Working Capital Management

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SEMINAR IN ECONOMIC POLICY THESIS

IMPACT OF WORKING CAPITAL MANAGEMENT ON PROFITABILITY
THE CASE OF KSE QUOTED OIL & GAS (E&P) FIRMS

KHALID HAMEED SHAIKH (9102)
INSTITUTE OF BUSINESS MANAGEMENT (IoBM)
SECTION A
December 28, 2011

IMPACT OF WORKING CAPITAL MANAGEMENT ON PROFITABILITY
THE CASE OF KSE QUOTED OIL & GAS (E&P) FIRMS

Abstract:

This research report investigates the effect of working capital management on the firm’s financial performance. The report hypothesize that working capital management leads to improved profitability in the Oil and Gas (Exploration & Production) Industry of Pakistan. The dependent variable, Return on Assets (ROA) is used as a measure of profitability and the relation between working capital management is studied for a sample of 4 Oil and Gas (E&P) companies listed in Karachi Stock Exchange using panel data analysis for the period 2006-2010. Specifically, results indicate that the cash conversion cycle and liquidity are associated with the firm’s profitability.

Introduction

Working capital, also referred to as net working capital (NWC), is an absolute measure of a company’s current operative capital employed and is defined as: (Net) working capital = Current assets – Current liabilities.

Today, many companies still underestimate the importance of working capital management as a lever for freeing up cash from inventory, accounts receivable, and accounts payable. By effectively managing these components, companies can sharply reduce their dependence on outside funding and can use the released cash for further investments or acquisitions. This will not only lead to more financial flexibility, but also create value and have a strong impact on a company’s enterprise value by reducing capital employed and thus increasing asset productivity. A frequently used measure for the effectiveness of working capital management is the so-called cash conversion cycle, or cash-to-cash cycle (CCC). It reflects the time (in days) it takes a company to get back one monetary unit spent in operations. The operative NWC positions are translated into “days outstanding”, the number of days during which cash is bound in inventory and receivables or financed by the suppliers in accounts payable. Companies need to manage all three components simultaneously across the value chain so as to drive fundamental reductions in asset levels.

Excess inventory is one of the most overlooked sources of cash, typically accounting for almost half of the savings from working capital optimization projects. By streamlining processes within the company as well as processes involving suppliers and customers, companies can minimize inventory. Many companies are early payers and late collectors, a formula for squandering working capital. Other companies’ particularly project-based businesses and manufacturers of large, costly products with lengthy production cycles have cash flow problems caused by a mismatch in timing between costs incurred and customer payments. Therefore, efficient management of receivables and prepayments received is crucial.

Background of Oil & Gas (E&P) Sector

Working capital, the measure of a company's current assets after subtracting its liabilities, can impact a company's cash flow. "There is a growing awareness throughout the oil and gas (E&P) industry of just how much value is being left on the table as a result of too little focus on working capital management". However, issues such as price volatility and, in particular, any interval of relatively higher oil and gas prices tend to draw attention away from sound working capital management. A key factor in the deterioration of the oil and gas (E&P) industry's C2C performance is inventory levels, which grew substantially from 2003 to 2009. While the meaning behind such a decline may not be immediately apparent, in general, this reflects the impact of much stronger oil prices on the value...
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