Effect of Working Capital on Profitability: A Case Study of UK Listed Super Markets (Research Paper Sample)

Effect of Working Capital on Profitability: A Case Study of UK Listed Super Markets
3874 Words
Abstract
Effective working capital management is necessary for business to make adequate profit without compromising liquidity needs of a firm. There is overwhelming evidence from the past studies that working capital is negatively correlated to profitability. Yet, some studies find a positive correlation between the two variables in some cases. This study sough to explore how working capital of 4 UK listed supermarkets affects the profitability of the firms between 2007-2013. The profitability was measured by operating profit margin while working capital has been measured using working capital ratio and quick ratio. Both Pearson correlation and regression analysis was used to test the relationship. Consistent with past studies, a negative correlation is found. However, contrary to the findings of the past studies, the effect of both independent variables on operating profit margin is insignificant. Thus, while supermarkets may need to lower their working capital to raise profits, the detriment in the profit will not be significant even if high working capital is maintained. The sample size was however relatively small compared to past studies, and may have led to sampling errors. Future studies need to enlarge the sample and period of study for more rigor.
Keywords: UK listed supermarkets, operating profit margin, working capital ratio, quick ratio, profitability , working capital
Table of Contents
TOC \o "1-3" \h \z \u Abstract PAGEREF _Toc380131784 \h 2
1.0 Introduction PAGEREF _Toc380131787 \h 5
2.0 Research aims and Objectives, Questions and/or Hypotheses PAGEREF _Toc380131790 \h 6
3.0 Literature Review PAGEREF _Toc380131803 \h 7
4.0 Data and Methodology PAGEREF _Toc380131813 \h 10
5.0 Results PAGEREF _Toc380131824 \h 11
5.1 Profitability and Working Capital Ratio PAGEREF _Toc380131825 \h 11
5.2 Profitability and Quick Ratio PAGEREF _Toc380131831 \h 14
5.3 : Multiple Regression: Working Capital Ratio and Quick Ratio PAGEREF _Toc380131836 \h 16
6.0 Conclusion PAGEREF _Toc380131839 \h 18
7.0 References PAGEREF _Toc380131841 \h 19
List of Tables TOC \h \z \c "Table"
Table 1: Correlations- operating profit margin and working capital ratio PAGEREF _Toc380131959 \h 11
Table 2: Model Summary Operating Profit Margin vs. Working Capital Ratio PAGEREF _Toc380131960 \h 12
Table 3: ANOVAb Operating Profit Margin vs. Working Capital Ratio PAGEREF _Toc380131961 \h 13
Table 4: Coefficientsa -Operating Profit Margin vs. Working Capital Rati PAGEREF _Toc380131962 \h 13
Table 5: Correlations - operating profit margin and quick ratio PAGEREF _Toc380131963 \h 14
Table 6: Model Summary- operating profit margin and quick ratio PAGEREF _Toc380131964 \h 15
Table 7: ANOVAb- - operating profit margin and quick ratio PAGEREF _Toc380131965 \h 15
Table 8: Coefficientsa operating profit margin and quick ratio PAGEREF _Toc380131966 \h 15
Table 9: Model Summary Multiple Regression PAGEREF _Toc380131967 \h 16
Table 10:ANOVAb - Multiple Regression PAGEREF _Toc380131968 \h 16
Table 11:Coefficientsa-Multiple Regression PAGEREF _Toc380131969 \h 17
1.0 Introduction
The value of working capital a firm is tremendously recognised in the existing body of knowledge. Various scholars assert the view that it is through dynamic management of working capital that solvency, liquidity and profitability of a firm is maintained (Filbeck & Krueger, 2005; Mukhopadhyay, 2004; Raheman & Nasr, 2007). Working capital is a descriptive term that refers to the difference between the current assets and current liabilities (WC=CA-CL) (Padachi et al., 2008). In a more specific context, working capital may be described as gross or net where the gross working capital essentially refers to the current assets while the net working capital is the value obtained after subtracting the current liabilities from the current assets (Yadav et al, 2009). As used in this study, the working capital will be referring to the net working capital. According to Arnold (2008), heavy investment in working capital is likely to lead to high level of liquidity in a firm at the expense of profit generation, because there will be low investment in the fixed assets required for profit generation. The profit generation may, however, be compromised because there are limited fixed assets invented in generation of more funds (Deloof, 2003). Besides, it is likely to result into a situation where there are excessive inventories, so that the firm again spends more on operation cost attributed to the management of the excessive inventory associated with high working capital (Raheman & Nasr, 2007). On the other hand, huge investment into working fixed assert and corresponding limited investment in working capital is likely to lead to a situation where there is good potential for profit generation (from the fixed assets) while the firm will be struggling with liquidity and solvency difficulties (Padachi, 2006). This results because the firm will not be having adequate liquidity capacity to meet the short term financial obligation, a scenario that may easily trigger bankruptcy and liquidation process (Vishnani & Shah, 2007).
Against the backdrop of the critical role of working capital, it is vital to ascertain the definitive, and possibly predictable relationship between working capital and profitability so that effective working capital management may e undertaken in a manner that leads to realization of desirable profit standards. This paper explores how working capital affects the profitability of UK listed supermarkets. Whereas the relationship between working capital and profitability has been a subject of massive scholarly attention, the past studies have not been specific to UK supermarkets. The study will therefore add to the existing body of knowledge on the two variables, by taking an industry specific approach to this significant theme. From practical perspective, the study is expected to contribute knowledge necessary for effective liquidity and profitability of supermarkets management, more so in UK 2 where the study is focused.
2.0 Research aims and Objectives, Questions and/or Hypotheses
The primary aim of this research is to examine the effect of working capital on profitability. In both cases, relevant ratios have been used, whereby profitability is measured by operating profit margin while working capital is measured by working capital ratio and quick ratio. Consistent with the overall aim of the study, this study seeks to attain the following specific objectives:
1 To ascertain how UK supermarkets’ working capital ratio correlates with their operating profit margin.
2 To ascertain how UK supermarkets’ quick ratios correlates with their operating profit margin.
3 To determine how the UK supermarkets’ working capital ratio and quick ratio multiply correlates with their operating profit margin.
Thus, the study seeks to address the following research questions:
1 What is the relationship between UK supermarkets’ working capital ratio does correlates with their operating profit margin?
2 What is the relationship between UK supermarkets’ quick ratios correlates with their operating profit margin?
3 What is the relationship between the UK supermarkets’ working capital ratio and quick ratio multiply correlates with their operating profit margin?
Based on the findings of the past studies in other sectors or countries, the study will proceed from the following hypotheses:
* H1: There is a significant negative correlation between UK supermarkets’ working capital ratio correlates with their operating profit margin.
* H2: There is a significant negative correlation between UK supermarkets’ quick ratios correlates with their operating profit margin.
* H3: There is a significant negative correlation between UK supermarkets’ working capital ratio and quick ratio and their operating profit margin.
3.0 Literature Review
The relationship between working capital and profitability has been a subject of intense scholarly attention, even though various studies have used various working capital and profitability metrics. As will be illustrated, majority of the studies have used ratios of these variables rather than the actual figures of working capital and profits. There are, however, a few studies that have non-ratio values to ascertain the relationship.
Shah and Sana’s (2006) study was based on five year profitability and working capital performance of Pakistani oil and gas sector. They used various working capital rations, namely inventory turnover, quick ratio, current ratio, average payment period and average collection period to measure working capital. Gross profit was use as a measure of profitability. Using correlation analysis, the study established a negative correlation between all measures of working capital and gross profit, with the exception of days payable. A loosely similar study was that of Padachi (2006) who used receivables and inventories to explore how working capital management correlated with the performance of a firm. Similar to Shah and Sana (2006), the study established a negative correlation between the working capital variables and firm performance.
Like Shah and Sana (2006), Nasr and Raheman (2007) explored the relationship between working capital and profitability of Pakistani listed companies over a six year period, ranging from 1999-2004. However, in addition to current ratio as a measure of working capital, they also used cash conversion cycle. Another difference was in their measure of profitability; unlike Shah and Sana (2006) who used gross profit, Nasr and Raheman (2007) used net...