Proceedings of Annual Spain Business Research Conference
26 - 27 May 2016, Novotel Barcelona City Hotel, Barcelona, Spain,
ISBN: 978-1-925488-05-0
Does Aggressive Working Capital Financing Equal
Profitability?
Elmarie Louw, John H. Hall and Leon M. Brümmer
The way a firm finances its working capital can have a decisive influence on the firm’s
profitability and liquidity. In view of the prominent role that the retail industry plays in the
South African economy, the purpose of this study was to investigate the effect of working
capital management on the profitability of South African retail firms. Eighteen retail firms that
had been listed on the Johannesburg Securities Exchange for a period of nine years (20042012) were analysed and categorised based on the financing approach they follow. The
findings show that a strategy of financing working capital with predominantly short-term debt
appears to improve the profitability of South African retail firms. However, results further
suggested that firm value can be compromised owing to an increase in risk associated with
short-term financing and should be considered by management before implementing a
financing policy.
Field of research: Finance: Corporate Finance
1. Introduction
The challenging status of the global economy highlights the importance of short-term
financial management of any organisation to improve the likelihood of financial
survival.Recent studies suggest that if firms can decrease their investment in working
capital, their profitability will improve (Deloof, 2003; Eljelly, 2004). However, not all studies
presented these findings (Lifland, 2010), suggesting that careful consideration should be
given to the type of firm and the jurisdiction in which it operates. International studies
focussing on the retail industry (Choudhary & Tripathi, 2012) emphasized the importance of
inventory management and subsequently decreasing the investment in working capital,
which will improve profitability. Regardless of the level of investment in working capital that
a firm aims for, working capital has to be financed by short-term or long-term liabilities or a
combination of both.The mix between short-term and long-term financing will be dependent
on factors such as management‟s perception of risk, industry factors and market share.
There are basically two approaches to financing working capital. The first one is an
aggressive financing policy whereby assets are financed predominantly by short-term debt.
The second approach is conservative financing where total liabilities are predominantly
made up of non-current liabilities, which is financially a relatively safe financing approach.
The question arises: which financing approach is the best and should be implemented by
management, financing its working capital with short-term or with long-term debt? Recent
studies have been contradictory in their findings. Chiou, Cheng and Wu (2006:154)
investigated the effect of a conservative financing approach on profitability and found that
increasing the investment in working capital will result in profitability decreasing. However,
Lifland (2010:45) found that following a conservative policy and investing more in current
________________________________________________________________________
Mrs. Elmarie Louw, Prof. John H. Hall, Prof. Leon M. Brümmer, University of Pretoria, South Africa, Financial
Management Department, Private bag x20, Hatfield, 0028, South Africa, Elmarie.louw@up.ac.za,
John.hall@up.ac.za, Leon.brummer@up.ac.za
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Proceedings of Annual Spain Business Research Conference
26 - 27 May 2016, Novotel Barcelona City Hotel, Barcelona, Spain,
ISBN: 978-1-925488-05-0
assets will result in an increase in profitability. Nazir and Afza (2009:19) found that following
an aggressive policy will not improve profitability whereas the results of the Ajiboladeand
Sankay (2013:247) study presented no significant impact. It is clear that this phenomenon
has been tested to some extent in different countries and industries, whichproduced in
different results.
To the best of the researchers‟ knowledge, limited studies have been performed to
investigate the effects of financing approaches on the profitability of South African retail
firms. The retail industry is the largest industry in South Africa (Smith & Fletcher,2009) and
inevitably it has a significant effect on the South African economy.
This study aims to investigate the effect of financing techniques of working capital not only
on the profitability of firms within the South African retail industry, but also to determine
whether a specific working capital financing policy can have an effect on the shareholders‟
wealth of the firm.The results of this study could assist retail firms, in implementing a
financing strategy which will have the best possible effect on their profitability and
shareholders‟ wealth creation.
The following section of the article is divided into four parts. First, a literature review is
presented of prior studies on the topic of financing techniques used to finance working
capital and the effect of the working capital composition on the profitability of a firm. Then
the research design and methodology adopted in the present study are explained. Next, the
results of the hypothesis testing are discussed. Lastly, conclusions are drawn on the
findings of the study and its impact on future research is considered.
2. LITERATURE REVIEW
The importance of working capital is not new to financial literature. Various studies have
found that management thereof will have a direct effect on the profitability of a firm (Bolek,
Kacprzyk & Wolski, 2012;Deloof, 2003;Louw, Hall & Brümmer, 2016; Lifland, 2010). The
investment in the different components of working capitalwill vary from firm to firm. Deloof
(2003) found that shareholder value can be created if managers reduce the value of
accounts receivable and decrease inventories to a reasonable minimum.In his study, Eljelly
(2004) found similar results, indicating that firms that held excess inventory incurred
unnecessary costs,which in turn resulted in lower profitability and would ultimately result in
shareholders‟ value decreasing.
Although most studies suggest that a reduction in working capital will result in profitability
decreasing, there have been studies thatfound the opposite results. One such study was
that of Barine (2012), who concluded that a decrease in the cash conversion cycle CCC
would not have a positive effect on the profitability of Nigerian firms. His results further
suggested that an improvement of working capital did not result in higher levels of returns
to shareholders. Reasons for these contradictory results could be that the sample
coveredonly one year‟s financial results and that all types of industries were included.
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Proceedings of Annual Spain Business Research Conference
26 - 27 May 2016, Novotel Barcelona City Hotel, Barcelona, Spain,
ISBN: 978-1-925488-05-0
Studies on South African data investigating the effect that the composition of working
capital will have on a firm‟s profitability was performed by Erasmus (2010) and Smith and
Fletcher (2009), withboth studies focussing on the South African industrial sector. Results
from South African studies were unanimous, suggesting that decreasing the amount
invested in working capital would result in profitability increasing.
Some international studies have focussed on the importance of inventory management in a
retail firm (Gosman & Kelly, 2003;Choudhary & Tripathi, 2012), highlighting the impact that
working capital management has on the profitability of a firm. There seems to be a gap in
existing literature as this phenomenon has not been tested in the retail industry of South
Africa.The present study‟s first objective is to establish the effect of working capital
management on the profitability of retail firms.
Hypothesis 1. A decrease in the working capital investment will result in profitability
increasing.
Once the required level of working capital is established based on its possible effect on
profitability, the financing policy (aggressive versus conservative) should be selected.
Results from the Russelland Izzo (2009) found that a more aggressive financing policy
would result in more cash being available to management and could create shareholders‟
wealth.However, some studies did find contradictory results, suggesting that an aggressive
policy would result in profitability decreasing (Nazir and Afza, 2009 The contradictory
results could be due to the context being significantly different, as the sample used by Nazir
and Afza (2009) were Pakistani firms whilethe Russelland Izzo study (2009) used firms
from the USA. Hence it appears that the country in which a firm operates will definitely have
an effect on the outcome of the working policy it follows.
Baňos-Caballero, Garcĩa-Teruel and Martĩnez-Solano(2012) investigated the influence of
the financing of working capital on a firm‟s profitability on a sample of non-financial Spanish
SMEs (small and medium enterprises). They found that, from a certain point, the financing
of working capital by means of short-term financing has a negative effect on a firm‟s
profitability and that working capital decisions should be focused not only on the amounts
invested in it, but also on the financing requirements with regard to working capital.
Political, economic and environmental elements of the countryin which a firm operates will
affect its risk profile.The risk preference of management will influence the mix of short- and
long-termfinancing (Duggal & Budden 2015:79). Results from their study found a difference
in the use of working capital across different industries, where industries with greater
uncertainty hold more cash than capital-intensive industries.
It is clear from recent literature that the working capital policy that firm implements will be
dependent on various factors such as the effect on profitability and cash flow, firm size and
the particular industry in which it operates. From this, the following hypothesis for the
present study is derived:
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Proceedings of Annual Spain Business Research Conference
26 - 27 May 2016, Novotel Barcelona City Hotel, Barcelona, Spain,
ISBN: 978-1-925488-05-0
Hypothesis 2. Companies following an aggressive financing approach in managing working
capital will be more profitable than companies following a conservative financing approach.
In the next section, the research method to achieve the research goals will be set out.
3. DATA AND METHODOLOGY
This section describes the research design and methodology used in the study, providing a
rationale for the methodology and research procedures.
The data used in this study was obtained from iNETBFA, a South African supplier of quality
financial data. When the data was obtained for the current study in 2013, there were 21
retail firms listed on the JSE. Three of these firms were newly listed and were excluded
from the data sample. Of the 18 remaining retail firms, 15 had been listed for 9 years or
longer, therefore the study analysed data over a nine-year period, 2004 to 2012, to limit the
amount of missing data. However, some firms included in the sample were not listed for the
total period under review and therefore missing data did exist. This resulted in SPSS
statistics data editor identifying 5 patterns of missing data in the dataset. For each pattern
of missing data identified, SPSS estimated the values using a multiple imputation model.
The original sample of 18 was therefore increased to 108 ((18 firms x 6 (original data
sample + 5 data samples for each missing pattern)). This procedure should not be seen as
a limitation of the present study as the purpose of a multiple imputation model is not to recreate the individual missing values as close as possible to the true ones, but to handle
missing data to achieve valid statistical inference (Schafer, 1997).
The hypothesis tests aimed to determine the effect of a firm‟s working capital management
and thefinancing approach followed on the profitability of retail firms. In the hypothesis, a
number of variables were identified and included in this study, as discussed below.
3.1
Dependent and independent variables
In hypothesis 1,the independent variable was the investment in working capital and was
measured with the cash conversion cycle and was calculated as follows:
Cash conversion cycle = Average age of receivables + average age of inventory – average
age of payables.
Short-term financing (STF) was the independent variable in hypothesis 2in order to
determine the approach that management follows to finance its working capital
(conservative versus aggressive) and to investigate the effect it has on a firm‟s profitability.
Short-term financing was measured as follows:
Short-term financing = Current liabilities ÷ Total liabilities.
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Proceedings of Annual Spain Business Research Conference
26 - 27 May 2016, Novotel Barcelona City Hotel, Barcelona, Spain,
ISBN: 978-1-925488-05-0
The calculations for the various dependent variables used in the hypotheses testswere the
following:
Return on average assets (ROA) = Profit available to ordinary shareholders ÷ total assets.
Return on equity (ROE) = Profit available to ordinary shareholders ÷ ordinary equity. Gross
profit margin (GPM) = Sales – Cost of sales ÷ sales. Economic value added (EVA) = Net
operating profit after tax - (Capital invested x weighted average cost of capital).
3.2
Method of analysis
The variables of each firm were analysed for each year for the total period under review,
2004 to 2012.
The following empirical models were estimated:
 Hypothesis 1:
ROA = β0 + β1CCC +ε
ROE = β0 + β1CCC +ε
GPM = β0 + β1CCC +ε
EVA = β0 + β1CCC +ε
 Hypothesis 2:
STF = β0 + β1ROA + β2ROE + β3GPM + β4EVA + ε
In the above equations, CCC is a measure for the investment in working capital; STF is a
measure of the financing approach followed, ROA is a measure of the return on assets,
ROE is a measure of the return on equity, GPM is a measure of gross profit margin; EVA is
a measure of economic value added and ε represents an error term.
A Pearson product movement correlation calculation was performed to establish whether
the variables were correlated with one another and to determine the nature of any
correlation. Multiple linear regression analysis was performed because the data set was
based on firm-specific observations over time (2004 to 2012) and more than one
explanatory variable was included in the study. The empirical results are discussed in the
next section.
4.
EMPIRICAL RESULTS
The findings presented include an analysis and a discussion of the results from the
statistical tests performed on the data sample.The descriptive statistics presented in Table
1 summarize the variables with their minimum, maximum, median and mean values, as
well as the standard deviation for each variable.
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Proceedings of Annual Spain Business Research Conference
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ISBN: 978-1-925488-05-0
4.1
Descriptive statistics
Table 1: Total sample
CCC days
ROA %
ROE %
GPM %
EVA R
N
Min
Max
Median
Mean
108
108
108
108
108
-21
1
5
8
-50 235
271
38
60
55
974 978
26
17
31
26
243 027
58
19
31
30
371 418
Standard
deviation
78
7
14
13
320 396
The wide range of the different variables was expected for the data sample. The CCC of a
food retailer selling goods predominantly on a cash basis was expected to have a very
short CCC, or even a negative CCC, whereas a retailer of luxury items would have a longer
CCC. This would also be true with regard to profitability as the percentage markup on
products would vary significantly among different types of retailers.
The descriptive statistics above suggest that the range of the values of the variables in the
data sample was large for both the profitability measures and the working capital
measures.
A Pearson correlation calculation was performed to establish whether the variables are
correlated with one another, and to determine the direction of any correlation. The
correlations are set out in Table 2.
Table 2: Correlation between the CCC and the profitability measures
CCC
ROA
ROE
GPM
EVA
CCC
1.00
0.16
-0.49**
0.44**
-0.21*
ROA
ROE
GPM
EVA
1.00
0.26**
0.39**
0.26**
1.00
-0.33**
0.66**
1.00
0.00
1.00
*Significant at a 5% level. **Significant at a 1% level.
With regard to the CCC, a significant correlation (p<.01)was found with the ROE and the
GPM, and a relative significantcorrelation was noted between the CCC and EVA (p<.05).
The two relatively strong correlations (ROE and the GPM with the CCC) indicates that a
decrease in the CCC results in a decrease in the GPM and a decrease in the CCC results
in an increase in both ROE and EVA. The negative correlation between the CCC and ROE,
and between the CCC and EVA, confirms that if a firm reduces its investment in working
capital,the excess funds are invested in more profitable and value-creating investments.
ROE and EVA are both value creation indicators that, based on the results of the present
study, react positively to a reduction in the CCC. In addition, the ROE and EVA are also
positively correlated with each other (p<.01), suggesting a movement in profitability and
value creation in the same direction.
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Proceedings of Annual Spain Business Research Conference
26 - 27 May 2016, Novotel Barcelona City Hotel, Barcelona, Spain,
ISBN: 978-1-925488-05-0
4.2
Multiple regression analyses
Hypothesis 1 postulates that a decrease in the working capital investment will result in
profitability to increase. Results of the multiple regression analysis are shown in Table 3.
Table 3:Multiple regression analysis between CCC and profitability
Intercept
CCC
2
R
2
Adjusted R
Fisher F test
ROA
Estimate t-value
17.922
20.25
0.161
1.675
0.026
0.017
2.806
ROE
Estimate
t-value
35.914
23.761
-0.492**
-5.82
0.242
0.235
33.870
GPM
Estimate
t-value
25.614
18.861
0.436**
4.987
0.190
0.182
24.871
EVA
Estimate
t-value
421943
11.171
-0.212*
-2.236
0.045
0.036
5.001
*Significant at the 5% level**Significant at the 1% level
The regression models used were:
ROE = 35.914 - 0.492(CCC) + ε
GPM = 25.614 + 0.436(CCC) + ε
EVA = 421 943 - 0.212(CCC) + ε
Of the four profitability predictors, three are statistically significant: ROE (p < .01), GPM (p <
.01) and EVA (p < .05). The adjusted R2 is the strongest for ROE at 23.5%, 18.2% for GPM
and the weakest for EVA at 3.6%. The results suggest that an increase in CCC will result in
a statistically significant decrease in ROE (β = -0.492) and in EVA (β = -0.212). Hypothesis
1 postulates that an increase in CCC will result in a decrease in profitability, which is true
asindicated by the decline in ROE and EVA. An increase in CCC will, however, result in an
increase of GPM. This suggests that if firms manage to decrease CCC, GPM will also
decrease but ROE and EVA will increase.
This indicates that, if a firm can reduce its CCC, profitability as measured with EVA will
increase.It can therefore be concluded that a reduction in CCC has a positive effect on
profitability (ROE) and on a firm's value (EVA). Hypothesis 1 is therefore accepted: a
decrease in CCC will result in profitability increasing.
Hypothesis 2postulates that companies following an aggressive financing approach of
working capital will be more profitable than companies following a conservative
approach.The 18 firms included in this study were categorised as „aggressive‟,
„conservative‟ or „neutral‟ based on their use of short-term financing as a percentage of total
external financing. A Boxplot performed on the short-term financing percentage presented
a mean value of 80% and a median of 83%. The lower median indicates that there are a
number of firms using a lower percentage of short-term debt in relationto the other
firms.Four firms were in the 1st quartile and hadshort-term debt ratios ranging between 59%
and 67%and were classified as firms implementing theconservative financing approach.
Four firms were in the 3rd quartile with short-term debt ratios ranging between 90% and
97%, so were therefore classified as firms following anaggressive financing approach. The
ten remaining firms were classified as neutral with short-term debt ratios between 68% and
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Proceedings of Annual Spain Business Research Conference
26 - 27 May 2016, Novotel Barcelona City Hotel, Barcelona, Spain,
ISBN: 978-1-925488-05-0
89%.Table 4presents the short-termdebt classification of each firm included in the data
sample is shown.
Table 4: Financing approach followed by firms
TYPE OF FINANCING APPROACH
Conservative
(59% – 67% short-term debt
ratio)
Firms:
Taste Holdings Limited
Woolworths Holdings Limited
The Foschini Group Limited
JD Group Limited
Neutral
(68% – 89% short-term debt
ratio)
Firms:
Alert Steel Holdings Limited
Combined
Motor
Holdings
Limited
Verimark Holdings Limited
Italtile Limited
Clicks Group Limited
Nictus Limited
Mr Price Group Limited
Rex Trueform Clothing Limited
Truworths International Limited
Lewis Group Limited
Pick n Pay Stores Limited
Aggressive
(90% – 97% short-term debt
ratio)
Firms:
Cashbuild Limited
Massmart Holdings Limited
Shoprite Holdings Limited
The Spar Group Limited
For each category multiple regression analysis was performed, with short-term financing as
the dependent variable and profitability as the independent variable. The summarised
results are shown in Table 5.
Table 5:Multiple regression analyses: short-term financing and profitability
Conservative
Low levels of short-term debt
Intercept
ROA
ROE
GPM
EVA
2
R
2
Adjusted R
Fisher F test
Estimate
0.814
-2.662*
4.110
0.294
-4.973
0.554
0.460
5.900
Estimate
0.819
0.803**
-0.202**
-0.679**
1.000
1.000
35089.49
Neutral
Moderate levels of shortterm debt
t-value
t-value
612.812
1.268
60.465
-2.146
-15.388
1.188
0.237
-191.951
-1.720
Aggressive
High levels of shortterm debt
Estimate
t-value
0.978
45.035
-0.681**
-5.862
-0.869**
-5.409
-0.600**
-5.314
1.936**
9.833
0.741
0.722
39.259
*Significant at the 5% level**Significant at the 1% level
The regression models used were:
Aggressive financing approach = 0.819 + 0.803ROA - 0.202ROE – 0.679EVA + ε
Conservative financing approach = 0.814 – 2.662ROA + ε
Neutral financing approach = 0.978 – 0.681ROA - 0.869ROE - 0.6GPM + 1.936EVA + ε
The R2 is relatively high for all three categories. From the table above it is clear that, if firms
have high levels of short-term financing as a percentage of total financing, their profitability
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Proceedings of Annual Spain Business Research Conference
26 - 27 May 2016, Novotel Barcelona City Hotel, Barcelona, Spain,
ISBN: 978-1-925488-05-0
(ROA) will increase (β = 0.803; p < .01). However, ROA will decrease for firms which have
lower levels of short-term financing as a percentage of total financing (β = -2.662; p < .05).
For the firms having neither high nor low levels of short-term financing as a percentage of
total financing ROA (β = -0.681; p < .01), ROE (β = -0.869; p < .01) and GPM (β = -0.600; p
< .01) profitability measures will decrease as a result of this neutral financing
approach.Figure 1 is a graphical illustration of the results from Table 5.
Figure 1:Comparison of short-term working capital financing methods
Short-term financing
100
100
Adjusted R2
90
80
72
70
ROA
60
50
ROA
ROE
46
40
GPM
ROE
30
20
ROA
EVA
EVA
10
0
Conservative
Neutral
Aggressive
Financing approach
The effect of the different financing approaches on profitability is summarised in Table 6.
Table 6: The effect of the different approaches on profitability
Profitability
measures
ROA
GPM
ROE
EVA
Neutral
Conservative
Aggressive
Moderate
levels of High
Low levels of shortlevels
short-term debt
term debt
short-term debt
The effect on profitability
Decrease
Not significant
Not significant
Not significant
Decrease
Decrease
Decrease
Increase
of
Increase
Not significant
Decrease
Decrease
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Proceedings of Annual Spain Business Research Conference
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ISBN: 978-1-925488-05-0
5. DISCUSSION AND CONCLUSION
Studies in the past have shown that a decrease in working capital will result in profitability
improving. Further to this, by following an aggressive approach to financing working capital,
profitability should increase as more funds are available to invest in more profitable or
productive assets.
Firstly,this study proposed that a decrease in the investment in working capital would result
in profitability increasing. Secondly,it was anticipated that firms following an aggressive
financing approach would be more profitable than those who donot.The hypotheses based
on these arguments were tested by collecting data over a nine-year period (2004-2012) for
South African retail firms. The results suggest that a reduction in working capital will result
in the gross profit margin decreasing, however shareholder value will improve. A reason for
the different directions of correlation between these predictors may be that retail firms
manage their working capital by decreasing their selling prices to increase sales, which
results in their gross profit margin decreasing. This reduction of selling prices will stimulate
sales and increase the number of items sold. The increase in sales could then result in an
increase in other profitability measures (ROE and EVA). Similar results were found by
Bolek et al. (2012:1) who found that a reduction of CCC of Polish firms resulted in the EVA
improving.
This study also found that if a firm follows an aggressive financing approach, profitability
will increase but it will affect shareholders‟ wealth negatively. This can be due to the
associated risk anticipated by shareholders when a firm follows an aggressive financing
approach. The results of the present study are consistent with Russell and Izzo (2009:107),
who found that USA firms following an aggressive approach improved their profitability.
However, Nazir and Afza (2009:27), who did a similar test on Pakistani firms, found that
implementing an aggressive financing approach resulted in profitability decreasing, which
could be the result of volatile economic conditions in Pakistan. Neither of these studies
focussed on only one industry, whereas the present study included only firms from the retail
industry.
Retail organizationswithin the same sector often make use of the same or similar suppliers
and owing to the large size of these retailers they may be in a position to negotiate better
credit terms. In his study, Hill et al. (2010:797) concluded that firms within a concentrated
industry have a better ability to negotiate more favourable credit terms. The four firms in the
present study, classified as using an aggressive financing approach, are relatively large
retailers and are in a position to negotiate favourable credit terms. Owing to the ROA
showing an increase when an aggressive financing approach is followed, it may be that
these firms decrease their investment in assets by shortening the cash conversion cycle
and increasing their return. The four firms (Cashbuild, Massmart, Shoprite and Spar)
classified as using the aggressivefinancing approach are mainly retailers of low cost
household items. Whereas the four firms (Taste, Woolworths, Foschini and JD Group)
classified as using the conservativefinancing approach are retailers of higher value goods.
The asset turnover for firms selling lower cost household items could be more than firms
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Proceedings of Annual Spain Business Research Conference
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ISBN: 978-1-925488-05-0
selling higher value household items because of a possible faster inventory turnover time,
resulting in an increase of ROA. Similar results were found by Duggal and Budden
(2015:81). When using the aggressive financing approach, the inventory levels will be
supported by predominantly short term liabilities, and owing to the fast moving inventory of
the firms classified in this study as using an aggressive financing approach, it was
expected.
However, according to the results of the present study, by following the aggressive
financing approach ROE and EVA will decrease A possible reason could be that the risk
profile of firms implementing an aggressive financing policy will change, and the expected
increase in risk will result in the required rate of return by shareholders to increase. This will
ultimately result in share value decreasing.
No study is without its limitations and this study had a relatively small sample of 18 firms,
but did contain some of the most prominent retailers in South Africa. Despite this limitation,
this study does contribute to the existing body of knowledge by shedding some light on the
working capital management of South African retail firms.
Future research could focus on other sectors within a South African context, for instance
the manufacturing or the service sector or healthcare providers. A comparison could then
be made of working capital management techniques between the retail sector and other
sectors. The effect of working capital management on profitability could also be established
for a larger sample and sectors other than the retail sector. The funding of the working
capital requirement should also be considered in future research, taking into account the
accessibility and cost of external funding.
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Proceedings of Annual Spain Business Research Conference
26 - 27 May 2016, Novotel Barcelona City Hotel, Barcelona, Spain,
ISBN: 978-1-925488-05-0
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