International Journal of Managerial Finance

Emerald Article: Effects of working capital management on SME profitability Pedro Juan Garca-Teruel, Pedro Martnez-Solano

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To cite this document: Pedro Juan Garca-Teruel, Pedro Martnez-Solano, (2007),"Effects of working capital management on SME profitability", International Journal of Managerial Finance, Vol. 3 Iss: 2 pp. 164 - 177 Permanent link to this document: http://dx.doi.org/10.1108/17439130710738718 Downloaded on: 10-09-2012 References: This document contains references to 25 other documents Citations: This document has been cited by 8 other documents To copy this document: permissions@emeraldinsight.com

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IJMF 3,2

Effects of working capital management on SME protability

a-Teruel and Pedro Mart nez-Solano Pedro Juan Garc
Deptartment of Management and Finance, Faculty of Economy and Business, University of Murcia, Murcia, Spain
Abstract
Purpose The object of the research presented in this paper is to provide empirical evidence on the effects of working capital management on the protability of a sample of small and medium-sized Spanish rms. Design/methodology/approach The authors have collected a panel of 8,872 small to medium-sized enterprises (SMEs) covering the period 1996-2002. The authors tested the effects of working capital management on SME protability using the panel data methodology. Findings The results, which are robust to the presence of endogeneity, demonstrate that managers can create value by reducing their inventories and the number of days for which their accounts are outstanding. Moreover, shortening the cash conversion cycle also improves the rms protability. Originality/value This work contributes to the literature in two ways. First, no previous such evidence exists for the case of SMEs. Second, unlike previous studies, in the current work robust test have been conducted for the possible presence of endogeneity problems. The aim is to ensure that the relationships found in the analysis carried out are due to the effects of the cash conversion cycle on corporate protability and not vice versa. Keywords Working capital, Prot, Small to medium-sized enterprises Paper type Research paper

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International Journal of Managerial Finance Vol. 3 No. 2, 2007 pp. 164-177 q Emerald Group Publishing Limited 1743-9132 DOI 10.1108/17439130710738718

1. Introduction The corporate nance literature has traditionally focused on the study of long-term nancial decisions. Researchers have particularly offered studies analyzing investments, capital structure, dividends or company valuation, among other topics. But the investment that rms make in short-term assets, and the resources used with maturities of under one year, represent the main share of items on a rms balance sheet. In fact, in the sample used in the present study, current assets of small and medium-sized Spanish rms represent 69 percent of their assets, and at the same time their current liabilities represent more than 52 percent of their liabilities. Working capital management is important because of its effects on the rms protability and risk, and consequently its value (Smith, 1980). Specically, working capital investment involves a tradeoff between protability and risk. Decisions that tend to increase protability tend to increase risk, and, conversely, decisions that focus on risk reduction will tend to reduce potential protability. Gitman (1974) argued that the cash conversion cycle was a key factor in working capital management. Actually, decisions about how much to invest in the customer and inventory accounts, and how much credit to accept from suppliers, are reected in the rms cash conversion cycle, which represents the average number of days between the date when the rm must start paying its suppliers and the date when it begins to collect payments from its
n CajaMurcia is gratefully acknowledged. Financial support from Fundacio

customers. Previous studies have used measures based on the cash conversion cycle to analyze whether shortening this cycle has positive or negative effects on the rms protability. Empirical evidence relating working capital management and protability in general supports the fact that aggressive working capital policies enhance protability (Jose et al., 1996; Shin and Soenen, 1998; for US companies; Deloof, 2003; for Belgian rms; Wang (2002) for Japanese and Taiwanese rms). This suggests that reducing working capital investment is likely to lead to higher prots. These previous studies have focused their analysis on larger rms. However, the management of current assets and liabilities is particularly important in the case of small and medium-sized companies. Most of these companies assets are in the form of current assets. Also, current liabilities are one of their main sources of external nance because they encounter difculties in obtaining funding in the long-term capital markets (Petersen and Rajan, 1997) and the nancing constraints that they face (Whited, 1992; Fazzari and Petersen, 1993). In this respect, Elliehausen and Wolken (1993), Petersen and Rajan (1997) and Danielson and Scott (2000) show that small and medium-sized US rms use vendor nancing when they have run out of debt. Thus, efcient working capital management is particularly important for smaller companies (Peel and Wilson, 1996). In this context, the objective of the current work is to provide empirical evidence about the effects of working capital management on protability for a panel made up of 8,872 small to medium-sized enterprises (SMEs) during the period 1996 to 2002. This work contributes to the literature in two ways. First, no such evidence exists for the case of SMEs in earlier studies. A sample of Spanish SMEs was studied that operate within the so-called continental model, which is characterized by its less developed capital markets (La Porta et al., 1997), and by the fact that most resources are channeled through nancial intermediaries n, 2000). All this suggests that Spanish SMEs have fewer alternative (Pampillo sources of external nance available, which makes them more dependent on short-term nance in general, and on trade credit in particular. As Demigurc-Kunt and Maksimovic (2002) suggest, rms operating in countries with more developed banking systems grant more trade credit to their customers, and at the same time they receive more nance from their own suppliers. The second contribution is that, unlike the previous studies (Jose et al., 1996; Shin and Soenen, 1998; Deloof, 2003; Wang, 2002) in the current work robust tests for the possible presence of endogeneity problems have been applied. The aim is to ensure that the relationships found in the analysis carried out are due to the effects of the cash conversion cycle on corporate protability and not vice versa. Our ndings suggest that managers can create value by reducing their inventories and the number of days for which their accounts are outstanding. Similarly, shortening the cash conversion cycle also improves the rms protability. From this point, the work is structured as follows: in section 2 the theoretical foundations of the study are presented; in section 3 the sample and variables used are described; in section 4 the methodology employed is outlined, and in Section 5 the analyses carried out and the ndings are presented; nally, the main conclusions are discussed.

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2. Theoretical foundations Working capital management is a signicant area of nancial management, and the administration of working capital may have an important impact on the protability and liquidity of the rm (Shin and Soenen, 1998). Firms can choose between the relative benets of two basic types of strategies for net working capital management: they can minimize working capital investment or they can adopt working capital policies designed to increase sales. Thus, the management of a rm has to evaluate the trade-off between expected protability and risk before deciding the optimal level of investment in current assets. On the one hand, minimizing working capital investment (aggressive policies) would positively affect the protability of the rm, by reducing the proportion of its total assets in the form of net current assets. However, Wang (2002) points out that if the inventory levels are reduced too much, the rm risks losing increases in sales. Also, a signicant reduction of the trade credit granted may provoke a reduction in sales from customers requiring credit. Similarly, increasing supplier nancing may result in losing discount for early payments. In fact, the opportunity cost may exceed 20 percent, depending on the discount percentage and the discount period granted (Wilner, 2000; Ng et al., 1999) On the other hand, and contrary to traditional belief, investing heavily in working capital (conservative policy) may also result in higher protability. In particular, maintaining high inventory levels reduces the cost of possible interruptions in the production process and of loss of business due to the scarcity of products, reduces supply costs, and protects against price uctuations, among other advantages (Blinder and Maccini, 1991). Also, granting trade credit favors the rms sales in various ways. Trade credit can act as an effective price cut (Brennan et al., 1988; Petersen and Rajan, 1997), incentivizes customers to acquire merchandise at times of low demand (Emery, 1987), allows customers to check that the merchandise they receive is as agreed (quantity and quality) and to ensure that the services contracted are carried out (Smith, 1987), and helps rms to strengthen long-term relationships with their customers (Ng et al., 1999). However, these benets have to offset the reduction in protability due to the increase of investment in current assets. Most empirical studies relating to working capital management and protability support the fact that aggressive working capital policies enhance protability. In particular, Jose et al. (1996) provide strong evidence for US companies on the benets of aggressive working capital policies. Shin and Soenen (1998) analyze the relation between the net trade credit and protability for a sample of rms listed on the US stock exchange during the period 1974-1994. Their results also show strong evidence that reducing the net trade credit increases rms protability. However, this relationship is not found to be very strong when the analysis is at the level of a specic industry (Soenen, 1993). More recently, Deloof (2003) analyzes a sample of large Belgian rms during the period 1992-1996. His results conrm that Belgian rms can improve their protability by reducing the number of days accounts receivable are outstanding and reducing inventories. Moreover, he nds that less protable rms wait longer to pay their bills. Finally, Wang (2002) analyzes a sample of Japanese and Taiwanese rms from 1985 to 1996, and nds that a shorter cash conversion cycle is related to better operating performance.

Theses results can be partially explained by the fact that there are industry benchmarks to which rms adhere when setting their working capital investment policies (Hawawini et al., 1986). Thus, rms can increase their protability by reducing investment on accounts receivable and inventories to a reasonable minimum, indicated by the benchmarks for their industry. Furthermore, as pointed out by Soenen (1993), cash conversion cycle management tries to collect cash inow as quickly as possible, and to postpone cash outow as long as possible. The result will be the shortening of the cash conversion cycle. 3. Data and variables 3.1 Data The data used in this study was obtained from the AMADEUS database. This database was developed by Bureau van Dijk, and contains nancial and economic data on European companies. The sample comprises small and medium-sized rms from Spain. The selection of SMEs was carried out according to the requirements established by the European Commissions recommendation 96/280/CE of 3rd April, 1996, on the denition of small and medium-sized rms. Specically, those rms meeting the following criteria for at least three years were selected: . fewer than 250 employees; . turnover less than e40 million; and . possession of less than e27 million of total assets. In addition to the application of those selection criteria, a series of lters were applied. Thus, the observations of rms with anomalies in their accounts were eliminated, such as negative values in their assets, current assets, xed assets, liabilities, current liabilities, capital, depreciation, or interest paid. Observations of entry items from the balance sheet and prot and loss account exhibiting signs that were contrary to reasonable expectations were removed. Finally, 1 percent of the extreme values presented by several variables were eliminated. As a result of applying these lters, the nal sample of 38,464 observations was arrived at. In order to introduce the effect of the economic cycle on the levels invested in working capital, information about the annual GDP growth in Spain was obtained from Eurostat. 3.2 Variables In order to analyze the effects of working capital management on the rms protability, the return on assets (ROA) was used as the dependent variable. This variable was dened as the ratio of earnings, before interest and tax, to assets. With regards to the independent variables, working capital management was measured using the number of days accounts receivable, number of days of inventory and number of days accounts payable. In this respect, number of days accounts receivable (AR) is calculated as 365 [accounts receivable/sales]. This variable represents the average number of days that the rm takes to collect payments from its customers. The higher the value, the higher its investment in accounts receivable. The number of days of inventory (INV) was calculated as 365 [inventories/purchases]. This variable reects the average number of days of

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stock held by the rm. Longer storage times represent a greater investment in inventory for a particular level of operations. The number of days accounts payable (AP) reects the average time it takes rms to pay their suppliers. This was calculated as 365 [accounts payable/purchases]. The higher the value, the longer rms take to settle their payment commitments to their suppliers. Considering these three periods jointly, the cash conversion cycle (CCC) was estimated. This variable is calculated as the number of days accounts receivable plus the number of days of inventory minus the number of days accounts payable. Longer cash conversion cycle indicates more time between outlay of cash and cash recovery. Together with these variables, control variables were introduced, such as the size of the rm, the growth in its sales, and its leverage. Size (SIZE) was measured as the logarithm of assets, the sales growth (SGROW) as (Sales1 2 Sales0)/Sales0, the leverage (DEBT) as the ratio of debt to liabilities. Deloof (2003) in his study of large Belgian rms also considered the ratio of xed nancial assets to total assets as a control variable. For some rms in his study such assets are a signicant part of total assets. However the present study focuses on SMEs whose xed nancial assets are less important. In fact, companies in the sample invest little in xed nancial assets (a mean of 3.92 percent, but a median of 0.05 percent). Nevertheless, the results remain unaltered when this variable is included. Furthermore, and since good economic conditions tend to be reected in a rms protability, controls were applied for the evolution of the economic cycle using the variable GDPGR, which measures the annual GDP growth. 3.3 Description of sample Current assets and liabilities have a series of distinct characteristics according to the sector of activity in which the rm operates. Thus, Table I reports the return on assets and number of days accounts receivable, days of inventory, and days accounts payable by sector of activity. The mining industry and services sector are the two sectors with the highest return on their assets, with a value of 10 percent. Firms that are dedicated to agriculture, trade (wholesale or retail), transport and public services, are some way behind at 7 percent. With regard to the average periods by sector, one nds, as one would expect, that the rms dedicated to the retail trade, with an average period of 38 days, take least time
ROA Agriculture Mining Manufacturing Construction Retail trade Wholesale trade Transport and public services Services 0.07 0.10 0.08 0.08 0.07 0.07 0.07 0.10 AR 71.45 116.14 108.12 145.06 38.00 97.92 94.97 86.47 INV 106.38 83.77 96.93 55.76 68.51 73.33 15.27 40.51 AP 83.00 141.37 108.33 145.66 56.87 77.78 110.86 120.42 CCC 95.15 58.54 96.81 55.48 49.55 93.49 2 0.79 6.94

Table I. Mean values, by sector

Notes: ROA measure return on assets; AR number of days accounts receivable; INV number of days inventories; AP number of days accounts payable; CCC cash conversion cycle

to collect payments from their customers. Construction sector rms grant their customers the longest period in which to pay more than 145 days. Next come mining sector rms, with a number of days accounts receivable of 116 days. Inventory is stored longest in agriculture, while stocks are stored least in the transport and public services sector. In relation to the number of days accounts payable, retailers (56 days) followed by wholesalers (77 days) pay their suppliers earliest. Firms are much slower in the construction and mining sectors, taking more than 140 days on average to pay their suppliers. However, as has been mentioned, these rms also grant their own customers the most time to pay them. Considering all the average periods together, it can be seen that the cash conversion cycle is negative in only one sector that of transport and public services. This is explained by the short storage times that are common in this sector. In this respect, agricultural and manufacturing rms take the longest time to generate cash (95 and 96 days, respectively), and hence need the most resources to nance their operational funding requirements. Table II offers descriptive statistics about the variables used for the sample as a whole. These are generally small rms, with mean assets of more than e6 million; their return on assets is around 8 percent; their number of days accounts receivable is around 96 days; and their number of days accounts payable is very similar: around 97 days. Together with this, the sample rms have seen their sales grow by almost 13 percent annually on average, and 24.74 percent of their liabilities is taken up by debt. In the period analyzed (1996-2002) the GDP has grown at an average rate of 3.66 percent in Spain. Table III shows the correlation matrix for the variables dened in the previous section. There is a signicant negative correlation between the return on assets and the number of days accounts receivable, days of inventory and days accounts payable. In the same way, the correlation with the cash conversion cycle is negative and signicant. This demonstrates that paying suppliers and collecting payments from customers earlier, and keeping products in stock less time, are all associated with an increase in the rms protability. Considering the three periods jointly, the negative correlation obtained indicates that shortening the cash conversion cycle is associated

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Variable ROA AR INV AP CCC ASSETS SGROW DEBT GDPGR

Obs. 38464 38464 38452 38371 38371 38464 32674 35237 38464

Mean 0.0792 96.8299 77.2140 97.8090 76.3117 6955.1090 0.1299 0.2474 0.0366

SD 0.0834 55.7682 70.0499 57.3568 90.6413 4461.3940 0.3105 0.1839 0.0075

Median 0.0678 96.2962 59.3042 93.8075 64.7704 13308 0.0862 0.2306 0.0420

10th perc. 0.0041 22.0945 6.8692 24.5344 2 19.6907 2718.5 2 0.0928 0.0098 0.0240

90th perc. 0.1768 165.2533 166.6171 174.9668 190.2017 5541 0.3492 0.5021 0.0430

Notes: ROA measure return on assets; AR number of days accounts receivable; INV number of days of inventory; AP number of days accounts payable; CCC cash conversion cycle; ASSETS value of assets in thousand euros; SGROW sales growth, DEBT nancial debt level; GDPGR annual GDP growth

Table II. Descriptive statistics

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ROA AR INV AP CCC SIZE SGROW DEBT GDPGR 1 0.0805 * * * 0.3555 * * * 0.4523 * * * 0.273 * * * 0.0168 * * * 0.0776 * * * 2 0.0063 1 0.1793 * * * 0.7087 * * * 0.1537 * * * 2 0.0673 * * * 0.1198 * * * 2 0.0103 * * 1 2 0.2757 * * * 0.1168 * * * 0.0211 * * * 2 0.0026 0.0076 1 0.214 * * * 2 0.0545 * * * 0.1423 * * * 2 0.017 * * *

Notes: *Signicant at 90 percent; * * Signicant at 95 percent; * * * Signicant at 99 percent; ROA measure return on assets; AR number of days

accounts receivable; INV number of days of inventory; AP number of days accounts payable; CCC cash conversion cycle; SIZE company size; SGROW sales growth; DEBT nancial debt level; GDPGR annual GDP growth

Table III. Correlation matrix AR INV AP CCC SIZE SGROW DEBT GDPGR 1 0.0607 * * * 0.0581 * * * 0.0425 * * * 1 0.0116 * * 0.0672 * * * 1 2 0.0112 * * 1

ROA

1 2 0.0419 * * * 2 0.0908 * * * 2 0.0324 * * * 2 0.075 * * * 0.006 0.1236 * * * 2 0.216 * * * 0.0306 * * *

with higher protability, which could justify the effect that a more efcient management of working capital has on corporate protability. With regard to the correlations between the independent variables, high values are found only between the cash conversion cycle and number of days accounts receivable (0.45) and number of days of inventory (0.70). This was taken into account in subsequent analyses in order to avoid potential multico linearity problems. 4. Methodology The effects of working capital management on SME protability was tested using the panel data methodology. Specically, estimates were obtained for the following equations: ROAit b0 b1 ARit b2 SIZEit b3 SGROWit b4 DEBTit b5 GDPGRit hi lt 1it ROAit b0 b1 INVit b2 SIZEit b3 SGROWit b4 DEBTit b5 GDPGRit hi lt 1it ROAit b0 b1 APit b2 SIZEit b3 SGROWit b4 DEBTit b5 GDPGRit hi lt 1it ROAit b0 b1 CCCit b2 SIZEit b3 SGROWit b4 DEBTit b5 GDPGRit hi lt 1it Where ROA measures the return on assets, AR the number of days accounts receivable, INV the number of days inventories, AP the number of days accounts payable, CCC the cash conversion cycle, SIZE the company size, SGROW the sales growth, DEBT the debt level, and GDPGR the annual GDP growth. hi (unobservable heterogeneity) measures the particular characteristics of each rm. The parameters lt are time dummy variables that change over time but are equal for all the rms in each of the periods considered. This methodology presents important benets. These include the fact that panel data methodology assumes that individuals, rms, states or countries are heterogeneous. Time-series and cross-section data studies not controlling for this heterogeneity run the risk of obtaining biased results. Furthermore, panel data give more informative data, more variability, less collinearity among variables, more degrees of freedom and more efciency (Baltagi, 2001). Estimating models from panel data requires the researchers rst to determine whether there is a correlation between the unobservable heterogeneity hi of each rm and the explanatory variables of the model. If there is a correlation (xed effects), it would be possible to obtain the consistent estimation by means of the within-group estimator. Otherwise (random effects) a more efcient estimator can be achieved by

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estimating the equation by generalized least squares (GLS). The normal strategy to determine whether the effects are xed or random is to use the Hausman (1978) test under the null hypothesis Ehi =xit 0. If the null hypothesis is rejected, the effects are considered to be xed, and the model is then estimated by OLS. If the null hypothesis is accepted, there would be random effects, and the model is then estimated by GLS. In this way the analysis can achieve a more efcient estimator of b. 5. Results 5.1 Univariate analysis A univariate analysis was conducted rst in order to determine if there are signicant differences in the variables studied between the most and least protable rms. Table IV reports the average value of the variables of the study for each quartile of the variable ROA. The quartiles were calculated annually, so the range of variation of ROA overlaps between quartiles. Subsequently, a parametric difference of means test was carried out based on students t, to determine whether the average values of the fourth quartile are signicantly different from those of the rst. The t statistic appears in the nal column of Table IV. In general, the mean values of the variables studied are signicantly different between the most protable (fourth quartile) and least protable (rst quartile) rms. Thus, in the most protable rms, we observe a shorter number of days accounts receivable, days of inventory and days accounts payable, as well as shorter cash conversion cycles. These rms are also larger, and have superior sales growth and lower leverage. These results are consistent with the correlations presented in Table III.
1st quartile Range ROA ROA AR INV AP CCC SIZE SGROW DEBT 2 0.75 to 0.03 2 0.0060 (0.0116) 97.4920 (93.3828) 81.8856 (61.7877) 97.0031 (92.0959) 82.4314 (66.6797) 8.6663 (8.6523) 0.0844 (0.0442) 0.2635 (0.2483) 2nd quartile 0.03 to 0.07 0.0506 (0.0504) 99.4343 (98.5074) 83.2270 (65.5985) 102.4277 (100.1461) 80.2427 (67.0962) 8.7104 (8.6910) 0.1177 (0.0766) 0.2992 (0.3012) 3rd quartile 0.06 to 0.12 0.0890 (0.0875) 96.2155 (97.4100) 75.5572 (58.3610) 98.3873 (95.0237) 73.4145 (62.9043) 8.7123 (8.6799) 0.1379 (0.0978) 0.2545 (0.2420) 4th quartile 0.10 to 1.05 0.1851 (0.1626) 93.6672 (95.2741) 65.5583 (49.6316) 94.1914 (88.7961) 65.1350 (57.7468) 8.6890 (8.6704) 0.1789 (0.1225) 0.1627 (0.1227) t 187.36 (0.00) 2 4.37 (0.00) 2 15.04 (0.00) 2 3.09 (0.00) 2 12.03 (0.00) 2.29 (0.00) 17.91 (0.00) 2 35.69 (0.00)

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Table IV. Mean values by ROA quartiles

Notes: Comparison of mean values of variables in function of return on assets quartiles; ROA quartiles created annually; Median values in parentheses; ROA measure return on assets; AR number of days accounts receivable; INV number of days of inventory; AP number of days accounts payable; CCC cash conversion cycle; SIZE company size; SGROW sales growth; DEBT nancial debt level; t statistic tests difference of means between 4th and 1st quartile; P-value in parentheses

However, the average values of many of these variables do not vary monotonically when passing from one quartile to the next. This implies that comparing the rst and fourth quarter is not sufcient to describe the relation between return on assets and the independent variables considered here. 5.2 Multivariate analysis Table V presents the results obtained after regressing the equations (1), (2), (3) and (4). The sign and signicance of the relations found is similar to that found in the previous analyses. An SMEs return on assets is reduced by lengthening the number of days accounts receivable, number of days of inventory and number of days accounts payable. This aspect, which is consistent with the results found by Deloof (2003) for large rms, underlines the importance of working capital management for rms. Lengthening the deadlines for clients to make their payments, although it may improve protability because greater payment facilities may raise sales, also negatively affects protability. Thus a more restrictive credit policy giving customers less time to make their payments improves performance. The rms protability can also be improved by reducing the number of days of inventory, so that keeping inventory for less time can also improve protability. Lengthening the number of days accounts payable
1 AR INV AP CCC SIZE SGROW DEBT GDPGR C Hausman Obs. 0.0186 * * * (9.06) 0.0207 * * * (17.09) 2 0.1337 * * * (2 30.12) 0.5408 * (1.63) 2 0.0476 * * (2 2.42) 0.00 30041 0.0128 * * * (6.42) 0.0203 * * * (16.59) 2 0.1354 * * * (2 30.49) 0.8345 * * * (2.52) 2 0.0212 (2 1.08) 0.00 30041 0.0181 * * * (8.92) 0.0210 * * * (17.35) 2 0.1534 * * * (2 34.20) 0.4902 (1.48) 2 0.0379 * (2 1.94) 0.00 30041 2 0.0002 * * * (2 14.93) 2 0.0001 * * * (2 11.98) 2 3 4

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2 0.0002 * * * (2 16.55)

2 0.0001 * * * (2 6.05) 0.0113 * * * (5.68) 0.0215 * * * (17.64) 2 0.1331 * * * (2 29.04) 0.9307 * * * (2.80) 2 0.0203 (2 1.04) 0.00 30041

Notes: t statistic in parentheses; *Signicant at 90 percent; * *Signicant at 95 percent; * * *Signicant at 99 percent; Hausman is p-value of Hausman (1978) test. If null hypothesis rejected, only within-group estimation is consistent. If accepted, random-effects estimation is best option, since not only is it consistent, but it is also more efcient than within-group estimator. ROA is dependent variable; AR measures number of days accounts receivable; INV number of days of inventory; AP number of days accounts payable; CCC cash conversion cycle; SIZE company size; SGROW sales growth; DEBT nancial debt level; GDPGR annual GDP growth. Results obtained using xed-effects estimation. Coefcients of time dummy variables not presented Table V. Effect of working capital management on return on assets (I)

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negatively affects protability. Deloof (2003) justies a similar result by arguing that less protable rms tend to delay payment of their bills. The integrated analysis of the number of days accounts receivable, days of inventory and days accounts payable was carried out using the cash conversion cycle. In contrast to Deloofs (2003) ndings for large Belgian rms, the present study shows that shortening the cash conversion cycle improves an SMEs protability. With reference to the control variables, all of these are signicant. Corporate protability is positively associated with size, so that large size seems to favor the generation of protability. The results do not change if the logarithm of sales is used to measure the size. Growth, which could be an indicator of a rms business opportunities, is an important factor allowing rms to enjoy improved protability, as can be seen in the positive sign for the variable SGROW. At the same time, as one would expect, it improves in periods of higher economic growth. Given that operational nancing requirements differ from one sector to another, all regressions in this paper were also estimated controlling for the sector of activity in which the rms operate. Since the analysis was conducted using panel data methodology it was not possible to introduce sector dummy variables. Thus, and in order to carry out these estimations, the number of days accounts receivable, days of inventory and days accounts payable and the cash conversion cycle were considered to be sectorial characteristics, and so their respective sectorial means were subtracted from the variables AR, INV, AP and CCC. The results presented do not differ when controlling for possible sectorial effects, and they are not presented here because of their similarity. Finally, tests robust to the possible presence of endogeneity problems were carried out. It was important to ensure that the relation found in the analysis carried out here was due to the effects of the cash conversion cycle on corporate protability and not vice versa. Indeed, as Deloof (2003) points out, the results obtained may be affected by potential endogeneity problems, insofar as the number of days accounts receivable, days of inventory and days accounts payable may be inuenced by the rms return on assets, the dependent variable of the work. In this respect, the negative relation between protability and the number of days accounts receivable and days of inventory could be explained if less protable rms incentivize their customers by granting them longer payment deadlines, or if rms with falling sales and consequently declining prots nd their stock levels rising. Likewise, the negative relation found between protability and number of days accounts payable could be a consequence of rms with more problems, and hence lower prots, delaying their payments. Deloof (2003) in his article discusses the endogeneity problems that might exist, but he does not specically control for them. To avoid the possible effect of this endogeneity problem, Table VI reports the results obtained after regressing equations (1), (2), (3), and (4) using instrumental variables. Specically, the rst lag of the variables AR, INV, AP and CCC were used as an instrument. In general, all the results are similar to those of Table V, except those for the variable AP, which now loses signicance. This result casts doubt on the effect that delaying payments to suppliers may have on SME protability. Perhaps, the multiple conicting effects that inuence in the relationship between ROA and accounts payable could explain why this relationship is not signicant.

1 AR INV AP CCC SIZE SGROW DEBT GDPGR C Obs. 0.0332 * * * (4.69) 0.0368 * * * (11.64) 2 0.1133 * * * (2 16.68) 2 0.2457 (2 0.5) 2 0.0929 * * * (2 2.75) 25483 2 0.0008 * * * (2 4.19)

Working capital

2 0.0010 * * * (2 12.47) 2 0.0018 (2 1.38) 0.0254 * * * (8.60) 0.0236 * * * (8.49) 2 0.1080 * * * (2 19.06) 0.3695 (0.97) 2 0.0553 * * (2 2.29) 25483 0.0766 (1.48) 0.0253 (1.55) 2 0.2532 * * * (2 2.90) 2 2.8906 (2 0.97) 2 0.2223 (2 1.28) 25483

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2 0.0006 * * * (2 10.47) 0.0154 * * * (5.87) 0.0314 * * * (12.52) 2 0.0600 * * * (2 6.89) 0.9547 * * * (2.57) 2 0.0322 (2 1.37) 25483

Notes: z statistic in parentheses; *Signicant at 90 percent; * *Signicant at 95 percent; * * *Signicant at 99 percent. ROA is dependent variable; AR measures number of days accounts receivable; INV number of days of inventory; AP number of days accounts payable; CCC cash conversion cycle; SIZE company size; SGROW sales growth; DEBT nancial debt level; GDPGR annual GDP growth. Results obtained from estimation using instrumental variables. Instrument used is rst lag of variables AR, INV, AP, and CCC respectively. Coefcients of time dummy variables not presented

Table VI. Effect of working capital management on return on assets (II)

6. Conclusions Working capital management is particularly important in the case of small and medium-sized companies. Most of these companies assets are in the form of current assets. Also, current liabilities are one of their main sources of external nance. In this context, the objective of the current research has been to provide empirical evidence about the effects of working capital management on the protability of a sample of small and medium-sized rms. To this end, a sample of Spanish rms was used to conduct a study with panel data for SMEs. Data on a panel of 8,872 SMEs was collected, covering the period from 1996 to 2002. The results are similar to those found in previous studies that focused on large rms (Jose et al., 1996; Shin and Soenen, 1998; Wang, 2002; Deloof, 2003), and the analyses carried out conrm the important role of working capital management in value generation in small and medium-sized rms. There is a signicant negative relation between an SMEs protability and the number of days accounts receivable and days of inventory. We cannot, however, conrm that the number of days accounts payable affects an SMEs return on assets, as this relation loses signicance when we control for possible endogeneity problems.

IJMF 3,2

Finally, SMEs have to be concerned with working capital management because they can also create value by reducing their cash conversion cycle to a minimum, as far as that is reasonable.
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Smith, K. (1980), Protability versus liquidity tradeoffs in working capital management, in Smith, K.V. (Ed.), Readings on the Management of Working Capital, West Publishing Company, St Paul, MN, pp. 549-62. Soenen, L. (1993), Cash conversion cycle and corporate protability, Journal of Cash Management, Vol. 13 No. 4, pp. 53-7. Wang, Y.J. (2002), Liquidity management, operating performance, and coroporate value: evidence from Japan and Taiwan, Journal of Multinational Financial Management, Vol. 12, pp. 159-69. Whited, T.M. (1992), Debt, liquidity constraints, and corporate investment: evidence from panel data, Journal of Finance, Vol. 47, pp. 1425-60. Wilner, B.S. (2000), The exploitation of relationships in nancial distress: the case of trade credit, Journal of Finance, Vol. 55, pp. 153-78. Corresponding author a-Teruel can be contacted at: pjteruel@um.es Pedro Juan Garc

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