Determinants of Profitability of Automobile Sector in Pakistan

Topics: Finance, Corporate finance, Capital structure Pages: 25 (7392 words) Published: June 19, 2013
Research Research

Impact of Working Capital Management and Capital Structure on Profitability

IMPACT OF WORKING CAPITAL MANAGEMENT AND CAPITAL STRUCTURE ON PROFITABILITY: THE CASE OF KSE QUOTED AUTOMOBILE FIRMS* H. Jamal Zubairi Finance and Accounting Department Mirza Aqeel Baig Economics Department College of Business Management, Karachi Abstract For any business concern the net profit or bottom line for a particular time period is the end result of its investing, financing and operating activities. These activities can be visualized as being influenced by management’s decisions and a host of internal and external environmental factors. This paper investigates how profitability of firms, in the automobile sector of Pakistan, is influenced by working capital management and capital structure of firms. The current ratio was taken as representative of the result of working capital management policy and financial leverage as the benchmark for capital structure. Supplementary analysis was also undertaken to assess the impact of operating leverage and firm size on profitability. The purpose of the research was to determine empirically, using pooled data analysis, whether the linkage of profitability with the selected indicators, is in line with the relevant generally accepted finance theory. Furthermore, the conclusions arrived through data analysis could be used in formulating some policy recommendations for a better management of profitability by automobile sector firms in Pakistan. Key Words: Profitability, Operating Leverage, Financial Leverage, Firm Size, Liquidity, Pakistan’s Automobile Industry, Panel Data JEL Classification: C23, G32, G33 *Refereed version of a paper earlier presented at the Second International Conference on ‘Promoting Socio-Economic Development of Sindh’ organised by the Institute of Business Management, Karachi in January 2010.

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PAKISTAN BUSINESS REVIEW OCTOBER 2010

Impact of Working Capital Management and Capital Structure on Profitability

Research

I. Introduction For managing liquidity efficiently, a company’s management has to decide on the optimum level of current assets and current liabilities that it should carry. A comprehensive ratio which captures the relationship between the level of current assets and current liabilities is the current ratio, calculated as current assets / current liabilities. In this study, current ratio has been used as the indicator for firm liquidity. Operating leverage measures the degree to which a business organization relies on fixed operating costs in its pursuit for maximizing its operating profit. Increase in profits results from spreading a given level of fixed operating costs over a larger number of units of the product. Thus, the degree of operating leverage is higher in those companies whose operating costs include a higher percentage of fixed operating costs. On the other hand companies whose operating costs comprise a relatively high percentage of variable costs have a low operating leverage. The operating breakeven point is higher for companies with a larger proportion of fixed operating costs. This makes such companies more risky because if the level of sales is not sufficiently high, the fixed operating costs may not be adequately covered, thereby resulting in an operating loss or a low operating profit. Thus, while a high degree of operating leverage will increase operating profit in times of rising sales; operating profits will reduce rapidly when sales are showing a declining trend. A similar impact can be visualized on the bottom line or net profit for a company with a high degree of financial leverage. For the foregoing reasons, a company having high operating costs as percentage of its total costs and also having a high financial leverage, will expose investors to a high risk. It is, therefore, important to realistically forecast future sales, if risk is to be contained. If sales are not sufficiently high to adequately cover...
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