Financial Analysis

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Working Capital Requirements
and the Determining Factors in Pakistan
Mian Sajid Nazir* and Talat Afza**

Literature on corporate finance has traditionally focused on the study of long-term financial decisions. Researchers have examined, in particular, the investment decisions, capital structure, dividends or company valuation decisions, among other topics. However, short-term assets and liabilities are important components of total assets and need to be carefully analyzed. Management of these short-term assets and liabilities warrants a careful investigation because working capital management plays an important role in a firm’s profitability as well as its value (Smith, 1980). The optimum level of working capital is determined, to a large extent, by the methods adopted by the management. Continuous monitoring is required to maintain optimum levels of various components of working capital, such as cash receivables, inventory and payables. In line with the studies of Afza and Nazir (2007 and 2008), the present study examines the factors that determine the working capital requirements of the firms. For this purpose, a study of 132 manufacturing firms from 14 industrial groups that were listed on Karachi Stock Exchange (KSE) between the period 2004-2007 was undertaken. While the working capital requirement was used as the dependent variable, various financial and economical factors, such as operating cycle of the firm, level of economic activity, leverage, growth of the firm, operating cash flows, firm size, industry, return on assets and Tobin’s q, were used as the determining factors of working capital management. Regression analysis was carried out on the panel data for 132 non-financial firms over a period of nine years. Finally, the study suggests some policy implications for the managers and investors of Pakistani markets.

Introduction
The corporate finance literature has traditionally focused on the study of long-term financial decisions, particularly investments, capital structure, dividends or company valuation decisions. However, short-term assets and liabilities are important components of total assets and need to be carefully analyzed. Management of these short-term assets and liabilities warrants a careful investigation, since the working capital management plays an important role in a firm’s profitability and risk as well as its value (Smith, 1980). Efficient management of working capital is very essential in the overall corporate strategy in creating shareholder value. Firms try to maintain an optimum level of working capital that maximizes that value (Deloof, 2003; Howorth and Westhead, 2003; and Afza and Nazir, 2007). In a broader spectrum, from the perspective of a Chief Financial Officer (CFO), working capital management is a simple and straightforward concept of ensuring the ability of the organization to fund the difference between short-term assets and short-term liabilities (Harris, 2005). However, a ‘total approach’ should be followed which covers all the activities * Lecturer, Department of Management Sciences, COMSATS Institute of Information Technology (CIIT), Lahore, Pakistan. He is the corresponding author. E-mail: snazir@ciitlahore.edu.pk * * Dean, Faculty of Business Administration, COMSATS Institute of Information Technology (CIIT), Lahore, Pakistan. E-mail: talatafza@ciitlahore.edu.pk

© 2009 The Icfai University Press. All Rights Reserved. The Icfai Journal of Applied Finance, Vol. 15, No. 4, 2009 28

of the company relating to vendors, customers and products (Hall, 2002). In practice, working capital management has become one of the most important issues in organizations, where many financial managers are finding it difficult to identify the important drivers of working capital and the optimum level of working capital (Lamberson, 1995). Consequently, companies can minimize risk and improve their overall performance if they can understand the role and determinants of working capital....
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