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276
The Impact of Working Capital Management on Profitability:
A Study on Banks and Finance Companies Listed on the
Colombo Stock Exchange
Vajeesha Edirisinghe
Department of Business Finance, Faculty of Management, University of
Peradeniya, Sri Lanka.
vpedirisinghe@gmail.com
Madushani Gunathilake*
Department of Business Finance, Faculty of Management, University of
Peradeniya, Sri Lanka.
madushanigunathilake@pdn.ac.lk
*Corresponding Author
INTRODUCTION
Working Capital Management (WCM) has a pivotal role in finance as a strategy
that focuses on maintaining a sufficient balance between a firm’s current assets
and liabilities. Eljelly (2004) has mentioned that an efficient WCM eliminates
the risk of short-term obligations by planning and controlling current assets and
liabilities. An efficient balance of Working Capital (WC) is essential because
excessive investment in current assets would impair the firm’s financial
performance. On the other hand, inadequate WC would threaten the firm’s
ability to meet its current obligations. Therefore, WCM is necessary to
maintaining the trade-off between profitability and liquidity.
Most of the studies carried out on WCM have focused on the importance of
WCM of firms that maintain high levels of inventories in different environments
such as manufacturing, plantation, and pharmaceutical industries. However, a
few studies have given attention to the association between WCM and the
277
financial sector’s profitability. Further, efficient liquidity management in a
country’s financial sectors is also more specific. Banks and finance companies
play a critical role in the financial system stability in Sri Lanka because they
provide liquidity to the entire economy while transforming the risk
characteristics of assets (Central Bank Annual Report, 2020). Menicucci and
Paolucci (2016) have stated a strong consensus that a stable banking system is
necessary for sustainable economic growth.
Therefore, the researchers have focused on filling the gap in exposure in the
financial sector concerning WCM. Moreover, the researchers intended to
highlight whether the Sri Lankan banks and finance companies maintain an
optimal liquid assets level to facilitate sustainable profitability. According to
Ukaegbu (2014), a firm’s working capital requirement differs from industry to
industry as the nature of businesses varies substantially. Hence, this study
focuses on the WCM and the profitability of banks and finance companies listed
on the Colombo Stock Exchange (CSE).
AIM/ OBJECTIVES
WCM is a susceptible area in finance that involves making decisions on the
amount, composition, and financing of current assets and liabilities. Therefore,
the study primarily aims to investigate the impact of WCM on the profitability
of banks and finance companies listed on the CSE. Further, the study examines
whether empirical findings on the relationship between WCM practices and
profitability of non-financial firms apply to financial firms.
METHODS
The researchers have used quantitative research methods in gleaning opinions on
attaining the objectives of the study. Panel data of 222 observations were
obtained using annual reports of ten licensed commercial banks, one licensed
278
specialized bank, and twenty-six licensed finance companies listed on the CSE
from 2015/2016 to 2020/2021. The study has focused on profitability as the
dependent variable measured using Return on Assets (ROA) and Return on
Capital Employed (ROCE). ROA was measured as profit after tax to total assets
and ROCE as profit before interest and tax to total equity. Further, the study has
focused on measuring WCM using Cash Conversion Cycle (CCC) and current
ratio (CR). CCC was measured as debtors’ collection period minus creditors’
payment period, and CR was measured as current assets to current liabilities.
There were five controlling variables, namely, Loans to Deposit ratio (LDR),
Leverage (LEV) and Credit Risk (Credit_Risk), Growth, and Company size.
Accordingly, the study has developed main four hypotheses to assess the impact
of WCM on the profitability of listed banks and finance companies on the CSE
as follows:
H1: There is a significant relationship between the CCC and ROA
H2: There is a significant relationship between the CCC and ROCE
H3: There is a significant relationship between the CR and ROA
H4: There is a significant relationship between the CR and ROCE
The panel data regression model was performed with fixed and random effect
models to assess the relationship between WCM and profitability. The Hausman
test was used to identify the appropriate panel regression model. Further, the
multicollinearity, heteroscedasticity, normality of the residuals, and model
specification errors have been investigated.
RESULTS
Table 1 presents the summary statistics for the Hausman test that recommends
the fixed-effect model for both ROA and ROCE (p<0.05). Accordingly, the
results obtained from the fixed effect panel data regression model are displayed
279
in Table 2. Table 2 suggests that CCC and CR negatively impact both ROA and
ROCE in banks and finance companies listed on the CSE (p<0.05).
Table 1: Hausman test
ROA
ROCE
chi2
13.50 (0.0358)*
21.25 (0.0017)*
Note: H0: Random Effect vs. H1: Fixed Effect, * indicates significant at 5% level,
p-values are in parenthesis
Table 2: Panel data analysis
ROA
ROCE
CCC
-0.00000434 (0.000)*
-0.0000419
(0.000)*
CR
-0.0494697 (0.005)*
-0.7379691
(0.000)*
LDR
0.0017794 (0.801)
-.0129873 (0.838)
Leverage
-0.0004363 (0.105)
0.0098379 (0.000)*
Credit_Risk
-0.1105128 (0.000)*
-1.236533 (0.000)*
Growth
0.0071592 (0.012)*
0.0694505 (0.007)*
Size
-0.0004964 (0.256)
-0.001842 (0.497)
R Squared
0.1013
0.1223
F Value
11.07 (0.0000)*
19.03 (0.0000)*
Note: * indicates significant at 5% level, p-values are in parenthesis
Further, test results suggest that the regression model is free from
multicollinearity, heteroscedasticity, non-normality, and model specification
errors.
DISCUSSION
The panel regression results indicate that CCC has a negative and significant
relationship with ROA and ROCE. Further, the current ratio also shows a
significant negative association with ROA and ROCE. Therefore, the findings of
the study support all four hypotheses highlighting the relationship between
WCM and profitability. Therefore, the profitability of banks and finance
280
companies is negatively affected by increasing the length of debtors’ collection
period and reducing the creditors’ payment period. These findings are consistent
with Garcia and Martinez (2007), and Yeboah and Yeboah (2014). Further, the
findings suggest that the relationship between WCM practices and the
profitability of non-financial firms apply to financial firms as well. Additionally,
the Credit Risk measured based on the non-performing loans ratio depicts a
significant negative relationship with ROA and ROCE. However, leverage
shows no significant association with ROA and ROCE, and growth has a positive
and significant association with ROA and ROCE. The other variables, loans to
deposit ratio and size, show no significant association with ROA or ROCE.
IMPLICATIONS
This study attempts to assess the impact of WCM on profitability based on the
financial service industry of Sri Lanka. The findings of the study conclude that
CCC and the current ratio in terms of WCM play an essential role in determining
the profitability of banks and finance companies in Sri Lanka. The negative
impact of CCC and the current ratio on profitability indicates that the more
extended debtors’ collection period and current assets and, shortened the
creditors’ payment period and current liabilities of the banks and finance
companies would decrease profitability. Therefore, profitability would be
optimized only when the bank and financial companies manage their liquidity
effectively and efficiently, fulfilling statutory liquidity requirements.
Researchers also suggest considering the impact of macroeconomic variables
and extending the sample period with the same topic to different sectors at CSE.
KEYWORDS
Working capital management, Profitability, Banks, and finance companies, CSE
281
REFERENCES
Central Bank Annual Report (2020), Colombo: Central Bank of Sri Lanka.
https://www.cbsl.gov.lk/en/publications/economic-and-financial-reports/annual-
reports/annual-report-2020
Eljelly, A. (2004), “Liquidity – profitability tradeoff: an empirical investigation in an emerging
market”, International Journal of Commerce and Management, Vol. 14, No. 2, pp. 48-
59.
Garcia, P. and Martinez, P. (2007), “Effects of working capital management on sme
profitability”, International journal of managerial finance, Vol. 3, No. 2, pp. 164-177.
Menicucci, E. and Paolucci, G. (2016), “The determinants of bank profitability: empirical
evidence from european banking sector”, Journal of Financial Reporting and
Accounting, Vol 14, No. 1, pp. 86-115.
Ukaegbu, B. (2014), “The significance of working capital management in determining firm
profitability: evidence from developing economies in Africa”, Research in International
Business and Finance, Vol. 31, pp. 1-16.
Yeboah, B. and Yeboah, M. (2014), “The effect of working capital management of Ghana banks
on profitability: panel approach”, International Journal of Business and Social Science,
Vol. 5, No. 10, pp. 294-304.
