International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 120 March, 2014

http://www.internationalresearchjournaloffinanceandeconomics.com

A Study of the Relationship between Net Trade Cycle and

Liquidity of Small Firms

Haitham Nobanee
Finance and Economics Department, College of Business Administration
Abu Dhabi University, United Arab Emirates
E-mail: nobanee@gmail.com
Tel: +971 2 5015709; Fax: +971 2 5860184

Jaya Abraham
Finance and Economics Department, College of Business Administration
Abu Dhabi University

Abstract
This paper aims to examine the relationship between the efficiency of working
capital management, firm’s size and liquidity. This relation is analyzed using Generalized
Method of Moment System Estimation applied to dynamic panel data for a sample of 5802
non-financial firms listed in the major US markets for the period 1990-2004. The results
show negative and significant relationship between net trade cycle as a comprehensive
measure of the efficiency in working capital management and liquidity for small firms.

Keywords: Working Capital Management; Small Firms; Liquidity

1. Introduction
Globally, the small business sector plays a major dynamic role in creating employment and promoting
technological innovation. Thus small and medium enterprises are crucial for the development of any
economy (Ovia, 2001). Historically, research has proved that small businesses are more financially
vulnerable compared to larger firms during times of economic turbulence. Peel and Wilson (2009)
commented that severe shortage of both long and medium term financing is one of the important
causes contributing to the financial failure of small firms. Early studies in the working capital
management area indicate that small businesses rely mostly on short-term debt and thus are generally
less liquid (Walker and Petty, 1978). Thus sustainability of small firms depends much on the working
capital management strategies.
The size of operations influences most of the financial decisions in a firm and could affect the
perceptions on working capital management. The financial profiles of smaller firms are significantly
different from that of larger corporations. These differences get reflected in the management's attitudes,
including the willingness to assume risk, which significantly impact small businesses. Furthermore, the
size makes these firms more vulnerable to working capital fluctuations (Padachi, 2006). They also
show fluctuating cash flow, focus on strategies to improve marginal returns, maintaining large
amounts of current assets, and indicating poor working capital management practices (Howorth and
Westhead, 2003). These problems are relevant in all life stages of small and medium firms (Dodge,
1994). Financial crisis and economic recession have brought more focus on the working capital
management issues of small firms in the light of their role in economic development.
Efficient working capital management irrespective of the size of the firm calls for a balance
between liquidity and profitability (Shin and Soenen, 1998; Nazir and Afza, 2009; Abuzayed, 2011).
International Research Journal of Finance and Economics - Issue 120 (2014) 9

During periods of economic boom, the goal of profitability assumes more importance (Lo, 2005)
whereas during the periods of economic recession the goal of liquidity and survival attains more
attention (Reason, 2008). Lazaridis and Tryfonidis (2006) added that proper and optimal handling of
the components of working capital by the executives can improve the profitability of their firms.
In this context, this paper aims to contribute to the knowledge of working capital management
and its relation to the liquidity of small firms. The main objective of the paper is to analyze the relation
between the firm’s net trade cycle and liquidity of 5802 U.S. non-financial firms listed in the New
York Stock Exchange, American Stock Exchange, NASDAQ Stock Market, and Over the Counter
Market for the period 1990-2004.

2. Previous Research
Most of the traditional working capital management papers examined the relationship between working
capital management and profitability of firms irrespective of their size. Traditionally, liquidity has been
measured using ratios such as current ratio and the quick ratio. They tend to focus on static balance
sheet figures and hence do not address the liquidity management issues of an on-going firm.
Lamberson (1995) studied the changes in working capital management of small firms in response to
economic changes using the index of annual average coincident economic indicator as a measure of
economic activity. The study found that there is only a negligible relation between working capital
management and economic changes in the case of small firms.
More recent research found that Cash Conversion Cycle (CCC) is an effective measure of
working capital management (Pinches, 1992). Cash conversion cycle is defined as the number of days
from the time the firm pays for its addition to the most basic form of inventory to the time that the firm
collects for the sale of the finished product (Gitman, 1974).
The length of the cash conversion cycle indicates the size of investment in working capital.
CCC analysis thus leads to policy measures to reduce the investments in current assets and thereby
improves the liquidity of the firm. Shin and Soenen’s (1998) popular investigation on the relation
between net trade cycle and profitability of 58,985 firms covering the period 1975-1994 confirms that
a strong and significantly negative relationship exists between net trade cycle and profitability for US
firms. Deloof (2003) showed significant and negative relationship between cash conversion cycle and
profitability of Belgian firms. He suggested that small firms who need to finance increasing amount of
debtors should reduce the number of days of accounts receivables and inventories.
Karaduman et al., (2011) employed panel data methods and reported that a negative relation
exists between CCC and Return on Asset (ROA) for selected companies listed in Istanbul Stock
Exchange. AlShubiri (2011) observed firms in Jordan and argued that funds committed to working
capital can be seen as hidden sources useful for improving the profitability of the firms. Gill
et.al.(2010) concluded that the cost of working capital investments increase while the benefits of
holding more inventories or extending the credit decrease with the increase in the cash conversion
cycle and reflect in the negative relation between corporate profitability and CCC. Nobanee and
Haddad (2014) employed dynamic panel data analysis and reported a negative relation between the
length of the CCC and profitability of Japanese firms.

3. Data and Methodology

The data sample consists of 5802 non-financial firms listed in the New York Stock Exchange,
American Stock Exchange, NASDAQ Stock Market and the Over the Counter Market for the period of
1990- 2004.
The Generalized Method of Moment System Estimation proposed by Arellano and Bover
(1995) and Blundell and Bond (1998), is used in this study as it allows for some of the explanatory
variables to be jointly determined with the dependent variables. It also controls the possible
unobserved province- specific effects correlated with the regressor variables (Nobanee et al., 2011)
10 International Research Journal of Finance and Economics - Issue 120 (2014)

This estimation approach leads to the following estimation equations:

c rit = α + β 1 c rit − 1 + β 2 ltd e it + β 3 s g it + β 4 6 n tc it + ε it (1)

q rit = α + β 1 q rit − 1 + β 2 ltd e it + β 3 s g it + β 4 6 n tc it + ε it (2)
In the above mentioned equation, ( crit ) is the first deference of the current ratio, and ( qrit ) is
the first difference of the quick ratio. The exploratory variables in our two models include the
differenced lagged dependent variables. In model (1) ( crit−1 ) represents the differenced lagged
dependent variable of current ratio, and ( qrit −1 ) in model (2) represents the differenced lagged
dependent variable of the quick ratio. The regressors in the two models also include ( ntcit ) which is the
first difference of net trade cycle measured as [(Receivable + Inventory – Payable) / sales]* 365. The
regressors in the two models also include control variables of ( sgit ) which represents sales growth [(this year’s
sales – previous year’s sales)/ previous year’s sales] and long term debt to equity ratio ( ltdeit ).

4. Empirical Results
This section discusses the results about the relation of the net trade cycle on liquidity for the full
sample and for and different size categories within the sample. Table (1) reports the regression results
of current ratio and quick ratio using the dynamic panel-data Two- steps General Methods of Moment
(GMM) system estimation for the full sample and for different size levels. The results of the lagged
independent variables in the two models indicate that the firm's liquidity in the previous period has a
strong positive effect on the firm’s liquidity in the current period for all study samples. The sale growth
has shown a significant and negative effect on firm’s liquidity for all study periods in model 1 except
for medium companies and insignificant effect on liquidity for all study samples in model 2. The
results also show that the coefficient of net trade cycle in model 1 (where the current ratio is the
dependent variable) is significant and negative for the small size companies and insignificant for all
other study samples. The results of model 2 (where the quick ratio is the dependent variable) also show
similar results except for the coefficient of net trade cycle which is significant and negative for the small
size companies and large size companies and insignificant for all companies and medium companies. These
findings confirm that shortening the net trade cycle improves the liquidity positions of small firms.

Table 1: Two-Steps Results of GMM System Estimation

Dependent Independent All Companies Small Companies Medium Large Companies

Variables Variables Companies
LD .2304061** .1660512** .1908083** .3268002**
LTDE -.0003376 .0051254 -.0005167 -.0068978
CR SG -.0003458* -.0002158** .0010169 -.0378349**
NTC -.0001678 -.0001984* .0004502 .0001806
CONS -.0141986* -.0758811** -.0062227 -.0040115
LD . 2194207** .1507826** .1703937** .2703465**
LTDE -. 0005315 .0040855 .0001276 -.0056662
QR SG 0000397 .0000442 .0013802 -.0038552
NTC -.0006053* -.000584** -.0001045 -.0007051*
CONS -.0110411 -.0912716** -.0097108 .0042231
Table 2 reports the results of dynamic panel-data two- steps GMM system estimation for the relationship between the net
trade cycle and firm's liquidity for an unbalanced sample of 5802 U.S. non-financial firms listed in the New York
Stock Exchange, American Stock Exchange, NASDAQ Stock Market and Over the Counter Market for the period
1990-2004. Dependent variable and independent variables are in the form of first difference. (CR) is the current
ratio , (QR) is the quick ratio, (LD) is the lagged dependent variable, (LTDE) is long term debt to equity, (SG) is
the sale growth, (NTD) is the net trade cycle, (CONS) is the constant.
* Significant at 95% confidence level, * *significant at 99% confidence level.
International Research Journal of Finance and Economics - Issue 120 (2014) 11

5. Conclusion
The purpose of this study was to investigate the relationship between the efficiency of working capital
and liquidity for all companies and of different size levels using Generalized Method of Moment
System Estimation applied to dynamic panel data analysis based on a large sample of non-financial
companies listed in the main US markets for the period 1990-2004. The results show significant and
negative relationship between working capital management and liquidity for small firms. Small firms
can improve their liquidity by shortening their net trade cycle. The results of this study are expected to
help the managers of small firms in achieving a good balance between current assets and current
liabilities. The results of this study are also expected to guide managers of small enterprises in
managing their current assets and current liabilities more efficiently in a way that improves the
liquidity of their enterprises and reduces the needs of expensive external financing. There is much to be
done about working capital of small firms in future. The study recommends that future research can be
conducted on the same topic with different countries and by updating the years of the sample.

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