Relationship of cash conversion cycle and PRGap with firm performance : an empirical study of Taiwanese companies

The study investigates how working capital management (WCM) impacts the profitability and operating performance of publicly traded companies in Republic of China, Taiwan. The authors use the quarterly data of 539 stocks listed on the Stock Exchange of Taiwan from 2008 to 2015, containing 17,248 observations. The study examines whether two WCM variables, namely, the cash conversion cycle (CCC), as well as the gap between days of payables outstanding and days of sales outstanding (PRGap) have any significant effects on firm profitability and operating performance. The findings demonstrate that there are significantly negative relationships between the CCC and performance indicators, whereas there are consistent positive relationships between PRGap and performance indicators.


Introduction
The corporate finance literature focuses on the study of long term financial decisions, particularly on investment, capital structure, dividends to firm performance. However, working capital management (WCM) has a significant influence on firm profitability and hence, plays a crucial role in a firm's financial management (Shin and Soenen, 1998). Gitman (1974) concluded that the most critical factor in WCM is the cash conversion cycle (CCC), which represents the average number of days between a firm paying for raw materials and receiving payment from accounts receivable.
An extensive strain of literature, largely emanating from Jose et al. (1996), examines the relationship between corporate returns and the CCC. Day-to-day management of a firm's short-term assets and liabilities influences the success of the firm. The CCC is normally defined as a metric that represents the length of time a firm takes to convert its products into cash. The CCC can be expressed as days of sales outstanding (DSO) plus days of inventory outstanding (DIO) minus days of payables outstanding (DPO). Many researchers have reviewed the relationship between firm profitability and the CCC; the majority showed a negative relationship, some showed a positive relationship. Methods for shortening the company CCC are employed, such as shortening the periods of selling goods or services, as well as accounts receivable, to increase firm profitability and performance (Wilner, 2000;Ng et al., 1999). Deloof (2003) observed that the relationship between WCM and corporate performance involves a tradeoff; specifically, a balance must be achieved between the higher cost and lower profitability, but lower default risk attained by maximizing the level of working capital and the lower cost and higher profitability, but higher default risk attained by minimizing the level of working capital. A company must have the most appropriate level of working capital for maximizing firm value, and high inventory policy and longer receivable conditions can decrease firm profit. Wang (2002) indicated that high inventory policy can reduce the risk of insufficient stock, and a longer payment term can boost sales. A higher number of days of accounts receivable enhances long-term customer relations (Ng et al., 1999).

CCC= DSO+DIO-DPO
To observe the results obtained after subtracting DIO, we use PRGap, the difference between DPO and DSO, to represent the bargaining power among suppliers' and customers' credit policies. DSO is a proxy for the willingness of a firm to lend to its customers, and DPO captures the supply of trade credit to a given firm from all suppliers. Fisman et al. (2004) found that monopoly power is negatively associated with credit provision. Giannetti et al. (2011) indicated that firms with more creditworthiness and higher buyer market power receive larger early payment discounts. How PRGap influences the profitability and operating performance is not known, but one theory suggests that the longer a firm's PRGap, the more it benefits from conserving cash. A negative correlation of firm performance to DSO and a positive correlation of firm performance to DPO have been identified by Mathuva (2010) and Hsieh and Wu (2013). By contrast, Sharma and Kumar (2011) suggested that a healthier firm has a shorter PRGap and higher performance.

Fig. 2. PRGap
The main purpose of this study is to ascertain how WCM affects the profitability and operating performance of publicly traded companies in Taiwan. This study contributes to the literature in the following ways. First, this is one of the first studies to analyze the influence of the CCC on Taiwanese companies of all industries and all sizes. Second, the study investigates not only firm profitability, but also operating performance to determine how these react to the CCC and PRGap. Finally, for the first time, we use PRGap as a measure, in addition to the CCC, for performance analysis.
This paper is organized as follows: section 1 provides a literature review and hypotheses. Section 2 describes the data and methodology. Section 3 presents the empirical results. The final section provides the conclusion together with the limitations of this study and recommendations for future research.

Literature review and hypotheses
The CCC has been suggested to be superior to classic working capital measures such as the current ratio proposed by Gitman (1974) and Gitman and Sachdeva (1982). The CCC represents the length of time a firm takes to convert its resources into cash flow and reflects firm profitability and the effectiveness of firm management.
The relationship between firm profitability and the CCC differs among previous studies. Most studies conclude a negative relationship, whereas some conclude a positive relationship. Deloof (2003) found WCM to have a negative, but not statistically significant, correlation with corporate profitability in a study of 1009 Belgian firms for 1992-1996. According to his results, DSO, DIO, and DPO have negative relationships with profitability. Lazaridis and Tryfonidis (2006) found WCM to have a significant correlation with firm profitability in a study of the Athens Stock Exchange by using a sample of 131 firms for the period 2001-2004. According to their results, DSO and DPO have a negative relationship with profitability, and DIO also has a negative relationship with profitability, but this relationship is not statistically significant. Bolek (2013)  The results of previous studies listed in Table 1 suggest that the relationship between the CCC and firm profitability may vary among countries and performance indicators. This leads to our first hypothesis:

Hypothesis 1: CCC has negative (positive) effect on the firm performance in Taiwan.
Studies have generally concluded a positive association between monopoly power and provision of credit, the suppliers of credit in competitive markets face difficulties in enforcing payment, because buyers may simply switch to alternative credit suppliers. Giannetti et al. (2011) indicated that the use of trade credit is associated with firm characters and that firms with more creditworthiness and buyer market power receive larger early payment discounts. However, Fisman et al. (2004) found that monopoly power is negatively associated with credit provision in Africa.
How PRGap influences the profitability and operating performance is not clear, but one theory suggests that the longer the PRGap of a firm, the more it gains from conserving cash and generating interest income. A negative correlation for firm performance with DSO and a positive correlation with DPO have been identified by Mathuva (2010), and Hsieh and Wu (2013). By contrast, Sharma and Kumar (2011) suggested that a healthier firm has a shorter PRGap, lower DPO, higher DSO, and higher performance. This leads to our second hypothesis.

Data and methodology
Data for this study are obtained from the Taiwan Economic Journal (TEJ). The TEJ provides comprehensive financial data including balance sheets, income statements, and cash flow statements covering China, Taiwan, Hong Kong, Japan, Korea, Malaysia, the Philippines, Singapore, and Thailand.
Our study, firstly, excludes financial service companies as prior studies do due to non-availability of inventory and, then, s real estate industry because of high volatility of DSO and DIO and, to avoid bias, finally we include only firms with complete data for all variables, namely, Return of Assets (ROA), the Operating Profit Ratio (OPR), Tobin's Q (Tobin Q), the CCC, PRGap, log market value (logMV), and Debt Ratio (DR) for the period from 2008 to 2015 on a quarterly basis. The data are ultimately reduced to 539 companies, yielding a balanced panel of 17,248 firms and quarterly financial observations. The data are classified into six sectors, namely electronicbackend, electronic-frontend, manufacturing, energy, retail, and others.
The research variables used in this study are defined as follows: The dependent variables are ROA and the OPR, representing firm profitability, and Tobin's Q, representing firm operating performance.
where Y denotes a firm's performance according to ROA, the OPR, and Tobin Q at time t, and Y -1 denotes the performance of firm i at time t-1.

Empirical results.
This section presents the results of an analysis of descriptive statistics and regressions performed using the Pearson correlation coefficient, the panel unit root test, the Hausman test, and fixed effects test.     Note: The data above are obtained through TEJ database. The sample includes 539 firms for 2008~2015 of Taiwanese listed firms concluding 17,248 observations. Return On Assets (ROA) is calculated through (net income/total assets), the Operating Profit Ratio (OPR) through (operating income/net sales), Tobin's Q (Tobin Q) through ((equity market value-total liabilities)/total assets), Cash Conversion Cycle (CCC) through (days sales outstanding + days inventory outstanding-days payable outstanding), Payable Receivable Gap (PRGap) through (days payable outstanding -days receivable outstanding), log market value (logMV) through log(price×shares) and Debt Ratio (DR) through (total liabilities/ total assets). *, ** and *** denote significant at 10%, 5% and 1%, respectively. Table 5 displays the Pearson correlation analysis of the independent and control variables. As Table 5 illustrates, all absolute correlation coefficients are less than 0.8; therefore, collinearity probably does not exist. Note: Cash Conversion Cycle (CCC), Payable Receivable Gap (PRGap), log market value (logMV) and Debt Ratio (DR). *, ** and *** denote significant at 10%, 5% and 1%, respectively.

Panel unit root tests.
When the data of 17,248 observations are examined through the unit root test, we find the data to be stationary at the 1% significance level. The results of the Levin, Lin, and Chut test reject the hypothesis that a common unit root exists; therefore, no common unit root exists in ROA, OPR, Tobin's Q, CCC, PRGap, logMV, and DR, indicating that the data are stationary.

Hausman tests and fixed effects tests. A
Hausman test is performed to determine whether a fixed effects regression model or random effects regression model is appropriate for the dependent variables ROA, the OPR, and Tobin Q. The null hypothesis of the random effects model is valid. All p-values of the Hausman test for regressions 1 to 6 are lower than 0.01%. As shown in Table 8, the null hypothesis is strongly rejected as apparent from chisquared test statistics and the level of significance. According to the results, the fixed effects regression model appears to describe the empirical data the most adequately. Note: *, ** and *** denote significant at 10%, 5% and 1%, respectively.

Regression analysis.
To examine the impact of the CCC and PRGap on firm performance (ROA, OPR, Tobin's Q), the study uses balanced panel data and fixed effects regression models. The results of the regression models are presented in Table 9.
The regression coefficients of the CCC with ROA, the OPR, and Tobin's Q in panel A are -8.43, -6.50, and 3.13 and are negative and significant at 99%, 99%, and 95% confidence levels, respectively. These negative results are consistent with those of Deloof (2003), Lazaridis and Tryfonidis (2006), and Bolek (2013), explaining that a decrease in the CCC probably increases firm profitability in terms of ROA and the OPR. This negative relationship is also an indication that a decrease in the CCC increases a firm's operating performance in terms of Tobin's Q. Therefore, our study concludes that by reducing the length of time a firm takes to convert its products into cash, a firm can increase its performance.  through (days payable outstanding -days receivable outstanding), log market value (logMV) through log(price×shares) and Debt Ratio (DR) through (total liabilities/ total assets). *, ** and *** denote significant at 10%, 5% and 1%, respectively.

Conclusions
The objective of this study is to provide a deeper understanding of how the CCC and PRGap affect firm performance in terms of ROA, the OPR, and Tobin's Q in Taiwan. The study has three main empirical findings: first, our regression results reveal that the CCC exhibits a negative relationship with firm profitability in terms of ROA and the OPR and firm operating performance of Tobin's Q. Second, we find that PRGap is positively correlated with all three performance indicators. Third, the CCC and PRGap both significantly affect firm performance by reducing the length of cash flow and strengthening firm bargaining power; thus, the firm achieves high profitability and operating performance.
This study makes several contributions to the literature. First, this is one of the first studies to analyze the influence of the CCC on Taiwanese companies of all industries and sizes. Second, the study investigates not only firm profitability according to ROA and the OPR but also operating performance according to Tobin's Q, concluding that the lower the CCC is, the higher the firm's profitability and operating performance. This correlation can be applied as evidence for facilitating decision-making by firm management. Finally, for the first time, we use PRGap as a measure in addition to the CCC for performance analysis. According to the results, consistency of the relationships of both PRGap and the CCC with firm performance in Taiwan is established. The CCC and PRGap both significantly affect firm performance, by decreasing the length of cash flow to improve the CCC and by strengthening bargaining power to increase PRGap, thus, registering high profitability and operating performance of the firms. We suggest that the Taiwanese companies should invest more resources on reducing the CCC and increasing PRGaps. Accounts receivables financing, factoring, might be a workable solution. This study is limited to Taiwanese firms. Further research should investigate the generalize ability of the findings to s outside Taiwan.