The role of advance payments in working capital management and profitability

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LAPPEENRANTA UNIVERSITY OF TECHNOLOGY Faculty of Technology Management

Department of Industrial Management

THE ROLE OF ADVANCE PAYMENTS IN WORKING CAPITAL MANAGEMENT AND PROFITABILITY

Instructors: Miia Pirttilä & Sari Viskari

Examiners: Professor Timo Kärri & Professor Hannu Rantanen

Lappeenranta, October 31^st, 2012 Anna-Maria Talonpoika

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ABSTRACT

Author: Anna-Maria Talonpoika

Title: The role of advance payments in working capital management and profitability

Year: 2012 Place: Lappeenranta

Master’s thesis. Lappeenranta University of Technology, Industrial Management.

51 pages, 9 figures, 3 tables and 2 appendices.

Examiners: Professor Timo Kärri and professor Hannu Rantanen

Keywords: advance payments, working capital, working capital management, profitability, cycle time, CCC, mCCC, DIO, DSO, DPO, DAO

The objective of this thesis is to study the role of received advance payments in working capital management by creating a new measurement and to study the relationship between advance payments and profitability. The study has been conducted using narrative literature review and quantitative research methods.

The research was made analyzing 108 companies listed in Helsinki Stock Exchange.

The results indicate that 68 % of the studied companies are receiving advance payments and the average cycle time for received advance payments is 13 days.

A new key figure is created to include received advance payments into the calculation of working capital. Received advance payments shorten the working capital cycle, by 13 days, when they are used in the calculation. The role of advance payments is not as significant as the role of receivables and inventories but advance payments may have a larger role than payables if the company is receiving noticeable amounts of advance payments. There are three branches where companies are receiving more advance payments than average companies.

The branches are project business and ICT and publishing sectors. There is a negative correlation between profitability and advance payments based on the results of this study.

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TIIVISTELMÄ

Tekijä: Anna-Maria Talonpoika

Työn nimi: Saatujen ennakoiden merkitys käyttöpääoman hallinnassa ja yrityksen kannattavuudessa

Vuosi: 2012 Paikka: Lappeenranta

Diplomityö. Lappeenrannan teknillinen yliopisto, tuotantotalous.

51 sivua, 9 kuvaa, 3 taulukkoa ja 2 liitettä.

Tarkastajat: professori Timo Kärri ja professori Hannu Rantanen

Hakusanat: ennakkomaksut, käyttöpääoma, käyttöpääoman hallinta, kannattavuus, kiertoaika, CCC, mCCC, DIO, DSO, DPO, DAO

Tämän työn tarkoituksena on selvittää saatujen ennakkomaksujen roolia käyttöpääoman hallinnassa työssä luotavan tunnusluvun avulla. Tämän lisäksi tutkitaan saatujen ennakkomaksujen suhdetta yrityksen kannattavuuteen.

Tutkimuksen tekemiseen käytetään kuvailevaa kirjallisuuskatsausta sekä kvantitatiivisia tutkimusmenetelmiä. Tutkimus toteutetaan analysoimalla 108 Helsingin pörssissä listattua yritystä.

Tulosten perusteella 68 % tutkituista yrityksistä saa ennakkomaksuja ja saatujen ennakkomaksujen keskimääräinen kiertoaika on 13 päivää. Saatujen ennakkomaksujen huomioimiseksi käyttöpääoman laskennassa, luotiin uusi tunnusluku. Saadut ennakkomaksut lyhentävät käyttöpääoman kiertoaikaa keskimäärin 13 päivällä, kun ne huomioidaan laskennassa. Saatujen ennakkomaksujen rooli ei ole yhtä merkittävät kuin myyntisaamisten ja varastojen, mutta ne voivat nousta ostovelkoja merkittävämpään asemaan, mikäli yritys saa ennakkomaksuja huomattavia määriä. Kolmella eri toimialalla yritykset saavat ennakkomaksuja keskimääräisiä yrityksiä enemmän. Nämä toimialat ovat projekti-, ICT- ja kustannustoimiala. Saatujen ennakkomaksujen ja kannattavuuden väliltä on löydettävissä negatiivinen korrelaatio tämän työn tulosten pohjalta.

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ACKNOWLEDGEMENTS

I am thankful to Professor Timo Kärri for giving this subject for my master’s thesis. I want to thank Professor Timo Kärri as well as Miia Pirttilä and Sari Viskari for patient guidance and excellent advices that made it possible for me to finish this thesis.

I am also grateful to my family and to my friends for support during my studies and especially during the thesis project. Special thanks go to my dog that keeps me going.

Lappeenranta, October 31^st, 2012

Anna-Maria Talonpoika

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FIGURES

Figure 1. The working capital cycle ... 6

Figure 2. Cycle times of working capital and profitability ... 23

Figure 3. Modified Cash Conversion Cycle ... 26

Figure 4. Distribution of the companies ... 28

Figure 5. The components of mCCC ... 29

Figure 6. The difference between CCC and mCCC ... 33

Figure 7. CCC and mCCC ... 35

Figure 8. The relationship between advance payments and profitability ... 38

Figure 9. The relationship between advance payments and profitability in the comparison group ... 39

TABLES

Table 1. Research questions ... 3

Table 2. Structure of the thesis ... 5

Table 3. Balance sheet ... 22

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ABBREVIATIONS

CCC Cash Conversion Cycle

mCCC modified Cash Conversion Cycle DIO Days of Inventory Outstanding DSO Days of Receivables Outstanding DPO Days of Payables Outstanding

DAO Days of Advance Payments Outstanding ROI Return on Investment

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1 INTRODUCTION

1.1Background

Working capital management has been studied all over the world. Most of these studies are made through a practical setting and not scientific (Tahir & Anuar 2011, 366-371). There are also few scientific researches about working capital management according to Viskari et al. (2011a, 9). These researches are often made using listed companies from a selected stock exchange. Most research projects have connected working capital management to profitability of a company. This master’s thesis will also connect those two.

There are two commonly used definitions for working capital. Companies often use the operational view of working capital but the financial view is often observed in the literature. The financial view considers the working capital to be the value of current assets less the value of current liabilities. This view can also be defined as net working capital. The working capital can be calculated in an operational view which uses three specific components. The components are inventories, accounts receivables and accounts payable. (Hampton 1983, 220;

Proctor 2006, 62)

Most companies calculate profitability for their investors but not working capital.

Working capital is sometimes calculated for the investors through the financial view. Cash Conversion Cycle (CCC) is the most used tool for working capital management research in academic world but there is almost no information about working capital management procedures in business life. CCC takes into account only inventories, accounts receivable and accounts payable but not advance payments which are also sometimes used when working capital is defined, for example Corporate Analysis Association in Finland includes advance payments on calculation of CCC. This thesis creates a new key figure for operative working capital management, modified Cash Conversion Cycle (mCCC), which also takes advance payments into account. There are no published working capital

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researches with the connection to advance payments. This thesis will connect received advance payments to working capital management.

Advance payments can be divided into received advance payments and paid advance payments. Received advance payments are payments that the company has received from its customers before the company has delivered the goods. Paid advance payments are the opposite side. The company pays to its suppliers beforehand in order to receive the product or service later. This research is concentrated in received advance payments. Therefore only advance payments are mentioned and they are referred to as received advance payments.

Working capital management is currently researched in Lappeenranta University of Technology by the Capital, Capacity and Cost Management (C³M) research group. The research is made with a broad scale concerning all aspects of working capital management. Most research subjects are studied through a value chain perspective. The linkage between working capital management and profitability is also part of the research project. This master’s thesis is partly connected to the current research project in Lappeenranta University of Technology.

1.2Research questions

Advance payments are in the center of this research and they are studied in two different ways: working capital management and profitability. The profitability is studied through the working capital management view. There are two main research questions that are divided into sub questions. The research questions are presented in table 1.

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Table 1. Research questions

Research questions The purpose of a research question What is the role of advance payments in

working capital management?

The main purpose of this thesis is to study changes in working capital management caused by advance payments.

How does CCC change when the advance payments are calculated into it?

The purpose is to create a new key figure which includes advance payments.

What is the cycle time for advance payments?

The purpose is to calculate advance payments in to the operational working capital and determine cycle times for advance payments in different branches.

Have companies with advance payments centered in some particular branches?

The purpose is to detect the branches and discover reasons for the concentration.

Do advance payments affect profitability? The purpose is to find changes in profitability caused by advance payments.

1.3Research methods

This thesis has two parts: theoretical and empirical. Theoretical part is executed as a narrative literature review. Salminen (2011, 7) classifies it a descriptive research method and it is often used to give theoretical guidelines to a study. General overview of the previous research is one type of narrative literature review and that is the type used in this thesis. The empirical part of this thesis contains the research of advance payments. The research is conducted using statistical methods as a part of quantitative methods. The statistical methods are used to conduct financial statement analysis. Creswell (2003, 18-19) describes quantitative approach in three different ways. Developing knowledge by postpositivist claims, using surveys and collecting data through predetermined instruments are all indications of quantitative approach. The statistical data for this research is collected using predetermined instruments but specific surveys have not been

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used. Postpositivist claims like hypothesis testing have not been used either but numerical information measurements have been widely executed in this research.

Data used in the empirical part is collected from financial statements of companies. This sort of data is called secondary data. Zikmund et al. (2010, 161) describes the secondary data as data that has been previously collected for some other purpose. The advantages of this type of data collection are availability and resources saving. These are also the reasons why secondary data was used in this study. Secondary data was the only available data for this study and it also enables the publicity of this thesis. The possible problems of secondary data are outdated information, variation in definition of terms, variations in units of measurement and data accuracy. The collected data was from the year 2010 so it is still fairly new and this sort of study can only be made from historical data. All listed companies in Finland have to make their financial statements according to IFRS (International Financial Reporting Standards) standard so the terms and units are invariable. The data is also accurate and it is verified by auditing.

1.4Structure

There are four chapters in this thesis. The first chapter will introduce the reader to the study and give some background information. The second chapter presents the current state of working capital research by written articles. The third chapter introduces a new figure that is then used to analyze advance payments. The results are also explained in this chapter. Recommendations for future research are also included in this chapter. The fourth chapter will summarize the results of this thesis.

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Table 2. Structure of the thesis

Input Chapter Output

The reason for this thesis. 1 Introduction

Background, research questions, methods and

structure of the study.

Literature about working capital management chosen by using

guidelines defined in the chapter 1.

2 Literature review

Short review of previous literature written about working capital management

and profitability.

Literature review from the

chapter 2 and collected data. 3 Analysis

Definition and usage of a new figure. Results and analysis of the research conducted in this thesis. Recommendations

for future research.

Literature review from chapter

2 and results from chapter 3. 4 Conclusions The summary of the research in this thesis.

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2 LITERATURE REVIEW

2.1Working capital

Working capital is needed every day until the on-going project is completed (Kumar et al. 2002, 100). Richards & Laughlin (1980, 34-35) discovered that working capital is needed in every step of the process but it changes after certain steps. The working capital cycle can be seen from the figure 1. The basic activities for companies are purchasing, production, sales and collection of payments. The cash is invested to the production cycle when resources are purchased. The tied up cash is back to use after the company has collected its payments. The cash that is invested in working capital cannot be invested to some profitable targets.

Figure 1. The working capital cycle (Mott 2008, 232)

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Mullins (2009, 5) considers that working capital is cash that a company needs to stay in business. The cash needs to be available in short terms so the company can pay to its employees and suppliers. The company will go out of business very fast if it cannot keep up the constant cash flow. Profitability is held very important but it does not help the company if it does not have any cash to pay its suppliers.

Companies should therefore consider a suitable working capital policy that can be implemented to the company.

The study of Filbeck & Krueger (2005, 17-18) indicates that working capital measures are not stable and they can change dramatically. The changes can be explained by macroeconomics. The most important macroeconomic factors for working capital are interest rate, rate of innovation and competition. The company also has to ensure excess liquidity to balance unexpected changes in amount of working capital (Richards & Laughlin 1980, 35). Kumar et al. (2002, 103) have introduced a fuzzy set theory which can be helpful for companies in order to improve cost allocation and financial planning. The theory can help managers understand the effects of qualitative factors in the assessment of the required amount of working capital.

The research of Padachi et al. (2008, 58) indicates that working capital is financed mainly with short-term assets like trade credit and other payables. Short-term bank credits are the most used external source of financing working capital. Small companies are trying to avoid external financing as long as they can so they would not get any financial troubles paying back the credits. García-Teruel & Martínez- Solano (2007, 175) discovered in their research that working capital is also especially important in small and medium- sized companies because most of their assets are in the form of current assets. Current liabilities are also the main source of external finance. Steyn et al. (2002, 47) considers that there are risks for companies that have large amounts of non-cash working capital and that are growing at a high rate. The companies that are growing too fast will not have the sufficient amount of cash needed for working capital. These companies will probably be liquidated or be combined with some larger companies.

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Mullins (2009, 5) has found that a company should always aim to negative working capital which means that the company receives cash from the product before they have to pay from it. Retail and manufacturing companies can both get into this ideal situation. One of the key elements on negative working capital is advance payments. Company can receive cash from the customer before the product is delivered.

2.2Optimal levels of working capital

The research of Hill et al. (2010, 27) indicates that optimal levels of working capital depend on the industry. There are several internal and external factors that are affecting the optimal level of working capital and every company should recognize them. Companies in concentrated industries do not need working capital as much than companies in competitive industries. Companies should also check the internal factors not only industry benchmarking when considering the optimal levels of working capital. Chiou et al. (2006, 155) have discovered that the factors affecting the optimal level are not only internal but also external. The most important internal factors are operating cash flow, growth rate, company performance and the size of the company. Industry is the most meaningful external factor.

Chiou et al. (2006, 155) considers that the optimal level of working capital is somewhere between meeting unexpected capital requirements and avoiding inefficient working capital management. Working capital levels might be too low and as a result of that company may miss profitable investment opportunities and suffer liquidity crises. The research of Appuhami (2008, 22) indicates that most important factors are capital, operating and finance expenditures as well as leverage, performance and operating cash flow. Capital expenditure and operating cash flow have the largest effect in working capital management. The research indicates that companies are changing their working capital management policies according to these factors.

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Optimal levels for all parts of working capital and profitability can be calculated by the optimal cash conversion cycle introduced by Nobanee & AlHajjar (2010a, 6-11). This function is similar to cash conversion cycle except it will be calculated with optimal levels of inventory conversion, receivable collection and payable deferral period. The optimal inventory level can be calculated with Economic Order Quantity model (EOQ) where total costs are combined costs of carrying and shortage costs. This is not the only possible model to calculate optimal inventory levels and there are several models presented in the literature. Optimal amount of granted credit can be calculated with the same method as inventory levels. The optimal amount is the sum of carrying and opportunity costs. The optimal amount of accounts payables is the sum of carrying costs and opportunity costs of short- term borrowings.

2.3Working capital management

Working capital management is a vital part of every company. Noreen et al.

(2009, 169) discovered it is conducted at the corporate level as opposed to local and regional levels. This indicates that working capital management is considered important. Sharma & Kumar (2011, 171) as well as Chiou et al. (2006, 155) consider working capital management to be very important part of financial management and therefore it should be the backbone for financial decisions of a company; unfortunately that is not the case in real life. Working capital management is basically balancing between liquidity and profitability as well as between financial and managerial decisions. Dramatic changes into one way or another will cause the finance of the company to go in wrong tracks.

Michalski (2008, 132-133) considers that the goal of working capital management is to create value for the company. The value creation is considered successful if the cost of tied up working capital is less than the cost of a debt. Working capital ties up cash that cannot be used for profitable investments. Increase in the amount of working capital ties up more cash and therefore reduces the free cash flow to the company. According to Chiou et al. (2006, 155) working capital management is basically finding short-term capital and implementing it properly. Working

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capital management will be ineffective if too much cash is tied up in the working capital. This will reduce the benefits of short-term investments. The research of Hutchison et al. (2007, 43-44) as well as Strischek (2001, 34-40) indicate that effective management of a company needs both profit and cash management.

Efficient working capital management also implicates larger cash flow which ends up increasing shareholder value. The company will have numerous benefits if it will have more cash available. Short cash conversion cycle also generates a better net present value and therefore higher value for the business.

Appuhami (2008, 22) discovered that working capital management is especially efficient when the company has growth opportunities and they can ensure the required capital expenditure to expand their business. Strischek (2001, 38-40) claims that working capital management is one of the things that banks check when they are allowing credit to their customers. Companies that have efficient working capital management will easily get external financing with low interest rate. The cost of capital is therefore lower for these companies and they are assumed to be more profitable.

The research of Howorth & Westhead (2003, 106-109) indicates that companies which do not manage their working capital as much as most of the companies will get a higher profitability. The companies with less working capital management will also have less interest in growth as well as less external finance. They do not usually buy in credit and they have short production cycles. The companies also have several on-time paying customers and they do not normally have cash flow problems. These companies are not smaller or younger than the average companies. Companies focus their working capital management only in one area because they have limited resources for working capital management. Companies with limited resources are not the smallest ones but these companies do not usually have advanced financial skills. These companies also need to be convinced that proper working capital management will improve their performance.

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Hutchison et al. (2007, 42-43) have found that a cash conversion cycle can be positive or negative. A positive cycle means that the company has to tie up working capital before it gets payment from the customer. Negative cycle means that the company gets cash from the customer before it has to pay its suppliers.

Essentially every company should have as short cash conversion cycle as possible.

Shorter CCC indicates that the company manages its cash flows efficiently.

Therefore it will have more cash cycles during a year and an invested dollar will generate more sales. Managers have in recent years noticed the importance of working capital management. The reduction in CCC will almost automatically lead to improvements in operational and financial management.

According to Strischek (2001, 38-40) the company can have numerous positive effects by improving its working capital management practices. Hutchison et al.

(2007, 43-44) found that the improvements depend on which variable will be improved. Ongoing expenses and inventory carrying costs are examples of these.

Payne (2002, 41-42) considers that the improvements usually start at the financial department but they will affect the whole company. Changes in financial operations do not usually remove the problem. The problems are hidden in the processes. The ordering system might be ineffective or the sales personnel might be offering too long payment times. The improvements will be effective after the root of the problems is found. All the companies should consider the optimization of working capital management even though the company would not be in crisis.

The changes in working capital management will end up showing as larger revenue for the company. The research of Richards & Laughlin (1980, 35) indicates that a company can shorten the cash conversion cycle with a few implementations. Payables will decrease the length of cycle time for working capital. The company should therefore use the offered credit. The different inventory managing techniques will also decrease the cycle time by ensuring the appropriate inventory levels. The company should also decide the right credit times for its customers.

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Hill et al. (2010, 27) discovered that working capital (CCC) has a positive relationship with operating cash flow and company size. There is also a negative relationship between working capital and financial distress as well as between working capital and market share. Essentially companies with weak internal financing abilities, limited access to capital markets and greater costs of external financing will more likely use payables than receivables or inventory in order to adjust the working capital.

Howorth & Westhead (2003, 106-107) discovered in their research that companies that have focused on cash management are usually larger and younger than average companies. They do not have that much cash sales and they work in seasons. These companies have more cash flow problems and they have more external financing. Companies that have focused on stock management are smaller and younger. They do not usually have that much external finance and they also have long production cycles. Companies with focus on credit management are not that profitable but they have an interest to grow. They usually do purchases on credit and their customers do not pay on time.

The research of Uyar (2009, 192) was conducted by analyzing companies listed in the Istanbul Stock Exchange. The research indicates that smaller firms have longer cash conversion cycles. The research also indicates that retail industry has a shorter cash conversion cycle than manufacturing industry. Textile industry has the longest cash conversion cycle in the manufacturing industry. The reason for shorter CCC is the fact that retail industry does not manufacture goods so therefore it does not need that much inventory. The retail industry also pays bills slowly and accepts only cash payments so it has optimized the cash conversion cycle.

The research of Filbeck & Krueger (2005, 13-14) was conducted by analyzing 1 000 U.S. companies during a five year period from 1996 to 2000. The results show that the average CCE was nine percent and it fluctuated between six and ten percent. The average CCC was 51.8 days and it fluctuated between 46 and 59

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days. The average rates for components of CCC were 50.6 days for DSO, 32 days for DIO and 32.4 days for DPO. Wang (2002, 168) has found evidence that Japanese companies have shorter cash conversion cycles than companies in Taiwan. The average cash conversion cycle length on Japanese companies is 87 days and 219 days in Taiwanese companies. The shortest cash conversion cycles are found (calculated from mean values) from food industry in Japan and transportation industry in Taiwan.

2.4Working capital management policies

Meszek & Polewski (2006, 226) discovered that working capital management of a company depends on the management policy or the lack of it. Different companies have variable approaches to working capital management. There are companies that do not control all components of working capital and therefore they do not have a holistic view over it but there are three policies that are widely used: aggressive, moderate and conservative. According to Kaur (2010, 13-14) companies should choose a policy that fits into their needs and financing capabilities. Yadav et al. (2009, 34) have found that working capital management policies of the companies are not static. They change over time. The changes in economy have the biggest effect on working capital management policy.

Aggressive policy is according to Michalski (2009, 132-133) financing the changes in working capital with short-term assets and conservative policy with long-term assets. Aggressive policy has been proved efficient when working capital management needs to be refined and it will bring most value for the company but it has also most risks. Hill et al. (2010, 27) claim that companies are using an aggressive policy if their sales are volatile and the company is growing.

Yadav et al. (2009, 34) on the other hand considers that companies use the conservative approach when the volatility of the business is high and aggressive approach when the volatility is low.

There are few things that need to be considered when planning working capital management policy for a company referred to Kaiser & Young (2009, 67).

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Companies should not use income statements as the primary source of financial information. Inventories and accounts receivables are tying up cash even though it cannot be seen on the income statement. The rewarding systems of the companies can also be the reason for problems in working capital management. Sales persons should not be rewarded only for completed sales because they will concentrate only to selling and not keeping up accounts receivables. Production quality is a good thing but if quality is emphasized it will lead to a slow-down of the production. Keeping the production in satisfying level and keeping up the speed will free some cash from the working capital. Companies sometimes connect accounts receivables and accounts payable. They are not related to each other so they should be handled separately. Current and quick ratios are measurements to calculate liquidity of the company. They do not give any information about working capital. Working capital management is balancing between liquidity and profitability. If they are not in balance the company will suffer. Benchmarking is a good way to recover information about the practices inside the industry.

Benchmarking does not tell the right levels of working capital and it should not be used that way.

2.5Challenges of working capital management

The problem of working capital management according to Richards & Laughlin (1980, 35) is to find the ideal level of working capital so the company can have enough cash as well as money to invest. The key issue is to find a balance between resources tied up in working capital and in capital investments.

Appuhami (2008, 22) has discovered that working capital management needs to be done efficiently or the company will invest too much money on working capital and profitability of the company will be reduced. Inefficient working capital management might also lead to situation where the company does not have enough working capital and it will cause the company some financial difficulties.

The risk of the company develops between these two situations. According to Hutchison et al. (2007, 43) the problem to find the balance can be divided into operational and financial decisions. The operational management wants to

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lengthen the CCC to increase liquidity and financial management wants to shorten the CCC to release cash for capital investments.

The research of Nobanee & AlHajjar (2010b, 15-19) indicates that working capital has a significantly negative relationship on performance of the company.

There are several factors in this relationship that affect the impact. The indication is that reduction of working capital does not increase profitability in every situation. Shortening of CCC may lead into trouble because the shortage costs will increase if the inventory is kept on a too low level. The reduction of receivable collection periods will louse the company some credit customers and lengthening of payable period will cause the company a bad reputation in the eyes of other companies. The most important piece of working capital management is therefore to find an optimal level of working capital which maximizes the profitability.

Payne (2002, 40) believes that working capital management can be a key to a better functioning company. The shortening of cash conversion cycle can free large amounts of cash for the company. Hard times in the economy can increase the need of cash in a company. Several companies issue short or long-term debts to cover the cash demand. The cost of debts is increasing rapidly and therefore it is not very wise to use a debt to pay another one. Companies should improve their working capital practices so they could get the needed amount of cash from inside the company. The improvement takes more time than negotiations at the bank but they are free of charge. Reilly & Reilly (2002, 15-18) introduces accounts receivable as one of the elements companies could improve most. Companies should do more effective evaluation of companies they are granting credit. Bad debts are costing the company a lot. Companies should also set policies for granting credit. Every salesperson should know the principles for granting credit.

Flexibility of payment methods is also one way of improving the accounts receivable. Company could offer several different ways to pay the bill and this way make sure the bill gets paid.

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Reilly & Reilly (2002, 13-14) consider that working capital management is these days financially oriented and it is conducted by financial managers. The measurements for working capital are traditionally financial ratios. These ratios do not tell where the origin of the problem is. The problems should be detected before they end up in financial statements. These situations require the company to focus its actions into reducing the inventory levels and accounts receivable as well as prolonging the accounts payable.

Molina & Preve (2009, 684) discovered that companies that have problems with profitability are more likely to increase the level of accounts receivables. This procedure is done in order to gain more market share. Companies that are in financial distress are doing the other way around and they reduce the level of accounts receivables. This way more working capital is released for other use.

Companies in competitive industries face difficulties when they reduce the accounts receivables because customers can easily choose another supplier.

Companies in concentrated industries do not face same sort of problem.

According to Bougheas et al. (2009, 306) companies can use accounts payables to finance the changes in inventories. The companies also have to find a balance between accounts payables and accounts receivables in order to run the business effectively.

The research of Long et al. (1993, 126-127) presents that small companies with unique products usually grant longer credit periods so the customers can verify the product quality before payment. Large companies with less unique products and high turnover do not need to grant trade credit. The companies that are granting trade credit do not usually buy on credit. Large and creditworthy companies are most likely to extend their trade credits. Extension of trade credit is also used by companies that have variable demand. Small companies with long production times are very likely to extend their trade credits in order to finance their receivables.

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Late payments are a common problem among small companies in UK according to Peel et al. (2000, 33). The companies have recognized the problem and are supporting the legislation for late payments. The companies also consider that the most helpful way to reduce late payments is interest. Almost all small companies have at least once paid late to their suppliers and about 15 percent do it regularly.

Small companies still are not the worst type of companies to pay late. Large companies pay late almost every time then the small companies and the medium sized companies pay on time.

2.6Measures of working capital management

Working capital management efficiency can be measured with several different ways. The calculation methods can be divided into financial and operational methods. Financial methods include for example Quick Ratio and Current Ratio.

Operational methods are for example Cash-to-Cash method and Cash Conversion Cycle (CCC). CCC is the most used measurement and there are few variations of it. Most commonly known versions are Cash Conversion Efficiency (CCE), Net Trade Cycle (NTC) and Weighted Cash Conversion Cycle (WCCC). All of these measurements are used in the business life and they might be used together because they measure working capital management in a different perspective.

(Farris & Hutchison 2003, 83; Filbeck & Krueger 2005, 12; Shin & Soenen 1998, 38)

Cash conversion cycle developed by Richards & Laughlin (1980, 34) is an important measurement in financial management. It measures liquidity of the company. The cash conversion cycle reflects the time between the moments when resources are purchased and the cash is recovered from sales. Basically it establishes the period of time needed to convert cash disbursements back to cash inflow. Cycle times for inventory and receivables are calculated to find out the liquidity of the company. Cash conversion cycle also adds cycle times for payables into this calculation. This calculation shows that when inventories and receivables increase the amount of working capital increases and it has to be therefore financed. The increase in payables in the other hand indicates that

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spontaneous working capital will accumulate during a longer period of time.

According to Farris & Hutchison (2003, 90) the management needs to understand the calculation of CCC in order to use it as a tool. Effective use of CCC requires information about the working capital from a longer period of time.

Shin & Soenen (1998, 38, 43) have developed net trade cycle (NTC) that can be easily used to check the efficiency of working capital management. NTC is a more simplified version of cash conversion cycle where the three components of cash conversion cycle are expressed as percentage of sales. The main goal of the NTC is to show the number of day’s sales the company needs to finance the needed working capital. NTC can be easily used when evaluating the required amount of working capital. A short NTC implicates that the company is managing its working capital efficiently and therefore the company does not need external financing for working capital. Reductions in the NTC are one option to create shareholder value and therefore working capital management should be done efficiently.

Gentry et al. (1990, 98-99) have developed a weighted cash conversion cycle that provides more accurate information than the traditional cash conversion cycle.

WCCC is a good measurement for short-term financial management. It focuses the management to the real engagement of resources in the working capital process. The WCCC describes of the amount and speed the working capital is changing in the company. Accounts payable is the factor that is causing the gap between CCC and WCCC.

CCC is calculated in this thesis using the equation 1 which is based on the calculation method of Shin & Soenen (1998, 38).

= + − (1)

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Where,

CCC = Cash Conversion Cycle DIO = Days of Inventory Outstanding

DSO = Days of Accounts Receivables Outstanding DPO = Days of Accounts Payables Outstanding

= × 365

(2)

= × 365

(3)

= × 365

(4)

2.7Working capital management and profitability

According to Raheman & Nasr (2007, 294) companies have invested large amounts of money into working capital. Working capital management has therefore a substantial effect on profitability of the companies. Several studies (for example Mojtahedzadeh (2011, 165), Lazaridis & Tryfonidis (2006, 34-35), Dong & Su (2010, 66), Eljelly (2004, 59)) indicate a significant negative relationship between the cash conversion cycle and profitability of the company.

A long cash conversion cycle is reducing the profitability and vice versa. Deloof (2003, 585) has found a relationship between profitability and all three aspects of cash conversion cycle. So there is a relationship between accounts payable and profitability as well as between account receivable and profitability. The research of Raheman & Nasr (2007, 294) indicates that the reduction of length of cash conversion cycle should be done reducing accounts receivables and inventories.

Basically the company will have a better profitability if it pays its bills more slowly. The payables deferral period has to be appropriate or otherwise the company will harm its own credit reputation.

Working capital management procedures in a company are affected by the operational profitability according to Lazaridis & Tryfonidis (2006, 34-35). Talha et al. (2010, 226) discovered that maintaining the acquired level of profitability

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requires companies to have the optimum amount of current assets needed in daily use. The companies also have to take care of their short-term maturities in order to survive. The basic rule is to have low liquidity and high profitability. Companies should efficiently use the working capital resources in order to increase profitability and the values of the company. Mathuva (2010, 10) considers that a company can increase profitability by decreasing the cash conversion cycle. The decrease needs efficient use of working capital management resources.

Lazaridis & Tryfonidis (2006, 35) found a significant relationship between gross operating profit and DPO in their research. DPO will increase when the gross operating profit is decreasing. This means that less profitable companies are paying their bills slower to take advantage of the credit period granted to them.

DSO and gross operating profit also has a negative relationship. The companies that are not so profitable are trying to decrease the accounts receivable in order to gain more cash. There is a negative relationship between DIO and gross operating profit. The relationship indicates that if sales are decreasing and the inventories are not managed properly the company will have lots of capital tied up in inventories and not available for investments.

There is a negative relationship between the measures of profitability and aggressiveness of working capital management according to Nazir & Afta (2009, 27-28). The companies will most likely have negative return if they have very aggressive working capital management policy. On the other hand companies that have aggressive management policy will get more investors because the aggressiveness is highly valued by them. Most investors believe that companies that have less equity and less long-term loans will perform better than other companies. Filbeck et al. (2007, 20) discovered that also companies that are ranked high in the CFO Magazine’s working capital survey are doing more return.

This indicates that there is a positive relationship between efficient working capital management and profitability. Investors also find companies with efficient working capital management policies interesting.

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Kieschnick et al. (2011, 12) finds working capital management to be important for the value of the company. The shareholder value can simply be increased by optimizing the cash conversion cycle and especially all its parts according to Deloof (2003, 585). The importance is understandable because significant amount of company assets are tied up in working capital in most companies. On the other hand outside investments to working capital are reducing the value of the company. The invested value is decreasing at the same pace than the invested amount is increasing. The reductions are not so dramatic if the company has an easy access to public capital markets. The research of Kieschnick et al. (2011, 19) indicates that the outside investments into the working capital of a company are not profitable. The value of the investment will be negative. Basically the investor will save his money by keeping it on cash than investing it to the working capital.

The research indicates that the pattern is similar in all industries.

Raheman et al. (2010, 426-427) have been analyzing 204 companies listed in Karachi Stock Exchange in the period 1998-2007. The results indicate that there is sectoral deviance between the different measures of working capital management.

The results vary significantly between the sectors. The measures may predict the profitability in some sectors but in others it has no role. Several researches on the other hand have indicated that there is a negative relationship between liquidity and profitability. This particular study shows that there might be a positive relationship as well as negative. There is also evidence that CCC and NTC measures liquidity differently than Current Ratio.

2.8Advance payments

Advance payments are one part of current liabilities. Their position in the balance sheet can be seen from the table 3. Leppiniemi (2002) considers that advance payments are liabilities from the moment they are received until the finished goods are delivered. Yritystutkimus (2011, 48) on the other hand does not see advance payments as liabilities when the goods are still work-in-progress.

Advance payments can also be part of long-term liabilities but the ones in current liabilities are studied in this thesis.

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Table 3. Balance sheet (modified from Yritystutkimus 2011, 28-29)

ASSETS LIABILITIES

Fixed assets Shareholder’s equity

Intangible assets Share capital

Tangible assets Retained earnings

Investments Profit for the period

Funds

Current assets Minority interest

Inventories Capital loans

Receivables

Current financial assets Liabilities

Cash and cash equivalents Long-term liabilities Current liabilities

Advance payments

Advance payments are considered as a part of working capital according to Yritystutkimus (2011, 68-69). Advance payments are reducing the amount of working capital needed. Advance payments are therefore one form of financing to the companies. Companies do not necessarily need to take any other liabilities to finance their working capital. Advance payments are also affecting profitability not only working capital. Advance payments can be considered as a one component of working capital and thus figure 2 can be drawn.

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Figure 2. Cycle times of working capital and profitability (modified from Viskari et al. 2011b, 352)

2.9Summary of the literature review

The amount of working capital can vary greatly between companies and between different situations in a company. The best situation for a company is when the working capital is negative. The company does not have to invest any cash to the working capital cycle. Optimal levels of working capital can be defined for all companies but it requires internal information about processes and costs. The components of Cash Conversion Cycle are often calculated but the Cash Conversion Cycle itself is not calculated that often.

Working capital management of companies is focused on management of accounts receivables. The reason for this is the mindset of companies that receivables bring cash to the company. Working capital is just tied to the inventories and companies cannot affect that just like payables are paid without larger considerations. Receivables have the biggest influence on working capital and inventories are at the same level with payables.

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Reductions of working capital can increase profitability of a company. There are results from several researches that working capital and profitability are linked together. The results indicate that efficient working capital management can increase profitability and add a larger cash flow to the company. Companies have to ensure the liquidity and not only profitability by reasonable working capital management in order to keep the company running. The company may fall in to problems if they do not have enough cash and they have poor profitability.

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3 ANALYSIS OF THE ADVANCE PAYMENTS

3.1Modified Cash Conversion Cycle

Modified Cash Conversion Cycle (mCCC) is an advanced version from the Cash Conversion Cycle. mCCC takes into consideration also the received advance payments which are normally left out from the calculation of working capital. The reason why they are not used is the fact that they were not included in the first research conducted by Richards and Laughlin. The CCC was originally used in scientific research to calculate long stock exchange lists during a longer time period. These days CCC is widely used in business life to evaluate the levels of working capital. Therefore companies should calculate DAO and mCCC instead of CCC because many companies have significant amounts of advance payments.

Advance payments, one part of the short time assets, can shorten the cycle time many days because the company will receive cash earlier than in the usual cycle.

The needed amount of working capital will be then reduced and it might sometimes even turn negative. The mCCC will therefore give a more accurate view of the working capital for the companies. mCCC can be seen from the figure 3.

mCCC is calculated through the same pattern than CCC. First all the components of mCCC are calculated. The components DIO, DSO and DPO are calculated similarly than in CCC. Days of Advance Payments Outstanding (DAO) is the only new component. DAO is calculated by dividing the amount of advance payments in a year with the same year’s turnover. The plain number is then multiplied with 365 days. DAO is then reduced from the CCC. The equation is presented below.

= + − − (5) = ! × 365

(6)

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Figure 3. Modified Cash Conversion Cycle (modified from Mott 2008, 232)

The figure 3 presents the modified Cash Conversion Cycle through a company which receives advance payments. This is only one possible example of these situations. The advance payments are received during the working process. The company does not have to keep the goods in inventory because they are already ordered and partially paid. The working capital is therefore not invested into inventories of finished goods and into accounts receivables. The company will get the final part of the payments as soon as the product is finished and delivered.

3.2Research design and procedure

This study has been done by analyzing company data from selected companies.

All studied companies are listed in Helsinki Stock Exchange. All other companies of the Exchange list have been included except companies working in the financial field. These companies are not included because the working capital structure is different in these companies. Companies were selected according to the list found from the website of Kauppalehti. The companies are listed there

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according to the branches. There are two companies that were left out because of various reasons. TeliaSonera was left out because it does not produce its financial statements in Euros and SieviCapital is also left out because it was in 2010 still called Scanfil. Scanfil is among the studied companies.

The data required for the study was collected from two different sources.

Information about ROI and sales were collected from the website of Kauppalehti.

Kauppalehti calculates ROI for every company the same way unlike companies which can calculate ROI differently. This way it was ensured that the data was comparable. All other data was recovered from the annual reports of the companies. The reports were found in their websites. The data was collected during January 2012. The website of Kauppalehti was at that point free of registration and fees. The used data is from the year 2010 because the annual reports of 2011 were not published at that point. Information used for this thesis is public and everyone can use it. All of the studied companies have made their financial statements according to the IFRS standard. Companies may assess their belongings differently but the basic principles are always the same. Therefore all collected data is equal.

The research was executed in two stages. The first stage was data collection and calculation. Data was collected from previously presented sources. Calculation was conducted after the data was collected. Calculation changed the raw data into figures. The second stage is analyzing. The results of calculation were analyzed.

The findings were described and they were compared to the previous researches presented in the beginning of this thesis.

The companies in this research were divided into two groups. The allocation was made by checking the amount of received advance payments. Histogram in the figure 4, which has been drawn from the data, shows that about 65 percent of the companies have DAO less than five days. The limit was then put into the five days. A closer look was taken to a comparison group which consists of companies that have their DAO more than five days. It can be said that these companies have

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received significant amount of advance payments. There are 38 companies in this group which is about 35 percent of all the studied companies.

Figure 4. Distribution of the companies

3.3The components of modified Cash Conversion Cycle

3.3.1 Days of Inventory Outstanding

Days of inventory outstanding (DIO) has the second highest impact on mCCC which can be seen from the figure 5. DIO is mainly less than 150 days in the companies studied in this thesis. The average DIO is 47 days. The companies in the comparison group have their DIO between 0 and 421 days. The average DIO in the comparison group is 51 days which is 4 days longer than the average DIO for all studied companies. The optimal level of DIO cannot be estimated with this study because all the companies are from different branches and therefore the need for an inventory is different.

There is a positive relationship between DIO and mCCC which means that the mCCC will increase when DIO increases. Inventory is naturally consuming cash required for working capital because all the manufactured or bought products are

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0 1 2 3 4 5 10 20 30 40 50 More

Percentage of companies

DAO

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valued there. Inventories also include raw materials and unfinished products.

Largest inventories can be found from the companies that are producing components as a subcontractor for a larger company and companies that are working in various fields. There are 16 companies that do not have any inventory.

These companies do not have inventory due to the nature of their business. The companies are providing only services and they are not manufacturing or selling any physical products. These companies are mainly working in the field of information technology.

Figure 5. The components of mCCC

3.3.2 Days of Accounts Receivables Outstanding

Days of receivables outstanding (DSO) has the biggest impact on mCCC which can be seen from the figure 5. DSO is mainly less than 120 days in the studied companies and it is increasing the amount of mCCC The average DSO is 58 days.

None of the companies have zero DSO which indicates that all companies are granting credit for their customers. The average DSO in the comparison group is 65 days which is 7 days longer than in all the studied companies. DSO is rather

0 10 20 30 40 50 60 70

DIO DSO DPO DAO mCCC

Days

Average cycle times

all

comparison

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long because the average credit time in Finland varies between 7 and 28 days. The shortest receivables collection times can be found from companies that are working close to consumers and longest receivable collection times can be found from companies that are doing business in the information technology sector.

The long DSO indicates that companies have difficulties to collect their receivables in time. Some of the long credit times can be explained with foreign sales. There are several countries where companies are used to get longer credit times and therefore they are not paying their bills on time. Companies may also grant longer credit times for these companies. One of the reasons for receivable collecting times is the current economic situation. There are companies that do not have any cash to pay the products or services they are bought. They will not get any credit from financial institutions so their only change is to use credit granted by their suppliers. This way they will ensure their working capital levels. The companies might also have difficulties to collect cash payments and therefore they will end up having receivables. Companies used to grant cash discounts to their buyers if they pay their purchase immediately or within the next seven days. It used be very profitable for the buyer the use this discount but these days only few companies can take advantage of the discounts. This is an effect caused by the financial crisis.

Previous researches indicate that companies concentrate on managing receivables even they would not otherwise manage working capital at all. Receivables bring cash to the companies and the concentration can be therefore easily explained.

This study shows that receivables are the most significant factor in working capital. The company has to manage them properly in order to minimize the working capital. Holistic view over working capital is still the best approach to working capital management because all components of working capital needs to be considered.

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3.3.3 Days of Accounts Payables Outstanding

Days of payables outstanding (DPO) has the third highest impact on mCCC among all companies and the fourth highest impact on comparison group. The difference can be seen from the figure 5. DPO is less than 60 days in most of the companies studied in this thesis. The average DPO is 32 days. The average DPO in the comparison group is 27 days which is 5 days shorter than the average DPO for all companies. These days a normal credit time is somewhere between 7 and 28 days so the average time is a bit long. Most of the companies are granting 28 days for their customers to pay their bills. But it is not by any means a standard.

This credit time is shortening all the time and the financial crisis decreased it even more. 14 days is probably the most popular credit time in the business-to-business environment. There same reasons for the behavior of accounts payables than accounts receivables because they are the same payment only looked from different sides of the coin. Companies that work closer to consumers have also shorter DPO.

mCCC and DPO has positive relationship which means that mCCC is increasing when DPO is increasing. This is controversial to the previous researches that indicate that mCCC will decrease when DPO is increasing. The definition of mCCC, as well as CCC, indicates that payables are subtracted from inventories and receivables. Companies should always use the longest possible payment times if the cash discounts are not significant. The company can ensure better liquidity if the payables are extended.

3.3.4 Days of Advance Payments Outstanding

Days of advance payments outstanding (DAO) has a higher impact on comparison group than among all studied companies. This can be seen from the figure 5.

DAOis less than 50 days among most of the companies that are receiving advance payments and that are studied in this thesis. The average DAO is 13 days. mCCC and DAO has a negative relationship which means that mCCC is reducing when DAO is increasing The average DAO in the comparison group is 35 days which is 22 days longer than within all the studied companies. There are 73 companies that

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are receiving advance payments of some sort which is 68 percent of all the studied companies. Most of the companies do not receive large amounts of advance payments because the focus of cash transactions is still after the product has changed its owner. The longest DAO can be found from the companies that are working in the project business.

There are various reasons for receiving advance payments. Smoothing of the cash flow can be seen as a one major factor for advance payments. Advance payments are helping both the producer as well as the customer to keep their finance in balance. Customers do not have to pay enormous amount of cash at once instead they can pay the cash in small portions. The advance payments are beneficial for the receiver as well because they are reducing the need of working capital.

Basically the producer does not need as much cash of their own as they would without the advance payments. The advance payments are a necessity in situations where the company just does not have enough working capital to start with. The companies that are working with private customers are using advance payments to secure the cash flow. Airline tickets for example are bought before the flight so that the company can make sure they get cash from all the customers on board.

3.4The difference between CCC and mCCC

Average CCC in this studied data is 73 days and the average mCCC is 60 days.

Average mCCC is 82 percent of CCC. These findings indicate that advance payments really help companies with working capital. The advanced payments are dropping the need of working capital by 13 days. The companies need almost a fortnight’s amount of less working capital to run their businesses. There is also a difference between CCC and mCCC in the comparison group. The average CCC in the comparison group is 89 days and the average mCCC is 54 days. mCCC is 60 percent out of CCC and the difference between these two is 35 days. The relationship of CCC and mCCC can be seen from the figure 6.

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Figure 6. The difference between CCC and mCCC

These results indicate that companies that are receiving large amounts of advance payments will have a shorter mCCC than the companies that are receiving only small amounts of advance payments. There are companies that would have a lot more difficult situation without the advance payments. This indicates that companies should always ask for advance payments so that they could reduce the amount of working capital in their business. These companies that are receiving advance payments do not look effective when they are measured with CCC.

mCCC gives a more truthful image of the efficiency of all companies. Changes in sales or in production will cause the working capital to change. The need of working capital will decrease in case of increased production if the company receives advance payments. Company that does not receive advance payments has to increase their working capital levels in case the production is increasing. The added working capital has to be paid with invested capital or with capital borrowed from outer sources.

There are 11 companies that have negative mCCC and 5 companies that have negative CCC. This means that there are 6 companies that are receiving advance

0 10 20 30 40 50 60 70 80 90 100

all comparison

Days

Cycle times

CCC mCCC

The role of advance payments in working capital management and profitability