the creditor’s payable days in order to
minimize the length of the working capital cycle. Increase in creditor’s payable days would
give opportunities to the company for further investments.
Turning to the literature on firm value, a well designed and implemented working capital
management is expected to contribute positively to the creation of a firm’s value. De Wet
(2005) has studied companies listed on the JSE Securities Exchange South Africa, using
market value added (MVA) as a proxy for shareholder value. The results suggest strong
relationship between MVA and cash flow from operations. The study also found very little
correlation between MVA and EPS, or between MVA and DPS, concluding that the
credibility of share valuations based on earnings or dividends must be questioned. The main
objective of a firm is to increase the market value. Working capital management affects
profitability of the firm, its risk, thus its value (Smith, 1980). In other words, efficient
management of working capital is an important component of the general strategy aiming at
increasing the market value (Afza & Nazir, 2007; Deloof, 2003 and Howorth & Westhead,
2003). Even though there are pros and cons of using MVA to measure the firm value, it has
been proved by the literature that MVA can be used as the better proxy for measuring the
value of the firm.
3. Methodology
Research methodology is mainly focused on discussing the hypotheses and relevant
variables that are considered in the research design to achieve its above mentioned research
problem.
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3.1 Hypotheses
The following hypotheses were formulated in the study to examine the impact of WCMP on
firm value.
H1: There is a negative relationship between the degree of aggressiveness of working capital
management investment policy and MVA of the companies in Sri Lanka.
H2: There is a negative relationship between the degree of aggressiveness of working capital
management financing policy and MVA of the companies in Sri Lanka.
3.2 Variables
3.2.1 Independent variables
For the study, independent variable is the working capital management policy and selected
two indicators to measure the degree of aggressiveness of WCMP based on followings two
aspects*.
Investment Policy (IP)
Financing Policy (FP)
With the support of available literature and relevant theories of WCM, the degree of
aggressiveness or conservativeness is measured by; (Afza, Nazir, 2007; Weinraub Visscher,
1998 and Salawu, 2006)
Total Current Assets to Total Assets Ratio (Investment Policy)
Total Current Liabilities to Total Assets Ratio (Financing Policy)
3.2.2 Investment Policy (IP)
It explains the way of firm can invest their funds in the short term or long term assets
resulting in minimal level of investment of the firm’s funds in current assets comparatively to
the fixed assets closes to the more aggressive and if it is vise-versa close to the
conservativeness. In order to measure the degree of aggressiveness or conservativeness,
following ratio will be used: (Afza, Nazir, 2007; Weinraub and Visscher, 1998 and Salawu,
2006)
IP = Total Current Assets (TCA) X 100
Total Assets (TA)
Where a lower ratio means a relatively aggressive policy.
Where a higher ratio means a relatively conservative policy.
3.2.3 Financing Policy (FP)
It discusses the way that a firm finances their permanent or temporary assets by using short
term or long term funds. If a firm utilizes higher levels of current liabilities and less long-term
debt to finance its current assets will be close to the aggressiveness and if a firm uses long
term funds to finance its permanent assets as well as current assets it closes to
conservativeness. The degree of aggressiveness or conservativeness of a financing policy
* See Afza, Nazir, 2007; Weinraub and Visscher, 1998 and Salawu, 2006 for further evidence
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adopted by a firm will be measured by: (Afza, Nazir, 2007; Weinraub and Visscher, 1998;
Salawu, 2006)
FP = Total Current Liabilities (TCL) X 100
Total Assets (TA)
Where a higher ratio means a relatively aggressive policy.
Where a lower ratio means a relatively conservative policy
When the degree of aggressiveness i.e. current assets as a percentage of total asset ratio is
close to zero, it is referred as aggressive working capital management policy while that ratio
is close to hundred, it is named as conservative working capital management policy. On the
other hand degree of aggressiveness i.e. current liabilities as percentage of total asset ratio is
close to zero, it is referred as conservative working capital management policy while that ratio
is close to hundred it named as aggressive working capital management policy.
3.2.4 Market Value Addition (MVA)
Market value is the difference between market value of the firm’s stock and the amounts
of equity capital supplied by investors. It measures the effect on value of management’s
decisions since the firm’s inception. Further it says how much management has added to
shareholder value over the company’s history.
The main distinguishing feature of MVA is that, it is largely a cumulative measure and
therefore communicates the market’s present verdicts on the Net Present Value (NPV) of all
the firms’ past, current and contemplated capital investment projects (O’Byrne, 1996). MVA
measures the effect on value of management’s decisions since the firm’s inception. It is
calculated as follows.
MVA = Market Value of Company – Total Operating Capital Invested
(O’Byrne, 1996)
Based on the above mentioned constructs and concepts following expression can be made;
Firm Value = f (Aggressive Investment Policy, Aggressive Financing Policy, Conservative
Investment Policy, Conservative Financing policy, Moderate Investment
Policy and Moderate Financing Policy )
Where the degree of aggressiveness or conservativeness is measured by
Total Current Assets to Total Assets Ratio (Investment Policy)
Total Current Liabilities to Total Assets Ratio (Financing Policy)
FVit
= β0 + β1 (TCA/TA
it) + β
2 (TCL/TA
it)
Where:
FV it
= Firm Value of firm i for time period t
TCA/TA it = Total Current Assets to Total Assets Ratio of firm i for time period t
TCL/TA it
= Total Current Liabilities to Total Assets Ratio of firm i for time period t
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3.3 Sample and sampling procedure
A sample of 74 companies is selected representing seven different sectors in the Colombo
Stock Exchange (CSE) out of the twenty sectors in the CSE sector categorization. The study
did not select bank, financial and insurance sector companies because of the more
regularization of the working capital practices in the industry as a result of inherent conditions
imposed to the financial sector organizations. Further, diversified holding sector was
eliminated from the sample due to the group financial statements are available and it may lead
to replication error of data with other sectors. Additionally, since the less number of
companies available in the sectors such as Construction and engineering, Foot ware textiles,
Health care, Information technology, Investment trust, Motors, Oil palms, Power and energy,
Services, Store suppliers and Telecommunication have not been included in to the sample.
Accordingly, the sample of 74 companies which covers the fifty percent of the total
population is considered for the study. It was drawn by using the stratified random sampling
technique from the 142 listed companies which are considered for the study selecting seven
different sectors in CSE. Finally researcher possesses the research with 370 firm year
observations.
Table 1: Distribution of sample companies listed in CSE according to the Industrial Sectors
Sector Number of
Companies Selected
Beverage Food and Tobacco (BFT) 11
Chemicals and Pharmaceutical (C & P) 6
Hotel and Travel (H & T) 16
Land and Property (L & P) 12
Manufacturing (Manu) 15
Plantations (Plant) 9
Trading (Trad) 5
Total 74
3.4 Data collection
With the evidences supported by the literature, most of the researchers have conducted
their researches based on the secondary data from the annual reports published by the
companies. This study also based on secondary quantitative data and data collected for the
period of 5 years starting from 2009 to 2014 using the annual reports published by the above
mentioned companies which have been listed in CSE. Further, the data is obtained from the
magnetic data library and the annual handbook published by the CSE.
3.5 Data analysis
Data comprises time series nature because it is for five years period and cross sectional
nature because it has 74 companies. Therefore, researcher used panel data from the year 2009
to 2014 representing 74 companies covering seven different sectors in the CSE and used
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SPSS for basic statistical analysis and E-views software package for panel data regressions to
analyse the data. With the secondary data obtained from the annual reports, following data
analysis techniques were used to meet the research objectives.
Measures of descriptive statistics such as mean, maximum, minimum, standard deviation
is used to analyse the variables. Regression analysis was used to examine the impact of
WCMP as IP and FP on Firm Value which is measured and MVA. Pearson’s correlation
coefficient is used to see the relationship between Firm Value and WCMP of the companies.
4. Results and Discussion
4.1 Results
4.1.1 Investment policy, Financing policy and firm value
Researcher regressed the firms’ investment policy and firms financing policy individually
with MVA as separate regression models. Relevant regression results are shown in the table
no. 2 below. Accordingly, model 1 of investment policy and MVA showed an adjusted R2 of
0.550 stating that 55% of variation in MVA was explained by IP of the firm. Its f value
recorded as 7.11 and p value was 0.000, revealing that the overall model is statistically
significant. According to the coefficient sign, there is a negative relationship of the IP policy
of the firm and the MVA (p=0.000). It explained that when CA/TA ratio increases or in the
other words, degree of aggressiveness of IP increases MVA of the firm decreases. It further
evidenced that a relatively conservative working capital investment policy leads to decrease
the MVA of the firm. Model 2 considered FP as independent variable and MVA as the
dependent variable and it explained 34% of the variation in MVA (p=0.000) by FP. Further,
FP and MVA showed a negative relationship which was not significant at 5% level.
Table 2: Investment policy, Financing policy and MVA
Investment policy and MVA Financing policy and MVA
Overall model IP Overall model FP
Adjusted R2 0.550 0.340
F value 7.11 3.580
t value -11.92 -1.77
Sig. level .000 .000 .000 .077
Sign of the coif. Negative Negative
4.1.2 MVA with Investment policy and Financing policy
Panel regression model which showed the overall model including MVA as dependent
variable with IP and FP as independent variables disclosed and adjusted R2 of 0.549.
Accordingly 55% of variation in MVA was explained by IP and FP of the firm. Recorded f
value was 7.00 with a p value of 0.000. According to the regression model, IP and FP both
showed a negative relationship to MVA as recorded in the individual models while FP
(p=.634) was not statistically significant.
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Table 3: MVA with Investment policy and Financing policy
Overall model IP FP
Adjusted R2 .549
F value 7.00
t value -11.72 -0.47
Sig. level .000 .000 .634
Sign of the coif. Negative Negative
According to the correlation analysis taking all the companies together, it recorded a
negative relationship between IP and MVA. According to the regression analysis, the
relationship between IP and MVA is significant. Also, FP and MVA is not significant.
4.2 Discussion of Findings
4.2.1 Investment Policy (IP) and MVA
The first hypothesis in the study states that there is a negative relationship between the
degree of aggressiveness of working capital management investment policy and MVA of the
companies in Sri Lanka. According to the Pearson’s correlation coefficients, IP indicated a
highly negative correlation to MVA as -.714 (p= .000). It explains that the increase in IP
which is measured in terms of the ratio of CA/TA resulted in decreasing the MVA of the firm.
Complying with the results laid down by the correlation coefficient between IP and MVA, the
regression IP and MVA as independent and dependent variables respectively, showed an
adjusted R2 of .550 (p= .000) and .549. It explains that on an average 55% of variation in
MVA is explained by IP of the firm. Further, both models record a significant negative
relationship between the IP and MVA. This negative relationship between the IP of the firm
and MVA explains that, when CA/TA ratio increases or in the other words, degree of
aggressiveness of IP increases, MVA of the firm decreases.
According to the statistical evidence given by the correlation as well as regression, first
hypothesis was failed to reject. It says that any firm invests more in to the current assets
compared to the total assets leads to have a lower level of MVA of firms. A firm with high
level of CA/TA ratio maintains a relatively conservative working capital management IP
which leads to have relatively lower level MVA. On the other way around, it concludes that,
if any firm has a low level of CA/TA ratio or a relatively aggressive working capital
management IP yields a relatively higher level of MVA.
In the empirical research domain, there are few specific evidences to justify the
relationship between IP and MVA. On the grounds provided by the literature, profitability has
a positive relationship with the value of the firm; this study results in consistent with the
findings of Soenen and Solano (1993). Their research was on the effects of working capital
management on the profitability of a sample of small and medium-sized Spanish firms with
the panel data, covering the period 1996-2002. This results demonstrated that managers can
create value by reducing their firm’s number of day’s accounts receivable and inventories, i.e.
by reducing the level of CA. Moreover, current finding complied with the study conducted by
Global Journal of Contemporary Research in Accounting, Auditing and Business Ethics (GJCRA)
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Deloof (2003). He analyzed a sample of large Belgian firms during the sample period 1992-
1996 and the results indicated that Belgium firms can improve their profitability by reducing
the number of accounts receivable days and by reducing inventories.
Results of the study can be further validated by examining reasons from the theoretical
aspects. Accordingly, one of the reasons for the negative relationship between WC investment
policy and the value of the firm is that, minimum level of CA decreases the level of
operational capital in the business yielding a high level of operational cash flows in the
business and finally it helps to create value to the firm. On the other hand low level of CA as
a percentage of TA, leads to have high level of FA which increases the future expansion
capacity and revenue generation capacity of the firm as an attractive indicator for the
investors. Therefore, it creates a high demand for the shares of the firm leading to increase the
market value of the firm.
Another reason for the negative relationship is that any firm invests more in the stocks
leads to have an unsold stock which tide up money unnecessarily and stock loss cost etc.
Similarly, keeping more money in the debtors, having more opportunity cost of cash and
possibility for bad debt, and it leads to have cash insufficiency to pay for creditors as a result
of financing alternatives with high borrowing cost. Additionally, any investment in working
capital more than its optimum, would increase the firm’s assets without a proportionate
increase in its returns and thus lowering the rate of return on investment. This low level of
return causes to have a low market demand for the shares and ultimately decrease the MVA.
Weston and Copeland (1992) also suggested that, given the optimum, increasing the cash
holding negatively affects the shareholder value.
Moreover, excessive exposure to have liquid assets generated higher sales revenues, but at
the same time the positive results of increase in the sales volumes have been offset by high
level of generated costs of keeping the high level of liquid assets and finally firm generates a
lower value. All these cause to have negative value for the firm as a result of high level of
investment in CA.
Even though the current findings are supported by the literature and theoretical aspects, as
decreasing level of CA as a percentage of TA yield to have higher MVA, in the
implementation by the firms, they should consider the liquidity as well as risk aspects. When
firms try to minimize the investment in CA, it causes to a lower level of liquidity, insufficient
stocks to run day today operations and lower level of debtors would result to decrease the
revenue. Finally, it leads to have a lower level liquidity and high level of operational risk to
the business. Therefore, it is worth to reduce the level of CA investment in such a way to have
proper balance between liquidity and risk associated with the business.
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4.2.2 Financing Policy (FP) and MVA
The second hypothesis of the study states that there is negative relationship between the
degree of aggressiveness of working capital management financing policy and MVA of the
companies in Sri Lanka. The regression model indicated a negative relationship between
working capital FP and MVA of the firm but relationship was not statistically significant at
5% level. Similar result was given by the Pearson’s correlation coefficients as FP has a lower
level negative correlation to MVA as -.129 (p= .013). According to the hypothesis, it explains
that the increase in FP measured by the ratio of CL/TA, leads to decrease the MVA of the
firm. On the other hand, the increase in CL/TA ratio means the degree of aggressiveness
Increases. Therefore, when degree of aggressiveness of the FP increases, the value of the firm
decreases. It further states that the relatively aggressive FP policy yields negative results of
MVA providing evidence that if the firms finance their TA more and more CL, leads to have
a lower level of MVA. Since the FP to MVA did not demonstrate a statistically significant
negative relationship, study rejected the hypothesis no 2 stated as “there is a negative
relationship between the degree of aggressiveness of working capital management financing
policy and MVA of the companies in Sri Lanka”.
According to the empirical studies, it has been concluded that there is no universally
applicable pattern in the FP and value of the firm. The FP is affected by the different
environmental conditions prevailed in different countries in different periods. It was further
confirmed by the present study findings that there was no linear negative relationship between
FP and MVA in Sri Lankan companies. One of the reasons that the negative relationship does
not exist in Sri Lankan market may be insufficiency of information to the investors about the
FP of the companies because of FP is more internally driven methodology while MVA is
more externally driven measurement tool.
5. Conclusion and Recommendation
Working capital management (WCM) is vital and an integral part in the financial
management which affects the profitability, liquidity, risk as well as the value creation.
Empirical research provided evidence that there is negative relationship between the degree of
aggressiveness of working capital investment and financing policies with the firm value,
stating that more aggressive working capital management is associated with higher
profitability leading higher value of the firm.
In the study of Working Capital Management Policy (WCMP) and firm value, Investment
Policy (IP) and Financing Policy (FP) were considered as independent variables. IP explains
the alternative ways in which a firm can invest their funds in assets, either in short term or in
long term. The minimal level of investment of the firm’s funds in current assets
comparatively to the fixed assets leads to the more aggressive IP. FP shows the way in which
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a firm uses temporary funds to finance all of its temporary assets, along with some or even all
of its permanent assets. The minimum level of short term funds to finance temporary and
permanent assets leads to more conservative FP.
Market Value Added (MVA) which, was selected as dependent variable is important tool
to measure the Value of the firm. Market value is the difference between market value of the
firm’s stock and the amounts of equity capital supplied by investors. It measures the effect on
value of management’s decisions from the firm’s inception.
The study identified that the WCMP followed by the firms as IP and FP with the ratios of
Current Assets (CA) as a percentage of Total Assets (TA) and Current liability (CL) as a
percentage of TA respectively, and examined the relationship of those policies with EVA and
MVA. Moreover, researcher identified impact on firm size to the WCMP and firm value as
moderator variable. In addition to the main objectives of the study, based on the IP and FP of
the firms, researcher examined the relationship between the different WCM practices
followed by the firms as aggressive, conservative or moderate with value of the firm.
The study used the sample of 74 listed companies including 370 firm year observations taken
over the last five year period from 2009 to 2014 representing seven different business sectors
in the Colombo Stock Exchange (CSE).
According to the correlation analysis taking all the sample companies together, recorded a
negative relationship between IP and MVA. Similar results were given from the sector-wise
correlation analysis. According to the sector-wise correlations, all the sectors’ IP recorded
significant negative relation to MVA, but provided insignificant negative relationship
between FP and MVA. Similarly, sector-wise correlation between FP and MVA was negative.
Results given by the regression analysis showed that the relationship between IP and MVA
was significant and results between FP and MVA were not significant. Regression results
derived for the different sectors did not deviate from the overall regression results. According
to the examination of sector-wise impact on MVA, study revealed that there is no significant
impact of the different sectors on the overall results.
According to the statistical evidence supported by the correlation and regression analysis,
researcher failed to reject the hypothesis no. 1(H1) which stated that there is a negative
relationship between the degree of aggressiveness of IP with MVA. Accordingly, researcher
concluded that the firms can maximize MVA by investing their minimum level of funds in
current assets compared to non-current assets. It proves the relatively aggressive WCM IP
gives higher MVA. Further, H2 states that there is a negative relationship between the degree
of aggressiveness of IP to MVA. The results do not provided sufficient statistical evidence to
accept the hypotheses no. 2 (H2). Therefore, researcher does not have enough evidence to
declare that the firms can improve their MVA by financing their assets with the short term
funds. Furthermore, there is no sector-wise impact from the overall sample. Sector-wise
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regression and correlation analysis of WCMP and firm value also provided the similar results
to overall sample correlation and regression results. It proved that there were no significant
sector- wise differences in the findings.
The first conclusion derived from the study is, the firms that are running with an
aggressive IP i.e. maintaining lower level CA as a percentage of TA, can improve their MVA.
Finally, the firms which followed MWCMP can improve the MVA of the listed non-financial
companies in Sri Lanka. Further, by analysing the different WCM practices used by the firms,
researcher identified that firms following MWCMP can improve the MVA compared to the
CWCMP.
In view of the above facts, the study reveals that the firms with an aggressive working
capital investment policy lead to improve the MVA. Therefore, firms with minimum level of
investment in CA in such a way to have enough liquidity to run day to day operations, can
improve the MVA.
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