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An Optimal Cash Conversion Cycle
Haitham Nobanee
College of Business Administration, Abu Dhabi University, P.O. Box 59911, Abu Dhabi, United Arab Emirates.
E-mail: nobanee@gmail.com;Tel: +971 2 5015709; Fax: +971 2 5860184
Maryam AlHajjar
College of Business Administration, Abu Dhabi University, P.O. Box 59911, Abu Dhabi, United Arab Emirates.
E-mail: maryam.hajjar@gmail.com Tel: +971 2 5015709; Fax: +971 2 5860184
Citation:
Nobanee, H. , AlHajjar, M. (2014) An Optimal Cash Conversion Cycle. International
Research Journal of Finance and Economics. March (120), 13-22.
Abstract
Although the operating cycle, the cash conversion cycle and the net trade cycle are more
comprehensive measures of working capital management compared with traditional measures such as
the current ratio and the quick ratio, these measures do not consider the optimal points of payables,
inventory, and receivables. In this study we suggest more accurate measures of the efficacy of
working capital management where optimal levels of inventory, receivables, and payables are
identified, and total holding and opportunity costs are minimized. In this paper, we suggest an optimal
operating cycle, an optimal cash conversion cycle, and an optimal net trade cycle as more accurate
and comprehensive measures of working capital management.
Keywords: Working Capital Management; Optimal Cash Conversion Cycle;
Optimal Net Trade Cycle; Optimal Operating Cycle; Profitability
1. Introduction
Historical experience shows that an average firm has 40% of its assets employed in current
assets, and the typical corporate financial manager spends 80% of her/his time in managing
day-to-day short term financial resources (Dandapani, et al, 1993). Yet, the traditional focus in
corporate finance had been on long-term financial decisions, particularly capital structure,
dividends, investments, and company valuation decisions. However, the recent trend in
corporate finance is the focus on working capital management (Ganesan, 2007). Some of the
existing literature suggests that companies, on average, over-invest in working capital. For
example, U.S. corporations had roughly $460 billion unnecessarily tied up in working capital
(Moussawi et al, 2006).
The basic elements of working capital management are based on speeding up
collections and slowing down disbursements (Nobanee et al, 2011). This working capital
management principle is based on the traditional concepts of the operating cycle, the cash
conversion cycle, the weighted cash conversion cycle and the net trade cycle. The operating
cycle of a firm is the length of time between the acquisition of raw materials and the
collections of receivables associated with the sales of finished goods. Although the operating
cycle considers the financial flows coming from receivables and inventory, it ignores the
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financial flows coming from account payables. In this regard, Richards and Loughlin (1980)
suggest a cash conversion cycle that considers all relevant cash flows coming from
operations. The cash conversion cycle can be defined as the length of time between cash
payments for purchase of raw materials and the collection of receivables associated with the
sale of finished goods. However, the cash conversion cycle focuses only on the length of time
of financial flows engaged in the cycle and does not consider the amount of funds committed
to a product as it moves through the cash conversion cycle. Therefore, Gentry, Vaidyanathan,
and Wai (1990) suggest a weighted cash conversion cycle that takes into consideration both
the timing of financial flows and the amount of funds committed to each stage of the cycle.
The weighted cash conversion cycle can be defined as the weighted number of days funds are
committed in receivables, inventories and payables, less the weighted number of days
financial flows are deferred to suppliers. In addition to its complexity, one limitation of the
weighted cash conversion cycle is the break-up of inventory into three components: raw
materials, work in process, and finished goods is not always available for outside
investigators; hence, Shin and Soenen (1998) suggest the net trade cycle as an alternative
measure for working capital management. They argue that the cash conversion cycle is an
additive concept wheareas the denominators for the inventory conversion period, the
receivable collection period, and the payable deferral period are all different, making the
addition of the cash conversion cycle components not really useful. They suggest equalizing
the denominators of the inventory conversion period, the receivable collection period, and the
payable deferral periods
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. The net trade cycle is basically equal to the cash conversion cycle
where the three components of the cash conversion cycle (receivables, inventory, and
payables) are articulated as a percentage of sales. This makes the net trade cycle easier to
calculate and less complex compared with the cash conversion cycle and the weighted cash
conversion cycle. Shin and Soenen (1998) also argue that the net trade cycle is a better
working capital efficiency measure compared with the cash conversion cycle and the
weighted cash conversion cycle because it indicates the number of "day sales" the company
has to finance its working capital and the working capital manager can easily estimate the
financing needs of working capital expressed as a function of the expected sales growth.
Although the operating cycle, the cash conversion cycle, the weighted cash
conversion cycle and the net trade cycle are powerful measures of working capital
management in contrast to the static traditional ratios such as the current ratio and the quick
ratio that are inadequate and misleading in the evaluation of the firm's liquidity, these cycles
do not consider the optimal levels of receivables, inventories, and payables. The traditional
link between these cycles (the operating cycle, the cash conversion cycle, the weighted cash
conversion cycle and the net trade cycle) and the firm's profitability, market value and
liquidity is that shortening these cycles increases the firm’s profitability, liquidity, and market
value (see, Shin and Soenen, 1998; Gentry, et al, 1990; Richards and Loughlin, 1980, Deloof,
2003). Fore example; a short cash conversion cycle indicates that the company manages and
processes inventory more quickly, collects cash from receivables more quickly and slows
down cash payments to suppliers. This increases the efficiency of the internal operations of a
firm and results in higher profitability, higher net present value of cash flows, and higher
market value of a firm (Gentry, et al, 1990; AlShattarat et al, 2010).
The cash conversion cycle and the net trade cycle can be shortened by reducing the
time that cash is tied up in working capital. This could happen by shortening the inventory
conversion period via processing and selling goods to customers more quickly, or by
shortening the receivable collection period via speeding up collections, or by lengthening the
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The cash conversion cycle formula is: (accounts receivables/sales)*365 +(inventory/CGS)*365 – (accounts
payables/CGS)*365
The net trade cycle formula is :{accounts receivable + inventory – accounts payables}*365/sales
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payable deferral period via slowing down payments to suppliers. On the other hand,
shortening the cash conversion cycle could harm the firm's profitability; reducing the
inventory conversion period could increase the shortage cost, reducing the receivable
collection periods could make the company losing its good credit customers, and lengthening
the payable period could damage the firm's credit reputation. A shorter cash conversion cycle
(net trade cycle and operating cycle) is associated with a high opportunity cost, and a longer
cash conversion cycle (net trade cycle and operating cycle) is associated with a high carrying
cost. Achieving the optimal levels of inventory, receivables, and payables will minimize both
the carrying cost and opportunity cost of inventory, receivables, and payables and maximize
sales, profitability and market value of firms. In this regard, we suggest an optimal cash
conversion cycle, an optimal net trade cycle, and an optimal operating cycle as more accurate
and comprehensive measures of working capital management.
1.1. Optimal Operating Cycle
The optimal operating cycle is an additive function. It measures the optimal length of
inventory conversion period plus the optimal length of receivables collection period (see
equation 1 and 2) bellow:
Optimal Operating Cycle = Optimal Inventory Conversion Period + Optimal
Receivables Collection Period ………………… …………………………… (1)
Optimal Operating Cycle = (Optimal Inventory/Cost of Goods Sold)*365 +
(Optimal Receivables/ Sales)*365
………………………………………………………..…... (2)
1.2. Optimal Cash Conversion Cycle
The optimal cash conversion cycle is an additive function. It measures the optimal length of
the inventory conversion period plus the optimal length of the receivables collection period
less the optimal length of payables deferral period (see equation 3 and 4) bellow:
Optimal Cash Conversion Cycle = Optimal Inventory Conversion Period + Optimal
Receivables Collection Period – Optimal Payable Deferral Period……………….(3)
Optimal Cash Conversion Cycle = (Optimal Inventory/Cost of Goods Sold)*365 +
(Optimal Receivables/ Sales)*365 – (Optimal Payables/Cost of Goods sold)*365..(4)
1.3. Optimal Net Trade Cycle
The optimal net trade cycle is also an additive function. It measures the optimal length of
inventory conversion period plus the optimal length of receivables collection period less the
optimal length of payables deferral period, the optimal inventory conversion period and
optimal length of payable deferral period are expressed in a day’s sales. (see equation 5, 6
and 7 below:
Optimal Net Trade Cycle = Optimal Inventory Conversion Period + Optimal
Receivables Collection Period – Optimal Payables Deferral Period…………….……
(5)
Optimal Net Trade Cycle = (Optimal Inventory/Sales)*365 + (Optimal Receivables/
Sales)*365 – (Optimal Payables/Sales)*365………………………………………...(6)
Or
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Optimal Net Trade Cycle = {(Optimal Inventory + Optimal Receivables - Optimal
Payables)*365}/Sales…………………………………………………………….….(7)
1.4. Optimal Inventory Level
One of the best-known optimal inventory level approaches is the Economic Order Quantity
model (EOQ)
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(see Ross et al, 2008). The basic idea of this model is plotting the total cost of
carrying inventory with different inventory quantities as in Figure 1. As shown in Figure 1
below, inventory carrying costs increase and inventory shortage costs decrease as inventory
levels increase and we attempt to identify the minimum total cost point Q*.
Figure 1: Optimal Inventory Level
1.5. Optimal Accounts Receivable
An optimal credit amount could be identified by the point where the incremental cash flows
from increased sales stimulated by offering credit to the customers equals the costs of
carrying additional investments in account receivables (Ross et al, 2008). Therefore, an
2
There are many ways to find the optimal inventory level, in addition to the classic EOQ model. Optimal
inventory level could be identified using Shortages Permitted Model, Production and Consumption Model,
Production and Consumption with Shortages Model , and EOQ with Shortages and Lead Time. Moreover, there
are many other new optimal inventory models developed in the recent literature, such as the EOQ model under
retailer trade credit policy suggested by Huang and Hsu (2008). This model identifies the optimal inventory
level under permissible delay in payments where the supplier would offer the retailer trade credit and the retailer
would also offer a trade credit to her/ his clients.
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optimal amount of credit extended could be identified by plotting the total cost of granting a
credit with different amounts of credit extended as in Figure 2.
Figure 2: Optimal Receivables
As shown in Figure 2, carrying costs increase and opportunity costs decrease as the amount
of credit extended increases. We attempt to identify the minimum total cost point $*. The
carrying costs associated with granting a credit essentially come from either the costs of cash
discounts offered by the firm who grant the credit to its customers who pay early, or it could
come from losses of bad debts, or it could be associated with managing credit or credit
collections or running the credit department. Opportunity cost is the additional profit that
results from credit sales that are lost because credit is not granted (Ross et al, 2008)
3
.
1.6. Optimal Accounts Payable
by out difficult to quantify as pointed are , theyeasy to identifyare of credit smany optimal amount Although
3
Ross et al, (2008). There were some attempts to quantify the optimal amount of credit as in the study of
Liebman (1972).
Carrying Costs
$*
Optimal Amount of Credit
Opportunity Costs
Total Costs
Amount of Receivables
Cost of Granting Receivables
Source: Ross, Westerfield, and Jordan, 2008, Corporate Finance Fundamentals, Eighth's Edition, McGraw Hill.
Carrying costs are increased when the amount of receivables granted are increased.
Opportunity costs are the lost sales resulting from not granting credit. These costs decreased when the amount of
receivables are increased.
Total costs are the sum of currying and opportunity costs.
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Trade credit is an alternative financing choice to the short-term borrowing. While trade credit
is “free”, short-term borrowing is “costly”. When a company extends its trade credit by
increasing its accounts payables it saves the cost of short-term borrowing. This means an
increase of accounts payable is associated with a decrease of short-term borrowing cost or
“opportunity cost of short-term borrowing”. When the accounts payable increases, some
other kind of cost also increases. For example, the carrying cost which is the cost of
managing and running the payable department increases as the account payable increases.
Other costs could also increase when payable increases accounts. For example, the possibility
that a company could delay its payment to suppliers increases when the company extends its
trade credit. This could damage the company’s credit reputation and it could lose some of the
cash discounts offered by its suppliers.
As shown in Figure 3, carrying costs increase and opportunity costs of short-term borrowing
decrease as accounts payable amount increases. We attempt to identify the minimum total
cost point $*
4
.
Figure 3: Optimal Payables
2. Data and Methodology
We examine the relationship between the cash conversion cycle and profitability for the full
sample period of 1990-2004 and for subsample periods. We hypothesize that the coefficients
of the cash conversion cycle are negative and significant for the full period and for all sub
periods. This indicates that the company manages and processes inventory more quickly,
some attempts to quantify the optimal amount of payables by Nerville and Tavis, (1973). also There were
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Carrying Costs
$*
Optimal Amount of Payables
Opportunity Cost
of Short-Term
Borrowing
Total Costs
Amount of Payables
Cost of Payables
Carrying costs and delay of payments costs increase when the amount of payables increases.
Opportunity costs of borrowing decreases when the amounts of payables increase.
Total costs are the sum of carrying and opportunity costs.
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collects cash from receivables more quickly and slows down cash payments to suppliers. This
increases the efficiency of the internal operations of a firm and results in higher profitability.
In contrast, if the coefficients of the cash conversion cycle in the full periods or the sub
periods are significant and positive, this indicate that shortening the cash conversion cycle
could harm the firm's profitability because reducing the inventory conversion period could
increase the shortage cost, reducing the receivable collection periods could lead to the
company’s loss of good credit customers, and lengthening the payable period could damage
the firm's credit reputation. We apply a similar analysis for the net trade cycle and the
operating cycle. If the coefficients of the cash conversion cycle, the net trade cycle and the
operating cycle are not significant and negative in all study periods, this signifies the
importance of identifying the optimal cash conversion cycle, the optimal net trade cycle and
the optimal operating cycle as more accurate measures of working capital management. A
dynamic panel data analysis is used to test for the relationships between our variables. Our
analysis is based on a sample of 5802 U.S. 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 1990-2004 (87030 firm-year observations).
To examine the relationships between our study variables we employ a Generalized
Method of Moment System Estimation (GMM) applied to dynamic panel data proposed by
Arellano and Bover (1995) and Blundell and Bond (1998). This estimation approach leads to
the following estimation equations:
ititititititititit cccpdpicprcpsgtdeqroisois it
87654321 1
(8)
itititititititititit nccpdpicprcpsgtdeqroisois
87654321 1
(9)
ititititititititit ocicprcpsgtdeqroisois
11 8654321
(10)
Where (
it
ois
) is the first deference the operating income to sales, the exploratory variables in
our model includes (
it
ois
) which is the differenced lagged dependent variable of operating
income to sales, (
it
rcp
) is the first difference of receivable collection period that measures the
average number of days from the sale of goods to collection of resulting receivables. It is
calculated as [(account receivable/sales) *365]. (
it
icp
) is the first difference of the inventory
conversion period which is the length of time on average needed to convert raw materials into
finished goods and for the sale of these goods. It is calculated as [(inventory/cost of good
sold)*365]. (
it
pdp
) is the first difference of the payable deferral period which is the average
length of time needed to purchase goods and the payments made for them. It is calculated as
[(account payable/cost of goods sold)* 365]. (
it
ccc
) is the first difference of the cash
conversion cycle which is calculated as [Receivable collection period + Inventory conversion
period - Payable deferral period]. (
it
ncc
) is the first difference of the net trade cycle which is
calculated as [Receivable collection period + Inventory conversion period - Payable deferral
period] where inventory conversion period and payable deferral period are expressed in the
form of day’s sales. (
it
oc
) is the first difference of the operating cycle which is simply
calculated as [Receivable collection period + Inventory conversion period]. The exploratory
variables in our models also include some control variables such as (
it
sg
), which represents
sales growth [(this year’s sales – previous year’s sales)/ previous year’s sales] and total debt
to equity ratio (
it
tde
). In addition, we examine the relationship between profitability and
8
liquidity using a traditional measure of liquidity - the quick ratio (
it
qr
). In this study we
hypothesize that shortening the length of the cash conversion cycle improves the company’s
performance. We also hypothesize that shortening the length of the net trade cycle improves
the company’s performance, and shortening the length of the operating cycle improves the
company’s performance. This means that the coefficient of the cash conversion cycle, the
coefficient of the net trade cycle, and the coefficient of the operating cycle should be
significant and negative for the whole period of the study and also for the sub periods. We
also hypothesis that shortening the length of the receivable collection period increases the
company’s performance, and we expect the coefficient of the receivables collection period to
be significant and negative for the whole period of the study and also for the sub periods.
Further, we hypothesize that shortening the length of the inventory conversion period
increases the company’s performance, and we expect the coefficient of the inventory
conversion period to be significant and negative for the whole period of the study and also for
the sub periods. Finally, we hypothesize that lengthening the payable deferral period should
increase the company's performance, and the coefficient of the payable deferral period should
be significant and positive for the full study period and also for the sub periods.
3. Empirical Results
In this section we present our estimation results concerning the factors of working capital
management affecting corporate performance. The estimated coefficients based on equation
(8) reported in table (1) show that the length of the cash conversion cycle (
it
ccc
) has a
negative and significant impact on the firm’s performance for the whole period. The results
also show that the coefficient of the cash conversion cycle for the first period is positive and
insignificant, that it is positive and insignificant for the second period, and it is negative and
significant for the third period. These results indicate that shortening the cash conversion
cycle does not always improve the firm’s profitability. The results also show that the
coefficients of the payable deferral period (
it
pdp
) for the whole period and all sub periods of
the study are significant and negative; this indicates that lengthening the payable deferral
periods reduces the firm’s performance instead of improving it. The results reported in table
(1) show that the coefficients of the receivables collection period (
1
it
rcp
) and the length of
the inventory conversion period (
1
it
icp
) had a positive rather than a negative impact on the
company’s performance measured using the operating income to sales (
it
ois
). This indicates
that shortening the cash conversion cycle (
1
it
ccc
) shortening the receivable collection period
(
1
it
rcp
) and shortening the inventory conversion period (
1
it
icp
) by reducing the time that
cash is tied up in working capital and by speeding up collections results in lower operating
income to sales (
it
ois
). However, the results in the existing literature show that the cash
conversion cycle (
1
it
ccc
), the receivable collection period (
1
it
rcp
), and the inventory
conversion period (
1
it
icp
) had a negative impact on the company's performance (
it
ois
)
(Deloof, 2003). The positive sign of the coefficient of the inventory conversion period
(
1
it
icp
) indicates that shortening the inventory conversion period (
1
it
icp
) could increase the
stock out cost (or shortage cost) of inventory which results in losing sales opportunities and
leads to poor performance. Similarly, the positive sign of coefficient of the receivable
collection period (
1
it
rcp
) indicates that shortening the receivable collection period (
1
it
rcp
)
makes the company to lose its good credit customers that results in a reduction in the
company’s sales. The results also show that the payable deferral period (
1
it
pdp
) had a
9
significant negative impact on performance (
it
ois
) instead of having a positive impact as
reported in the existing literature (Deloof, 2003). The negative sign of the payable deferral
period (
1
it
pdp
) implies that slowing down payments to suppliers causes damage to the
company’s credit reputation and results in a poor performance. The lagged operating income
to sales (
1
it
ois
) indicates that the company's performance in the previous period has a strong
positive effect on its performance in the current period. We also examine whether the
company’s performance is affected by other variables; the results show that an increase in the
quick ratio (
it
qr
) is negatively associated with the firm’s performance (
it
ois
). This result
certifies the traditional trade-off between profitability and liquidity. Sales growth (
it
sg
) is
positively related to the firm’s performance (
it
ois
). The results show that total debt to equity
(
it
tde
), as a measure of capital structure, is not significantly related to profitability (
it
ois
).
The results of the Sargan test does not reject our instrument used, and the results of Arellano-
Bond test that the average autocoveriance in residuals of order 1 and 2 is 0 which does not
reject the null hypothesis of no second-order serial correlation.
Table 1: Two-Step Results of GMM System Estimation for the Relationship between Working
Capital Management Measures Including the Cash Conversion Cycle and the Firm's Performance
Dependent Variable: OIS
Coefficients
Exploratory
Variables:
Full period 1990-2004
First period 1990-1994
Second period 1995-1999
Third period 2000-1994
LOIS
0.1093742**
0.3891377
0.1754836**
0.0521925**
QR
-0.0209257*
0.0071134
-0.0309328*
0.0572961*
TDE
6.04e-08
-2.97e-07
-4.49e-07
5.30e-07
SG
0.0027879
0.004226
0.0293055
0.0018839
RCP
-0.0169117**
0.0002769
-0.001792
-0.0169529**
ICP
-0.0015936**
0.0011912
0.0023982**
-0.0020329
PDP
-0.0057129**
-0.0014022
-0.0038863**
-0.0069267**
CCC
-0.0024813**
-0.0006869
-0.0014406**
-0.002616**
Constant
-0.0196783**
0.0017403
0.0016587
-0.0401378*
Sargan
101.76
4.17
24.47
63.14
Order 1
-1.16
-1.67
-1.53
-1.14
Order2
0.79
-1.03
0.16
0.87
Note: * significant at 95% confidence level, * *significant at 99% confidence level
Table 1 reports the results of Arellano-Bond dynamic panel-data two- steps GMM system estimation for the relationship between the components of
working capital management and the firm's performance 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 the Over The Counter Market for the period 1990-2004 and the three sub-
periods. The dependent variable and all the independent variables are in the form of first difference. (OIS) is the dependent variable of operating
income to sales, the exploratory variables are: (LOIS) is the lagged operating income to sales, (QR) is the quick ratio, (TDE) is the total debt to
equity ratio, (SG) is the sales growth, (RCP) is the receivables collection period, (ICP) is the inventory conversion period, (PDP) is the payable
deferral period, and (CCC) is the cash conversion cycle. Sargan is the Sargan test of over-identifying restrictions, P> Chi2. Order 1 is the Arellano-
Bond test that average autocovariance in residuals of order 1 is 0, and Order2 is the Arellano-Bond test that average autocovariance in residuals of
order 2 is 0.
10
Table 2: Two-Steps Results of GMM System Estimation for the Relationship between Working
Capital Management Measures Including the Net Trade Cycle and the Firm's Performance
Dependent Variable: OIS
Coefficients
Exploratory
Variables:
Full period 1990-2004
First period 1990-1994
Second period 1995-1999
Third period 2000-1994
LOIS
-0.8633548**
-1.877821**
.0608843**
-0.0459073
QR
-0.2516475**
-0.0145362**
-.1053771**
-0.0037797
TDE
-1.37e-08
7.52e-09
-6.87e-06
3.12e-06
SG
-0.2422801**
-0.5252024**
.0156748**
-0.0167827
RCP
0.0082238**
0.002182**
.0039755**
0.0058274
ICP
-0.0302019**
-0.0020263**
-.01653**
-0.0174298
PDP
-0.0045405**
-0.0112586**
-.0036845**
-0.0038884
NTC
0.0012844**
-0.0003207**
-.0021981**
-0.001714
Constant
-0.025087**
-0.0502549**
-.0201984**
-0.0079269
Sargan
95.34
118.19*
108.15
124.41*
Order 1
-1.00
-1.26
-1.12
-1.49
Order2
-0.48
-0.97
-1.01
-1.50
Note: * significant at 95% confidence level, * *significant at 99% confidence level
Table 1 reports the results of Arellano-Bond dynamic panel-data two- steps GMM system estimation for the relationship between the components of
working capital management and the firm's performance 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 the Over The Counter Market for the period 1990-2004 and the three sub-
periods. The dependent variable and all the independent variables are in the form of first difference. (OIS) is the dependent variable of operating
income to sales. The exploratory variables are: (LOIS) is the lagged operating income to sales, (QR) is the quick ratio, (TDE) is the total debt to
equity ratio, (SG) is the sales growth, (RCP) is the receivables collection period, (ICP) is the inventory conversion period, (PDP) is the payable
deferral period, and (NTC) is the net trade cycle. Sargan is the Sargan test of over-identifying restrictions, P> Chi2. Order 1 is the Arellano-Bond
test that average autocovariance in residuals of order 1 is 0, and Order2 is the Arellano-Bond test that average autocovariance in residuals of order 2
is 0.
Table 3: Tow-Steps Results of GMM System Estimation for the Relationship between Working
Capital Management Measures Including the Operating Cycle and Firm's Performance
Dependent Variable: OIS
Coefficients
Exploratory
Variables:
Full period 1990-2004
First period 1990-1994
Second period 1995-1999
Third period 2000-1994
LOIS
0.3568988**
-0.2534245**
0.643047**
0.2360323**
QR
0.0592325**
0.1027286**
-0.0325934**
-0.0181161**
TDE
-7.14e-07
6.18e-06**
-5.46e-06*
4.56e-08
SG
0.1050283**
-0.0413975**
0.0875618**
0.1721182**
RCP
-0.0020604**
-0.0038678**
-0.0041003**
0.0020457**
ICP
0.0015482**
0.005273**
0.0020449**
-0.0031134**
OC
-0.0013115**
-0.0017843**
-0.0019953**
-0.0001568
Constant
0.0033737*
-0.0049928**
0.0031675*
-0.0023532*
Sargan
110.81
99.26
90.10
124.34*
Order 1
-2.02*
-0.91
-2.09*
-0.99
Order2
-1.01
0.85
0.61
-1.16
Note: * significant at 95% confidence level, * *significant at 99% confidence level
Table 1 reports the results of Arellano-Bond dynamic panel-data two- steps GMM system estimation for the relationship between the components of
working capital management and the firm's performance 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 the Over The Counter Market for the period 1990-2004 and the three sub-
periods. The dependent variable and all the independent variables are in the form of first difference. (OIS) is the dependent variable of operating
income to sales, the exploratory variables are: (LOIS) is the lagged operating income to sales, (QR) is the quick ratio, (TDE) is the total debt to
11
equity ratio, (SG) is the sales growth, (RCP) is the receivable collection period, (ICP) is the inventory conversion period, (PDP) is the payable
deferral period, and (OC) is the operating cycle. Sargan is the Sargan test of over-identifying restrictions, P> Chi2. Order 1 is the Arellano-Bond
test that average autocovariance in residuals of order 1 is 0, and Order2 is the Arellano-Bond test that average autocovariance in residuals of order 2
is 0.
The results of the empirical analysis of this paper suggest that shortening the cash conversion
cycle decreases rather than increases firm’s profitability. This signifies the importance of
identifying an optimal length of the cash conversion cycle where the total holding and
opportunity costs of current assets are minimized and the profitability of firms is maximized.
The results of the net trade cycle and the operating cycle can be interpreted similarly for the
results of the cash conversion cycle.
4. Conclusion
One of comprehensive measures of working capital management efficiency is the cash
conversion cycle that considers all financial flows associated with inventory, receivables and
payables. The traditional link between the cash conversion cycle and the firm's profitability is
that reducing the cash conversion cycle by reducing the time that cash is tied up in working
capital improves the firm’s profitability. This could happen by shortening the inventory
conversion period via processing and selling goods to customers more quickly, by shortening
the receivables collection period by speeding up collections, or by lengthening the payable
deferral period via slowing down payments to suppliers. On the other hand, shortening the
cash conversion cycle could harm the firm's profitability; reducing the inventory conversion
period could increase the shortage cost, reducing the receivables collection period could
make the company to lose its good credit customers, and lengthening the payable period
could damage the firm's credit reputation. However, achieving the optimal levels of
inventory, receivables and payables will minimize the carrying cost and opportunity cost of
holding inventory, receivables, and payables and lead to an optimal length of the cash
conversion cycle. Hence, we recommend the optimal cash conversion cycle, the optimal net
trade cycle and the optimal operating cycle as more accurate and comprehensive measures of
working capital management that maximizes sales, profitability and market value of firms.
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