joimial of Business Fiiunife if .Aicmmting, 30(.^) & (4), April/May 2003, 0306-686X

Does Working Capital ManagementAffect Profitability of Belgian

Firms?

MARC DELOOF*

I. INTRODUCTION

Most firms bave a large amount of cash invested in workingcapital, as well as substantial amounts of short-term payables as asource of financing. For instance, according to the National Bankof Belgium, in 1997 accounts receivable and inventories wererespectively 17% and 10% of total assets of all Belgian non-financial firms. Accounts payable were 13% of total assets of thesefirms. It can be expected tbat the way in which working capital ismanaged will have a significant impact on the profitability offit ms. Accordingly, for many firms working capital management(\V(;M) is a very important component of their financialmanagement.

Firms may have an optimal level of working capital thatmaximizes their value. On the one hand, large inventory and agenerous tiade credit policy may lead to higher sales. Largerinventory reduces the risk of a stock-out. Trade credit maystimulate sales because it allows customers to assess productquality before paying (Long, Malitz and Ravid, 1993; andDeloof and Jegers, 1996). Because suppliers may have

* I hf iiiillinr is from Llit- F;nii!iy ol Applied Economics L FSI.VRL'tJA, L'liivcrsity of.-\mwi-ip. Me is vt'iy gialefiil lo Marc Jegers, Luc Sot-nrn, list- \'<Tscliiieien and ananonymous referee tor liclpf'iil coiiuiifiils and suggestions. The nsual disclainitr applies.(I'aper received November 2001, revised and accepted January 20(12)

Address for correspondence: Marc Deloof, Faculty of Applied Kconoriiics LFSIA-RL CA. L'nivcisitv o[ Aiilwerp. Frinssn^aai Kt, 2(100 Antwerp. Belgium,t-mail: rnaix.rlcloolf" ua.ac.be

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574 DELOOF

significant cost advantages over financial institutions inproviding credit to their customers, it can also be an inexpensivesource of credit for customers {Petersen and Rajan, 1997). Theflip side of granting trade credit and keeping inventories is thatmoney is locked up in working capital.

Another component of working capital is accounts payable.Delaying payments to suppliers allows a firm to assess thequality of the products bought, and can be an inexpensive andflexible source of fmancing for the firm. On the other hand, latepayment of invoices can be very costly if the Rrm is offered adiscount for early payment. In a 1996 survey of trade creditpolicies in Europe, Svensson (1997) found that 75% of Belgianfirms offered a'discount for prompt payment {within 10 days),and the average discount offered was 3%. The averagecontractual credit period was 41 days, but the average actualpayment period was 61 days: 49% of all trade credit was paid toolate. In a 2001 survey by the Institute for Credit Management ofthe Vlerick Leuven Ghent School for Management of tradecredit policies of Belgian fhms, it was found that the medianBelgian firm offers a 2/10n30 discount for quick payment.

Compared with payment periods in the USA, paymentperiods of Belgian firms appear quite long. In Belgium, as inmany other continental European countries, capital markets areunderdeveloped in the sense that information and agencyproblems are particularly pronounced. La Poita et al. {1997 and1998), who find that countries with poorer investor protectionhave smaller and narrower external capital markets, show thatBelgium has weak legal protections of corporate shareholdersand creditors, making bank financing and trade credit moreattractive. Fisnian and Love {2001) argue that trade creditorsmitigate weak creditor protection and imperfect informationbetter than formal lenders, and find that firms in countries withless developed financial markets use informal credit pr(n ided bytheir suppliers to finance growth.

A popular measure of WCM is the cash conversion cycle, i.e.the time lag between the expenditure for the purchases of rawmaterials and the collection of sales of finished goods. The longerthis time lag, the larger the investment in working capital. Alonger cash conversion cycle might increase profitability becauseit leads to higher sales. However, corporate profitability might

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WORKING CAPITAL MANAGEMENT AND PROFITABILITY 5 7 5

also decrease with the cash conversion cycle, ifthe costs of higherinvestment in working capital rise faster than the benefits ofholding more inventory and/or granting more trade credit tocnstomers. Shin and Soenen (1998) investigate the relationbetween a measure of the cash conversion cycle and corporateprofitability. For a large sample of listed American firms for the1975-1994 period, they find a .strong negative relation. Thisresult indicates that managers can create value for theirshareholders by reducing the cash conversion cycle to areasonable minimum.

In this paper, I investigate the relation between WCM andcorporate profitability for a sample of 1,009 large Belgian non-financial firms for the 1992-1996 period. Number of daysaccounts leceivable, inventories and accounts payable are usedas measures of trade credit and inventory policies. The cashconversion cycle is used as a comprehensive measure of WCM.The results suggest that managers can increase corporateprofitability by reducing the number of days accounts receivableand inventories. Less profitable firms wait longer to pay theirbills.

The paper proceeds as follows. In the next section the sampleand the variables used in the empirical analysis are presented.The results of the empirical analysis are presented in Section 3.Section 4 discusses tbe causality in the relation between WCMand corporate profitability. Section 5 concludes.

2. SAMPLE AND VARIABLES

The sample is based on a database provided by the NationalBank of Belgium that consists of financial statements of the2,000 most important Belgian firms. The sample wasconstructed as follows. I started with the 1,637 firms forwhich a financial statement was available for each year of the1991-1996 period. Because of the specific nature of theiractivities, firms in NACE-industries 1 ('energy and water'),8 ('banking and finance, insurance, business services, renting')and 9 ('other services') were excluded from the sample.' Somefirms with missing data were also removed. Finally, the firmswith the \7( outlying values for number of days accounts

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576 DELOOF

receivable, number of days inventories, tiumber of daysaccounts payable, net operating income and gross operatingincome were left out. Thus a balanced panel set of 5,045 firm-year observations was obtained, with observations of 1,009 firmsover the 1992-1996 period."

Profitability is measured by gross operating income, which isdefined as sales minus cash costs of goods sold, and is divided bytotal assets minus financial as.sets. For a number of firms in thesample, financial assets, which are mainly shares in other firms,are a significant part of total assets. That is also the reason whyreturn on assets is not considered as a measure of profitability:when a firm has mainly financial assets on its balance sheet, itsoperating activities will contribute little to the overall return onassets. Profitability measures based on stock market valuationare not considered because only a limited number of Belgianfirms is listed on a stock exchange.

Number of days accounts receivable is calculated as [accountsreceivable x 365]/sales. Number of clays inventories is[inventories x 365]/cost of sales. Number of days accountspayable is [accounts payable x 365]/purchases. A more detaileddescription of the definitions of these variables, which involve anumber of Belgian financial statement items, can be found inTheunisse and Jegers (1994).

The cash conversion cycle is used as a comprehensivemeasure of WCM. The cash conversion cycle is simply [numberof days accounts receivable -I- number of days inventory —number of days accounts payable]. Gentry, Vaidyanathan andLee (1990) developed a weighted cash conversion cycle, whichscales the liming by the amount of funds in each step of thecycle. However, this measure cannot be used because not allinformation necessary for calculation is available."*

In addition, size (the natural logarithm of sales), sales growth([this year's sales - previous year's salesj/pievious years sales), thefinancial debt ratio (financial debt/total assets), and the ratio of fixedfinancial assets to total assets are included as control variables in theregressions. Fixed financial assets are shares in other (mainlyaffiliated) firms, intended to contribute to the activities of the firmthat holds them, by establishing a lasting and specific relation, andloans that were granted with the same purpose. For some firmssuch assets are a significant part of total assets.

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I also consider variability of net operating income (divided bytotal assets minus financial assets) as a control variable.Variability is the standard deviation of net operating incomeof each firm over the 1991-1996 period.

Table 1 presents descriptive statistics. Gross operating incomeis on average 12.2% of [total assets - financial assets], whilethe median is 10.6%. The average cash conversion cycle is 44.5days (median is 59.6 days). Firms receive payment on sales afteran average of 54.6 days (the median is 51.4 days). It takes onaverage 46.6 days to sell inventory (median is 33.8 days) and firmswait on average 56.8 days to pay their purchases (median is 52days).

Mean sales growth is only 2.H%, while median sales growth iseven less at 1.69 . On average about a quarter of all assets arefinanced with financial debt (median is 22.4%). It is alsonoteworthy that while for the median firm in the sample,fixed financial assets are only 2.4% of total assets, the meanfixed financial assets ratio is much higher at 12%. For a numberof firms, a large proportion of total assets are fixed financialassets.

3. EMPIRICAL ANALYSIS

(i) Correlation Analysis

Table 2 presents Pearson correlation coefficients for all variablesconsidered. There is a negative relation between grossoperating income on the one band and tbe measures of WCM(number of days accounts receivable, inventories and accountspayable and casb conversion cycle) on the other hand. This isconsistent with the view tbat the time lag between tbeexpenditure for tbe purchases of raw materials and thecollection of sales of finished goods can be too long, and thatdecreasing this time lag increases profitability.

A shortcoming of Pearson correlations is that they do not allowto identify causes from consequences. A negative relationbetween number of days accounts payable and profitability isconsistent with the view that less profitable firms wait longer topay their bills. In that case, profitability affects accounts payable

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policy, and not vice verm. An alternative explanation for anegative relation between the tiumber of days accounts payableand profitability could be tbat firms wait too !ong to pay tbeiraccounts payab!e. Speeding up paytiieiits to suppliets migbtincrease profitability because Belgian firms often receive asubstantial discount for prompt payment. However, in Belgianfuiancial statements, discounts received for prompt paytnentsbould be booked as financial iticome, atid .sbould not aflectoperating income.

(ii) Regression Analysis

Next, I use regression analysis to investigate the impact of WCMon corporate profitability. Ihe detertninants of corporateprofitability are estimated with a fixed effects model. Fixedeffects estimation assumes firm specific intercepts, whichcapture the effects of those variables that are particular to eachfirm and that are constant over time.^ A disadvantage of fixedeffects estimation is that it eliminates anything that is time-invariant from the model. Variability of income, which ismeasured by the standard deviation of net operating incomeover the 1991-1996 period, can therefore not be included in afixed effects model. I also estimate plain OLS-models, which notonly include all variables of the fixed effects tnodel, but alsovariabihty of income, 4 year dummies and 37 industrydummies, which are based on 2-digit NACE-code. In allregressions, standard errors are calculated using White'scorrection for heteroscedasticity.

The determinants of gross operating income are investigatedfor all 5,045 firm-year observations. The results can be foundin Table ?>. Regression (1) is estimated with fixed effectsand includes tiumber of days accounts receivable as a measureof accounts receivable policy. The coefficient of the accountsreceivable variable is negative and highly significant, andimplies that an increase in the number of days accoitntsreceivable by 1 day is associated with a decline in gtossoperating income (divided by total assets minus fitiaticialassets) by 0.048*%. The coefficients of the other variablesincluded in the model are also highly significant. Gross

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W(iRKIN(; CAPITAL MANAGEMENT AND PROFITABtLITY 5 8 1

operating income increases with firm size {measured by thenatural logarithm of sales), sales growth and fixed financialassets, and decreases with financial debt. In tegtession (2), asignificant negative relation is found betweeti gross operatingincome and number of days inventories (p-value = 0.015).Regression ('i) shows a very significant negative relationbetween gross operating income and number of days accountspayable. This negative relation confirms the negativecorrelation between operating income and number of daysaccoutits payable in Table 2.

The cash cotiveision cycle is included in regression (4). "I hecoefficient ofthe cash conversion cycle variable is negative, but itis not significantly cfifferent from zero {/?-value = 0.668). That isnot a stu prise: gross operating income declines with the tiutiiberof days accounts receivable and inventories, but also with thenutnber of days accounts payable, which is subtracted tocalctdate the cash conversion cycle.

rhe tesults of regressions (1) to (4) suggest that managers canincrease corporate profitability by reducing the number of daysaccounts receivable and inventories. An explanation for thenegative relation between accounts payable and gross operatingincome is that less profitable firms wait longer to pay their bills.

In regressions (5) to (8), the determinants of gross operatingincome are estimated using plain OLS instead of fixed effectsestimation, and include variability of income, 4 year dummiesand ;i7 itidttstry dtttnmies as independent variables. OLSestimation does not take into account firm specific differencesin profitability. The results are generally consistent with theresults of regressions (1) to (4). Gross operating incomedecreases with niunber of days accounts receivable, inventoriesand accounts payable. One difference between fixed efFectsestimation and OLS estimation is that in regression {8} grossoperating income decreases with the cash conversion cycle:the coefficient is highly significant (p-value = 0.000).In regression (4), it was not significant. It is interesting totiote that the adjusted /?"s of the OLS regressions are muchlower than the adjusted 'within' R~s of the fixedeffects regressions. The regression models explain a muchhigher poition ofthe variations in profitability within firms thanbetween firms.''

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3. DOES PROFIl ABILITY AFFECT WCM, OR I'ICK VERSA}

It cannot be rtiled ont that the negative relation between WCMand profitability is to some extent a consequence ofprofitability affecting WCM, and not vice versa. Indeed, the mostplausible explanation for the negative relation between accountspayable and profitability is that less profitable firms wait longer to paytheir bills. A negative relation between inventory and profitability canbe caused by declining sales, leading to lower profits and moreinventory.

An alternative explanation for the negative relation betweenaccounts receivable and profitability could be that customerswant more time to assess the quality of products they buy fromfirms with declining profitability. However, finance basedmodels explaining trade credit (e.g. Schwartz, 1974) arguethat firms able to obtain funds at a low cost will offer tradecredit to firms facing higher financing costs. Emery (1984) seestrade credit as a more profitable short term investment thanmarketable securities. These models imply that higher profitsshould lead to more accounts receivable, because firms withhigher profits have more cash to lend to customers. This isconfirmed by Deloof and jegers (1996), who find that Belgianfirms with a shortage oi cash reduce investment in accountsreceivable.

Figure 1 shows the median number of days accoimtsreceivable, accounts payable and inventories, all partitionedby gross operating income deciles. Consistent with thehypothesis that less profitable firms wait longer to pay theirbills, the number of days accounts payable is much higher forthe lowest income deciles than for the other income deciles.The median number of days accounts payable is 62.5 daysfor the first income decile (gross operating income = 0.009)and 65.8 days for the second income decile (gross operatingincome — 0.039). For the other income deciles, the mediannumber of days accounts payable ranges from 47.1 days(fourth income decile) to 54.3 days (sixth income decile).Figure 1 does not show a clear trend in the median numberof days inventories and accounts receivable across incomedeciles.

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WORKINC; CAPITAL MANAGEMENT .ANO PROFITABILITY 585

Figure 1

Median No. of Days Accounts Receivable, Accotints Payable andInventories, Partitioned by Gro.ss Operating Income Deciles (1,009

Belgian Non-financial Firms, 1992-1996: 5,045 Firm-yearObservations)

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4. CONCLUSION

Most firms have a large amount of cash invested in w{)rkingcapital. It can therefore be expected that the way in whichworking capital is managed will have a significant impact on theprofitability of firms. Shin and Soenen (1998) find a strongnegative relation between the cash conversion cycle andcorporate profitahility for a large sample of listed Americanfirms for the 1975-1994 period. In this paper, I find asignificant negative relation between gross operating incomeand the iuimber of days accounts receivable, inventories andaccounts payable of Belgian firms.

These results suggest that managers can create value for theirshareholders by reducing the number of days accountsreceivable and inventories to a reasonable minimum. Thenegative relation between accounts payable and profitability isconsistent with the view that less profitable firms wait longer topay tlieir bills.

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NOTES

1 The NACE industrial classification serves the same purpose as the wellknown SIC classification, and has been established for industry taxonomywithin the European Union. For details, see Eurostat (1985).

2 The 1991 data were needed to calculate some oi the variables.3 All regressions in the paper were also estimated with net operating income

(sales minus cash an<} nati cusli cost of goods sold) instead of gross operatingprofit as the dependent variable, with similar results.

4 Sliin and Soeneii (199S) use the net tnidi' cycle as a comprehensive measureofWCM. I he net trade cycle is simply [accounts receivable + inventory —accounts payable] x 365/sales. All regressions in this paper that Include thecash conversion cycle were also estimated with the net trade cycle instead ofthe cash conversion cycle. The results (not reported) confirm the estimationresults i>f ihf regressions with the cash conversion cycle.

5 An important feature of the fixed effects model is that it concentrates ondiflerences 'within' firms. Ilie fixed effects model is estimated by (1)computing the means lor each variable h /i'lii, (2) subtracting the firmmeans from each variable and {?>] running a regression on tht- transformeddata. Fixed effects estimation explains why the variables differ from theirmeans, hut not why the fnm means diffier from each other.

6 For a number of fn nis in the sample, a large proportion of total assets arcfixed financial assets, which might influence the results. I re-estimated allpanel regressions for the firms for which the average fixed financial assetsratio over the 1992-1996 period is below ihe median value (0.034). All OLSregressions were re-estimated for the observations for which the fixedfuiancial assets ratio is below the median value (0.024). The results of allthese regressions (not reported) are very similar to the ones reported in thepaper.

REFERENCES

Deloof, M. and M. Jeger (199fi). ' Irade Oedit. Product Quality, andIntragroup Irade: Some European Evidence". Financial Mana^i-menl,Vol. 25, No. 3, pp. 945-(i8.

Emery, G.W. (1984), 'A Pure Financial Explanation for Trade Credit", fournalof Fhianuial and Qiiantilative Analysis, Vol. 9, No. :i pp. 271-85.

Eurostat (1985), NACE: General Industrial Classificatum of Economic Acliviliesivithin tlw European Communities (Brussels, ECSC-EEE-EAEC).

Fisman, k. and I. Love (2001). 'Trade Credit. Financial intermediaryDevelopment and Industry Clrowtb', Unpublished Manuscript ((ColumbiaUniversity).

Gentry, J.A., R. Vaidyanthan and H.W. Lee (1990), 'A Weighted Cash(^.onversion C^ycle', financial Matiagemevl. Vol. 19, No. I, pp. 90-99.

La Porta, R., F. Lopez-de-Silanes, A. Shleifer and R. Vishny (1997),'Legal Determinants of External Finance", Journal of Finance, Vol. 52,pp. 1131-50.

A. Shleifer and R. Vishny (1998), 'Law and Finance, fournal ofPolitical Economy, Vol. lOfi, pp. 1113-55.

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WORKING CAPITAL MANAGEMENT AND PROFITABILITY 5 8 7

Long, M.S., LB. Malitz and S.A. Ravid (1993), T rade Credit, QualityGuarantees, and Product Marketability', Fmancial Management, Vol. 22,No. 4, pp. 117-27.

PiMersen, M.A. and R.G. Rajan (1997), 'Trade Credit: Theories and Evidence',Rn'ien< of Fuiantial Studies, Vol. 10, No. 3, pp. 6(il-91.

Schwartz, R.A. (1974), 'An Kcononiic Model (jf Ttade Cred'il', Joiinuil ofFitiaiina! and Qjiaiitildlive Aria/ysi.s, Vol. 9, No. 4, pp. 64.'i-57.

Shin, H.H. atid L. Soenen (199H), 'Efficiency of Working Capital andCorporate Profitability', Finanrinl Praclire and Education, Vol. 8, No. 2,pp. 37-45.

Svens.son, K. (1997), 'Trade CJedits in Europe loday: Credit Cultures,Payment Morality and Legal Systems', Unpublished Manuscript (LundLlniversity).

•| heunisse H. and M. Jegers (1994), Elementen van Boekhouden en Analyse vanJaanrkeningen (Brussels, VUBPress).

Blackwell Publishing t,td 2(103