Description
In probability theory, a stochastic system is one whose state is non-deterministic. The subsequent state of a stochastic system is determined both by the system's predictable actions and by a random element.
Case Study on Working Capital Structure and Financing Pattern of Mauritian SME
ABSTRACT The competitive nature of the business environment requires firms to adjust their strategies and adopt good financial policies to survive and sustain growth. Most firms have an important amount of cash invested in current assets, as well as substantial amounts of current liabilities as a source of financing. This paper therefore analyses the working capital structure and financing pattern of small to medium-sized Mauritian manufacturing firms, using primarily secondary data. Structural differences in working capital and the financing pattern of the sample firms are analysed and the results showed significant structural changes over the study period. The research finding revealed disproportionate increase in current asset investment in relation to sales resulting in sharp decline in working capital turnover. The analysis also revealed an increasing trend in the short-term component of working capital financing; in particular trade credit and other payables have financed the major part of working capital. This overconcentration on short-term funds is a reality of the SMEs as they often faced difficulties in raising finance and they are viewed to be information ally opaque. Using multivariate analysis, the determinant of working capital financing is investigated and the results confirmed the dominance of short-term financing, proxy as a proportion of current liabilities over total assets. Key words: Working Capital Structure; SMEs, Working Capital Financing; Multivariate Analysis INTRODUCTION Anybusiness idea requires resources to become a reality and financing of this need become a major decision of managers. Business firms of all sizes select their financial structure in view of the cost, nature and availability of financial alternatives (Pettit and Singer, 1985). They further argued that the ‘level of debt and equity in a smaller firm is more than likely a function of the characteristics of the firm and its managers’. An enterprise, which commits itself to an activity, requires finance. No business firm can be promoted, established and expanded without adequate financial resources. Success and survival of a business depends on how well its finance function is managed. The competitive nature of the business environment requires firms to adjust their strategies and adopt good financial policies to survive and sustain growth. Most firms have an important amount of cash invested in accounts receivable, as well as substantial amounts of accounts payable as a source of financing (Mian and Smith, 1992; Deloof and Jegers, 1999). The capital of a company comprises of fixed capital and working capital, which generates production capacity and utilisation of that capacity.Financing of working capital has become a
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very significant area of financial management, more specifically for the SMEs (Watson and Wilson, 2002). Given the changing economic conditions, which is more and more characterised by globalisation and increasing competition, the area of working capital financing (WCF) has assumed added importance as it greatly affects firm’s liquidity and profitability(Shin and Soenen, 1998; Deloof, 2003; Padachi, 2006). In the words of Adam Smith: ‘the goods of the merchant yield him no revenue or profit till he sells them for money and the money yields as little till it is again exchanged for goods. His capital is continuously going from him in one shape and returning to him in another, and it is only by means of such circulation, or successive exchanges, that it can yield him any profit. Such capital, therefore, may very properly call circulating capital’. Generally working capital is financed by a combination of long-term and short-term funds. Long-term sources of funds consist of capital (equity from owners) and long-term debt, which only provide for a relatively small portion of working capital requirement(finance theory will
dictate that only the permanent portion of working capital should be supported by long-term financing, Gitman, 2000). This portion is the net working capital; that is the excess of current assets over
current liabilities. On the other hand, short-term sources of working capital finance consist of trade credit, short-term loans, bank overdraft, tax provision and other current liabilities used to finance temporary working capital needs. Sometimes, working capital deficit exists if current liabilities exceed current assets. In such a situation, short-term funds are used to finance also part of non-current assets and the firm is said to be adopting an aggressive working capital policy (Bhattacharya, 2001). No doubt, easy accessibility of finance is an important factor to decide about the source of finance, but its impact on risks and return cannot be ignored (Gitman, 2000). The financing preferences of firms are often explained using Myers’ (1984) pecking order theory. Though this theory was developed for large quoted companies, it is equally applicable to small firms.Firms tend to use cash credit as a first choice for financing their working capital needs. However, the excessive reliance on the banking system for WCFexerts some pressure on the banks and a significant part of available resources are first channelled to the large firms (Narasimhan and Vijayalakshmi, 1999). They also noted that the long-term source of funds for working capital seems to be dominant in many industries and cash credit is the next major source of financing of working capital. Another important dominant source of funding working capital
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requirement is trade credit.It is usually called spontaneous source of finance and normally available as part of the trade terms. There are a few studies that have addressed the financing and capital structure of SMEs, mostly for developed countries (Hughes, 1997; Watson and Wilson, 2002; Zoppa and McMahon, 2002) and a few developing countries (Peterson and Shulman, 1987; Aidis, 2005; Abor, 2005). However, research into this area for small island economies is scant and therefore this paper looks at working capital structure and financing practices of small to medium-sized firms as an attempt to bridge this gap and to add to the growing literature on financing decisions of SMEs. This paperattempts to examine the differences in working capital structure of small to mediumsized manufacturing firms operating in diverse industry groups. A second objective of the research is to analyse the WCF pattern of the sample firms and to investigate into the role of short term funds as a source of financing.A multivariate model is used to examine the important variables that are expected to influence the level of short-term financing. The rest of the paper is organised into four sections. Section II reviews both the theoretical and empirical literature on financing preferences of SMEs, with emphasis on working capital financing. The next section provides support for the methodological approach and briefly elaborates on the data collection. The econometric model and the variables used are also covered. Section IV reports on the analysis and findings of the study and the discussion of the results is given within the concluding part. WORKING CAPITAL STRUCTURE AND FINANCING Working capital structure refers to the elements of working capital and it shows which of the components is responsible for the sizeable amount of working capital. It is encapsulated in the concept of working capital management, which refers to the financing, investment and control of net current assets within the policy guidelines. It may be regarded as the lifeblood of the business and its effective provision can do much to ensure the success of the business, while its inefficient management or lack of attention may lead to the downfall of the enterprise. In many countries, several empirical studies have indicated that small business managers experience problems in raising capital for the development of their businesses. Different studies (e.g, Bolton, 1971; Wilson, 1979; Holmes and Kent, 1991; Winborg, 2000) have frequently
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referred to the concept of a ‘financial gap’, in order to explain why many small businesses face this sort of problem.Access to finance has been identified as a key element for the SMEs to succeed in their drive to build productive capacity, to compete, to create jobs and to contribute to poverty alleviation in developing countries. Despite their dominant numbers and importance in job creation, SMEs traditionally have faced difficulty in obtaining formal credit or equity. A study conducted in Lithuania (Aidis, 2005) revealed that the most important barriers were low
purchasing power followed by lack of working capital and official bureaucracy. Traditional
commercial banks and investors have been reluctant to service SMEs for a number of well known reasons: ? SMEs are regarded by creditors and investors as high- risk borrowers due to insufficient assets and low capitalisation, vulnerability to market fluctuations and high mortality rates; Information asymmetry arising from SMEs’ lack of accounting records, inadequate financial statements or business plans makes it difficult for creditors and investors to assess creditworthiness of potential SME proposals; High administrative/transaction costs of lending or investing small amounts do not make SME financing a profitable business.
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Viewed from the owner-managers’ angle, major financial problems are: inadequate availability of working capital, a wide gap between working capital and term loans, banks’ insistence on collateral and third party guarantees, a risk averse banking system for small projects, delayed payments of bills by large firms. Many governments and international financial institutions have tried to address the problems of high transaction costs and risks by creating subsidised credit programmes and/or providing loan guarantee. Such projects have often fostered a culture of nonrepayment or failed to reach the target group or achieve financial self-sustainability. Hughes (1997) study of the financial structure of large and small UK businesses found that small businesses tend to rely more on short-term debts in comparison with large businesses. The result showed that small businesses have a higher proportion of debts as trade credit that are attributed to the fact that small firms face greater problems in attracting long-term debts than large businesses. However, this could also be explained by the mere preferences of owner-manager’s attitudes to debt capital.
Pecking Order Hypothesis
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Myers (1984) has tried to explain business managers’ financial preferences from a ‘pecking order approach’. According to Myers business managers prefer internal to external financing, and debts to external equity.In summary, the pecking order hypothesis states that businesses adhere to a hierarchy of financing sources and prefer internal financing when available; and if external financing is required, debt is preferred over equity. This hierarchical ‘ranking’ is due to the presumed fact that the relationship between the financier and the manager is characterised by information asymmetry. Holmes and Kent (1991) suggest that even if Myers’ discussion of the ‘pecking order approach’ is related to large listed businesses, the reasoning is equally applicable to small firms. Several empirical studies have supported Myers’ reasoning (e.g, Holmes and Kent, 1991; Norton 1991; Scherr et al., 1993). Thus, Holmes and Kent (1991) found that owner-managers prefer internal funds, as this form of funding ensures the maintenance of control over operations and assets. If debt financing becomes necessary the managers are assumed to favour short-term debt, as this source does not tend to involve any demand for collateral security.Zoppa and McMahon (2002)foundthe increased dependence on short-term financing for less profitable firms. The less profitable an SME is, and therefore the less self-sufficient it is through reinvestment of profits, the more likely it will need to depend upon short-term debt financing for its assets and activities. It is also observed that growth in sales creates financing pressures that are most probably met by short-term funding. This study also revealed that as the SMEs grow in size (measured in terms of assets), the more dependence they become on short-term funds for those assets. This would be the case where the sample units have limited access to long-term debt and equity financing arising from an alleged ‘finance gap’, prevented the business from following the financial management dictum of matching the term of finance used to the term of assets acquired (the so-called ‘matching’ or ‘hedging’ principle). Since SMEs is often characterised by a low fixed assets base, as observed in the study of Padachi (2006), the dependence on short-term funds is proportionately high which conforms with the matching or hedging principle (Bhattacharya, 2001).In line with this reasoning, the owner-manager’s desire to maintain control and independence are enough to support the explanation of his/her financial preferences. It is perceived that external providers of funds may interfere in the management of the business.
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It may thus, be concluded that the two approaches discussed above lend support to the financial choices of the small businesses. Most of the studies in small business finance have in one way or the other bring evidences as to the dual factors, that is, the characteristics of the small business and that of the small business manager are important to explain the financial preferences and choices (Pettit and Singer, 1985; Levin and Travis, 1987; Barton and Mathews, 1989; Ang, 1991; Scherr et al., 1993; Cosh and Hughes, 1994; Hamliton and Fox, 1998; Winborg, 2000). Small firm owners tried to meet their finance requirements from a pecking order of, first, their own money (personal savings, retained earnings); second, short-term borrowings; third, long-term debt; and, least preferred of all, from the introduction of new equity investors, which represent the maximum intrusion (Cosh and Hughes, 1994). METHODOLOGY In the present paper, the components of gross working capital is analysed to see whether there has been any structural changes over the period of study. The role of short-term funds as a source ofWCF is also investigated. This is achieved by analysing the components of working capital and the pattern of WCF for the sample units over the six years period. The study also attempts to assess the liquidity of the 101 sample manufacturing firms, using a comprehensive test based on liquidity ranks.This is calculated first by assigning individual ranking to the four main components of current assets and then sum up the individual scores to arrive at an ultimate rank. The second part of the paper attempts to model the use of short-term financing using multivariate analysis. Given the character of the data, this part of the analysis applied a panel data methodology. The empirical study is based on a sample of 101 small manufacturing companies. The data was hand collected from the financial statements of the sample firms, having a legal entity and had filed their annual return at the Registrar of Companies. The sample was drawn from the directory of (SEHDA), which is a database for registered manufacturing firms operating in diverse activities and for which data was available for a six year period, covering the accounting period 1998 to 2003. The rationale for selecting only those firms registered with SEHDA as a priori they are expected to be more organised and have undergone training programme in the functional areas of their businesses. This is a precondition and benefits that the small firms gain when
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registering with the agency. The companies qualified for the above two conditions are further grouped into industries based on the classification as listed in the 2005 directory. The companies spanned a range of industries including chemical, rubber and detergents, food and beverages, leather and garments, paper products and printing, metal products and wood furniture. Sample Criteria This includes all firms for which secondary data was compiled to examine the working capital structure and financing patterns of the small to medium-sized Mauritian manufacturing firms. A random sample of businesses was selected from the 2005 directory of SMEs. For a firm to be included in this study, it must satisfy the following criteria: ? ? ? ? It must have filed accounts for the period of the study; Have not been struck off from the database i.e., they are not defunct companies; Have not been eligible to file an ‘abridged version’ of accounts following the new provision of the Companies Act 2001; and Do not have inconsistent financial data for more than two accounting periods.
As a result of the above conditions, a number of firms were discarded for which data was not available for the whole period, either because they were newly formed or having missing values for more than two years. If this caused the number of companies in the industry to fall below 15, that industry would be excluded in the cross-sectional analysis. Since all the firms sampled have the same financial year, inter-industry comparability is facilitated and this eliminates the distorting impact of different reporting periods and seasonality patterns. Companies were randomly chosen subject to sufficient financial data was available throughout the six year period. These selection criteria result in a sample of 101 firms and 588 firms’ observations and therefore produce an unbalanced panel data.
DATA ANALYSIS AND RESULTS This section analyses the small to medium-sized Mauritian manufacturing firms’ working capital structure to examine the structural changes over the period of the study. It also analyses the pattern of WCF and to establish whether short-term funds have a major role in the financing of
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SMEs working capital, as confirmed in the literature. Attempt is also made to assess the relevance of ‘POT’ to the WCF of the sample firms.The main theoretical arguments and empirical evidences around the small firms demand for finance were discussed, with more focus on WCF. Descriptive Statistics The descriptive statistics for the sample are displayed in Table 1. Current liabilities are on average 60 % of total assets and the share of account payable in current liabilities is to the tune of 62% (Table 4). As for the assets, current assets constitute on average 59% of total assets while accounts receivable represents 43% of current assets. Thus, the sample units are net receivers of trade credit which confirms the importance of trade credit as a source of financing for the small to medium-sizedMauritian manufacturing firms. A similar finding was reported in the study of Howorth and Wilson (1998). It is observed that a lesser proportion of long-term funds are used to finance working capital, which implies that the sample units have no choice than to rely on shortterm sources to fund both the permanent and circulating part of their current assets. Stocks, another major component of current assets, are on average 28% of total assets (median value is 22%). However, on average only 6.5% of assets are financed with short-term financial debt and another 24% is granted as cash credit by banks. The share of long-term debt used to finance working capital is insignificant and thus confirms the priori claim that small firms face difficulties to secure long-term financing and it accords with the ‘POH’. Average long-term debt is about 23% of total assets, including shareholders loan and leasing. Thus,there is less scope for the sample firms to accommodate late payment by increasing equity or long term debt and a similar finding was observed in Bannock (1991). Therefore the two main avenues open to an SME suffering from late payment are to increase short-term bank borrowing, or delay payments to creditors. The mean long-term debt (GEAR) of the sample firms is 0.22 while that of short-term debt (CLTA) is 0.60, which clearly shows the importance of short-term debt over long-term in SME financing. Interestingly internal equity financing appears to constitute 18% of the capital of the Mauritian manufacturing SMEs. Contrary to finance theory (Van Horne, 1995) even the permanent component of current assets are financed out of short-term funds, which
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predominantly include trade credit and cash credit. However, the share of short-term financial debt represents only 6% of the financing need of the SMEs; thus confirming the difficulties which the sample firms faced in procuring WCF. One would therefore expect firms with more short-term assets, ceteris paribus, to have a higher demand for short-term credit in general and accounts payable in particular. The sample firms have an average of 61% as current assets and this isbeing financed out of short-term funds (60%), comprise mainly of trade credit, cash credit, short-term borrowing and other payables. While analysing the firms’ specific data, the sample firms tend to bridge shortfall in long-term financing by leasing some of the fixed assets and raise loans from their directors. A similar finding was observed in the study of Deloof and Jegers (1999) for a sample of large Belgian nonfinancial firms and this accord well with the ‘POH’ (Myers, 1984). Trends in Working Capital Table 2 analyses the trends in gross working capital and net working capital for the sample firms and also to see whether over the six year period, the firms have adopted different WCF policies, by calculating the ratio current liabilities to current assets.Throughout the period 1998 to 2003, the sample firms displayed a positive net working capital, but the ratio of current liabilities to current assets shows thatnearly 85%of the current assetsare met out of current liabilities. Given that easy accessibility of finance dictates the decision of the owner-manager, the sample units have predominantly use short-term finance to support its current operations.The sample units have thus followed an aggressive policy in financing current assets. The diversion of current funds to permanent current assets is not desirable and may affect future cash flows.Given this trend, the working capital structure is analysed to discuss briefly the important sources of WCF.
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Sources of Working Capital Deciding the size and means of financing the current assets is a continuous challenge to financial manager or owner manager of small firms. Table 3 shows the trends and composition of current liabilities and the financing patterns of working capital for the sample firms. As showed in Table 3, short-term funds (namely trade credit, other payables, bank overdraft, short-term borrowing and other current liabilities) have played a dominating role throughout the period of the study. It has provided over 85% of the WCF needs and this over-concentration is a reality of the SME sector. This could be explained by the fact that suppliers may have significant cost advantages over financial institutions when it comes to providing credit to their customers. Petersen and Rajan (1997) identified three sources of such cost advantages, namely informational advantage as a result of continued trading relationship; control over the actions of the buyer and can seize the goods if buyer defaults. Given that trade credit is limited to the amount of credit offered by the suppliers, the small firms tend to delay payment of their other payables such as monthly utility bills and repairs and maintenance. In a matching context one would in the first place expect other categories of shortterm debt to be substitutes for trade credit. The share of short-term bank debt has average to 6.5% while the sample firms’ reliance on bank overdraft has showed a downward trend, which testified the difficulties of the Mauritian SMEs in getting traditional sources of finance. Financing Patterns of Working Capital Table4 also exhibits an overall increasing trend in the use of long-term funds as a source of working capital during the period. It rises from 10.3% in 1998 to 19.1% in 2001. This trend speaks of difficulty in procuringWCF. This source of finance is to a large extent supplement by shareholders/directors loan, especially where the sample firms lack collateral assets. The same finding was observed in the study of Ahmad and Ghufran (2005) for a sample of Marketing Cooperative Societies in Eastern Uttar Pradesh. It is generally believed that short-term borrowings finance the major portion of working capital needs and long-term funds may be employed for this purpose in case of necessity only(Banerjee and Hazra, as cited in Mallick and Sur, 1999).
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Financing is yet another important issue in the management of working capital of a firm. Firms with inadequate working capital suffer from underutilisation of capacity resulting in the extension of break-even point. It is observed that the sample firms have diverted long-term funds to finance working capital as the share of traditional sources of finance has declined. But, however, in practice a firm has to choose a combination of the two modes of financing a particular level of working capital. This obviously depends on a multiple of factors like flexibility, risk preference, demand and supply position in the money market, and cost of financing. The other payables (19%) are the major short-term (internal) sources that are used till their time for payment becomes due. Diversion of working funds for meeting long-term requirement because of negative net working capital was observed for some of the selected firms.They have limited access to external longterm debt and thus have to rely on shareholders loan to finance the business activities. This practice accords well with the ‘POH’ where small firms prefer to use external debt and internal equity than to rely on external equity. This is inline with the argument that small enterprises as a whole would prefer internal financing as external financing is either more costly or more difficult to obtain due to greater monitoring or other agency costs and greater information asymmetries (Pettit and Singer, 1985). These findings are generally consistent with prior studies (Ang, 1991, Holmes and Kent, 1991; Cosh and Hughes, 1994 and Fama and French, 2000). Analysis of the sample firms’ financing data showed that there are four main categories of sources of working capital which are as follows: ? ? ? ? Trade debt and other payables Provisions and other non-bank short-term borrowings Short-term bank borrowings Net working capital from equity and/or long-term borrowings
The first two sources of WCF constitute the non-bank current liabilities. Thus, total current assets minus ‘total non-bank current liabilities’ represents the ‘working capital gap’. It is expected that this gap to be met partly by bank borrowing or cash credit facilities, the balance being supported by equity and/or long-term borrowings. Table5 showing the percentage composition of WCF, clearly demonstrates the increasing dependence on this source for additional funds.
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Trade debt and other payables have grown at a rate faster than the rate of increase in sales, as indicated by the growth trend index. It may thus conclude that the sample firms postpone payments to creditors as a way out to ease their financial difficulties. It is noted that the small firms do not have much scope to use non-bank short-term borrowings (a lower share of the composition of WCF). Equally short-term bank borrowing represents a lower share of the overall WCF and its dependence has showed a declining trend. Table 6 gives supplementary information on the firms’ pattern of WCF, including sales data and growth trend index. The rate of growth in bank borrowing lagged well behind that of sales and has remained more or less constant, except for
the year 2003, where the growth rate is in line with that of sales.
The ‘net working capital’, representing residual support to working capital from equity and/or long-term borrowing though accounting for only a small fraction of total WCFhas increased over the period of study. This demonstrates that the increase in sales which could be partly ‘seasonal’ is being financed out of long-term sources, which accords well with the finance literature. However, for the sample firms, this is partly met by a disguised form of equity; that is, shareholders loan. The working capital, constituting support from equity and/or long-term borrowings was as low as 13% of working capital funds. The firms’ reliance on short-term bank borrowing has declined over the period of study and the fluctuations in sales are mainly financed by postponing payments to suppliers and long-term sources. In all the years the ranking of the contribution to gross working capital was the same; that is trade debt; short-term bank borrowing, equity and/or long-term borrowing and lastly non-bank short-term borrowing, except for the year 1998. Interesting the growth index for the sample firms’ long- term finance has more than triple over the period of the study, though it finances only 20% of the gross WC. Liquidity Ranks An attempt has been made to assess the liquidity of the 101 sample manufacturing firms, using a comprehensive test based on liquidity ranks (Mallick and Sur, 1999). This is calculated first by assigning individual ranking to the four main components of current assets and then sum up the individual scores to arrive at an ultimate rank. The four criteria as showed in Table 7 are stock to current assets ratio (STCR), debtors to current assets ratio (DTCR), cash and bank balances to current assets ratio (CTCR) and other current assets to current assets ratio (OTCR).
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Investment in the various categories of current assets has an incidence on the liquidity of an enterprise. The category of current assets which forms the largest component in total current assets will, therefore, affect liquidity of the enterprise in a significant way. A comprehensive test based on the sum of scores (liquidity ranks) of separate individual ranking under the four criteria are given in Table 7. A high value of DTCR, CTCR, and OTCR indicate greater liquidity and ranking has been done in that order. On the other hand, a low STCR shows a more favourable position and hence ranking has been done in that order. For the manufacturing enterprises, stock of raw materials and finished goods are a significant item and tying a large proportion of current assets in stock means the business enterprise will face liquidity problems. Kendall’s coefficient of concordance (W) is computed to determine the degree of uniformity among the four sets of rankings and Chi-square test has been applied for testing the significance of such coefficient. Table 7 shows that the year 2002 recorded the most sound position followed by 2003, 2000, 2001, 1999 and 1998 respectively, in that order. It indicates that the overall liquidity of the sample firms in the later years was better than in the early years of the study. The notable decline in stock level is a contributing factor alongside the increasing trend in cash and bank balances. The computed value of W is 0.58 and is not statistically significant. It reveals that there is no close association among the liquidity of various components of working capital during the period of study. Relationship between Liquidity and Profitability Most standard finance text book have a section which emphasises on the trade-off between liquidity and profitability. The theory stipulates a negative relationship whereby a high level of liquidity sacrifices profitability. Table 8 attempts to measure the degree of relationship between liquidity and profitability of the sample units by computing Spearman’s rank correlation coefficient R?p. The above figures confirmed the negative relationship between profitability and liquidity, though showing a weak significance. The years 2002 and 2003 which reported a better liquidity position adversely affected the profitability of the sample units. Shin and Soenen (1998) and more recently Deloof (2003) empirically showed that a lengthening of the trade cycle impact negatively on the profitability of large corporate companies. It may be deduced that in the later
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period of the study, the sample units have maintained higher level of debtors and cash and bank balances, but to the detriment of profitability. Multivariate Analysis The major part of the analysis has examined the sample firms’ working capital structure and the financing pattern, using non-econometric techniques. The average values and ratios of the various working capital elements (uses and sources of funds) have been worked out using secondary financial data. In order to understand the WCF of the Mauritian manufacturing firms and to determine the significance of the variables as discussed below, multivariate analysis is applied by specifying a regression model as in equation (1). Given the panel nature of the data, there may be an argument to support the use of a static framework for examining the relationship of the sample firms’ short term financing to a number of variables expected to influence that decision. The lack of financial data points over time suggested that employing a static framework was more appropriate. In particular, the limited data points over time would most likely lead to high standard errors on such panel analysis, resulting in a relatively low powered test.
Variables
A brief definition of the variables and the expected relationship between the dependent variable and the explanatory variables are given below. The dependent variable is CLTA, the ratio of current liabilities to total assets and is used as a measure of short-term financing.
GEAR is used to denote the long-term debt as a proportion of total assets. The literature review
section has provided both theoretical arguments and empirical evidences on the use and availability of such financing mode to the SMEs. A firm’s share of short-term financing is expected to increase as its ability to raise debt is constrained by external or internal factors. It is therefore hypothesised that the variable GEAR is negatively associated with the dependent variable.
ROTA is a measure of the firm’s profitability with respect to the level of investment. It is
calculated as operating income divided by total assets. As firms become profitable, they are
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expected to use internally generated funds to meet their working capital needs and place less reliance on short-term financing. Empirical evidences examining SMEs lend support to the negative relation between debt (long-term and short-term) and profitability (Chittenden et al., 1996; Michaelas et al., 1999; Cassar and Holmes, 2003). Based on that, a negative relationship between profitability and short-term financing is hypothesised.
CATA is a measure of the asset structure and is the ratio of current assets to total assets. As this
ratio increases, by an increase in the level of stocks and debtors, they mirror an increase in the use of trade credit, cash credit and short-term borrowing. This variable is thus positively related to the short-term debt and this was evidenced from the earlier analysis. The variable is further disaggregated into the working capital composition; that is SKCA and TDCA to separately identify the significance of each element in the WCF of the sample firms.
TURNCA is sales divided by current asset and is a measure of the firms’ operational efficiency in
using gross working capital to generate sales. The greater the efficiency in the utilisation of current assets to generate sales, the lesser is the need to rely on short-term financing to meet working capital requirements. A priori a negative relationship between the variable TURNCA and
CLTA is expected. GROWTH is growth in sales measured by computing the percentage increase/decrease in the
yearly sales for each firm. Applying the pecking order arguments, firms which are in the growth path would place more reliance on internally generated funds. Also, where growth is not spectacular, the firms may use retained profit and supplement by the less secured short-term debt before considering the more secured long-term debt financing. This should lead to firms with relatively high growth to use more short-term financing.
SIZE is proxied by the natural logarithm of sales and there are several theoretical reasons (informational asymmetries, transaction costs, managerial preferences etc) as to why size is related to
the financing decision of SMEs. The empirical evidence investigating the relationship between size of firms and financing supports a positive link between size of firms and leverage (Cassar and Holmes, 2003).
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The independent variables as briefly discussed above are summarised below and are expressed in equation (1):
CLTAit ? ? 0 ? ?1 ln salesit ? ? 2 gearit ? ?3rotait ? ? 4turncait ? ?5 growthit ? ? 6catait ? ? it (1)
Where the dependent variable is CLTA and the subscript i denoting firms (cross-section dimension) ranging from 1 to 101 and t denoting years (time-series dimension), ranging from 1 to 6.
lnsales = natural logarithm of sales, a proxy for size gear = long-term debt to total assets rota = return on total assets before interest growth = growth index of sales (for each firm over the six years period) turnca = sales divided by current assets as a measure of Gross working capital efficiency cata = current assets to total assets as a measure of gross working capital requirements skca = stock to current assets (Model 2) tdca = debtor to current assets (Model 3) Table 1 provides a summary of the descriptive statistics of the dependent and independent variables. The mean short-term financing of the sample firms is 0.60 and the mean long-term debt suggests that it represents 22% of the capital of the SMEs. This highlights the importance of short-term debt over long-term debt in SME financing and a similar finding was confirmed by Cassar and Holmes (2003). The remaining 18% is represented by the owners’ equity which provides evidence that SMEs tend to be undercapitalised. The growth index for the sample firms is only 0.7% and is an indication that the SMEs are constrained by the market, especially in a small island economy. The correlation matrix between the dependent variables and the explanatory variables are shown in Table 9. Examining the univariate relationships between the dependent variables and independent variables, of particular note is the consistent direction of the relationship, though not all of them are significant. A priori a positive relationship between TDCA and the dependent variable (CLTA) is expected, but the coefficient is negative and significant. Strong correlations between GEAR and the asset structure are also observed, for example the higher the proportion of current assets in total assets, the lesser is the use of long term debt in the financing decision of SMEs. This provides evidence of a matching financing policy, where the sample firms tend to
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finance their current assets out of current liabilities (a significant positive correlation between CATA
and CLTA).
Finally, examining the variable size against the correlations of the other independent variables it is observed that larger firms have a lower proportion of long-term debt, as they appear to be more profitable (ability to generate funds internally). Apart from being profitable, the larger firms report a higher proportion of current assets and this is also reflected in the significantly positive correlation between SIZE and GROWTH. Most of the coefficients have a low value, except for the correlation between TURNCA and CATA, showing a significant negative value of 0.5193. Thus, the data set is not affected by multicollinearity and it is safe to proceed with the multivariate analysis.
Estimation method
A multivariate empirical model is used to facilitate the interpretation of the marginal importance of each of the variable.
The regression models
When using a static panel framework, the decision to use either a fixed-effects model or a random-effects model arises. Panel data analysis allows the consideration of a firm-specific timeinvariant effect. In order to determine which of these two regressions models should be run, the Hausman test is used to determine the appropriate model. The techniques examine whether difference between the estimators generated by random-effects regression and the estimators generated by fixed-effects regression approximates zero. The diagnostic tests favour a randomeffects model and the results are reported in Table 10.
Analysis of Results
The prime objective is to examine closely the determinants of WCF, subject to the data restriction. The results for the four models (1) - (4) to test for the separate effect of working capital components (CATA, SKCA and TDCA) and the operational efficiency (TURNCA, Model 4) are displayed in the table together with t-values and statistical tests.
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The main variable CATA (Model 1) which shows the extent of aggressiveness in the asset management of the sample firms is strongly confirmed and follows a matching financing principle. The coefficient is positive and highly significant at the 1% level. As expected, the sample firms meet the working capital requirements out of current liabilities which include mainly trade credit, cash credit, short-term borrowing and other payables. This is also evidenced in Table 4 where only the working capital gap is met out of long-term debt. Interestingly, the findings tend to corroborate other finance related SMEs studies (Chittenden et al., 1996; Cassar and Holmes, 2003), though not specifically investigating the use of short-term debt. The hypothesis that firms with growth potential borrow on the short-term is not confirmed, instead a significant negative relationship is observed for all the models. A partial interpretation of this finding could be that the sample firms are not pursuing any growth strategy as confirmed by the low mean value for the variable growth in sales. However, the measurement scale used may also not a good measure of growth for the sample. Consistent with the pecking order arguments, the coefficient for ROTA is negative and statistically significant in all the regressions models. This suggests that profitable firms manage to meet their working capital requirements out of cash flow generated from operating activities. Interestingly the small to medium-sized Mauritian manufacturing firms do not have to exert pressure on the short-term financing mode and may be viewed as a welcoming strategy to strengthen the supply chain relationship. The relationship between firm size and WCF (CLTA) is positive and statistically significant in all the models, except model 3 showing a weak significance. This finding has implications for larger firms which need to support high working capital requirements. The positive relationship is consistent with the theoretical arguments, where the larger firms demand for finance may be more attractive than request from smaller firms. Because of the transaction cost theory, lending institutions may find it costly to lend to small firms, and they may be further credit rationed as they are informationally opaque. The hypothesis that firms which is pursuing a matching principle; that is using long-term debt to finance the permanent part of current assets and the fixed assets is statistically confirmed. In every regression, the coefficient of GEAR is large and significant at the 1% level. As the
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proportion of long-term debt financing increases, the share of current liabilities to total assets falls and confirms that firms seek to match the maturities of assets and liabilities (Heyman et al., 2008). The two variables used to examine the separate effect of stock and debtor in the working capital composition of the sample firms are showed in regression model 2 and model 3. As expected, the coefficient for SKCA is positive and statistically significant at the 1% level. This suggests that as the firms build up stocks in anticipation of higher sales level, the need for short-term WCF increases. Empirical evidences have confirmed such relationship and how important is the use of trade credit as a source of finance has been widely research. However, as the firms liquidate its stock level and the asset changes its form into debtors, the need for extra financing in the form of bank overdrafts or bank loans is less felt. This is confirmed by the significantly negative relationship between the variable TDCA and the dependent variable CLTA. CONCLUSION AND DISCUSSIONS Using a sample of 101 small manufacturing firms, operating in six different industry groups for the 1998 – 2003 period, the results confirmed that short-term sources more particularly trade credit and other payables play a significant role in financing working capital. Trade credit is primarily used to finance short-term assets (Deloof and Jegers, 1999). Short-term bank credit plays not only a significant but also a dominating role as a major external source of financing working capital requirements of the sample firms. It ranges from 27% to 34%. This is evidenced by the low level of short-term borrowings with a mean value of 7% over the period of study. Therefore to bridge the shortfall in working capital requirements the sample units have no choice than to rely on their banks for overdraft facilities. The regression results showed that the small to medium-sized Mauritian manufacturing firms have a financing pattern, which is influenced by the asset structure, leverage, profitability, operational efficiency and size of firms. As suggested by Rajan and Zingales (1995), the results showed a negative and statistically significant relation between growth and the level of shortterm debt. It is generally assumed that short-term funds are first directed to WCF, the working capital gap is met out of long-term funds. Equity option is the least preferable option as evidenced by the low ownership ratio. This is often explained by the strong desire to keep
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control of the business within the family and the owner managers would consider external equity as a last resort. Evidence on this issue provides insight into the financing behaviour of the sample units and contributes to the understanding of financing choices of SMEs. The findings are comparable to similar studies as reviewed in the literature section and the findings are consistent with these a priori hypotheses. Thus, the results provide confirming evidence that small firms face borrowing constraints due to agency costs and asymmetry information (Ang, 1991; Cosh and Hughes, 1994; Winborg, 1997). In theoretical terms the study confirms Myers’ (1984) reasoning about ‘pecking order approach’, that is, the small business managers prefer internal (inclusive of loan from shareholders) to external financing, and debts to external equity. In terms of policy-making the study will question the large efforts that have been made in many countries to increase the supply of capital to small businesses. However, the case for Mauritius may be different since the recent budgetary measures make provision for WCF schemes and these are partly subsidised by the government and may thus be attractive to the small business managers. The most significant coefficient in the regression models consistently show that short-term financing is negatively correlated with the level of profitability. While the profitable firms may be more attractive from the lending institutions perspective, the need for overdraft and loans may possibly be lower if retained profits are sufficient to meet the sample firms’ working capital requirements. Thus, the pecking order arguments that predict a negative relationship between profitability and debt are validated for the sample (Myers, 1984). The regression models consistently showed that firms exposed to high level of current assets make the most use of short-term financing. This supports the finance theory and a number of empirical findings from previous studies. Similarly there is no evidence that operational efficiency has a negative impact on the use of short-term financing. This could be linked to the poor financial management practices of small firms where they not only take longer to collect their receivables they also tend to keep high level of stocks. If this is supported, then firms have no choice than to delay payment to suppliers (use of trade credit) and increase reliance on cash credit.
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Finance is one of the most cited problems faced by SMEs. Government financial support schemes and debt from financial institutions are important source of capital for small firms to bridge the financial gap (Berger and Udell, 1995). However, the financial burden of debt on a firm’s financial viability has been recognised in the finance literature and is often the causes for firms’ bankruptcy (Carter and Van Auken, 2006). If such is the case, then it is important for owner manager to undergo training in finance-related matters. The SEHDA and Human Resource Development Council (HRDC) have a role to play in this area and need to be addressed given the international perspective. SMEs can be particularly affected by typical asymmetric information problems like adverse selection and moral hazard. As a result they tend to rely mostly on short-term debt financing and such source of finance is even more attractive given that owner manager of SMEs may decide not to seek financing that dilutes their ownership and therefore limits their ability to act. In this respect, they generally turn their attention to debt once internal resources have been fully utilised. It is therefore presumed that cash flow from operations represents the ultimate option of financing and thus, it is important that profits are quickly converted into cash through efficient WCM practices.
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REFERENCES Abor, J. (2005). The effect of capital structure on profitability: an empirical analysis of listed firms in Ghana.The Journal of Risk Finance, 6(5), 438-445. Aidis, R. (2005).Why Don't We See More Small- and Medium-sized Enterprises (SMEs) in Lithuania?: Institutional Impediments to SME Development.Journal of Small Business Economics, 25(4), 305-317. Ahmad, R., & Ghufran, A. (2005). An analytical study of working capital management of Marketing Cooperative Societies.Management and Accounting Research, 9(1-2), 35-51. Ang, J.S. (1991). Small business uniqueness and the theory of financial management.Journal of Small Business Finance, 1(1), 1-13. Bannock, G. (1991).Venture Capital and the Equity Gap, National Westminster Bank, London. Barton, S.L. & Mathews, C.H. (1989). Small Firm Financing: Implications from a Strategic Management Perspective.Journal of Small Business Management, 27(1), 1-7. Berger, A. N., & Udell, G. F. (1995). Relationship lending and lines of credit in small firm finance.Journal of Business, 68(3), 351-81. Bhattacharya, H. (2001).Working Capital Management: Strategies and Techniques, Prentice Hall, New Delhi. Bolton, J. (1971).Report of the Committee of Inquiry on Small Firms.HMSO Cmd 4811, London. Carter, R., & Van Auken, H. (2006). Small Firm Bankruptcy. Journal of Small Business Management, 44(4), 493-512. Cassar, G., & Holmes, S. (2003). Capital structure and financing of SMEs: Australian evidence.Journal of Accounting and Finance, 43, 123-147. Chittenden, F., Hall, G., & Hutchinson, P. (1996). Small firm growth, access to capital markets and financial structure: A review of issues and an empirical investigation.Small Business Economics, 8, 59-67. Cosh, A., & Hughes, A. (1994).Size, financial structure and profitability; UK companies in the 1980s. (Eds. A Hughes and D Storey), in: Finance and the Small Firm, Routledge, London. Deloof, D. (2003). Does Working Capital Management Affect Profitability of Belgian Firms? Journal of Business Finance and Accounting, 30(3/4), 573 – 587. Deloof, M., & Jegers, M. (1999). Trade Credit, Corporate groups, and the Financing of Belgian Firms.Journal of Business Finance and Accounting, 26(7/8), 945-965. Fama, E., & French, K. (2000). Forecasting profitability and earnings.Journal of Business, 73, 161-176. Gitman, L.J. (2000).Principles of Managerial Finance, Addison Westley, Longman. Hamilton, R.T.,& Fox, M.A. (1998). The financing preferences of small firm owners.International Journal of Entrepreneurial behaviour & Research, 4(3), 239-248. Heyman, D., Deloof, M.,& Doghe, H. (2008). The Financial Structure of Private Held Belgian Firms.Journal of Small Business Economics, 30, 301-313. Holmes, S.,&Kent, P. (1991). An empirical analysis of the financial structure of small and large Australian manufacturing enterprises.The Journal of Small Business Finance, 1 141–154. Howorth, C.A. & Wilson, N. (1998). Late Payment and the small firm: An examination of case studies.Journal of Small Business and Enterprise Development, 5(4), 307-315. Hughes, A. (1997). Finance for SMEs: A UK Perspective. Small Business Economics, 9, 151-66.
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Levin, R. I., & Travis, V. R. (1987). Small company finance: what the books don’t say.Harvard Business Review, Nov/Dec, 30-32. Mallick, A.,& Sur, D. (1999). Working Capital Management: A Case Study of Hindustan Lever Ltd.Finance India, 13(3) 857-871. Mian, S.L.,& Smith, C.W. (1992). Accounts receivable management policy: theory and evidence.Journal of Finance, 47, 169-200. Michaelas, N., Chittenden, F., & Poutziouris, P. (1999). Financial policy and capital structure choice in UK SMEs: empirical evidence from company panel data.Small Business Economics, 12(2), 113-130. Myers, S.C. (1984). The capital structure puzzle.Journal of Finance, 39(3), 575-92. Narasimhan, M. S.,& Vijayalakshmi, S. (1999). An Inter-industry Analysis of Working Capital Management on components, efficiency and financing pattern, Research Bulletin (ICWAI),18(July-Dec Issue), 65-75. Norton, E. (1991). Capital Structure and Small Growth Firms.Journal of Small Business Finance, 1(2),161-177. Padachi, K. (2006). Trends in Working Capital Management and its Impact on Firms Performance: An Analysis of Mauritian Small Manufacturing Firms, International Review of Business Research Papers,2(2), 45-58. Petersen, M.A.,& Rajan, R.G. (1997). Trade Credit: Theories and Evidence.Review of Financial Studies, 10(3), 661–91. Peterson, R., & Shulman, J. (1987). Capital structure of growing small firms: a twelve country study on becoming bankable.International Small Business Journal, 5(4), 10-22. Pettit, R., & Singer, R. (1985). Small Business Finance: A Research Agenda.Financial Management,Autumn Issue, 47-60. Rajan, R.G.,& Zingales, L. (1995). What do we know about Capital Structure? Journal of Finance,50(5), 1421-1460. Scherr, F. C., Sugure, T.F.,& Ward, J.B. (1993). Financing the small firm start-up: determinants for debt use. Journal of Small Business Finance, 3(1), 17-36. Shin, H.H.,& Soenen, L. (1998). Efficiency of working capital and corporate profitability.Financial Practice and Education, 8(2), 37-45. Van Horne, J. C. (2008).Financial Management and Policy,Pearson Education; Singapore. Watson, R., & Wilson, N. (2002). Small and Medium Size Enterprise Financing: A note on some of the implications of a Pecking Order.Journal of Business Finance and Accounting, 29 (3/4), 557-578. Wilson Committee (1979).The Financing of Small Firms, Interim Report of the Committee to Review the Functioning of the Financial Institutions, Cmnd 7503, HMSO, London. Winborg, J. (1997). Finance in Small Businesses: A Widened Approach to Small Business Managers Handling of Finance. Licentiate Thesis, Scandinavian Institute for Research in Entrepreneurship, Lund University, Sweden. Winborg, J. (2000). Financing Small Businesses- developing our understanding of financial bootsrapping behaviour, Halmstad, Sweden. Zoppa, A., & McMahon, R. (2002). Pecking order theory and the financial structure of manufacturing SMEs from Australia’s business longitudinal survey, Research paper series: 02–1, The Flinders University of South Australia.
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Appendix 1 Variables Definition OPM ROTA GEAR OSHIP CATA CLTA SKCA TDCA TURNCA LNSALES STCR DTCR CTCR OTCR GROWTH Operating Profit Margin is PBIT/Sales Return on total assets is PBIT/Total Assets Gearing is Total Debt/Total Assets Ownership ratio is Shareholders Funds/Total Assets Current Assets to Total Assets Current Liabilities to Total Assets Stocks to Current Assets Trade Debtors to Current Assets Current Assets Turnover is Sales/Current Assets LNSALES is the natural logarithm of sales (Proxy for size) Stocks to Current Assets ratio Debtors to Current Assets ratio Cash and Bank Balances to Current Assets ratio Other Current assets to Current Assets ratio Growth index of sales (for each firms over the six years period)
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Table 1: Summary statistics (101 small manufacturing firms, 1998 – 2003)
Median Accounts payable Cost of sales Sales growth Assets: Total assets (Rs’000s) Non-financial fixed assets Current assets Accounts receivable Inventories/Stocks Cash and bank balances Other short-term assets Sources of funds: Short-term funds (CL) Short-term financial debt Short-term bank debt (OD) Long-term funds Long-term financial debt Long-term non-bank debt* Ownership ratio 21% 99% 0.025% 4,025,038 31% 54% 20% 22% 0% 12% 52% 5% 14% 15% 10% 5% 25% Average 32% 126% 0.7% 8,115,219 36% 61% 26% 28% 5% 19% 60% 6% 15% 22% 15% 8% 18% Standard Deviation 48% 98% 4.11% 11,900,000 39% 78% 48% 32% 14% 21% 68% 9% 14% 33% 21% 12% 70%
Notes: All variables are percentages of total assets, except total assets and sales growth *Includes Shareholders loan and Leasing, which is a common source of finance for the Mauritian SMEs
Table 2: Trends in current assets, current liabilities and NWC for the period 1998 – 2003
Year 1998 1999 2000 2001 2002 2003 Current Assets Rs’000s 371,579 419,947 464,703 497,462 570,487 593,400 Current Liabilities Rs’000s 343,327 362,940 414,340 423,904 489,323 503,129 Net Working Capital – Rs’000s 28,252 57,007 50,363 73,558 81,164 90,271 CL/CA 0.92 0.86 0.89 0.85 0.86 0.85
Table 3: Composition of current liabilities: sources of working capital-(figures in Rs’000s)
1998 N=95 122,023 36% 58,000 17% 44,554 13% 95,790 28% 21,117 6% 343,327 100% 1999 N=99 129,800 36% 65,380 18% 46,860 13% 96,154 26% 22,679 6% 362,940 100% 2000 N=100 157,987 38% 84,008 20% 37,315 9% 106,089 26% 27,005 7% 414,340 100% 2001 N=101 185,173 44% 80,738 19% 24,155 6% 103,065 24% 29,117 7% 423,904 100% 2002 N=98 228,022 47% 89,238 18% 33,927 7% 101,802 21% 29,465 6% 489,904 100% 2003 N=95 200,975 40% 112,963 22% 40,815 8% 99,873 20% 42,266 7% 503,129 100% Average N=588 170,660 40% 81,720 19% 37,940 9% 100,460 24% 28,610 6.5% 422,920 100%
Trade Credit Other Payables Other Current Liabilities Overdraft Short Term Borrowings Current Liabilities
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Table 6: Pattern of Working Capital Finance(figures in Rs million)
1998 827 372 1999 871 420 101 Selected Firms 2000 2001 995 1010 465 497 2002 1072 570 2003 1183 593
Net Sales Total Current Assets Financed by: Trade debts and other payables Provisions and other non-bank short-term borrowings Total non-bank current liabilities Working Capital gap: (Current assets minus non-bank current liabilities) (as a % of current assets) Met by: Bank borrowings: Short-term Net WC from equity and/or L-T borrowings Total Growth trend index: Net sales Total current assets Trade debts and other payables Provisions and other non-bank short-term borrowings Bank borrowings: Short-term Net WC from equity and/or L-T borrowings Index: 1997-1998 Base = 100
180 44 224 148 40% 117 31 148
195 47 242 178 42% 119 59 178
242 37 279 186 40% 133 53 186
266 24 290 207 42% 132 75 207
317 34 351 219 38% 131 88 219
314 41 355 238 40% 142 96 238
100 100 100 100 100 100
105 113 108 107 102 190
120 125 134 84 114 171
122 134 148 54 113 242
130 153 176 77 112 284
143 159 174 93 121 310
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Table 4: Financing patterns of working capital(figures in Rs’000s)
1. Gross working capital 2. Sources of WC: (i) short term funds (ii) long term funds 3. Total long term funds 4. % of LT funds used to finance WC 5. Shareholders loan LT borrowings 6. Owners equity 1998 371,579 1999 419,947 2000 464,703 2001 497,462 2002 570,487 2003 593,400
343,327 28,252 274,850 10.3% 24,465 62,767 187,618
362,940 57,007 323,174 17.6% 27,062 75,626 220,486
414,340 50,363 353,691 14.2% 40,578 90,782 222,331
423,904 73,558 385,977 19.1% 40,974 106,914 238,089
489,323 81,164 444,788 18.2% 25,734 112,363 306,691
503,129 90,271 452,305 20% 31,534 98,295 322,477
Table 5: Percentage composition of working capital finance(figures in %)
Trade debts and other payables Provisions and non-bank STB Short-term bank borrowings Net working capital Total Current Assets or GWC 1998 48 12 31 9 100 1999 46 11 28 15 100 2000 52 8 29 11 100 2001 54 5 27 14 100 2002 56 6 23 15 100 2003 53 7 24 16 100
Table 7: Statement of ranking in order of liquidity: 101 firms for the period 1998 - 2003
Year STCR % 49 47 45 46 42 43 DTCR % 32 34 35 36 38 35 CTCR % 5 6 7 8 8 11 OTCR % 14 13 13 10 12 11 STCR 6 5 3 4 1 2 DTCR 6 5 3 2 1 3 Liquidity Ranks CTCR OTCR Total Rank 6 1 19 5 4 2 2 1 2 2 6 4 5 17 12 14 8 11 Ultimate Rank 6 5 3 4 1 2
1998 1999 2000 2001 2002 2003
Kendall coefficient of concordance among four sets of liquidity ranks ( W) is 0.58 and Chi-square value of W is 11.60. Critical value of X2 at 0.005 per cent for (r-1) (c-1), i.e 15 degree of freedom is 32.80 Variables definition in Appendix 1
Table 8: Analysis of rank correlation between liquidity and profitability
1998 Liquidity Rank as per Table (L) Operating Profit Profitability Rank (P) 6 1999 5 2000 3 2001 4 2002 1 2003 2 Rank Correlation between liquidity and profitability (Rlp) is -0.794 and ‘t’ value of Rlp is 0.059 being significant at 0.10 level. Critical value of ‘t’ at 0.10 level with 5 degrees of freedom is -1.476
6 1
6 1
5 3
4 4
1 5
-1 6
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Table 9: Pearson correlation matrix between variables
1. clta 2. rota 3. gear 4. skca 5. tdca 6. cata 7. turnca 8. lnsale 9. growth
c, b, a
1 1.000 -0.013 -0.086b 0.103b -0.107b 0.157c 0.154c 0.064 -0.062
2 1.000 -0.164c -0.151c 0.085b 0.010 0.024 0.152c 0.170c
3
4
5
6
7
8
9
1.000 0.188c -0.010 -0.185c 0.125c -0.341c 0.049
1.000 -0.424c 0.182c -0.063 -0.177c -0.028
1.000 -0.178c 0.057 -0.005 0.003
1.000 -0.519c 0.117b 0.004
1.000 -0.054 0.056
1.000 0.379c
1.000
denotes significance level at 1%, 5% and 10% respectively. Variables definition in Appendix 1
Table 10: Static panel estimates (Generalised Least Square) regressions of short-term financing
(Dependent Variable: CLTA) Variable Constant Model 1 0.9670 (4.14)*** Lnsales 0.0634 (4.03)*** rota -0.3701 (-6.38)*** gear -0.2538 (-7.19)*** growth -0.0093 (-4.06)*** turnca Model 2 0.7812 (2.81)** 0.0448 (2.23)** -0.3581 (-5.48)*** -0.3397 (-8.91)*** -0.0054 (-1.86)* Model 3 1.1314 (4.37)*** 0.0290 (1.70)* -0.3803 (-6.13)*** -0.3390 -(8.90)*** -0.0057 (-2.16)** Model 4 0.5167 (2.11)** 0.0573 (3.47)*** -0.3935 (-6.12)*** -0.3222 (-9.46)*** -0.0081 (-3.27)*** 0.0367 (13.79)*** cata 0.3600 (11.79)*** skca 0.2608 (8.97)*** tdca -0.1959 (-7.54)*** 0.7617 (25.71)***
Wald (chi2)
399.87 (0.0000)
247.88 (0.0000)
307.28 (0.0000)
1671.08 (0.0000)
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doc_781779566.docx
In probability theory, a stochastic system is one whose state is non-deterministic. The subsequent state of a stochastic system is determined both by the system's predictable actions and by a random element.
Case Study on Working Capital Structure and Financing Pattern of Mauritian SME
ABSTRACT The competitive nature of the business environment requires firms to adjust their strategies and adopt good financial policies to survive and sustain growth. Most firms have an important amount of cash invested in current assets, as well as substantial amounts of current liabilities as a source of financing. This paper therefore analyses the working capital structure and financing pattern of small to medium-sized Mauritian manufacturing firms, using primarily secondary data. Structural differences in working capital and the financing pattern of the sample firms are analysed and the results showed significant structural changes over the study period. The research finding revealed disproportionate increase in current asset investment in relation to sales resulting in sharp decline in working capital turnover. The analysis also revealed an increasing trend in the short-term component of working capital financing; in particular trade credit and other payables have financed the major part of working capital. This overconcentration on short-term funds is a reality of the SMEs as they often faced difficulties in raising finance and they are viewed to be information ally opaque. Using multivariate analysis, the determinant of working capital financing is investigated and the results confirmed the dominance of short-term financing, proxy as a proportion of current liabilities over total assets. Key words: Working Capital Structure; SMEs, Working Capital Financing; Multivariate Analysis INTRODUCTION Anybusiness idea requires resources to become a reality and financing of this need become a major decision of managers. Business firms of all sizes select their financial structure in view of the cost, nature and availability of financial alternatives (Pettit and Singer, 1985). They further argued that the ‘level of debt and equity in a smaller firm is more than likely a function of the characteristics of the firm and its managers’. An enterprise, which commits itself to an activity, requires finance. No business firm can be promoted, established and expanded without adequate financial resources. Success and survival of a business depends on how well its finance function is managed. The competitive nature of the business environment requires firms to adjust their strategies and adopt good financial policies to survive and sustain growth. Most firms have an important amount of cash invested in accounts receivable, as well as substantial amounts of accounts payable as a source of financing (Mian and Smith, 1992; Deloof and Jegers, 1999). The capital of a company comprises of fixed capital and working capital, which generates production capacity and utilisation of that capacity.Financing of working capital has become a
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very significant area of financial management, more specifically for the SMEs (Watson and Wilson, 2002). Given the changing economic conditions, which is more and more characterised by globalisation and increasing competition, the area of working capital financing (WCF) has assumed added importance as it greatly affects firm’s liquidity and profitability(Shin and Soenen, 1998; Deloof, 2003; Padachi, 2006). In the words of Adam Smith: ‘the goods of the merchant yield him no revenue or profit till he sells them for money and the money yields as little till it is again exchanged for goods. His capital is continuously going from him in one shape and returning to him in another, and it is only by means of such circulation, or successive exchanges, that it can yield him any profit. Such capital, therefore, may very properly call circulating capital’. Generally working capital is financed by a combination of long-term and short-term funds. Long-term sources of funds consist of capital (equity from owners) and long-term debt, which only provide for a relatively small portion of working capital requirement(finance theory will
dictate that only the permanent portion of working capital should be supported by long-term financing, Gitman, 2000). This portion is the net working capital; that is the excess of current assets over
current liabilities. On the other hand, short-term sources of working capital finance consist of trade credit, short-term loans, bank overdraft, tax provision and other current liabilities used to finance temporary working capital needs. Sometimes, working capital deficit exists if current liabilities exceed current assets. In such a situation, short-term funds are used to finance also part of non-current assets and the firm is said to be adopting an aggressive working capital policy (Bhattacharya, 2001). No doubt, easy accessibility of finance is an important factor to decide about the source of finance, but its impact on risks and return cannot be ignored (Gitman, 2000). The financing preferences of firms are often explained using Myers’ (1984) pecking order theory. Though this theory was developed for large quoted companies, it is equally applicable to small firms.Firms tend to use cash credit as a first choice for financing their working capital needs. However, the excessive reliance on the banking system for WCFexerts some pressure on the banks and a significant part of available resources are first channelled to the large firms (Narasimhan and Vijayalakshmi, 1999). They also noted that the long-term source of funds for working capital seems to be dominant in many industries and cash credit is the next major source of financing of working capital. Another important dominant source of funding working capital
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requirement is trade credit.It is usually called spontaneous source of finance and normally available as part of the trade terms. There are a few studies that have addressed the financing and capital structure of SMEs, mostly for developed countries (Hughes, 1997; Watson and Wilson, 2002; Zoppa and McMahon, 2002) and a few developing countries (Peterson and Shulman, 1987; Aidis, 2005; Abor, 2005). However, research into this area for small island economies is scant and therefore this paper looks at working capital structure and financing practices of small to medium-sized firms as an attempt to bridge this gap and to add to the growing literature on financing decisions of SMEs. This paperattempts to examine the differences in working capital structure of small to mediumsized manufacturing firms operating in diverse industry groups. A second objective of the research is to analyse the WCF pattern of the sample firms and to investigate into the role of short term funds as a source of financing.A multivariate model is used to examine the important variables that are expected to influence the level of short-term financing. The rest of the paper is organised into four sections. Section II reviews both the theoretical and empirical literature on financing preferences of SMEs, with emphasis on working capital financing. The next section provides support for the methodological approach and briefly elaborates on the data collection. The econometric model and the variables used are also covered. Section IV reports on the analysis and findings of the study and the discussion of the results is given within the concluding part. WORKING CAPITAL STRUCTURE AND FINANCING Working capital structure refers to the elements of working capital and it shows which of the components is responsible for the sizeable amount of working capital. It is encapsulated in the concept of working capital management, which refers to the financing, investment and control of net current assets within the policy guidelines. It may be regarded as the lifeblood of the business and its effective provision can do much to ensure the success of the business, while its inefficient management or lack of attention may lead to the downfall of the enterprise. In many countries, several empirical studies have indicated that small business managers experience problems in raising capital for the development of their businesses. Different studies (e.g, Bolton, 1971; Wilson, 1979; Holmes and Kent, 1991; Winborg, 2000) have frequently
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referred to the concept of a ‘financial gap’, in order to explain why many small businesses face this sort of problem.Access to finance has been identified as a key element for the SMEs to succeed in their drive to build productive capacity, to compete, to create jobs and to contribute to poverty alleviation in developing countries. Despite their dominant numbers and importance in job creation, SMEs traditionally have faced difficulty in obtaining formal credit or equity. A study conducted in Lithuania (Aidis, 2005) revealed that the most important barriers were low
purchasing power followed by lack of working capital and official bureaucracy. Traditional
commercial banks and investors have been reluctant to service SMEs for a number of well known reasons: ? SMEs are regarded by creditors and investors as high- risk borrowers due to insufficient assets and low capitalisation, vulnerability to market fluctuations and high mortality rates; Information asymmetry arising from SMEs’ lack of accounting records, inadequate financial statements or business plans makes it difficult for creditors and investors to assess creditworthiness of potential SME proposals; High administrative/transaction costs of lending or investing small amounts do not make SME financing a profitable business.
?
?
Viewed from the owner-managers’ angle, major financial problems are: inadequate availability of working capital, a wide gap between working capital and term loans, banks’ insistence on collateral and third party guarantees, a risk averse banking system for small projects, delayed payments of bills by large firms. Many governments and international financial institutions have tried to address the problems of high transaction costs and risks by creating subsidised credit programmes and/or providing loan guarantee. Such projects have often fostered a culture of nonrepayment or failed to reach the target group or achieve financial self-sustainability. Hughes (1997) study of the financial structure of large and small UK businesses found that small businesses tend to rely more on short-term debts in comparison with large businesses. The result showed that small businesses have a higher proportion of debts as trade credit that are attributed to the fact that small firms face greater problems in attracting long-term debts than large businesses. However, this could also be explained by the mere preferences of owner-manager’s attitudes to debt capital.
Pecking Order Hypothesis
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Myers (1984) has tried to explain business managers’ financial preferences from a ‘pecking order approach’. According to Myers business managers prefer internal to external financing, and debts to external equity.In summary, the pecking order hypothesis states that businesses adhere to a hierarchy of financing sources and prefer internal financing when available; and if external financing is required, debt is preferred over equity. This hierarchical ‘ranking’ is due to the presumed fact that the relationship between the financier and the manager is characterised by information asymmetry. Holmes and Kent (1991) suggest that even if Myers’ discussion of the ‘pecking order approach’ is related to large listed businesses, the reasoning is equally applicable to small firms. Several empirical studies have supported Myers’ reasoning (e.g, Holmes and Kent, 1991; Norton 1991; Scherr et al., 1993). Thus, Holmes and Kent (1991) found that owner-managers prefer internal funds, as this form of funding ensures the maintenance of control over operations and assets. If debt financing becomes necessary the managers are assumed to favour short-term debt, as this source does not tend to involve any demand for collateral security.Zoppa and McMahon (2002)foundthe increased dependence on short-term financing for less profitable firms. The less profitable an SME is, and therefore the less self-sufficient it is through reinvestment of profits, the more likely it will need to depend upon short-term debt financing for its assets and activities. It is also observed that growth in sales creates financing pressures that are most probably met by short-term funding. This study also revealed that as the SMEs grow in size (measured in terms of assets), the more dependence they become on short-term funds for those assets. This would be the case where the sample units have limited access to long-term debt and equity financing arising from an alleged ‘finance gap’, prevented the business from following the financial management dictum of matching the term of finance used to the term of assets acquired (the so-called ‘matching’ or ‘hedging’ principle). Since SMEs is often characterised by a low fixed assets base, as observed in the study of Padachi (2006), the dependence on short-term funds is proportionately high which conforms with the matching or hedging principle (Bhattacharya, 2001).In line with this reasoning, the owner-manager’s desire to maintain control and independence are enough to support the explanation of his/her financial preferences. It is perceived that external providers of funds may interfere in the management of the business.
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It may thus, be concluded that the two approaches discussed above lend support to the financial choices of the small businesses. Most of the studies in small business finance have in one way or the other bring evidences as to the dual factors, that is, the characteristics of the small business and that of the small business manager are important to explain the financial preferences and choices (Pettit and Singer, 1985; Levin and Travis, 1987; Barton and Mathews, 1989; Ang, 1991; Scherr et al., 1993; Cosh and Hughes, 1994; Hamliton and Fox, 1998; Winborg, 2000). Small firm owners tried to meet their finance requirements from a pecking order of, first, their own money (personal savings, retained earnings); second, short-term borrowings; third, long-term debt; and, least preferred of all, from the introduction of new equity investors, which represent the maximum intrusion (Cosh and Hughes, 1994). METHODOLOGY In the present paper, the components of gross working capital is analysed to see whether there has been any structural changes over the period of study. The role of short-term funds as a source ofWCF is also investigated. This is achieved by analysing the components of working capital and the pattern of WCF for the sample units over the six years period. The study also attempts to assess the liquidity of the 101 sample manufacturing firms, using a comprehensive test based on liquidity ranks.This is calculated first by assigning individual ranking to the four main components of current assets and then sum up the individual scores to arrive at an ultimate rank. The second part of the paper attempts to model the use of short-term financing using multivariate analysis. Given the character of the data, this part of the analysis applied a panel data methodology. The empirical study is based on a sample of 101 small manufacturing companies. The data was hand collected from the financial statements of the sample firms, having a legal entity and had filed their annual return at the Registrar of Companies. The sample was drawn from the directory of (SEHDA), which is a database for registered manufacturing firms operating in diverse activities and for which data was available for a six year period, covering the accounting period 1998 to 2003. The rationale for selecting only those firms registered with SEHDA as a priori they are expected to be more organised and have undergone training programme in the functional areas of their businesses. This is a precondition and benefits that the small firms gain when
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registering with the agency. The companies qualified for the above two conditions are further grouped into industries based on the classification as listed in the 2005 directory. The companies spanned a range of industries including chemical, rubber and detergents, food and beverages, leather and garments, paper products and printing, metal products and wood furniture. Sample Criteria This includes all firms for which secondary data was compiled to examine the working capital structure and financing patterns of the small to medium-sized Mauritian manufacturing firms. A random sample of businesses was selected from the 2005 directory of SMEs. For a firm to be included in this study, it must satisfy the following criteria: ? ? ? ? It must have filed accounts for the period of the study; Have not been struck off from the database i.e., they are not defunct companies; Have not been eligible to file an ‘abridged version’ of accounts following the new provision of the Companies Act 2001; and Do not have inconsistent financial data for more than two accounting periods.
As a result of the above conditions, a number of firms were discarded for which data was not available for the whole period, either because they were newly formed or having missing values for more than two years. If this caused the number of companies in the industry to fall below 15, that industry would be excluded in the cross-sectional analysis. Since all the firms sampled have the same financial year, inter-industry comparability is facilitated and this eliminates the distorting impact of different reporting periods and seasonality patterns. Companies were randomly chosen subject to sufficient financial data was available throughout the six year period. These selection criteria result in a sample of 101 firms and 588 firms’ observations and therefore produce an unbalanced panel data.
DATA ANALYSIS AND RESULTS This section analyses the small to medium-sized Mauritian manufacturing firms’ working capital structure to examine the structural changes over the period of the study. It also analyses the pattern of WCF and to establish whether short-term funds have a major role in the financing of
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SMEs working capital, as confirmed in the literature. Attempt is also made to assess the relevance of ‘POT’ to the WCF of the sample firms.The main theoretical arguments and empirical evidences around the small firms demand for finance were discussed, with more focus on WCF. Descriptive Statistics The descriptive statistics for the sample are displayed in Table 1. Current liabilities are on average 60 % of total assets and the share of account payable in current liabilities is to the tune of 62% (Table 4). As for the assets, current assets constitute on average 59% of total assets while accounts receivable represents 43% of current assets. Thus, the sample units are net receivers of trade credit which confirms the importance of trade credit as a source of financing for the small to medium-sizedMauritian manufacturing firms. A similar finding was reported in the study of Howorth and Wilson (1998). It is observed that a lesser proportion of long-term funds are used to finance working capital, which implies that the sample units have no choice than to rely on shortterm sources to fund both the permanent and circulating part of their current assets. Stocks, another major component of current assets, are on average 28% of total assets (median value is 22%). However, on average only 6.5% of assets are financed with short-term financial debt and another 24% is granted as cash credit by banks. The share of long-term debt used to finance working capital is insignificant and thus confirms the priori claim that small firms face difficulties to secure long-term financing and it accords with the ‘POH’. Average long-term debt is about 23% of total assets, including shareholders loan and leasing. Thus,there is less scope for the sample firms to accommodate late payment by increasing equity or long term debt and a similar finding was observed in Bannock (1991). Therefore the two main avenues open to an SME suffering from late payment are to increase short-term bank borrowing, or delay payments to creditors. The mean long-term debt (GEAR) of the sample firms is 0.22 while that of short-term debt (CLTA) is 0.60, which clearly shows the importance of short-term debt over long-term in SME financing. Interestingly internal equity financing appears to constitute 18% of the capital of the Mauritian manufacturing SMEs. Contrary to finance theory (Van Horne, 1995) even the permanent component of current assets are financed out of short-term funds, which
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predominantly include trade credit and cash credit. However, the share of short-term financial debt represents only 6% of the financing need of the SMEs; thus confirming the difficulties which the sample firms faced in procuring WCF. One would therefore expect firms with more short-term assets, ceteris paribus, to have a higher demand for short-term credit in general and accounts payable in particular. The sample firms have an average of 61% as current assets and this isbeing financed out of short-term funds (60%), comprise mainly of trade credit, cash credit, short-term borrowing and other payables. While analysing the firms’ specific data, the sample firms tend to bridge shortfall in long-term financing by leasing some of the fixed assets and raise loans from their directors. A similar finding was observed in the study of Deloof and Jegers (1999) for a sample of large Belgian nonfinancial firms and this accord well with the ‘POH’ (Myers, 1984). Trends in Working Capital Table 2 analyses the trends in gross working capital and net working capital for the sample firms and also to see whether over the six year period, the firms have adopted different WCF policies, by calculating the ratio current liabilities to current assets.Throughout the period 1998 to 2003, the sample firms displayed a positive net working capital, but the ratio of current liabilities to current assets shows thatnearly 85%of the current assetsare met out of current liabilities. Given that easy accessibility of finance dictates the decision of the owner-manager, the sample units have predominantly use short-term finance to support its current operations.The sample units have thus followed an aggressive policy in financing current assets. The diversion of current funds to permanent current assets is not desirable and may affect future cash flows.Given this trend, the working capital structure is analysed to discuss briefly the important sources of WCF.
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Sources of Working Capital Deciding the size and means of financing the current assets is a continuous challenge to financial manager or owner manager of small firms. Table 3 shows the trends and composition of current liabilities and the financing patterns of working capital for the sample firms. As showed in Table 3, short-term funds (namely trade credit, other payables, bank overdraft, short-term borrowing and other current liabilities) have played a dominating role throughout the period of the study. It has provided over 85% of the WCF needs and this over-concentration is a reality of the SME sector. This could be explained by the fact that suppliers may have significant cost advantages over financial institutions when it comes to providing credit to their customers. Petersen and Rajan (1997) identified three sources of such cost advantages, namely informational advantage as a result of continued trading relationship; control over the actions of the buyer and can seize the goods if buyer defaults. Given that trade credit is limited to the amount of credit offered by the suppliers, the small firms tend to delay payment of their other payables such as monthly utility bills and repairs and maintenance. In a matching context one would in the first place expect other categories of shortterm debt to be substitutes for trade credit. The share of short-term bank debt has average to 6.5% while the sample firms’ reliance on bank overdraft has showed a downward trend, which testified the difficulties of the Mauritian SMEs in getting traditional sources of finance. Financing Patterns of Working Capital Table4 also exhibits an overall increasing trend in the use of long-term funds as a source of working capital during the period. It rises from 10.3% in 1998 to 19.1% in 2001. This trend speaks of difficulty in procuringWCF. This source of finance is to a large extent supplement by shareholders/directors loan, especially where the sample firms lack collateral assets. The same finding was observed in the study of Ahmad and Ghufran (2005) for a sample of Marketing Cooperative Societies in Eastern Uttar Pradesh. It is generally believed that short-term borrowings finance the major portion of working capital needs and long-term funds may be employed for this purpose in case of necessity only(Banerjee and Hazra, as cited in Mallick and Sur, 1999).
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Financing is yet another important issue in the management of working capital of a firm. Firms with inadequate working capital suffer from underutilisation of capacity resulting in the extension of break-even point. It is observed that the sample firms have diverted long-term funds to finance working capital as the share of traditional sources of finance has declined. But, however, in practice a firm has to choose a combination of the two modes of financing a particular level of working capital. This obviously depends on a multiple of factors like flexibility, risk preference, demand and supply position in the money market, and cost of financing. The other payables (19%) are the major short-term (internal) sources that are used till their time for payment becomes due. Diversion of working funds for meeting long-term requirement because of negative net working capital was observed for some of the selected firms.They have limited access to external longterm debt and thus have to rely on shareholders loan to finance the business activities. This practice accords well with the ‘POH’ where small firms prefer to use external debt and internal equity than to rely on external equity. This is inline with the argument that small enterprises as a whole would prefer internal financing as external financing is either more costly or more difficult to obtain due to greater monitoring or other agency costs and greater information asymmetries (Pettit and Singer, 1985). These findings are generally consistent with prior studies (Ang, 1991, Holmes and Kent, 1991; Cosh and Hughes, 1994 and Fama and French, 2000). Analysis of the sample firms’ financing data showed that there are four main categories of sources of working capital which are as follows: ? ? ? ? Trade debt and other payables Provisions and other non-bank short-term borrowings Short-term bank borrowings Net working capital from equity and/or long-term borrowings
The first two sources of WCF constitute the non-bank current liabilities. Thus, total current assets minus ‘total non-bank current liabilities’ represents the ‘working capital gap’. It is expected that this gap to be met partly by bank borrowing or cash credit facilities, the balance being supported by equity and/or long-term borrowings. Table5 showing the percentage composition of WCF, clearly demonstrates the increasing dependence on this source for additional funds.
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Trade debt and other payables have grown at a rate faster than the rate of increase in sales, as indicated by the growth trend index. It may thus conclude that the sample firms postpone payments to creditors as a way out to ease their financial difficulties. It is noted that the small firms do not have much scope to use non-bank short-term borrowings (a lower share of the composition of WCF). Equally short-term bank borrowing represents a lower share of the overall WCF and its dependence has showed a declining trend. Table 6 gives supplementary information on the firms’ pattern of WCF, including sales data and growth trend index. The rate of growth in bank borrowing lagged well behind that of sales and has remained more or less constant, except for
the year 2003, where the growth rate is in line with that of sales.
The ‘net working capital’, representing residual support to working capital from equity and/or long-term borrowing though accounting for only a small fraction of total WCFhas increased over the period of study. This demonstrates that the increase in sales which could be partly ‘seasonal’ is being financed out of long-term sources, which accords well with the finance literature. However, for the sample firms, this is partly met by a disguised form of equity; that is, shareholders loan. The working capital, constituting support from equity and/or long-term borrowings was as low as 13% of working capital funds. The firms’ reliance on short-term bank borrowing has declined over the period of study and the fluctuations in sales are mainly financed by postponing payments to suppliers and long-term sources. In all the years the ranking of the contribution to gross working capital was the same; that is trade debt; short-term bank borrowing, equity and/or long-term borrowing and lastly non-bank short-term borrowing, except for the year 1998. Interesting the growth index for the sample firms’ long- term finance has more than triple over the period of the study, though it finances only 20% of the gross WC. Liquidity Ranks An attempt has been made to assess the liquidity of the 101 sample manufacturing firms, using a comprehensive test based on liquidity ranks (Mallick and Sur, 1999). This is calculated first by assigning individual ranking to the four main components of current assets and then sum up the individual scores to arrive at an ultimate rank. The four criteria as showed in Table 7 are stock to current assets ratio (STCR), debtors to current assets ratio (DTCR), cash and bank balances to current assets ratio (CTCR) and other current assets to current assets ratio (OTCR).
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Investment in the various categories of current assets has an incidence on the liquidity of an enterprise. The category of current assets which forms the largest component in total current assets will, therefore, affect liquidity of the enterprise in a significant way. A comprehensive test based on the sum of scores (liquidity ranks) of separate individual ranking under the four criteria are given in Table 7. A high value of DTCR, CTCR, and OTCR indicate greater liquidity and ranking has been done in that order. On the other hand, a low STCR shows a more favourable position and hence ranking has been done in that order. For the manufacturing enterprises, stock of raw materials and finished goods are a significant item and tying a large proportion of current assets in stock means the business enterprise will face liquidity problems. Kendall’s coefficient of concordance (W) is computed to determine the degree of uniformity among the four sets of rankings and Chi-square test has been applied for testing the significance of such coefficient. Table 7 shows that the year 2002 recorded the most sound position followed by 2003, 2000, 2001, 1999 and 1998 respectively, in that order. It indicates that the overall liquidity of the sample firms in the later years was better than in the early years of the study. The notable decline in stock level is a contributing factor alongside the increasing trend in cash and bank balances. The computed value of W is 0.58 and is not statistically significant. It reveals that there is no close association among the liquidity of various components of working capital during the period of study. Relationship between Liquidity and Profitability Most standard finance text book have a section which emphasises on the trade-off between liquidity and profitability. The theory stipulates a negative relationship whereby a high level of liquidity sacrifices profitability. Table 8 attempts to measure the degree of relationship between liquidity and profitability of the sample units by computing Spearman’s rank correlation coefficient R?p. The above figures confirmed the negative relationship between profitability and liquidity, though showing a weak significance. The years 2002 and 2003 which reported a better liquidity position adversely affected the profitability of the sample units. Shin and Soenen (1998) and more recently Deloof (2003) empirically showed that a lengthening of the trade cycle impact negatively on the profitability of large corporate companies. It may be deduced that in the later
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period of the study, the sample units have maintained higher level of debtors and cash and bank balances, but to the detriment of profitability. Multivariate Analysis The major part of the analysis has examined the sample firms’ working capital structure and the financing pattern, using non-econometric techniques. The average values and ratios of the various working capital elements (uses and sources of funds) have been worked out using secondary financial data. In order to understand the WCF of the Mauritian manufacturing firms and to determine the significance of the variables as discussed below, multivariate analysis is applied by specifying a regression model as in equation (1). Given the panel nature of the data, there may be an argument to support the use of a static framework for examining the relationship of the sample firms’ short term financing to a number of variables expected to influence that decision. The lack of financial data points over time suggested that employing a static framework was more appropriate. In particular, the limited data points over time would most likely lead to high standard errors on such panel analysis, resulting in a relatively low powered test.
Variables
A brief definition of the variables and the expected relationship between the dependent variable and the explanatory variables are given below. The dependent variable is CLTA, the ratio of current liabilities to total assets and is used as a measure of short-term financing.
GEAR is used to denote the long-term debt as a proportion of total assets. The literature review
section has provided both theoretical arguments and empirical evidences on the use and availability of such financing mode to the SMEs. A firm’s share of short-term financing is expected to increase as its ability to raise debt is constrained by external or internal factors. It is therefore hypothesised that the variable GEAR is negatively associated with the dependent variable.
ROTA is a measure of the firm’s profitability with respect to the level of investment. It is
calculated as operating income divided by total assets. As firms become profitable, they are
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expected to use internally generated funds to meet their working capital needs and place less reliance on short-term financing. Empirical evidences examining SMEs lend support to the negative relation between debt (long-term and short-term) and profitability (Chittenden et al., 1996; Michaelas et al., 1999; Cassar and Holmes, 2003). Based on that, a negative relationship between profitability and short-term financing is hypothesised.
CATA is a measure of the asset structure and is the ratio of current assets to total assets. As this
ratio increases, by an increase in the level of stocks and debtors, they mirror an increase in the use of trade credit, cash credit and short-term borrowing. This variable is thus positively related to the short-term debt and this was evidenced from the earlier analysis. The variable is further disaggregated into the working capital composition; that is SKCA and TDCA to separately identify the significance of each element in the WCF of the sample firms.
TURNCA is sales divided by current asset and is a measure of the firms’ operational efficiency in
using gross working capital to generate sales. The greater the efficiency in the utilisation of current assets to generate sales, the lesser is the need to rely on short-term financing to meet working capital requirements. A priori a negative relationship between the variable TURNCA and
CLTA is expected. GROWTH is growth in sales measured by computing the percentage increase/decrease in the
yearly sales for each firm. Applying the pecking order arguments, firms which are in the growth path would place more reliance on internally generated funds. Also, where growth is not spectacular, the firms may use retained profit and supplement by the less secured short-term debt before considering the more secured long-term debt financing. This should lead to firms with relatively high growth to use more short-term financing.
SIZE is proxied by the natural logarithm of sales and there are several theoretical reasons (informational asymmetries, transaction costs, managerial preferences etc) as to why size is related to
the financing decision of SMEs. The empirical evidence investigating the relationship between size of firms and financing supports a positive link between size of firms and leverage (Cassar and Holmes, 2003).
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The independent variables as briefly discussed above are summarised below and are expressed in equation (1):
CLTAit ? ? 0 ? ?1 ln salesit ? ? 2 gearit ? ?3rotait ? ? 4turncait ? ?5 growthit ? ? 6catait ? ? it (1)
Where the dependent variable is CLTA and the subscript i denoting firms (cross-section dimension) ranging from 1 to 101 and t denoting years (time-series dimension), ranging from 1 to 6.
lnsales = natural logarithm of sales, a proxy for size gear = long-term debt to total assets rota = return on total assets before interest growth = growth index of sales (for each firm over the six years period) turnca = sales divided by current assets as a measure of Gross working capital efficiency cata = current assets to total assets as a measure of gross working capital requirements skca = stock to current assets (Model 2) tdca = debtor to current assets (Model 3) Table 1 provides a summary of the descriptive statistics of the dependent and independent variables. The mean short-term financing of the sample firms is 0.60 and the mean long-term debt suggests that it represents 22% of the capital of the SMEs. This highlights the importance of short-term debt over long-term debt in SME financing and a similar finding was confirmed by Cassar and Holmes (2003). The remaining 18% is represented by the owners’ equity which provides evidence that SMEs tend to be undercapitalised. The growth index for the sample firms is only 0.7% and is an indication that the SMEs are constrained by the market, especially in a small island economy. The correlation matrix between the dependent variables and the explanatory variables are shown in Table 9. Examining the univariate relationships between the dependent variables and independent variables, of particular note is the consistent direction of the relationship, though not all of them are significant. A priori a positive relationship between TDCA and the dependent variable (CLTA) is expected, but the coefficient is negative and significant. Strong correlations between GEAR and the asset structure are also observed, for example the higher the proportion of current assets in total assets, the lesser is the use of long term debt in the financing decision of SMEs. This provides evidence of a matching financing policy, where the sample firms tend to
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finance their current assets out of current liabilities (a significant positive correlation between CATA
and CLTA).
Finally, examining the variable size against the correlations of the other independent variables it is observed that larger firms have a lower proportion of long-term debt, as they appear to be more profitable (ability to generate funds internally). Apart from being profitable, the larger firms report a higher proportion of current assets and this is also reflected in the significantly positive correlation between SIZE and GROWTH. Most of the coefficients have a low value, except for the correlation between TURNCA and CATA, showing a significant negative value of 0.5193. Thus, the data set is not affected by multicollinearity and it is safe to proceed with the multivariate analysis.
Estimation method
A multivariate empirical model is used to facilitate the interpretation of the marginal importance of each of the variable.
The regression models
When using a static panel framework, the decision to use either a fixed-effects model or a random-effects model arises. Panel data analysis allows the consideration of a firm-specific timeinvariant effect. In order to determine which of these two regressions models should be run, the Hausman test is used to determine the appropriate model. The techniques examine whether difference between the estimators generated by random-effects regression and the estimators generated by fixed-effects regression approximates zero. The diagnostic tests favour a randomeffects model and the results are reported in Table 10.
Analysis of Results
The prime objective is to examine closely the determinants of WCF, subject to the data restriction. The results for the four models (1) - (4) to test for the separate effect of working capital components (CATA, SKCA and TDCA) and the operational efficiency (TURNCA, Model 4) are displayed in the table together with t-values and statistical tests.
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The main variable CATA (Model 1) which shows the extent of aggressiveness in the asset management of the sample firms is strongly confirmed and follows a matching financing principle. The coefficient is positive and highly significant at the 1% level. As expected, the sample firms meet the working capital requirements out of current liabilities which include mainly trade credit, cash credit, short-term borrowing and other payables. This is also evidenced in Table 4 where only the working capital gap is met out of long-term debt. Interestingly, the findings tend to corroborate other finance related SMEs studies (Chittenden et al., 1996; Cassar and Holmes, 2003), though not specifically investigating the use of short-term debt. The hypothesis that firms with growth potential borrow on the short-term is not confirmed, instead a significant negative relationship is observed for all the models. A partial interpretation of this finding could be that the sample firms are not pursuing any growth strategy as confirmed by the low mean value for the variable growth in sales. However, the measurement scale used may also not a good measure of growth for the sample. Consistent with the pecking order arguments, the coefficient for ROTA is negative and statistically significant in all the regressions models. This suggests that profitable firms manage to meet their working capital requirements out of cash flow generated from operating activities. Interestingly the small to medium-sized Mauritian manufacturing firms do not have to exert pressure on the short-term financing mode and may be viewed as a welcoming strategy to strengthen the supply chain relationship. The relationship between firm size and WCF (CLTA) is positive and statistically significant in all the models, except model 3 showing a weak significance. This finding has implications for larger firms which need to support high working capital requirements. The positive relationship is consistent with the theoretical arguments, where the larger firms demand for finance may be more attractive than request from smaller firms. Because of the transaction cost theory, lending institutions may find it costly to lend to small firms, and they may be further credit rationed as they are informationally opaque. The hypothesis that firms which is pursuing a matching principle; that is using long-term debt to finance the permanent part of current assets and the fixed assets is statistically confirmed. In every regression, the coefficient of GEAR is large and significant at the 1% level. As the
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proportion of long-term debt financing increases, the share of current liabilities to total assets falls and confirms that firms seek to match the maturities of assets and liabilities (Heyman et al., 2008). The two variables used to examine the separate effect of stock and debtor in the working capital composition of the sample firms are showed in regression model 2 and model 3. As expected, the coefficient for SKCA is positive and statistically significant at the 1% level. This suggests that as the firms build up stocks in anticipation of higher sales level, the need for short-term WCF increases. Empirical evidences have confirmed such relationship and how important is the use of trade credit as a source of finance has been widely research. However, as the firms liquidate its stock level and the asset changes its form into debtors, the need for extra financing in the form of bank overdrafts or bank loans is less felt. This is confirmed by the significantly negative relationship between the variable TDCA and the dependent variable CLTA. CONCLUSION AND DISCUSSIONS Using a sample of 101 small manufacturing firms, operating in six different industry groups for the 1998 – 2003 period, the results confirmed that short-term sources more particularly trade credit and other payables play a significant role in financing working capital. Trade credit is primarily used to finance short-term assets (Deloof and Jegers, 1999). Short-term bank credit plays not only a significant but also a dominating role as a major external source of financing working capital requirements of the sample firms. It ranges from 27% to 34%. This is evidenced by the low level of short-term borrowings with a mean value of 7% over the period of study. Therefore to bridge the shortfall in working capital requirements the sample units have no choice than to rely on their banks for overdraft facilities. The regression results showed that the small to medium-sized Mauritian manufacturing firms have a financing pattern, which is influenced by the asset structure, leverage, profitability, operational efficiency and size of firms. As suggested by Rajan and Zingales (1995), the results showed a negative and statistically significant relation between growth and the level of shortterm debt. It is generally assumed that short-term funds are first directed to WCF, the working capital gap is met out of long-term funds. Equity option is the least preferable option as evidenced by the low ownership ratio. This is often explained by the strong desire to keep
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control of the business within the family and the owner managers would consider external equity as a last resort. Evidence on this issue provides insight into the financing behaviour of the sample units and contributes to the understanding of financing choices of SMEs. The findings are comparable to similar studies as reviewed in the literature section and the findings are consistent with these a priori hypotheses. Thus, the results provide confirming evidence that small firms face borrowing constraints due to agency costs and asymmetry information (Ang, 1991; Cosh and Hughes, 1994; Winborg, 1997). In theoretical terms the study confirms Myers’ (1984) reasoning about ‘pecking order approach’, that is, the small business managers prefer internal (inclusive of loan from shareholders) to external financing, and debts to external equity. In terms of policy-making the study will question the large efforts that have been made in many countries to increase the supply of capital to small businesses. However, the case for Mauritius may be different since the recent budgetary measures make provision for WCF schemes and these are partly subsidised by the government and may thus be attractive to the small business managers. The most significant coefficient in the regression models consistently show that short-term financing is negatively correlated with the level of profitability. While the profitable firms may be more attractive from the lending institutions perspective, the need for overdraft and loans may possibly be lower if retained profits are sufficient to meet the sample firms’ working capital requirements. Thus, the pecking order arguments that predict a negative relationship between profitability and debt are validated for the sample (Myers, 1984). The regression models consistently showed that firms exposed to high level of current assets make the most use of short-term financing. This supports the finance theory and a number of empirical findings from previous studies. Similarly there is no evidence that operational efficiency has a negative impact on the use of short-term financing. This could be linked to the poor financial management practices of small firms where they not only take longer to collect their receivables they also tend to keep high level of stocks. If this is supported, then firms have no choice than to delay payment to suppliers (use of trade credit) and increase reliance on cash credit.
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Finance is one of the most cited problems faced by SMEs. Government financial support schemes and debt from financial institutions are important source of capital for small firms to bridge the financial gap (Berger and Udell, 1995). However, the financial burden of debt on a firm’s financial viability has been recognised in the finance literature and is often the causes for firms’ bankruptcy (Carter and Van Auken, 2006). If such is the case, then it is important for owner manager to undergo training in finance-related matters. The SEHDA and Human Resource Development Council (HRDC) have a role to play in this area and need to be addressed given the international perspective. SMEs can be particularly affected by typical asymmetric information problems like adverse selection and moral hazard. As a result they tend to rely mostly on short-term debt financing and such source of finance is even more attractive given that owner manager of SMEs may decide not to seek financing that dilutes their ownership and therefore limits their ability to act. In this respect, they generally turn their attention to debt once internal resources have been fully utilised. It is therefore presumed that cash flow from operations represents the ultimate option of financing and thus, it is important that profits are quickly converted into cash through efficient WCM practices.
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Appendix 1 Variables Definition OPM ROTA GEAR OSHIP CATA CLTA SKCA TDCA TURNCA LNSALES STCR DTCR CTCR OTCR GROWTH Operating Profit Margin is PBIT/Sales Return on total assets is PBIT/Total Assets Gearing is Total Debt/Total Assets Ownership ratio is Shareholders Funds/Total Assets Current Assets to Total Assets Current Liabilities to Total Assets Stocks to Current Assets Trade Debtors to Current Assets Current Assets Turnover is Sales/Current Assets LNSALES is the natural logarithm of sales (Proxy for size) Stocks to Current Assets ratio Debtors to Current Assets ratio Cash and Bank Balances to Current Assets ratio Other Current assets to Current Assets ratio Growth index of sales (for each firms over the six years period)
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Table 1: Summary statistics (101 small manufacturing firms, 1998 – 2003)
Median Accounts payable Cost of sales Sales growth Assets: Total assets (Rs’000s) Non-financial fixed assets Current assets Accounts receivable Inventories/Stocks Cash and bank balances Other short-term assets Sources of funds: Short-term funds (CL) Short-term financial debt Short-term bank debt (OD) Long-term funds Long-term financial debt Long-term non-bank debt* Ownership ratio 21% 99% 0.025% 4,025,038 31% 54% 20% 22% 0% 12% 52% 5% 14% 15% 10% 5% 25% Average 32% 126% 0.7% 8,115,219 36% 61% 26% 28% 5% 19% 60% 6% 15% 22% 15% 8% 18% Standard Deviation 48% 98% 4.11% 11,900,000 39% 78% 48% 32% 14% 21% 68% 9% 14% 33% 21% 12% 70%
Notes: All variables are percentages of total assets, except total assets and sales growth *Includes Shareholders loan and Leasing, which is a common source of finance for the Mauritian SMEs
Table 2: Trends in current assets, current liabilities and NWC for the period 1998 – 2003
Year 1998 1999 2000 2001 2002 2003 Current Assets Rs’000s 371,579 419,947 464,703 497,462 570,487 593,400 Current Liabilities Rs’000s 343,327 362,940 414,340 423,904 489,323 503,129 Net Working Capital – Rs’000s 28,252 57,007 50,363 73,558 81,164 90,271 CL/CA 0.92 0.86 0.89 0.85 0.86 0.85
Table 3: Composition of current liabilities: sources of working capital-(figures in Rs’000s)
1998 N=95 122,023 36% 58,000 17% 44,554 13% 95,790 28% 21,117 6% 343,327 100% 1999 N=99 129,800 36% 65,380 18% 46,860 13% 96,154 26% 22,679 6% 362,940 100% 2000 N=100 157,987 38% 84,008 20% 37,315 9% 106,089 26% 27,005 7% 414,340 100% 2001 N=101 185,173 44% 80,738 19% 24,155 6% 103,065 24% 29,117 7% 423,904 100% 2002 N=98 228,022 47% 89,238 18% 33,927 7% 101,802 21% 29,465 6% 489,904 100% 2003 N=95 200,975 40% 112,963 22% 40,815 8% 99,873 20% 42,266 7% 503,129 100% Average N=588 170,660 40% 81,720 19% 37,940 9% 100,460 24% 28,610 6.5% 422,920 100%
Trade Credit Other Payables Other Current Liabilities Overdraft Short Term Borrowings Current Liabilities
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Table 6: Pattern of Working Capital Finance(figures in Rs million)
1998 827 372 1999 871 420 101 Selected Firms 2000 2001 995 1010 465 497 2002 1072 570 2003 1183 593
Net Sales Total Current Assets Financed by: Trade debts and other payables Provisions and other non-bank short-term borrowings Total non-bank current liabilities Working Capital gap: (Current assets minus non-bank current liabilities) (as a % of current assets) Met by: Bank borrowings: Short-term Net WC from equity and/or L-T borrowings Total Growth trend index: Net sales Total current assets Trade debts and other payables Provisions and other non-bank short-term borrowings Bank borrowings: Short-term Net WC from equity and/or L-T borrowings Index: 1997-1998 Base = 100
180 44 224 148 40% 117 31 148
195 47 242 178 42% 119 59 178
242 37 279 186 40% 133 53 186
266 24 290 207 42% 132 75 207
317 34 351 219 38% 131 88 219
314 41 355 238 40% 142 96 238
100 100 100 100 100 100
105 113 108 107 102 190
120 125 134 84 114 171
122 134 148 54 113 242
130 153 176 77 112 284
143 159 174 93 121 310
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Table 4: Financing patterns of working capital(figures in Rs’000s)
1. Gross working capital 2. Sources of WC: (i) short term funds (ii) long term funds 3. Total long term funds 4. % of LT funds used to finance WC 5. Shareholders loan LT borrowings 6. Owners equity 1998 371,579 1999 419,947 2000 464,703 2001 497,462 2002 570,487 2003 593,400
343,327 28,252 274,850 10.3% 24,465 62,767 187,618
362,940 57,007 323,174 17.6% 27,062 75,626 220,486
414,340 50,363 353,691 14.2% 40,578 90,782 222,331
423,904 73,558 385,977 19.1% 40,974 106,914 238,089
489,323 81,164 444,788 18.2% 25,734 112,363 306,691
503,129 90,271 452,305 20% 31,534 98,295 322,477
Table 5: Percentage composition of working capital finance(figures in %)
Trade debts and other payables Provisions and non-bank STB Short-term bank borrowings Net working capital Total Current Assets or GWC 1998 48 12 31 9 100 1999 46 11 28 15 100 2000 52 8 29 11 100 2001 54 5 27 14 100 2002 56 6 23 15 100 2003 53 7 24 16 100
Table 7: Statement of ranking in order of liquidity: 101 firms for the period 1998 - 2003
Year STCR % 49 47 45 46 42 43 DTCR % 32 34 35 36 38 35 CTCR % 5 6 7 8 8 11 OTCR % 14 13 13 10 12 11 STCR 6 5 3 4 1 2 DTCR 6 5 3 2 1 3 Liquidity Ranks CTCR OTCR Total Rank 6 1 19 5 4 2 2 1 2 2 6 4 5 17 12 14 8 11 Ultimate Rank 6 5 3 4 1 2
1998 1999 2000 2001 2002 2003
Kendall coefficient of concordance among four sets of liquidity ranks ( W) is 0.58 and Chi-square value of W is 11.60. Critical value of X2 at 0.005 per cent for (r-1) (c-1), i.e 15 degree of freedom is 32.80 Variables definition in Appendix 1
Table 8: Analysis of rank correlation between liquidity and profitability
1998 Liquidity Rank as per Table (L) Operating Profit Profitability Rank (P) 6 1999 5 2000 3 2001 4 2002 1 2003 2 Rank Correlation between liquidity and profitability (Rlp) is -0.794 and ‘t’ value of Rlp is 0.059 being significant at 0.10 level. Critical value of ‘t’ at 0.10 level with 5 degrees of freedom is -1.476
6 1
6 1
5 3
4 4
1 5
-1 6
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Table 9: Pearson correlation matrix between variables
1. clta 2. rota 3. gear 4. skca 5. tdca 6. cata 7. turnca 8. lnsale 9. growth
c, b, a
1 1.000 -0.013 -0.086b 0.103b -0.107b 0.157c 0.154c 0.064 -0.062
2 1.000 -0.164c -0.151c 0.085b 0.010 0.024 0.152c 0.170c
3
4
5
6
7
8
9
1.000 0.188c -0.010 -0.185c 0.125c -0.341c 0.049
1.000 -0.424c 0.182c -0.063 -0.177c -0.028
1.000 -0.178c 0.057 -0.005 0.003
1.000 -0.519c 0.117b 0.004
1.000 -0.054 0.056
1.000 0.379c
1.000
denotes significance level at 1%, 5% and 10% respectively. Variables definition in Appendix 1
Table 10: Static panel estimates (Generalised Least Square) regressions of short-term financing
(Dependent Variable: CLTA) Variable Constant Model 1 0.9670 (4.14)*** Lnsales 0.0634 (4.03)*** rota -0.3701 (-6.38)*** gear -0.2538 (-7.19)*** growth -0.0093 (-4.06)*** turnca Model 2 0.7812 (2.81)** 0.0448 (2.23)** -0.3581 (-5.48)*** -0.3397 (-8.91)*** -0.0054 (-1.86)* Model 3 1.1314 (4.37)*** 0.0290 (1.70)* -0.3803 (-6.13)*** -0.3390 -(8.90)*** -0.0057 (-2.16)** Model 4 0.5167 (2.11)** 0.0573 (3.47)*** -0.3935 (-6.12)*** -0.3222 (-9.46)*** -0.0081 (-3.27)*** 0.0367 (13.79)*** cata 0.3600 (11.79)*** skca 0.2608 (8.97)*** tdca -0.1959 (-7.54)*** 0.7617 (25.71)***
Wald (chi2)
399.87 (0.0000)
247.88 (0.0000)
307.28 (0.0000)
1671.08 (0.0000)
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