Management Decision

Working capital financing and corporate profitability of Indian manufacturing

firms
Ajaya Kumar Panda, Swagatika Nanda,
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WCF and
Working capital financing and corporate
corporate profitability of Indian profitability

manufacturing firms
Ajaya Kumar Panda 441
Department of Accounts and Finance,
Received 21 July 2017
National Institute of Industrial Engineering, Mumbai, India, and Revised 6 October 2017
Swagatika Nanda Accepted 26 November 2017
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Department of Management Studies,

Vidyalankar School of Information Technology, Mumbai, India

Abstract
Purpose – The purpose of this paper is to provide empirical evidence about the relationship between working
capital financing (WCF) and firm profitability in six key manufacturing sectors of Indian Economy. It also aims
to capture the change in the financing of working capital requirement over different scenarios of price-cost
margin and financial flexibility.
Design/methodology/approach – The study is undertaken on a sample of 1,211 firms from 6 key
manufacturing sectors of Indian economy from 2000 to 2016. The non-linear relationship between WCF and
profitability is studied using two-step generalized model of moments (GMM) estimator.
Findings – The study finds a convex relationship between WCF and profitability among firms in chemical,
construction, and consumer goods sectors. Firms in these sectors can finance larger portion of their working
capital requirements through short-term debt without negatively impacting profitability. However, a concave
pattern of relationship for firms in machinery, metal, and textile industries implies increasing debt financing
of working capital requirement would increase profitability for the firms who have financed lower portion of
their working capital by short-term bank borrowing. But when a higher proportion of working capital
requirements are already financed by short-term debt, a further increase in debt financing may impact
profitability negatively. Moreover, the study finds that firms with high financial flexibility and high price-cost
margin (except textile) can increase profitability by financing larger portion of working capital requirement
through short-term debts and the continuation with risky WCF could increase profitability.
Originality/value – The study contributes to the literature on working capital in a number of ways. First, no
previous study has been undertaken to explore the non-linear relationship between WCF and corporate
profitability over a large sample of firms from six key manufacturing sectors of Indian economy.
Second, the study uses a quadratic function to explore the non-linear relationship between WCF and profitability.
Third, the study explores the relationship between WCF and profitability with respect to the price-cost margin
and financial flexibility of firms under different manufacturing sectors of Indian economy. Finally, the study uses
advanced two-step GMM, the panel data techniques to handle unobservable heterogeneity and issues of
endogeneity within the data sample.
Keywords Firm performance, Generalized model of moments, Financial flexibility, Non-linear modelling,
Markup, Working capital financing
Paper type Research paper

1. Introduction
Modigliani and Miller’s (1958) theorem of capital structure is based on the thinking that the
value of a firm is unaffected by the mode of financing in an efficient market where there is
absence of taxes, bankruptcy costs, agency costs, and cost of any information. Later on,
Smith (1980) provided a new look to the literature by emphasizing the role of working
capital on firm profitability, risk, and, consequently, on its value. The management of
working capital gradually gained importance due to its contribution to shareholders value Management Decision
Vol. 56 No. 2, 2018
pp. 441-457
The authors are grateful to the anonymous referees of the journal for their extremely useful comments © Emerald Publishing Limited
0025-1747
and suggestions to improve the quality of the research paper. Usual disclaimers apply. DOI 10.1108/MD-07-2017-0698
 MD by maintaining a trade-off between profitability and risk (see Wang, 2002; Deloof, 2003;
56,2 Lazaridis and Tryfonidis, 2006; Chiou et al., 2006; García-Teruel and Martínez-Solano, 2007;
Narender et al., 2008; Nazir and Afza, 2009; Baños-Caballero et al., 2010; Mansoori and
Muhammad, 2012; Ukaegbu, 2014; Kieschnick et al., 2013; de Almeida and Eid, 2014).
The available literatures have focused on identifying the determinants of managing
working capital required for a firm. Managing the optimum requirement of working capital
442 can influence the efficiency of working capital management (Schall and Haley, 1980;
Kaur, 2010), and an efficient management of current asset and current liability can help in
increasing profitability without creating liquidity problems (Yunos et al., 2015).
An efficient working capital management is based on short-term financing decisions and is
essential for maintaining a healthy balance between liquidity and profitability of a firm.
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In other words, it is all about managing current asset, current liability, and the way the
financing is made. If a firm follows a conservative strategy by holding more current assets, the
firm may have to bear with high cost of liquidity, whereas an aggressive strategy of holding low
current asset may push the firm to bear high cost of illiquidity. In both the cases, profitability is
at stake. This disproportional feature of working capital management develops the possibility of
non-linear relationship of working capital with profitability, thereby emphasizing the need to
study all possibilities of financing working capital as is required for a firm.
In fact, holding a high level of net working capital (NWC) or larger inventory protects a
firm from adversities of input price fluctuations and minimizes the loss of sales because of
potential stock-outs (see Schiff and Lieber, 1974; Blinder and Maccini, 1991; Fazzari and
Petersen, 1993; Corsten and Gruen, 2004). Similarly, high level of NWC or over investment
in working capital increases the holding and financing costs (Kieschnick et al., 2013),
which, in turn, leads to high interest expenses and higher credit risk (Aktas et al., 2015).
In continuation with this, Baños-Caballero et al. (2012, 2014, 2016) showed the relationship
between working capital and firm performance using a quadratic functional form.
More recently, Aktas et al. (2015) further documented the non-linear relation between
excess NWC and stock performance.
While large number of studies are assessing the performance of working capital
management by linking working capital requirement with firm performance, the present
study examines the structure of working capital financing (WCF) and its impact on firm
profitability under different circumstances such as price-cost margin and financial
flexibility. To the best of our knowledge, this is one of the few literatures that employ a
quadratic function to explore the impact of WCF on firm profitability, and studying
the Indian manufacturing industry is itself a unique feature. The study contributes to
available literature on working capital in a number of ways. First, the study is undertaken
on a large number of firms (1,211) from six key manufacturing sectors of Indian economy,
and we have considered over 17 years of time period. Second, the study uses a quadratic
function to explore the non-linear relationship between WCF and profitability. Third, the
study explores the relationship between WCF and profitability according to the price-cost
margin and financial flexibility of firms under different manufacturing sectors of the Indian
economy. Finally, the study uses generalized model of moments (GMM), i.e. panel data
techniques to handle unobservable heterogeneity and issues of endogeneity.
Some studies have used the logic of quadratic equation to explore the non-linear
characteristics (see Lensink and Murinde, 2006; Baños-Caballero et al., 2010, 2014, 2016;
Jeanneret, 2015; Ben-Nasr, 2016). However, in the present study, the WCF idea of
Baños-Caballero et al. (2016) has been extended for its implementation in the Indian context.
The structure of the paper is as follows: Section 2 discusses the theoretical background of
WCF, price-cost margin, and financial flexibility, and explains the possible scope of
non-linearity. Section 3 discusses the empirical model and variables. Section 4 presents
analysis and results and Section 5 concludes.
 2. WCF, price-cost margin, and financial flexibility WCF and
2.1 Relevance of WCF to firm profitability corporate
WCF implies the proportion of working capital requirement financed by short-term debts. profitability
A larger portion of working capital financed by short-term debt involves a riskier WCF, and
firms have the choice to decide the proportion of working capital to be financed through
debt. There are specific reasons to adopt the short-run debt financing for improving
profitability. Studies have found that the short-term debt has certain advantages in relation 443
to the different aspects of corporate finance issues. According to Flannery (1986), “the debt
market has a pooling equilibrium in short-term debt, and no one will issue long-term debt,
despite the fact that assets have a long maturity.” Kale and Noe (1990) further found that
companies with high-quality investment projects use short-term debt to transmit their good
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market prospects, and also observed that the use of short-term debt even depends on the
nature of firms, where good firms always prefer to issue short-term debts and the bad firm
always has the incentive of following good firms. Similarly, Barclay and Smith (1995),
Guedes and Opler (1996), Stohs and Mauer (1996), and Ozkan (2001) found that more
short-term debt reduces conflicts between shareholders and creditors as well as between
managers, shareholders, and different groups of shareholders (also see Datta et al., 2005;
Arslan and Karan, 2006; García-Teruel and Martínez-Solano, 2010). Moreover, lenders may
prefer short-term debt, as it will enable them to monitor loan conditions more frequently as
well as facilitate the bank to change the terms of contract or renew the loan according to
their feasibility (see Diamond, 1991; Rajan, 1992; Demirgüç-Kunt and Maksimovic, 1999;
Díaz-Díaz et al., 2016). The existence of agency cost can also be mitigated by using
short-term debt (see Rajan and Winton, 1995; García-Teruel and Martínez-Solano, 2010).
In the context of this study, identifying the source of short-term debt is equally relevant as
per the requirement of short-term debt. In Indian capital market, financing costs tend to be
higher, and short-term capital is less readily available than in developed countries, which
makes it difficult for some Indian firms to get finance for fulfilling their working capital
needs. In such case, banks play an important role, as a fairly developed banking-oriented
institutional financing system is easily assessable for meeting the financial needs in
comparison to less developed equity and bond market. Thus, the short-term bank financing
for the fulfillment of working capital requirement in Indian economy plays a crucial role for
determining the strategies behind working financing for Indian firms. Hence, the present
study has used short-term bank loans as proxy for short-term debt in WCF.
Considering the advantages and disadvantages of short-term debt, it is clear that firm’s
profitability can be affected by the different proportion of the short-term bank financing to
firm’s working capital requirement. When a low proportion of working capital
requirement is financed by short-term bank debt, an increase in bank financing to
working capital requirement may increase profitability, if firms are able to expedite the
positive effects of short-term bank financing. It may continue till an optimum limit of bank
financing beyond which an increase in short-term bank financing to firm’s working capital
requirement would lead to decrease in profitability owing to increase in riskier WCF.
It establishes an inverted U-shape relationship between WCF and firm profitability, where
the point of inflexion or vortex is at maximum. The positive relationship between WCF
and profitability is demonstrated by the left of the vertex, when the lower portion of
working capital requirement is financed by short-term bank debt; and the negative
relationship is demonstrated by the right of the vertex when the higher portion of working
capital requirement is financed by short-term bank debt. Baños-Caballero et al. (2016)
nicely set the primary hypothesis as “There is a positive relationship between WCF and
profitability when lower percentage of WCR are financed by short-term bank debt.
However, this relationship is negative when firms finance a higher percentage of their
working capital requirement through short tern bank debt.” But there is always a
 MD possibility that the relationship may take a U-shape, where the vortex/point of inflexion
56,2 will be at its minimum. In such case, a riskier WCF boosts firm profitability. It happens
when firms follow aggressive working capital management strategies by holding lower
current asset to fixed asset ratio, and greater proportions of working capital requirement
are financed through debts. The effect of this risky WCF may end with high-risk and
high-return scenario. The reason behind it is that the short-term interest rates fluctuate
444 more than long-term interest rates, thus the short-term date will role year after year,
which, in turn, will lead to increase in financing costs. Even though rolling over the
short-term debt every year seems to increase cost of short-term borrowing due to increase
in the renewing cost and refinancing cost, firms may prefer to accept it to avoid the risk of
insolvency of long-term financing. In such case, we hypothesized that “There is a positive
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relationship between riskier short-term financing and firm profitability, if the firm adopts
aggressive WCF strategy.”

2.2 WCF and profitability under the different levels of markup and Financial flexibility
The above hypothesis may be questioned for firms under different financial status. Under
a given cost structure, firms with high price-cost margin, i.e. firms of high markup, are
under favorable situation to earn higher profit margin out of each unit of sales and would
be relatively better to bear the cost of riskier WCF than low-markup firms. These firms
could absorb higher interest rate risks and the increasing refinancing cost of short-term
debt by adjusting the margin in the short run without affecting profitability. Nevertheless,
the higher price-cost margin may not be the only reason to immunize firm’s profit from
adverse effect of riskier WCF. The internal financial flexibility may give added advantage
to the firm to mitigate the negative effects of riskier WCF on profitability. It helps in
mitigating the problems of underinvestment and also reduces the cost of financial distress
owing to resources constraints. Moreover, financial flexibility is an indicator, which
is not directly measurable. Researchers have used proxies based on various financial and
operational logics to measure financial flexibility. Gamba and Triantis (2008),
Byoun (2008), Marc Steffen Rapp et al. (2014), Faulkender and Wang (2006), Bonaimé
et al. (2016), and Baños-Caballero et al. (2016) measured financial flexibility for firms with
various holding like high cash holding, lower leverage, firm’s ability in accessing
and restructuring its low cost finance, etc. Jagannathan et al. (2000) linked financial
flexibility with the manner the stocks are repurchased by US corporations. Gamba
and Triantis (2008) showed the ways in which the value of financing flexibility depends on
various aspects of costs of external financing, the level of tax rates, cost of holding cash,
etc. Since a firm’s profitability depends on proper WCF with stability, firms with higher
financial flexibility may adopt multiple financial strategies, or follow favorable
financial practices that contribute to profitability. This section of the study explores the
net impact of WCF on corporate profitability. On the basis of the above literature
(see Baños-Caballero et al., 2016), we classified financial flexibility of a firm according to
firms holding low debt ratio and high cash holdings during the study period. Hence, firms
with total debt to total assets ratio lower than sample median (i.e. firms with lower debt
ratio) and cash holding higher than sample median are considered as firms with greater
financial flexibility.

3. Empirical model and variables

To establish the relationship between WCF and firm profitability, model 1 has been
developed and estimated. The study uses a quadratic function to capture the features of
parabolas and to find the vortex, i.e. the point of inflection beyond which the relationship
between explained and explanatory variable changes. The estimated signs of the
coefficients of the linear and quadratic coefficients of Equation (1) would test the hypothesis
 of the study, which is based on the shape of the relationship. The model is explained below: WCF and
corporate
ROAit ¼ a0 þg1 WCFit þg2 WCF2it þb1 Sizeit1 þb2 Growthit1 þb3 DLInvit1
profitability
þb4 Debt ratioit1 þb5 Liquidityit1 þlt þZi þeit (1)
The study attempted to control the effects of firm size (log of total asset), firm growth (rate of
growth of sales), change in long-term investment (ΔLInv), debt ratio (ratio of total debt to total 445
asset), and liquidity (current ratio). These time-varying firm-level control variables are lagged
by one year to avoid the effect of simultaneity. λt is the time dummy that varies with time but
remains same for all firms over the time period. For all firms considered in the sample, the
annual time effect indicating temporal discrepancies on firm profitability is same. These time-
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fixed effects control for common macroeconomic shocks on ROA are caused by changes in the
business cycle, effect of trade liberalizations, impact of technology advancements, etc. Hence,
this coefficient captures the effect of economic factors that firms cannot control. Similarly,
ηi is time invariant firm specific fixed-effect component that allows us to control firm’s
unobservable individual characteristics. Panel regression models have the advantage of
controlling the time and fixed-effect impacts of heterogeneous sample. Finally, εit is the model
error term. Since the aim of the paper is to analyze the effect of WCF on firm profit, the linear
and quadratic coefficient of WCF (i.e. γ1 & γ2) obtained from Equation (1) are worth explaining.
The change in ROA due to change in WCF would be zero ((∂ROA)/(∂WCF)) ¼ 0 at a break
point or at point of inflection at vortex, which is equal to (−γ1/2γ2). The relationship between
WCF and ROA would take an inverted U-shape, if the coefficient of the quadratic term (γ2) is
negative, and the relationship would be U-shape, if γ2 is positive. Larger γ2 would make the
parabola narrow, whereas smaller γ2 would make the parabola wider.

3.1 Market power

Previous literature (see Campa and Goldberg, 1995, 1999; Swift, 2006; Caglayan and Torres,
2008; Kandilov and Leblebicioğlu, 2011) have used the concept of price-cost margin,
i.e. markup in various issues of exchange rate pass-through, and we have introduced the
concept of firm-level markup to capture the interaction of their market power with WCF and
to learn about its transition to profit. In this case, a firm with high markup implies that the
firm enjoys a favorable price-cost margin to maximize profit. In the short run, firms never
change their capital structure and pattern of investment to mitigate negative shocks of
short-term WCF, rather these firms absorb the shock by adjusting profit margin. Hence, the
effect of WCF on firms’ profitability is more likely to be impacted differently based on the
level of firm’s price-cost margin. To get this effect, model 1 is re-estimated for the group of
high-markup and low-markup firms, where markup is defined as follows:
 
Value of Sales þD in InventoriesCost of Materials
Markup ¼
Value of Sales þD in Inventories
A firm is considered as high-markup firm, if the firm’s average markup in the study period
is higher than the median markup of the sector during the same study period and vice versa.

3.2 Financial flexibility

Financial flexibility is classified on the basis of firms holding low debt and high cash. Hence,
firms with total debt to total assets ratio lower than sample median are considered as firms
with lesser financial flexibility, whereas firms with lower debt and cash holding higher than
sample median are considered as firms with greater financial flexibility. To capture this effect,
Equation (1) is extended by the introduction of financial flexibility dummy. “D” is the dummy
variable that takes value 1 for firms with greater financial flexibility and 0 otherwise.
 MD Hence, Equation (1) is extended to the following equation:
56,2
ROAit ¼ a0 þ g1 WCFt þ g2 WCF2 it þðg1 þd1 Dit ÞWCFt þ ðg2 þd2 Dit ÞWCF2 it

þb1 Sizeit1 þb2 Growthit1 þ b3 DLInvit1 þb4 Debt ratioit1

446 þb5 Liquidityit1 þlt þZi þeit (2)

The point of inflection of Equation (2) the above equation for the firms with financial
flexibility is captured by −(γ1 + δ1)/2(γ2 + δ2).
The study moves one step forward to study the combined effect of markup and financial
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flexibility on influencing WCF to affect profitability. Equation (2) is further extended with a
modified dummy, where D1 ¼ 1, when firm has high markup and high financial flexibility,
or otherwise D1 ¼ 0:



ROAit ¼ a0 þ g1 WCFt þg2 WCF2it þ g1 þj1 Dit WCFt þ g2 þj2 Dit WCF2it

þb1 Sizeit1 þb2 Growthit1 þb3 DLInvit1 þb4 Debt ratioit1

þb5 Liquidityit1 þlt þZi þeit (3)

The point of inflection of Equation (3) for the firms with financial flexibility is captured by
−(γ1 + φ 1)/2(γ2 + φ2). for firms with high flexibility and high markup, D ¼ 1, and D ¼ 0
otherwise. All the models in the study are estimated by using the two-step GMM estimator
(Arellano and Bond, 1991).

3.3 Data and sample

The firm-level data used in this paper are collected from subscribed sources of Center for
Monitoring Indian Economy database. The sample consists of 1,211 firms from six Indian
manufacturing sectors spanning from 2000 to 2016. Sector-level breakup of firms is
presented in Table I.
The firms within the sectors are selected on the basis of the availability of data.
Firms having maximum data points over the study period are given priority. The variables
used in the study are return on total assets, short-term bank borrowing, working capital
requirements (derived from the difference between current assets and trade payables), total
assets, sales, long-term investment (i.e. change in net fixed assets), debt ratio (i.e. debt over
total assets), liquidity, and markup. Markup is calculated as values of sales plus change in
inventory less cost of material over vales of sales plus change in inventory and financial
flexibility that is considered as firms having high holding of cash and cash equivalent with
lower debt ratio.

S.no Sector name No. of firms

1 Chemical and chemical products 345

2 Construction and construction materials 88
3 Consumer goods 109
4 Machinery 292
Table I. 5 Metal and metal products 164
Sector-level breakup 6 Textile 213
of firms Total firms in the sample 1,211
 4. Analysis and results WCF and
4.1 Correlation analysis corporate
Table II reports the pairwise correlation coefficients with their respective level of profitability
significance for the six sectors. Uniformly, in all the cases, profit (ROA) is negatively and
significantly correlated with WCF and its square term. There is significant correlation
among firm-specific control factors – size, growth rate of firm, long-term investment, debt
ratio, and liquidity – and firm profitability. Overall, many variables are significantly 447
correlated with each other in most of the cases. Table III reports the summary statistics of
firm characteristics for all the sectors. Firm size in all the six sectors is approximately more
close to normal distribution with skewness closer to 0 and kurtosis nearing to 3. The rest of
the variables are largely non-normally distributed with sharp peaks, i.e. too high excess
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kurtosis. Only ROA is negatively skewed, whereas most of the variables are positively
skewed, except the long-term investment of consumer goods industry. For this reason, in
many cases, median is less than mean.

4.2 WCF and firm profitability

Table IV presents the estimated statistics of Equation (1) that explains the relationship
between WCF and profit. The linear and quadratic coefficients γ1 and γ2 are statistically
significant for all the six sectors of the Indian manufacturing industry. The negative
coefficient γ1 and positive coefficient γ2 of chemical, construction, and consumer goods sector
confirm that there is a convex relationship between WCF and firm profitability. The positive
relationship implies profitability in these sectors that increase by riskier WCF. Hence, firm in
these three sectors can increase their profitability by following aggressive WCF strategy,
which leads to the confirmation of our second hypothesis. Contrary to this, the relationship
between WCF and profitability in machinery, metal, and textile industries presents an
inverted U-shape, thereby implying that financing lower portion of the working capital by
short-term debt results in increase of debt financing to working capital requirement that
ultimately lead to increase in profitability. In case a higher proportion of working capital
requirements are already financed by short-term debt, a further increase in debt financing
may impact profitability negatively. Hence, a positive relationship between WCF and firm
profitability continues until an optimal-level debt financing is achieved, and increase in debt
financing to WCR beyond the optimum point eventually leads to decrease in profitability,
which ultimately results in a negative relation between them. Besides this, one more point is
worth noticing in the metal industry. Negative coefficients of γ1 and γ2 imply that the axis of
symmetry shifts to left, which leave very less scope for the firms of metal and metal product
sector to experience the positive relationship between WCF and firm profitability. Firms in
this sector may follow some matching strategy to finance working capital requirement
because only relying on short-term debt financing may not generate a situation of profit
maximization. Other than the estimated coefficients, Table IV also contains several test
statistics that enlightens the model’s stability. A significant Wald χ2 validates the overall level
of significance of the models with an alternate hypothesis, which states that all the estimated
coefficients are significant other than zero. Similarly, Breusch-Pagan and White’s test
measures the nature of heterogeneity within the panels. Sargan test captures the validity of
the overidentification restrictions used by GMM model, and finally, the Arellano-Bond test for
zero autocorrelation in the first-differenced errors have been evaluated. All these pre- and
post-estimation test statistics increase the estimated accuracy of the models.

4.3 WCF and firm profitability under different levels of markup

To capture the impact of WCF on firm profitability for firms under different levels of
markup, in this study the firms under each sector have been divided into firms with high
 MD Profit WCF WCF2 Size Growth ΔLInvest. Debt ratio Liquidity
56,2
Correlation matrix of the variables of chemical and chemical products industry
Profit 1
WCF −0.20* 1
WCF2 −0.034** 0.817* 1
Size 0.16* 0.011 −0.012 1
448 Growth 0.147* −0.032** −0.012 0.0289** 1
ΔLInvest. 0.113* −0.014 −0.014 0.101* 0.129* 1
Debt ratio −0.382* 0.3531* 0.353* −0.022** 0.0143 −0.061* 1
Liquidity −0.016 −0.004 −0.0045 −0.0176 −0.0396** −0.010 −0.035** 1
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Correlation matrix of the variables of construction and construction material industry

Profit 1
WCF −0.341* 1
WCF2 −0.289* 0.871* 1
Size 0.186* 0.003 −0.0253 1
Growth 0.1914* −0.063** −0.0591** 0.097** 1
ΔLInvest. 0.138* −0.054** −0.064** 0.179* 0.1097* 1
Debt ratio −0.353* 0.186* 0.143* −0.002 −0.046 −0.1035** 1
Liquidity 0.201* −0.246* −0.174* 0.0542** −0.042 −0.023 −0.127* 1
Correlation matrix of the variables of consumer goods industry
Profit 1
WCF −0.141* 1
WCF2 −0.012 0.128* 1
Size 0.208* 0.047** −0.043 1
Growth 0.196* −0.023 −0.011 0.118* 1
ΔLInvest. 0.072** −0.008 −0.005 0.065** 0.058** 1
Debt ratio −0.252* 0.154* −0.005 0.027 −0.051** −0.044 1
Liquidity 0.001 −0.093** −0.001 0.044 −0.033 −0.036 0.0051 1
Correlation matrix of the variables of machinery industry
Profit 1
WCF −0.055** 1
WCF2 −0.032** −0.943* 1
Size 0.104* 0.047** −0.0415** 1
Growth 0.028** −0.004 −0.001 −0.012 1
ΔLInvest. 0.111* 0.0004 −0.001 0.058* 0.041** 1
Debt ratio −0.14* 0.101* −0.001 −0.027 −0.003 −0.042** 1
Liquidity 0.047** −0.034** −0.007 −0.102* 0.001 −0.028** −0.102* 1
Correlation matrix of the variables of metal and metal products industry
Profit 1
WCF −0.246* 1
WCF2 −0.167* 0.157* 1
Size 0.085* 0.037** 0.079* 1
Growth 0.193* −0.060** −0.060** −0.004*** 1
ΔLInvest. −0.128* 0.018 −0.018 −0.122* −0.116* 1
Debt ratio −0.194* 0.119* 0.063** −0.032 −0.0012 0.066** 1
Liquidity 0.172* −0.170* −0.098* −0.018 −0.036 0.003 −0.156* 1
Correlation matrix of the variables of textile industry
Profit 1
WCF −0.157* 1
Table II. WCF2 −0.304* 0.136* 1
Correlation Size −0.059** −0.037** 0.092* 1
coefficients matrix
of the variables used
in the study (continued )
 Profit WCF WCF2 Size Growth ΔLInvest. Debt ratio Liquidity
WCF and
corporate
Growth 0.142* −0.040b −0.070* 0.023** 1 profitability
ΔLInvest. 0.070* −0.012 −0.049** 0.014 0.112* 1
Debt ratio −0.266* 0.204* 0.249* 0.003 −0.055** −0.038** 1
Liquidity 0.121* −0.061** −0.197* −0.140* 0.0003 −0.0179 −0.166* 1
Notes: ROA represents firm’s profit; WCF is the ratio of short-term bank debt to WCR; WCF2 is the square of
WCF introduced in the study to incorporate the graph features of a quadratic function; size represents firm 449
size with a proxy of log of total assets; growth represents rate of growth of sales, a proxy for firm’s growth
rate; ΔLInvest is the change in long-term investment (or long-term capital formation) calculated as year on
year change in net fixed asset; debt ratio represents debt over total asset; and liquidity represents (current
ratio) firm’s liquidity. *,**,***Significant at 1, 5 and 10 percent levels, respectively Table II.
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and low markup. A firm is considered as a high-markup firm if the firm’s average markup in
the study period is higher than the median markup of the sector during the same study
period and vice versa. The estimated statistics of Equation (1) is re-estimated for
low-markup and high-markup firms and are presented in Table V. The relationship between
WCF and profitability is convex, for both low-markup and high-markup firms of chemical,
construction, and consumer goods industries. A larger γ2 of high-markup firms of
construction sector implies that a narrow parabola increases the slope of the relationship,
thereby making profitability more sensitive to change in WCF. The profitability of firms in
these sectors increases with aggressive WCF strategy, and the rate of increase in
profitability for high-markup firms of construction sector is expected to increase at a faster
rate in relation to other sectors because of a narrow parabolic nature of the relationship.
All the high- and low-markup firms of machinery, metal, and textile sectors are experiencing
a concave (i.e. inverted U-shape) relationship between WCF and profitability. This implies
that in case of firms where short-term debt financed lower proportion of the firm’s working
capital, profitability is enhanced through an increase in debt financing, but it is not same for
firms where a larger portion of their working capital have been already finance through
debt. However, the high-markup firms of machinery and metal sectors even though
experiencing concave shaped parabola, the axis of symmetry is expected to shift leftward,
thus leaving very less scope for the firms to experience the positive relationship between
WCF and profit. In such case, a conservative WCF strategy may not add much opportunity
to firms to maximize profit. Hence, these firms may explore some new matching approach to
finance working capital requirements that can maximize profit. The other related statistics
of the estimated GMM model is presented in Table V along with the estimated coefficients.

4.4 WCF and firm profitability of firms with high markup and high financial flexibility
Tables VI and VII present the estimated statistics of Equations (2) and (3), respectively that
the tables incorporate the impact of financial flexibility alone and financial flexibility along
with markup while studying the relation between WCF and firm profitability. Firms are
considered to be financially flexible on two conditions: one if the firm’s average cash holding
is higher than the median cash holding of the sector during the study period, and the other is
that the firm’s average debt ratio is lower than the median debt ratio of the sector during the
same study period. We have used a dummy variable to distinguish financially flexible firms
from others. The finding of the study looks similar to the findings of Equation (1) presented
in Table IV. Chemical, construction, and consumer goods sectors demonstrate that the
relationship between WCF and firm profitability presents a convex shape, which indicates
that an aggressive WCF strategy could increase firm profitability. However, for machinery,
metal, and textile sectors, the relationship between WCF and firm profitability presents a
 MD Variable Obs. Mean Median SD Skewness Kurtosis
56,2
Chemical products & chemical products
ROA 5,865 2.62 3.23 11.12 −3.39 44.15
WCF 5,865 0.436 0.29 1.18 19.22 567.16
WCF2 5,865 1.65 0.06 33.83 43.39 2,060.7
Size 5,865 2.99 2.89 0.89 0.063 4.06
450 Growth 5,865 0.136 0.112 0.392 10.64 390.62
ΔLInvest. 5,865 0.089 0.001 0.375 6.42 92.14
Debt ratio 5,865 0.362 0.31 0.481 8.01 106.92
Liquidity 5,865 1.94 1.25 16.63 68.67 4,983.89
Construction and construction material
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ROA 1,496 0.94 1.95 13.17 −1.24 29.30

WCF 1,496 0.425 0.31 0.578 3.499 20.010
2
WCF 1,496 0.497 0.1 1.716 7.386 68.426
Size 1,496 3.12 3.21 1.009 −0.785 4.426
Growth 1,496 0.114 0.1 0.41 5.55 97.77
ΔLInvest. 1,496 0.059 −0.02 0.333 2.441 26.831
Debt ratio 1,496 0.452 0.37 0.494 3.826 26.911
Liquidity 1,496 1.22 1.08 1.01 4.99 56.47
Consumer goods
ROA 1,853 1.46 1.77 14.96 −0.08 38.81
WCF 1,853 0.374 0.15 1.16 14.14 272.29
WCF2 1,853 1.013 0.02 18.45 29.66 905.09
Size 1,853 2.626 2.81 1.220 −0.685 3.159
Growth 1,853 0.112 0.08 0.45 1.11 22.48
ΔLInvest. 1,853 0.057 −0.01 0.55 −1.62 154.91
Debt ratio 1,853 0.376 0.23 0.79 7.02 63.94
Liquidity 1,853 1.646 1.22 2.247 7.654 105.697
Machinery products
ROA 4,964 1.88 2.53 12.277 −3.279 34.722
WCF 4,964 0.266 0.15 2.374 −59.493 4,006.201
WCF2 4,964 5.58 0.21 18.85 70.39 4,957.96
Size 4,964 2.796 2.84 0.962 −0.633 4.341
Growth 4,964 0.234 0.08 3.41 55.08 3,451.05
ΔLInvest. 4,964 0.106 0.001 0.584 7.984 153.491
Debt ratio 4,964 0.339 0.21 1.04 15.83 306.44
Liquidity 4,964 1.763 1.33 2.19 11.15 222.03
Metal and metal products
ROA 2,788 2.156 2.2 8.936 −1.186 11.799
WCF 2,788 0.438 0.3 0.836 6.806 120.261
WCF2 2,788 0.458 0.1 2.311 25.725 936.923
Size 2,788 3.145 3.00 0.911 0.577 3.316
Growth 2,788 0.162 0.1 0.404 1.503 15.295
ΔLInvest. 2,788 −0.047 0.00 0.329 4.777 105.178
Debt ratio 2,788 0.416 0.4 0.697 15.882 329.343
Liquidity 2,788 1.45 1.2 1.288 5.197 40.585
Textiles products
ROA 3,621 0.3997 1.8 10.67 −3.20 32.76
WCF 3,621 0.600 0.4 4.132 −1.447 531.11
WCF2 3,621 0.470 0.2 1.041 5.918 49.212
Size 3,621 2.99 3.01. 0.719 0.097 3.268
Growth 3,621 0.139 0.12 0.439 4.959 70.585
ΔLInvest. 3,621 0.128 0.01 0.807 11.288 230.646
Table III. Debt ratio 3,621 0.54 0.5 0.803 11.216 168.287
Summary statistics Liquidity 3,621 1.573 1.2 1.615 5.693 54.363
 Chemical and Construction and Metal and
WCF and
Independent chemical construction Consumer Machinery metal Textiles corporate
variables products materials goods products products products profitability
WCF −1.79* −7.45* −0.78* 1.87* −0.07** 0.02***
WCF2 0.04* 1.15* 0.01* −0.01* −0.09* −1.38*
Size −1.48* −2.54* −0.87* −1.11* −4.13* 6.76*
Growth 1.35* 1.61* 3.47* 0.02 0.56* 0.78* 451
ΔLInvest. −0.79* −1.70* −0.58* −0.04 −0.93* 0.05
Debt ratio 2.31* 1.35* −3.69* 1.41* 0.88* 1.01*
Liquidity −0.001** 0.36* 0.33* −0.42* −0.23* −0.04
Constant 6.33* 10.40* 4.14* 5.60* 14.24* 20.89*
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No. of obs. 5,175 1,320 1,635 4,380 2,460 3,195

Wald χ 2
6,314.21* 363.82* 177.01* 818.42* 4,504.89* 1,182.32*
B & P test 6,116.7* 905.19* 196.84* 551.04* 116.20* 199.8*
White’s test 845.89* 153.19* 102.03* 112.82* 241.05* 305.6*
Sargan test 14.38 21.18 19.05 15.57 11.96 15.04
Autocorr.
test −03.64* −04.98*** −2.12** −5.40* −5.003* −5.185*
Notes: Wald χ2 statistics presents overall significance level of the model by rejecting the H0 that all the
coefficients of the model are significantly other than zero; B & P test indicates Breusch-Pagan/Cook-Weisberg test
for heteroskedasticity; White’s test tests the H0: homoskedasticity against H1: unrestricted heteroskedasticity; Table IV.
Sargan test the hypothesis whether overidentifying restrictions used in GMM are valid; and finally autocorr. test Working capital
represents Arellano-Bond test for zero autocorrelation in first-differenced errors. The dependent variable is ROA financing and firm
used as proxy for firm profitability. *,**,***Significant at 1, 5 and 10 percent levels, respectively profitability

concave shape, which indicates that these firms can finance a greater portion of their
working capital through short-term debt without compromising firm profitability.
We have extended the study one step ahead by segregating firms that are not only
financially flexible but also are high-markup firms using dummy variable. D ¼ 1, if the firms
are financially flexible and are of high markup, otherwise D ¼ 0. The estimated coefficients
of Equation (3) are presented in Table VII. Our study findings state that firms with high
financial flexibility and high price-cost margin in chemical, construction, consumer goods,
machinery, and metal sectors can increase their profitability by following aggressive WCF
strategy. Financing a greater portion of working capital requirement through short-term
borrowing and continuing with risky WCF could increase profitability because the
relationship between WCF and profitability is convex. But this is not for firms of textile
sector, where the relationship between WCF and profitability is concave for the high
financially flexible and high price-cost margin firms. But the negative sign of linear and
quadratic coefficients implies that the axis of symmetry shifts to left, which insists that the
highly flexible firms of the textile sector must explore some new finance mix to boost their
profitability.

5. Conclusion
The present study analyzes the relationship between WCF and firm profitability for six
sectors of the Indian manufacturing industry over 17 years from 2000 to 2016. Although
there are a good number of literatures focusing on working capital management and its
impact on firm performance, the present study attempts to explore the different patterns of
relationship between WCF and firm profitability under different circumstances of financial
flexibility and price-cost margin for a large number of firms in the Indian manufacturing
sector. At the best of our knowledge, this is only one new literature that uses a quadratic
function to capture the non-linear relationship between WCF and firm profitability in a large
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MD
56,2

452

markup
Table V.
Working capital

different levels of
profitability under
financing and firm
Chemical and Construction and Metal and metal
chemical products construction materials Consumer goods Machinery products products Textiles products
Independent variables Low MKP High MKP Low MKP High MKP Low MKP High MKP Low MKP High MKP Low MKP High MKP Low MKP High MKP

WCF −0.92* −2.68* −7.14* −7.82* −0.89* −4.47* 3.66* −1.43* 0.23* −0.31* 0.05* 0.13*
WCF2 0.02* 0.09* 0.31*** 1.60* 0.01*** 0.44* −0.16* −0.01* −0.49* −0.05* −0.35* −0.75*
Size −1.75* −2.14* −2.39* −1.32** −2.44* 0.64* −0.67* −2.61* −4.91* −4.59* −7.01* −9.20*
Growth 1.42* 0.66* 2.45* 1.34* 4.73* 1.35* 0.05* 0.08* 1.16* 0.08* 1.17* 0.03
ΔLInvest. −0.26** −0.94* −3.27* −0.11 −0.48*** −1.38* −0.04 −0.04 −0.49* −1.22* 0.21* −0.26*
Debt ratio 3.30* 1.22* 0.82 0.17 −0.14 −5.99* 0.95* 0.55* −0.25* 1.82* 1.40* 0.99*
Liquidity 0.13* −0.004* 1.24* −0.34 −0.13 0.19* −0.21* −0.84* −0.47* −0.13* 0.11* 0.25*
Constant 5.56* 9.15* 9.70* 7.93* 7.71* 2.24* 3.01* 12.59* 17.16* 15.77* 20.89* 26.96*
No. of obs. 2,610 2,565 660 660 825 810 2,190 2,190 1,230 1,320 1,605 1,590
Wald χ2 2,013.7* 386.12* 106.91* 841.15* 922.3* 504.3* 809.2* 972.3* 528.0* 123.3* 528.3* 464.0*
B & P Test 891.29* 427.68* 499.7* 289.8* 18.37* 142.13* 126.1* 338.4* 49.4* 338.34* 114.9* 253.02*
White’s test 424.5* 640.63* 153.6* 133.6* 66.72* 289.6* 209.7* 62.64* 71.7* 249.3* 215.6* 177.7*
Sargan test 12.51 11.6 03.36 13.99 14.42 04.41 20.98 22.8 11.8 17.8 10.6 08.9
Autocorr. test −5.24* −2.82* −2.16* −2.81* −1.78*** −2.36** −4.37* −3.44* −4.46* −3.38* −4.30* −3.63*
Notes: Wald χ2 statistics presents overall significance level of the model by rejecting the H0 that all the coefficients of the model are significantly other than zero; B & P
test indicates Breusch-Pagan/Cook-Weisberg test for heteroskedasticity; White’s test tests the H0: homoskedasticity against H1: unrestricted heteroskedasticity; Sargan
test the hypothesis whether overidentifying restrictions used in GMM are valid; and finally autocorr. test represents Arellano-Bond test for zero autocorrelation in
first-differenced errors. The dependent variable is ROA used as proxy for firm profitability. Firms under each sector are divided under two groups, i.e. firms with high
markup and low markup. A firm is considered as high-markup firm if the firm’s average markup in the study period is higher than the median markup of the sector
during the same study period and vice versa. *,**,***Significant at 1, 5 and 10 percent levels, respectively
 Chemical and Construction and Metal and
WCF and
Independent chemical construction Consumer Machinery metal Textiles corporate
variables products materials goods products products products profitability
WCF −2.55* −6.26* −0.262* −2.021* 1.176** 0.198*
WCF2 0.06* 0.79* 0.005** −0.013* −0.087* −1.543*
D × WCF 1.11* −6.34* −3.989* 3.527* −0.820* 0.211*
D × WCF2 0.09* 0.67*** 0.229* 0.055*** −0.009*** 0.302** 453
Size −1.51* −2.66* −0.867* −1.105* −4.190* −6.692*
Growth 1.33* 1.63* 3.269* 0.020 0.558* 0.757
ΔLInvest. −0.79* −1.76* −0.514* −0.048 −0.945** 0.041*
Debt ratio 2.34* 1.16* −3.628* 1.408* 0.870* 1.012*
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Liquidity −0.001* 0.43* 0.297* −0.428* −0.226* −0.016

Constant 6.54* 10.95* 4.236* 5.564* 14.39* 20.64*
No. of obs. 5,175 1,320 1,635 4,380 2,460 3,195
Wald χ2 705.3* 1,315.3* 177.02* 853.3* 748.06* 1,311.2*
B & P test 611.2* 912.5* 170.7* 564.2* 113.09* 198.8*
White’s test 838.7* 162.3* 130.78* 128.09* 274.8* 340.8*
Sargan test 14.2 17.52 13.4 16.07 18.17 15.02
Autocorr.
test −3.63* −1.82*** −2.13** −5.43 −5.01* −5.18*
Notes: Wald χ2 statistics presents overall significance level of the model by rejecting the H0 that all the
coefficients of the model are significantly other than zero; B & P test indicates Breusch-Pagan/Cook-Weisberg test
for heteroskedasticity; White’s test tests the H0: homoskedasticity against H1: unrestricted heteroskedasticity; Table VI.
Sargan test the hypothesis whether overidentifying restrictions used in GMM are valid; and finally autocorr. test Working capital
represents Arellano-Bond test for zero autocorrelation in first-differenced errors. D is the dummy variable. D ¼ 1 financing and firm
if the firm is high financially flexible or D ¼ 0 otherwise. The dependent variable is ROA used as proxy for firm profitability under
profitability. *,**,***Significant at 1, 5 and 10 percent levels, respectively financial flexibility

section of the Indian manufacturing industry. The present study is motivated by Lensink
and Murinde (2006), Jeanneret (2015), and Baños-Caballero et al. (2016) to implement the ides
quadratic equation modeling of WCF in the Indian context.
The findings of the study indicate that different sectors of Indian manufacturing
industries are experiencing different patterns of relationship between WCF and firm
profitability. Firms in chemical, construction, and consumer goods sectors can finance
larger portion of their working capital requirements through short-term debt. Aggressive
WCF strategy can increase firm performance without impacting profitability negatively.
A conservative financing strategy, like financing lower portion of working capital through
short-term bank debt, may not appropriately boost profitability of these sectors. Contrary
to this, the relationship between WCF and profitability for firms in machinery, metal, and
textile industries is represented by an inverted U-shape, which implies that financing
lower portion of the working capital by short-term bank debt leads to increase in debt
financing to working capital requirement that ultimately results in enhancing
profitability. But when a higher proportion of working capital requirements are already
financed by short-term debt, a further increase in debt financing may impact profitability
negatively. In this case, a positive relationship between WCF and firm profitability
continues till an optimal level of debt financing is reached, as beyond this level, the
negative relation begins. Furthermore, by grouping the firms into high- and low-markup
category, the present study could capture some interesting points. The high-markup firms
of machinery and metal sector are having very less scope to increase profitability through
increase in debt financing to working capital requirements even when lower portion of
working capital are financed by short-term debt. These firms should explore some new
matching approach to finance working capital requirements that can maximize profit.
 MD Chemical and Construction and Metal and
56,2 Independent chemical construction Consumer Machinery metal Textiles
variables products materials goods products products products

WCF −1.965* −6.71* −0.616* −1.947* −0.028*** −0.001***

WCF2 0.236* 0.83* 0.007* −0.012* −0.082* −1.263*
D1×WCF −2.456* −4.30* −3.878* −6.285* −7.57* −5.782*
454 D1×WCF2 −0.120** 0.21*** 0.346* 6.088* 1.450* 0.592**
Size −1.528* −2.77* −0.903* −1.151* −4.051* −6.953*
Growth 1.316* 1.63* 3.363* 0.021 0.596* 0.794*
ΔLInvest. −0.776* −1.59* −0.575* −0.065 −0.966* 0.103
Debt ratio 2.297* 1.34* −3.672* 1.420* 0.845* 0.993*
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Liquidity −0.001* 0.38* 0.309* −0.425* −0.241* −0.024

Constant 6.442* 11.03* 4.431* 5.767* 14.17* 21.82*
No. of obs. 5,175 1,320 1,635 4,380 2,460 3,195
Wald χ2 637.5* 2668.02* 192.06* 791.4* 476.23* 1,313.06*
B & P test 592.2* 911.25* 223.75* 556.8* 120.0* 217.3*
White’s test 870.05* 162.07* 133.04* 120.4* 258.27* 395.5*
Sargan test 13.01 18.9 198.45 16.6 14.7 15.5
Autocorr.
test −3.64* −1.83*** −2.13** −5.51* −4.98* −5.33*
Notes: Wald χ2 statistics presents overall significance level of the model by rejecting the H0 that all the
Table VII. coefficients of the model are significantly other than zero; B & P test indicates Breusch-Pagan/Cook-Weisberg
Working capital test for heteroskedasticity; White’s test tests the H0: homoskedasticity against H1: unrestricted
financing and firm heteroskedasticity; Sargan test the hypothesis whether overidentifying restrictions used in GMM are valid;
profitability of firms and finally autocorr. test represents Arellano-Bond test for zero autocorrelation in first-differenced errors. D is
with high markup and the dummy variable. D ¼ 1 if the firm is high financially flexible and with high markup or D ¼ 0 otherwise.
high financial The dependent variable is ROA used as proxy for firm profitability. *,**,***Significant at 1, 5 and 10 percent
flexibility levels, respectively

Moreover, our study findings state that firms with high financial flexibility and high
price-cost margin (except textile) can increase profitability by following an aggressive
WCF strategy. Financing a greater portion of working capital requirement through
short-term borrowing and continuing with risky WCF could increase profitability.
The present study has potential contribution to the existing literature on corporate finance.
The study has specifically decomposed the relationship between WCF and corporate
profitability for Indian manufacturing firms under different circumstances of financial
flexibilities and price-cost margin. The study settles a clear guideline for firm managers to
adopt WCF strategies that encourages profitability and provides the clue for the scope to
identify new methods of investing WCF for certain sectors to enhance profitability.
The present study is not free from limitations. To begin with, the intensity of financial
flexibility may vary subject to firm size, nature of industry, types of capital structure, etc.
Hence, measuring financial flexibility for all the six sectors using single measure criteria
may not be much effective. Measuring financial flexibility sectorwise incorporating firm size
and capital structure may provide exciting insights on impact of financial flexibility on
WCF. The study can also be extended to cluster the firms under high- and low-markup firms
sector wise to capture its net impact on WCF. Moreover, a unique dimension would be to
explore impact of monetary policy and term structure of interest rate on WCF. Unlike firms
from developed countries, Indian firms mostly depend on institutional borrowing,
i.e. borrowing from banks and non-banking financial intermediaries to finance their working
capital requirements. Since interest rate is a target variable of modern monetary policy, and
central banks regulate interest rates to manage money supply, the impact of monetary
policy could be reflected on the decisions of institutional-based WCF via interest rate
 cannels. This would also insist us to follow robust econometric modeling to segregate policy WCF and
and target variables and control their impacts on WCF. Panel vector auto-regression models corporate
are expected to be appropriate models in capturing responses of WCF due to 1 standard profitability
deviation shocks on monetary policy instruments (i.e. interest rate). The impact of monetary
policy could also be studied under the scenarios of tight and easy monetary policy to capture
their impacts under different business cycles.
455
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Economist, Vol. 14 No. 2, pp. 71-89.

Corresponding author
Ajaya Kumar Panda can be contacted at: akpanda@nitie.ac.in

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