1. Inevitably, it is the foundation of

1. Introduction

1.1.
Property Sector of the Philippine Market

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The
construction industry provides the very infrastructure that supports other
sectors of the Philippine economy. It is primarily concerned with preparation
as well as construction of real estate properties. According to Lamudi Real
Estate Market Report, quarter-on-quarter, the Philippines’ Gross Domestic
Product grew by 1.7% in the three months leading up to December 2016. This was
1% greater than the growth that was initially estimated for that period.
According to Remo (2017), there
seems to be an exponentially increasing growth in the real estate industry. Consequently,
its related industries involving both current and expected developments support
this optimistic forecast. This has been and remains to be a booming
industry because of the continuous process of development especially in
developing countries such as the Philippines.

This
paper attempts to study the effect of working capital management to the
profitability of selected publicly-listed real estate firms in the property
sector of the Philippine Stock Exchange.

 

1.2.
Working Capital Management

Working
Capital Management (WCM) is the management of short term financing requirements
of a firm. The main goal is for firms to develop a policy that will maintain an
optimal capital structure to balance elements such as receivables, inventory,
and payables and using cash efficiently to carry out daily operations. It
affects the firm’s activities such as inventory management, debt management,
revenue collection, and payments to suppliers. To optimize working capital is
to minimize working capital requirements and make maximum possible revenues.

WCM
is fundamental not only to growth of any business but also to its stability and
survival. Inevitably, it is the foundation of efficient and effective
management of a company’s resources. From the perspective of the Chief
Financial Officer (CFO), working capital management is generally a simple and
straightforward concept of ensuring the ability of the organization to fund the
difference between the short-term assets and short-term liabilities (Harris,
2005). An optimal level of working capital would be the one in which a balance
is achieved between risk and efficiency. It requires continuous monitoring to
maintain proper level in various components of working capital, such as cash,
receivables, inventory and payables, and other more. (Nazir and Afza, 2009)

Although
firms are conventionally focused on long term capital budgeting and capital
structure, the recent trend is that many companies across several industries
shifted their focus on Working Capital Management (WCM). As previously
mentioned, firms are generally more concerned with short-term financial
strategies than long term strategies. Consequently, firms are more focused on
working capital management which is the core of all short-term financial
concerns. Maintaining adequate working capital is actually not only crucial in
the short term. Enough level of liquidity must be maintained to ensure the
survival of the business in the long run.

 

1.2.1..
Definition of Working Capital

Working
capital is the difference between current assets and current liabilities. Based
on paragraph 66 of the International Accounting Standards 1 (IAS 1), an entity
shall classify an asset as current when it expects to realise the asset, or
intends to sell or consume it, in its normal operating cycle; it holds the
asset primarily for the purpose of trading; it expects to realise the asset
within twelve months after the reporting period; or the asset is cash or a cash
equivalent unless the asset is restricted from being exchanged or used to
settle a liability for at least twelve months after the reporting period. The
most common line items in this category are cash and cash equivalents,
short-term investments, accounts receivable, inventories and other various
current assets.

An
entity shall classify a liability as current when it expects to settle the
liability in its normal operating cycle; it holds the liability primarily for
the purpose of trading; the liability is due to be settled within twelve months
after the reporting period; or the entity does not have an unconditional right
to defer settlement of the liability for at least twelve months after the
reporting period.

The
operating cycle of an entity is the time between the acquisition of assets for
processing and their realisation in cash or cash equivalents which is assumed
to be 12 months when not clearly identifiable.

Working
capital can also be defined as the investment which a business needs to make to
cater to its daily operations that is necessary to carry adequate stocks if
applicable, allow trade credit to debtors, and pay creditors. The working
capital ratio which is the ratio between Current Assets and Current Liabilities,
indicates whether a company has enough short term assets to cover its short
term debt. Anything below 1 indicates negative working capital. While anything
over 2 means that the company is not investing excess assets. Most believe that
a ratio between 1.2 and 2.0 is already sufficient.  This is also known as the net working
capital.

 

1.2.2.
Elements of Working Capital

            There are two primary elements of
working capital, the current assets and the current liabilities. Currents
assets are as important as non-current assets since real estate construction is
not only capital-intensive but also working capital intensive. The massive use
of equipment, machinery and land is very essential to complete a project. All
non-current assets needed to build a property depends on the availability of
current assets for its financing. Without
doubt, cash plays an important role in any kind of industry. Additionally,
trade receivables allow revenue to be recognized when it is earned even if it
has not yet been received. It enables a real estate company to accept sales
even only with contracts and agreements. 
Last is inventory, which is the main cause and basis of profit. Real
estate companies generate sales and continue its operating cycle because of its
production.

On
the other hand, the operating cycle cannot be complete without acquisition of
raw materials which in the case of real estate contractors come in the form of
hardware and construction supplies. Most often, the capital provided by the
owners is insufficient to cover all of the expenses, especially when the
company has just started its operations. 
To resolve this, accounts payable is needed. Contractors acquire the
necessary materials first, and then pay the amount owed to suppliers
thereafter. Furthermore, short-term loans also help contractors provide
additional capital because there are times when acquiring short-term
liabilities is more advantageous than collecting more from owners, or having
more owners. Lastly, unearned revenue, in contrast with accounts receivable,
enables a company to recognize a sale that is already paid but not yet
performed or earned.

 

1. 2.3.
Impact of Working Capital Management to Accounts

Devising
an effective working capital policy is a crucial investment for firms since in
will result to an increased free cash flow which in turn increases the firm’s
expansion opportunities. It could therefore reflect the financial health of a
firm. Working capital is a good indication of the movements in the capital of a
firm. An increase in working capital figure wherein current assets are greater
than current liabilities, requires additional cash to be tied up in operations
because an increase in current assets is a net outflow. In contrast, a decrease
in working capital position means the firm has more cash available that can be
used for other projects since an increase in current liabilities is a net
inflow.

To
reduce Accounts Receivable (A/R), a firm may create strict collection policies
and limited credit sale schemes for clients. Doing so would increase cash
inflow but may however lessen sales and consequently minimize the Net Income
(NI). To maximize Inventory on the other hand will drastically increase cash
outflow and increase Accounts Payable (A/P) but minimizing Inventory on the other
hand may also cause the firm to lose sales due to the lack of inventory that
are ready for sale.

There
are two ways to achieve higher inventory turnover. First is to prompt sales and
second is to reduce production of inventories. Product and process innovation
could help companies in its decision making. Product innovation simply
introduces new kinds of products. Although new products do not necessarily
result in a success, there is a high probability of creating more sales. Since
innovative products could generate more sales, demand would rise in a certain
degree and customers would repeatedly request for product variability. (Lee,
Zhou & Hsu, 2015)

 Process innovation affects inventory through
cost reduction and minimizing production. An example is enhancing the
manufacturing process that can advance efficiency in production and improve
product quality. Process innovation will also result in improved performance if
it leads to more flexible, responsive, coordinative, and team-oriented work at
the operational level. (Lee, Zhou & Hsu, 2015). The production life cycle
has been a good indicator of process efficiency because shorter time needed for
production definitely results in an increased inventory turnover. Another
significant effect of inventory reduction is downsized wastes that can be a
means of decreasing product price and can stimulate greater demand. (Lee, Zhou
& Hsu, 2015)

 

2. Research Questions

The
following questions are formulated to guide the researchers throughout this
paper.

Main
Research Question:

What is the effect of a working capital
management to the profitability and liquidity of selected real estate
contractors in Metro Manila, Philippines?

Specific
Research Questions:

What
are the factors affecting the contractor’s measurement of the optimal
ratio between current assets and current liabilities?
What
is the relationship between a change in net working capital level, to the
profitability and liquidity of a real estate contractor?
What
is the impact of short term financing decisions to start up and normal
operating costs?
What
are the factors that accelerate the cash conversion cycle?
What
are the factors affecting inventory management and how does every factor
impact the operating cycle of real estate contractors?

 

3. Theoretical Framework

Working
capital management establishes the methods and policies for maintaining
admissible liquidity, efficiency, solvency, profitability and maximization of
shareholder’s equity according to  Brigham,
1999 and Gitman, 1997. Its theories propose that appropriate management of
working capital would result to adequate financing and proper monitoring of
cash, accounts receivable, inventory, accounts payable and other short-term
debts. Furthermore, effective and efficient measurement of a firm’s performance
and right estimation of the cash conversion cycle would be demonstrated.
(McInnes, 2000)

An
individual firm’s investment in working capital and the policies that it adopts
are asserted to be in connection to the industry it operates in. Financing
decisions is differentiated from working capital investment decisions. The
former is generally concerned about all the financial aspects, like how working
capital should be financed and how much should be allocated in each of the
accounts included therein. The latter, on the other hand, primarily talks about
how the firm’s resources should be invested. To be able to establish the most
favourable level of working capital, a firm should consider its size, nature of
industry, risks forecast, growth rate and other external factors. (Anand, 2001)

 

3.1.
Cash Conversion Cycle Theory

According
to Richards & Laughlin (1980), this method was considered as part of a
broader framework of analysis called the Working Capital Cycle. This theory
shows the relationship between the working capital and the cash inflows and
outflows of a firm. This can be useful to determine the amount of cash required
for any level of sales. It is the period of time between the outflow of cash
for raw materials and the inflow of cash from sale of finished products. It
also shows the operating days for which financing is needed. It is computed by
adding Inventory Conversion Period to Receivables Collection Period and
subtracting Payables Deferral Period. The longer the cash conversion cycle, the
greater the amount of investment required in working capital. It can be helpful
for the managers to distinguish the operations that would require their
attention and if they want to adjust the amount of cash in their current
assets.

 

3.2.
Operating Cycle Theory

An
entity’s operating cycle is the period of time from the purchase of raw
materials to the collection of cash from the sale of the finished goods. The
theory encompasses two major short-term asset categories, inventory and
accounts receivable. Two ratios were used to measure operating cycle, these are
the Average Age of Inventory and Average Collection Period. These two ratios
are summed up to compute the Operating Cycle. If the company grants a longer
credit period for the customers, then the profit is expected to be high but if
the firm is to face some liquidity problems then it would take time before the
accounts receivable would be converted into cash (Bhattacharya, 2009).