Liquidity is not a matter of life and death, it’s more important than that.: How does working capital management affect the profitability of Swedish SMEs? 

Liquidity is not a matter of life and death, it’s more important than that

How does working capital management affect the profitability of Swedish SMEs?

Master thesis

Author: Cikotic, Adis & Hörnell, Eric Supervisor: Willesson, Magnus Examiner: Jansson, Andreas Term: VT20

Subject: Finance Level: Advanced Course code: 4FE17E

A BSTRACT

Master Thesis in Business Finance, School of Economics, Linnaeus University

Authors: Adis Cikotic and Eric Hörnell Supervisor: Magnus Willesson

Examiner: Andreas Jansson

Title: "Liquidity is not a matter of life and death, it is more important than that"

Background: One of the biggest concerns for Swedish small and medium businesses is their lack of capital, which might lead to lower profitability. A significant reason behind this is said to be the buyer's long payment terms contrary to the supplier's payment terms for their own expenses, which increases the risk of an imbalance between the inflows and outflows of money.

This situation occurs due to, for example, power relations and institutional factors, which might affect a firm's Cash Conversion Cycle and furthermore the firm's profitability.

Purpose: The primary purpose of the thesis is to examine whether the length of a firm's Cash Conversion Cycle has an impact on the profitability of Swedish SMEs. Moreover, the purpose is to determine if the presence of Buyers Power affects a firm's profitability.

Method: The thesis has a deductive research approach where the theories applied, Cash Conversion Cycle and Buyers Power, lead to the formulated hypotheses. The quantitative research methodology is based on a data set of approximately 38 000 Swedish SME's between the years 2015-2018.

Conclusions: It could be seen that there is a concave relationship between firm's Cash Conversion Cycle and a firm's profitability for Swedish SMEs.

The interpretation is therefore that both too short and too long Cash Conversion Cycle is not optimal, and the optimal length of the Cash Conversion Cycle is 36 days for Swedish SMEs. Moreover, the result showed that a presence of Buyers Power has a positive relationship with profitability, meaning that a larger ratio between a firm's accounts receivables and accounts payables increases the firm's profitability.

K EY WORDS

Profitability, Cash Conversion Cycle, Buyers Power, Institutional Theory, Reverse Factoring, Working Capital Management

A CKNOWLEDGMENTS

First of all, we want to thank our supervisor Magnus Willesson for his valuable help in the progress of this study. We also want to thank our co-examiner Andreas Jansson for his opinions regarding improvements for this thesis.

Furthermore, we want to thank our loved ones who have been understanding during this spring when the thesis has taken all of our time.

Thank you!

Växjö, 25^th of May 2020

Adis Cikotic Eric Hörnell

T ABLE OF CONTENTS

I Introduction ... 1

I.I Background ... 1

I.II Problematization ... 2

I.II.I The new era ... 6

I.III Purpose and framing of questions ... 8

I.IV Disposition ... 8

II Scientific method ... 10

II.I Research approach ... 10

III Theoretical framework ... 11

III.I Choice of theories ... 11

III.II Cash Conversion Cycle ... 12

III.II.I Cash conversion cycle and profitability ... 13

III.III Porter’s five forces ... 14

IV Empirical method ... 17

IV.I Quantitative method ... 17

IV.II Longitudinal study ... 17

IV.III Sample selection ... 18

IV.III.I Data collection ... 18

IV.III.II Data processing ... 19

IV.III.III Drop out ... 19

IV.III.IV Reliability ... 19

IV.III.V Validity ... 20

IV.III.VI Operationalization of variables ... 20

IV.III.VI.I Standard vs log transformed variables ... 21

IV.III.VI.II Dependent variable ... 21

IV.III.VI.III Independent variables. ... 22

IV.III.VI.III.I Cash Conversion Cycle ... 22

IV.III.VI.III.II Buyers Power ... 22

IV.III.VI.III.III Summary table of the independent variables ... 23

IV.III.VI.IV Control variables ... 23

IV.III.VI.IV.I Size ... 23

IV.III.VI.IV.II Growth ... 24

IV.III.VI.IV.III Age ... 24

IV.III.VI.IV.IV Industry ... 24

IV.III.VI.IV.V Explanatory table of the industries ... 25

IV.III.VI.IV.VI Summary table of the control variables ... 26

IV.III.VI.IV.VII Explanatory table of the variable names ... 26

IV.III.VI.V P-values and confidence interval ... 27

IV.III.VII Random-effects regression ... 27

IV.III.VII.I Final model ... 28

IV.III.VII.II Statistical controls ... 28

IV.III.VII.II.I Extreme values ... 28

IV.III.VII.II.II Heteroscedasticity ... 29

IV.III.VII.II.III Multicollinearity ... 29

IV.III.VII.II.IV Autocorrelation ... 29

IV.III.VII.II.V Correlation analysis ... 30

IV.III.VIII Ethical positions ... 30

V Results ... 31

V.I Descriptive statistics ... 31

V.I.I Dependent variable ... 31

V.II Bivariate analyze ... 35

V.III Multivariate analyze ... 36

V.III.I Concave relationship between Y & X1/X1sq ... 39

VI Analysis ... 40

VI.I Cash Conversion Cycle ... 40

VI.II Buyers power ... 41

VI.III Control variables ... 41

VII Conclusions ... 43

VII.I Cash Conversion Cycle ... 43

VII.II Buyers power ... 44

VII.III Institutional theory ... 45

VII.IV Reverse factoring ... 45

VII.V Future research ... 46

VIII Appendix ... 54

VIII.I Concepts ... 54

VIII.I.I Working Capital ... 54

VIII.I.II Profitability ... 54

VIII.I.II.I Profitability ratios ... 55

VIII.I.III Payment terms ... 55

VIII.I.III.I Credit Policy ... 55

VIII.I.III.II Trade credit ... 56

VIII.I.III.III Advantages with trade credit ... 56

VIII.I.III.IV Disadvantages with trade credit ... 57

VIII.I.IV Financing options ... 57

VIII.I.IV.I Factoring ... 57

VIII.I.IV.II Supply Chain Finance ... 58

VIII.I.V Institutional theory ... 59

2020-06-01 1

I I NTRODUCTION

This introductory chapter gives the reader a background regarding one of the most substantial problems for small and medium (SMEs) businesses in Sweden, namely their lack of capital, which often leads to liquidity, growth, and profitability problems. Furthermore, this is a well-known problem for SMEs around the world, and studies show that institutional disparities between countries together with power relations affect firm’s behavior regarding the working capital management for the firms. This problem ends up in a problematization, which includes discussions about why this situation occurs for SMEs around the world and why lousy working capital management, which leads to longer Cash Conversion Cycle, has effects on the firm’s profitability. Additionally, the definition Reverse Factoring is presented as this notion has been exciting research subject to help SMEs with their liquidity problems. Lastly, this introductory chapter ends with a disposition for the progress of the study.

I.I B

Dagens Industri (2017) describes that one of the biggest concerns for SME’s in Sweden is their lack of capital, which might lead to liquidity, growth, and profitability problems. They continue and state that one of the reasons behind this is the buyer's long payment terms contrary to the supplier's payment terms for their expenses, which increases the risk of an imbalance between the inflows and outflows of money. Nils Wiberg, CEO at Prioritet Finans, states that big firms in Sweden have a lot of power over their smaller suppliers and subcontractors, which is shown by the fact that the large firms make demands on extended payment terms (Göteborgs Posten, 2019). Daniel Wiberg, CFO at Företagarna, agrees and states that this is not a sustainable and responsible enterprise and that a competitive and modern industry requires a trust that works throughout the whole chain (Företagarna, 2018). Tillväxtverket (2019) describes that they have seen the same problem during the last five or six years and thereby an investigation was carried out to reduce the extended payment terms between the large firms and the smaller suppliers and subcontractors.

This problem was further shown by the fact that as much as 64% of the firms surveyed admitted that they had accepted longer payment terms in the year 2018 than they actually could manage (Tillväxtverket, 2019).

2020-06-01 2 Tillväxtverket (2019) states that the average payment terms between large Swedish firms and their smaller suppliers and subcontractors were in 2018 as much as 33 days. Furthermore, Tillväxtverket (2019) shows that it exists a strong correlation between liquidity and accounts receivable as a proportion of the firm's turnover and that this correlation increases the smaller the company is. According to their research, a decrease of one day in average payment days would lead to a liquidity shift from the large to the smaller firms. Small firms generally are considered to have higher use of each SEK because it is a more significant percentage of a smaller firm's turnover than a larger firm. This possible decrease in one day would give a positive socio-economic effect of almost 104 million SEK, which is considered an enormous amount in contrary to the reduction of just one day.

Anand (2005) and, Banos-Caballero, Garcia-Teruel and Martinéz-Solano (2012) mean that it exists differences between countries regarding this area, as it exists institutional disparities that affect the norms and behaviors within a firm's daily and long-time operations which in the long run have an impact on firm’s profitability. This is similar to what the European Commission (2020) stating that despite the decrease in average payment times in Europe in recent years, there are still substantial differences between countries. Moreover, according to a report from Intrum (2019), these institutional disparities still exist where the main conclusion was that these institutional disparities affect behavioral patterns and norms in firm's that influence payment times in countries.

I.II P

Profitability is the main reason why SMEs do not grow at the speed they should or to the potential they could, where certain aspects affect the profitability of the SMEs describes Isenberg (2019). For example, a firm's cash flow management practices is often a leading indicator as to whether they will face liquidity issues argues Kim and Bettis (2014). Therefore, cash is valued as an essential asset and that effective cash-flow management is beneficial for the firm's sustainability and performance. Furthermore, smaller firms are more sensitive to the cash flow in contrary to larger firms that have a lower demand for cash due to more advanced financial aspects, according to Pinkowitz, Stulz and Williamson (2006).

2020-06-01 3 Sweeney (2019) states that 69% of small business owners are concerned about their cash flows, driven by many different factors. One reason behind the cash flow problems is the managing of both the receivables and payables. For example, one-third of the small businesses in USA states that they have got more than 20 000 USD in outstanding receivables to their buyers. As mentioned before, Kouvelis and Xu (2019) says that many SMEs have problems with their cash flow and, therefore, have difficulties in financing their daily operations. This problem occurs because the buyers force to increase their payment times to the suppliers and that this is due to the power in the relationships argues Isenberg (2019).

The size of the buyer that, in most cases are considerably more prominent than the SMEs, gives them an upper hand that they can dominate and not follow the agreements made over the payment terms which could be described as Buyers Power according to Porter (1980) and Klapper (2006). But because of the power relations between the SMEs as suppliers and the more prominent companies as buyers, it occurs a problem from the SMEs perspective. Since SMEs rely on the more prominent firms as buyers, they cannot afford to lose them, which leads to the SMEs accepting the buyer's behavior regarding the payment terms. These situations make the power relations arguably one of the toughest and hard-solved equations for SMEs, making it an existing problem that the SMEs cannot solve on their own, which often harms the firm's profitability according to Isenberg (2019).

Carpenter and Petersen (2002) and, Fagiolo and Luzzi (2006) state after doing empirical studies that liquidity constraints are one of the biggest problems regarding firm profitability, which is highly related to prolonged payment terms to the buyer. Furthermore, Bottazzi and Secchi (2013) describes that for many young firms, the most important thing to enable firm growth and profitability is to generate positive cash flow. Additionally, McMahon and Stanger (1995) have the same opinion and summarizes their thoughts regarding the importance of liquidity with a statement, explicitly considering small and medium businesses: the liquidity is a matter of life and death. They also state that a small company can survive for a long time without making profits, but when the company is not able to pay its debts, they will fail.

Dagens Industri (2017) states that the average payment terms in Sweden have increased a lot during the last decade, where SME's often have to pay their

2020-06-01 4 expenses within thirty days while their own sales invoices get paid, most likely between two or three times as long as the original period. A consequence of this is that SME's act like banks for the larger buyers, which, according to Dagens Industri (2017), is neither good nor preferable for investments, growth and profitability for these SME’s.

Martin and Lopes (2016) states the obvious, namely that it exists plenty of factors that determine a firm's strategy regarding focus on and how to create profitability. They continue to argue that national cultures and norms impact organizational cultures, which, in turn, impact SME's profitability. They exemplify this with the fact that differences in norms, values, laws and regulations are connected with differences in profitability where the conclusion drawn is that countries with lower uncertainty avoidance, power distance, long-term orientation and higher indulgence tended to have higher profitability. These characteristics mentioned above are considered to exist in countries such as Ireland, Denmark, Finland and Sweden. The contrary is deemed to exist in countries such as Germany, Czech Republic, Russia, France and Italy, to name a few.

Richards and Laughlin (1980) states that liquidity for a firm includes both the firm's payment times to their suppliers and their payment times to their buyers.

They describe that the net time interval it takes for the organization to transform their expenditures in their inventory to receiving cash from their sales is called the Cash Conversion Cycle. They argue that the length of a firm's Cash Conversion Cycle is correlated with a firm's profitability where the argumentation is that a longer Cash Conversion Cycle reduces the firm's flexibility regarding the cash flow management. Bolek, Kacprzyk and Wolski describes that a long Cash Conversion Cycle entails that financial capitals are tied up in the firm, which in the long run might lead to a declining profitability for the firm. Additionally, studies from Oseifuah and Gyekye (2016) and, Yazdanfar and Öhman (2014) showed that a longer Cash Conversion Cycle is correlated with lower profitability, which for example, means that if the collection period of the firm's account receivables increases, it affects the firm's profitability negatively.

However, Baños-Caballero, Garcia-Terual and Martinez Solano (2012) and, Hoang, Xiao and Akbar, (2019) argue that research regarding the length of the Cash Conversion Cycle and working capital management is ambiguous.

The optimal levels of the different aspects vary depending on the researcher’s

2020-06-01 5 findings. For example, the above-mentioned researchers together with Smith (1980) state that in order to achieve high profitability, the firm have to implement an aggressive policy with the purpose of lowering the Cash Conversion Cycle. On the contrary, Deloof (2003) and, Deloof and Jegers (1996) argue that a policy that implies longer Cash Conversion Cycle using trade credit to buyers could positively impact a firm's profitability. These various views regarding different strategies and if there is any way to optimize profitability make it enjoyable to examine if it exists any optimal level of the Cash Conversion Cycle and therefore, this study may leave an impact on the firm's policy choices.

Summarizing the problem regarding SMEs' profitability can be displayed as a vicious cycle presented below, in which the SMEs are running a high risk of liquidity-, relationship-, growth and in the long run, profitability problems if broken. As mentioned earlier, Isenberg (2019) described the growing problem that SMEs are experiencing, whereas, they are not growing or generating the expected profitability. If the SMEs cannot progress through growth nor profitability, the stance in their power relations will maintain and therefore, the buyers will take advantage of their power describes Klapper (2006) and Porter (1980). With these thoughts in mind, the payment terms will be extended by the buyers as they are comfortable in their relationship with the SMEs as suppliers. Therefore, the SME's liquidity will be harmed and thus, their profitability will not increase describes Bottazzi and Secchi (2013).

2020-06-01 6

Picture 1. The vicious cycle of profitability.)

I.II.I THE NEW ERA

All of the earlier presented researchers could be said to have focused on just how the specific firm works with their working capital management and Cash Conversion Cycle and how that might affect a firm's profitability. For example, if a supplier suffers longer payment terms to a buyer than they want, the liquidity gets negatively affected, which therefore also affects their Cash Conversion Cycle and, in the long run, also profitability argues Vousinas (2019). These aspects start a negative domino effect for the whole chain, in which the supplier relies on short-term borrowing at rates higher than those the buyer could attain to be able to have sufficient working capital. Therefore, in the end, these higher costs tend to find their way back to the buyers by such as increasing the price or reduce the service. This imply that the buyers thereby have the incentive to minimize these costs by giving their suppliers better terms by helping them out according to Vousinas (2019).

One way of solving the problem mentioned before could be using a more integrated supply chain finance describes Klapper (2006). Supply chain finance is a broad concept where a part of it is called reverse factoring. This happens when a lender purchase accounts receivable between a supplier and a buyer from the high-quality buyers that are informationally transparent and have better risk rating and after that pays the supplier. The purpose of this is to achieve more robust and more stable solutions for the whole chain, thereby

Growth

Power Relations

Payment Terms Liquidity Profitability

2020-06-01 7 optimizing the liquidity and working capital for the different businesses that it includes, from the supplier to the buyer. In a report from Financial Review, Isenberg (2019) argues that one of the existing problems is a conflict of power between the buyer and the supplier, specifically in scenarios where the buyer is the stronger part. The buyers are trying to push the trade credit period to even higher number of days where the suppliers are not able to withstand the demand from the buyers because a big part of their business depends on the more prominent firms as buyers. Isenberg (2019) therefore argues that these kinds of conflicts, which could be associated with Buyers Power described by Porter (1980) and Klapper (2006), turn to a statement such as take it or leave it for the suppliers where they cannot afford to walk away and leave it. These statements clarify the need for some change in the supply chain, such that the use of reverse factoring seems to be a useful one.

The definition and use of reverse factoring have become more and more used for researchers to examine the possible effects of a more integrated network in the whole supply chain. Wuttke et al (2013) stated that a more integrated supply chain, where the high-end user could help the smaller supplier to increase their liquidity with reverse factoring, can be beneficial for all participating firms. Moreover, Wuttke et al (2013) suggest that the new way of doing business-to-business should include a more value creation process where buying firms could help their suppliers by lowering the payment times.

This could be done using reverse factoring and thereby improve the suppliers working capital, which in the long run would be beneficial for both firms, whereas Randall and Farris II (2009) have similar views. They argued that this approach relies on trust, cooperation, and commitment between parties, where effective use often results in lower overall costs for these parties, thereby, in theory, higher profitability. The main advantage by using reverse factoring is that it, in general, reduces the Cash Conversion Cycle by using the buyer's better risk rating when the lender buys the accounts receivables and thereby pays the weaker supplier argues Wuttke et al (2013).

These different statements and perspectives regarding reverse factoring and the problem for Swedish SMEs with their liquidity imply that there are ambiguities and difficulties for firms regarding how to choose a strategy and manage firms' working capital to increase profitability. This study aims to bring new knowledge regarding whether there is an optimal level for a firm's Cash Conversion Cycle to increase profitability and if a presence of Buyers Power affects profitability, which hopefully would make it easier for

2020-06-01 8 Swedish SMEs to choose a strategy to manage their working capital management.

I.III P

Based on the problematization above, the primary purpose of this study is to examine whether the length of a firm's Cash Conversion Cycle has an impact on the profitability of Swedish SMEs. Furthermore, the purpose is to examine if the presence of Buyers Power has an impact on firm’s profitability. This purpose turns into two framings questions, presented below.

How does the length of the Cash Conversion Cycle affect a firm's profitability in Swedish SMEs?

How does a possible existence of Buyers Power affect a firm's profitability in Swedish SMEs?

I.IV D

This first chapter introduces the reader to the fact that one of the biggest problems for Swedish SMEs is lousy working capital management, which might lead to liquidity problems and lower profitability. The problematization also includes the definition of reverse factoring, which is a notion where a lender buys accounts receivable at the buyer's rate to increase the liquidity of the often-weaker supplier.

Chapter 2 - Scientific method

This section presents the arguments behind the chosen scientific method and includes the essay's research approach and design. It is stated that the thesis is deductive with a quantitative research approach.

Chapter 3 - Concepts

This chapter contains descriptions regarding concepts that are important for the understanding of the thesis. The idea behind this is to make it easier for the reader to absorb the theoretical framework and the different concepts later in this study.

Chapter 4 - Theoretical framework

2020-06-01 9 The purpose of the theoretical framework is to give the reader a more detailed picture of the theories used in this thesis, which are Cash Conversion Cycle and Buyers Power. Lastly, the essays two hypotheses are presented as a result of the theories applied.

Chapter 5 - Empirical method

This chapter gives the reader a more detailed description of the method used to realize the essay's purpose and the framing questions. Moreover, this section covers the data collection and how the variables were selected and operationalized.

Chapter 6 - Empirical results

This section initiates with the descriptive statistics regarding both the dependent-, independent- and control variables. After that, different tests are presented, which includes both bivariate and multivariate analyses.

Chapter 7 - Analysis

In this section, the two hypotheses are discussed where the results from the regressions are connected and tied up to the theoretical framework to see whether the hypotheses should be accepted or rejected.

Chapter 8 - Conclusion

This chapter allows the authors to discuss the eventual connection between the empirical results and the applied theoretical framework more freely. The main focus is to discuss the acceptance or rejection of the hypotheses and why the empirical findings showed what it showed.

2020-06-01 10

II S CIENTIFIC METHOD

The section of the scientific method aims to provide the reader with the research approach and design of the study, where the research approach of the study is of deductive nature and research design is a longitudinal study.

Since the essay developed hypotheses, the choice of the deductive study came naturally as well as the choice of longitudinal type because of the statistical research over time.

II.I R

As mentioned before, this study is deductive, which is when the researcher phrases hypothesis based on the theoretical framework describes Bryman and Bell (2017). After that, the formulated hypotheses are tested against the collected data, and then it is possible to see if the hypothesis should be accepted or rejected. Further, this method is one of the most common ways of researching in finance, making the choice of method reliable.

Based on the fact that it exists literature and theory that leads to the formulated hypotheses and the intention is to achieve a more generalizable result, the decided approach was deductive. While obtaining a more generalizable result, it is easier to make comments on the decided population or an entire market argues Bryman and Bell ( 2017), which is in line with the purpose of the study.

Furthermore, Bryman and Bell (2017) describe that deduction is associated with quantitative research, where the purpose is to emphasize quantification and to have an explanatory intention. Contrary to this, there is qualitative research that is associated with an inductive approach where the objective is to highlight the individual's interpretation and perception. Since this study aimed to draw generalizing conclusions regarding Swedish SMEs, this study thereby used a quantitative approach. Therefore, the choice of a longitudinal type of study came naturally as its often derived from a deductive approach and since it was that type of procedure that was found appropriate for this study. The longitudinal approach made it possible not only to get a better overview of the considered observations over time but also to see each specific observation by themselves instead of comparing it with other observations.

just mentioned.

2020-06-01 11

III T HEORETICAL FRAMEWORK

This section describes the theoretical framework that are used in this thesis. It begins with Cash Conversion Cycle and after that, the theory regarding Buyers Power is described with the relevant information that is needed to facilitate for the reader.

III.I C

The hypotheses in this study originate from previous research and theories that could be applied in the field. In this study, two different theories were applied, namely Cash Conversion Cycle and Buyers Power. Cash Conversion Cycle was used since it has been the most used theory and measurement in similar studies made in other countries and with different samples according to Baños-Caballero, Garcia-Terual and Martinez Solano (2012). This metric is characterized as a more flexible measurement in contrary to more static ones, for example current ratio. Schiff and Lieber (1974) also state that the Cash Conversion Cycle is the right way to go since it includes the interrelationship between policies regarding account receivables, account payables and inventory.

The emergence of the theory Buyers Power was a bit more unconventional, which has its origin in the author's workplace at Visma SPCS, which is the biggest company in accounting and salary software for SMEs in Sweden. In the past year, both authors have talked to a lot of SME’s owners in Sweden, where several have complained about long payment terms to their stronger buyers. With that in mind, the authors discussed with each other and the owners why this problem occurs for SME's business owners in Sweden. One of the explanations seemed to be that the SME's business owners were afraid of losing their larger buyers if they demanded shorter payment terms. These statements lead the authors into the field of theories regarding power relations, where Porter's five forces (1980) emerged as a conceivable theory to apply.

Upon a careful examination of this theory, an interesting perspective of the theory was detected, namely Buyers Power, which Isenberg (2019) and Klapper (2006) argued, impact SME's owners' liquidity and in the long run the profitability.

2020-06-01 12 Another theory that did not lead to a formulated hypothesis in this study due to the difficulty of quantifying the theory into a useful and credible variable was Institutional Theory. This theory, as mentioned in the background and problematization, clearly affects the overall policies and strategies within firms regarding the working capital management, including the Cash Conversion Cycle and Buyers Power. Therefore, Institutional Theory was used as a tool in the latter parts of the study. The purpose was to deduct if there were any similarities or differences between this study's results and results from studies from other countries.

III.II C

C

C

Richards and Laughlin (1980) describe that financial analysts often use the current ratio as their crucial indicator of how well a firm’s liquidity is. This way of measuring liquidity is considered static and not reliable, thereby Richards and Laughlin (1980) find a more flexible measurement. The Cash Conversion Cycle is their contribution to research. The theory measures the net time interval as it takes for the organization to transform their inventory expenditures to receiving cash from their sales. Another way of describing the theory is that the Cash Conversion Cycle measures the time for one net input dollar to convert from production costs to cash flows received from sales.

Furthermore, Richards and Laughlin (1980) mean that this net time interval is highly correlated with how the company works with their working capital management. Bolek, Kacprzyk and Wolski (2012) agree with this more flexible measurement regarding a firm’s liquidity status and state that this way of measuring a firm’s liquidity is a more credible way of analyzing the firm’s situation.

As can be seen below, the Cash Conversion Cycle is the time from when the firm purchases resources to the inventory until the cash from the inventory sold are received according to Richards and Laughlin (1980). The time between the supplies being purchased and the inventory being sold is called the inventory period. This period is often associated with an accounts payable period when the firm gets a trade credit from their supplier. From the moment the firm sells the inventory to its buyers until the cash is received is called the accounts receivable period.

2020-06-01 13 Picture 2. Cash Conversion Cycle - Richards and Laughlin (1980)

III.II.I CASH CONVERSION CYCLE AND PROFITABILITY

Bolek, Kacprzyk and Wolski (2012) states that a longer Cash Conversion Cycle implies that more financial capital is tied up in the company, resulting in a higher weighted average cost of capital. By extension, this might lead to a decline in the firm's profitability and negatively impact the firm's general opinion from investors. Moreover, Richards and Laughlin (1980) describe that the longer the Cash Conversion Cycle is, the less flexibility the company has regarding cash flow management in an uncertain economic world. Oseifuah and Gyekye (2016) study regarding the Johannesburg Stock Exchange showed a negative correlation between the time it takes for a company to convert its accounts receivables and its profitability. Moreover, the study showed that there is a positive correlation between a company's accounts payables time and their own profitability. Yazdanfar and Öhman's (2014) study regarding Cash Conversion Cycle and its eventual impact on a firm's profitability showed that Cash Conversion Cycle clearly affects a firm's profitability. This means that if the average collection period of the firm's account receivables increases, it negatively affects the firm's profitability.

Baños-Caballero, Garcia-Terual and Martinez Solano (2012) state that many researchers find that there is a negative correlation between the Cash Conversion Cycle and the profitability for the firms. However, these authors state that the other researchers ignore the fact that a too short Cash Conversion Cycle is highly associated with risks with for example loss of sales or malfunctions in the production stages. With these thoughts in mind, Baños-

2020-06-01 14 Caballero, Garcia-Terual and Martinez Solano (2012) argues that the Cash Conversion Cycle have an optimal level, leading to a correlation between a firm's Cash Conversion Cycle and its profitability is concave instead of linear.

Another study made by Hoang, Xiao and Akbar (2019) concludes that the relationship between profitability and both trade credit receivables and trade credit payables have an inverted U-shape, therefore they argue that there is an optimal level.

These various views regarding how to implement working capital management and the standard of the length of the Cash Conversion makes it interesting to examine whether there exists an optimal level of the Cash Conversion Cycle to increase profitability. This leads to the use of two variables whereas the first one is linear and the second one is squared in order to examine the optimal level of the Cash Conversion Cycle. The calculation of the Cash Conversion Cycle for each company the information from each year's balance sheet regarding accounts receivables, sales, purchases, inventories and accounts payables were collected. These different components lead to the total number of days in the Cash Conversion Cycle, which was calculated using an average of each element used in the consideration. The descriptions mentioned above lead to the essay's first hypothesis.

Hypothesis 1: There is a concave relationship between the Cash Conversion Cycle and a firm's profitability.

III.III P

’

Porter's five forces' theorem is founded on the five fundamental aspects and the interactions between them, making the forces highly interdependent according to Porter (1980). When applied, Porter's five forces and the importance of the interdependency between the forces make a strong case on the firm's strategic management rather than being used and analyzed as single forces describes Grundy (2006). Down below, a full view of Porter's five forces is portrayed.

2020-06-01 15 Full description of Porter’s five forces by Michael E. Porter (1980).

Since all of the forces are highly interdependent, and if only one effect is observed and analyzed without taking the interaction between the forces into account, valuable information might be neglected implies Grundy (2006). For example, one way to explain one particular effect without ignoring the dynamics of the model is to put the force in the middle of the model so that it maintains the interdependency and interactions with the other forces and its functions. Therefore, the model as a whole was analyzed but mainly focused on Buyers Power as it is the most logical and coherent force to be used in the thesis.

Putting the Buyers Power in the center of the model becomes the focal point of the interactions with the other aspects where the different elements adapt oneself to the focal part argues Grundy (2006). For example, the Buyers Power issues from larger firms with smaller suppliers with aspects such as intense rivalry, high availability for substitutes, low entry barriers and low

2020-06-01 16 supplier power that together creates an advantageous situation for the buyers.

The buyer's beneficial situation is giving them the ability to do as they wish without consequences since the supplier with low power cannot afford to lose them. With these scenarios in mind, Grundy (2006) argues that it might be complicated to look at a specific interaction between two forces, but that it gives a glimpse of the actual situation and adds even more effect to the case a more understanding general view.

Furthermore, Porter (1980) discusses the potential effects and results of Buyers Power in different scenarios depending on the various sizes of the buyers and suppliers. The size of the buyer firm and its purchases in contrary to the supplier and its sales is what lead to the actual amount of power that the buyer possesses. For example, a buyer that purchases large volumes relative to the sales of the supplier automatically possesses an advantageous ability to the supplier argues Porter (1980). From the supplier's perspective, they are not given much of choice since the firm and its profitability depends on its sales to the specific buyer which therefore leads to accepting the buyer's terms whether it is longer payment terms or lower prices. This concept holds good even in an opposite fashion from the supplier's perspective, the more significant amount of power that the supplier possesses, the higher the profitability since the buyers will not be able to obtain lower prices nor longer payment terms argues Porter (1980). Therefore, it is described that the involved firms should expect lower profit when the Buyers Power is high.

Moreover, Isenberg (2019) states that one of the biggest concerns for SMEs regarding payment terms is the power that buyers have over the suppliers. This often leads to that the buyers demand longer payment times in contrary to their own payment’s times to their suppliers and, by extension, lower profitability.

With the theoretical aspects in mind, the calculation for Buyer's Power has been done by taking the accounts receivables and the accounts payables from the ending balance sheet for each year as an assumption that each specific year possesses similar numbers throughout the fiscal year. The discussions mentioned above lead to the thesis's second hypothesis.

Hypothesis 2: There is a negative relationship between Buyers Power and profitability for the supplier.

2020-06-01 17

IV E MPIRICAL METHOD

This chapter aims to provide the reader with knowledge regarding the study's workflow and which methods and approaches that were used to fulfill the purpose of the thesis. Initially, a brief explanation of quantitative research is stated, which follows up with the thesis sample selection, data collection and data processing. Then follows a section that includes a description of the regression model that was used in the thesis. All of the mentioned aspects below are taken into consideration throughout the whole dissertation and, in particular, throughout the empirical method. Finally, the dropouts and the author's ethical positions are presented.

IV.I Q

Denscombe (2009) explains that quantitative research is often associated with extensive studies that involve a more significant number of respondents, making it easier to draw generalizing conclusions. Eliasson (2018) states that a quantitative method is the most suitable one when the data is containing numbers. Since this study’s purpose is to examine whether the length of the Cash Conversion Cycle and the possible existence of Buyers Power for a firm influence the profitability of Swedish SMEs, quantitative research was the most suitable. Moreover, Backman (2008) states that quantitative research implicates collecting of statistics, which then converts to numerical observations.

IV.II L

As mentioned before, this study’s purpose was to examine whether the length of the Cash Conversion Cycle and the possible existence of Buyers Power have any influence on a firm’s profitability. Furthermore, this study had a longitudinal research design, which means that data has to be taken from at least two different occasions and times describes Bryman and Bell (2017). The data was collected from the years between 2015 and 2018, which means that it was examined for four years in total. Moreover, this longitudinal study was a type of panel study, saying that the sample of the survey objects is a part of the whole population for more than one year. The advantage of a panel study instead of a cohort study is that the panel study is considered beneficial for drawing a generalizable conclusion.

2020-06-01 18 Additionally, with a longitudinal perspective, it was possible to read out any eventually year changes with the use of this perspective. Further, this type of study increases generalizability since several years are examined and thereby it is more likely to avoid coincidence. A possible adverse effect of using a longitudinal study is that it is considered time-consuming to gather all the data for a long time. However, this was not the case in this study since the authors collected data from previous years, which meant that it was not that time- consuming.

IV.III S

According to Bryman & Bell (2017), sample selection is one of the most critical procedures for quantitative research. This means that the chosen data must be verified and relevant for the purpose of the study. This study aimed to examine Swedish SME’s, which led to the fact that the selected sample from the database only included Swedish firms with equal or less than 50 million EUR in yearly turnover and equivalent or less than 249 employees (European Commission, 2020).

IV.III.I DATA COLLECTION

The data for this study was collected from the database retriever business, where the authors gathered information from 38876 Swedish SME’s regarding different ratios and general information. In this database, one could limit the searches to the criteria mentioned in section about sample selection, leading to a total number of the firms. The ratios that were gathered were: EBIT, Sales, Cost of sales, Accounts receivables, Accounts payables, Total assets and Inventories, taken from the company’s annual reports. Further, the general information that was gathered from the firms was the number of employees, registration data and which industry the firms operate in. As mentioned before, this was a longitudinal study, which meant that the authors gathered information from four years between 2015 to 2018. Its purpose was to draw more relevant conclusions regarding how the Cash Conversion Cycle and the possible existence of Buyers Power influence the profitability of a company.

As mentioned above, the data was gathered from retriever business, which can be explained as secondary data. Bryman and Bell (2017) states that it is always a risk while using secondary data, this is a fact because the authors cannot be sure that the data from the database match the real ones from the annual

2020-06-01 19 reports. However, this eventual problem was considered low since the database used is well-used and credible. To test this database and its credibility, the authors took some samples for each variable and compared them with the annual reports for the firms tested. Additionally, the use of secondary data reduced the risk for manual errors and significantly reduced the time required for the data collection phase.

IV.III.II DATA PROCESSING

After the data had been extracted from retriever business, it was compiled explicitly into excel to facilitate the transfer to STATA where the regressions were made. This process also included work on removing those firms that did not meet all the requirements that were needed. These requirements are presented below in the section regarding the thesis dropouts.

IV.III.III DROP OUT

The data that was gathered from retriever business contained information from 38876 Swedish SME’s during the years 2015 - 2018. However, some of these firms did not have annual reports for all these examined years, which lead to that the authors decided to exclude firms that had two or more missing years to be able to draw more credible conclusions from the regressions.

Furthermore, some firms admittedly had annual reports but were missing several variables, which also lead to the decisions that these firms should be excluded. The total amount of firms that were included in the regressions was 31422 firms.

IV.III.IV RELIABILITY

Bryman and Bell (2017) state that while conducting quantitative research, it is essential to ensure that the knowledge that emerges is built on reliable sources.

This means that independent actors with the same data could reproduce the research. This means for example that the research must be free from bias from the authors that doing the study. Moreover, it is essential to control that there are no temporary errors that affect the process of emerging knowledge. In summary, a test result has high reliability if the result will be the same for repeated measurements and regardless of which researcher that do the research.

2020-06-01 20 To achieve high reliability, the author's endeavor has always been to clearly show how, for example, the data collection and data processing has been performed. Moreover, all ongoing work has been documented to avoid losing relevant and vital information. Results and conclusions have also been documented with the sole purpose of understanding the continuing work and to increase replicability. Lastly, the authors have tried continuously to strive for impartiality throughout the study's progress to achieve high reliability.

IV.III.V VALIDITY

While doing quantitative research, Bryman and Bell (2017) describe another vital factor to consider, namely validity. To be able to achieve high validity, the thesis must have high reliability. The concept validity is about the relevance of the measurements, in order words how the research really measures what it is supposed to measure. Furthermore, validity in a thesis depends on what is measured and if it is in harmony with the research questions. In summary, a study is said to have high validity if the measuring instrument's ability to measure, what is actually to be measured, is high.

The validity of this thesis is considered to be high for several different reasons.

First of all, the independent variable regarding the Cash Conversion Cycle that have been used in this thesis have been used before in similar research done by respected scientists. However, the other independent variable regarding the possible existence of Buyers Power has not been used in similar studies.

Though, the literature that has been explained before suggests that buyers that demand long payment times in many cases do this because they seem to have power over their suppliers in contrary to the power they possess over their own suppliers. Thereby, the independent variable Buyers Power also is considered to measure what is supposed to measure. Moreover, the control variables in this thesis have also been used before in studies like this, which thereby is considered to give the result expected. In summary, the focus has been on using previously proven methods to obtain high validity.

IV.III.VI OPERATIONALIZATION OF VARIABLES

Down below, the operationalization of the variables used in the model is presented. According to Bryman and Bell (2017), operationalization of variables means the measurement of concepts.

2020-06-01 21 IV.III.VI.I STANDARD VS LOG TRANSFORMED VARIABLES

This study contains plenty of different variables, where some of them are standard variables but some are log-transformed, which according to Bruin (2006), is the right way to go when the values in a variable have significant differences and thereby was not normally distributed. Furthermore, Hair (2010) states that it is generally good to transform variables into log variables when the mean is considerably higher than the median. The coefficient of a standard variable's interpretation is that one-unit change in one of the independent variables predicts to change the study's dependent variable with the coefficient value. On the other hand, the interpretation of a log-transformed variable is that one percent change in the independent variable in mind is predicted to change the dependent variable with the value of the coefficient if the dependent variable is log-transformed. However, the interpretation of log- transformed independent variables is slightly different if the dependent variable is not log-transformed. If that is the case, if the coefficient for a log- transformed independent variable is 1.55, a one percent increase is predicted to increase the dependent variable with 1.55/100 = 0.0155.

IV.III.VI.II DEPENDENT VARIABLE

Montgomery, Peck and Vining (2006) states that the dependent variable in a multiple linear regression often is denoted with a Y and the variable is determined by the independent variables in the regression. In this thesis, the dependent variable is profitability (PRO) and is calculated as the gross operating income, which is the total amount of sales minus the cost of sales divided by the total assets. The argumentation behind the choice of profitability ratios is that in similar studies done in other countries, this ratio has been the most used on according to Garcia-Teruel and Martinéz-Solano (2007), Deloof (2003) and Baños-Caballero, Garcia-Terual and Martinez Solano (2012). However, due to the ratio cost of sales being absent for more than 23.000 of the total sums of over 30.000 firm's the authors decided to adjust the used ratio. Instead of the total amount of sales minus the total assets' cost, this study finally used Earnings Before Interest & Taxes (EBIT) divided by the total assets. The data set contained a few firms with observations that were considered outliers based on boxplots and histograms, these were removed to make the data normally distributed. In numbers, each observation that was higher than 100% or lower than -100 were removed to get a credible and relevant result. This was done by using the drop if command in Stata. The

2020-06-01 22 dependent variable was calculated by examining the firm's income statements taken from the database and is presented below.

PRO = ((EBIT) / Total assets)

IV.III.VI.III INDEPENDENT VARIABLES.

According to Montgomery, Peck and Vining (2006), the independent variables are used to predict or calculate the dependent variable and the independent variables are often denoted as X. The model in the thesis has two different independent variables, namely Cash Conversion Cycle and Buyers Power.

IV.III.VI.III.I CASH CONVERSION CYCLE

First of all, the variable Cash Conversion Cycle was calculated by integrating three different variables into one, the calculation is shown below in table 1. As for the dependent variable explained earlier, this data was also taken from the database, but this time from the balance sheet. If a firm did not have any inventory at the end of the year, for example service firms, the inventory variable was excluded. Furthermore, the data set contained a few firms that had some years with a high or low Cash Conversion Cycle due to their extortionate high proportion of payables compared to their expenses or an extortionate high portion of receivables to their sales which lead to values that were considered not relevant and thereby removed. In numbers, every Cash Conversion Cycle observation that was higher than 250 or lower than -150 were excluded based on the boxplot and histogram that were done to detect outliers. This was done by using the drop if command in Stata and down below, the calculation for this variable is presented. In order to examine if there was an optimal level of the Cash Conversion Cycle, this variable was also squared in the regression with the original.

IV.III.VI.III.II BUYERS POWER

The second independent variable that was examined was whether the presence of Buyers Power affects firm’s profitability, which in this thesis is said to happen when the company has a higher proportion of accounts receivables than accounts payables. Furthermore, a firm that has a higher percentage of accounts receivable is thus assumed to suffer from the fact that their buyers are forcing longer payment times than they have to their suppliers themselves.

Abbreviated, the company thereby was believed to suffer from Buyers Power.

In this thesis model, this variable was calculated by taking the amount of

2020-06-01 23 accounts receivables divided by the account payables. Furthermore, the data set contained firms that had negative values in accounts receivables or accounts payables, which lead to that Buyers Power for these firms became negative and thereby were removed to get a credible and relevant result. In numbers, every Buyers Power observation that was higher than 50 or lower than -20 were excluded based on the boxplot and histogram that were done to detect outliers. This was done by using the drop if command in Stata and down below, the calculation for this variable is presented.

IV.III.VI.III.III SUMMARY TABLE OF THE INDEPENDENT VARIABLES

Cash Conversion

Cycle

!𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠

𝑆𝑎𝑙𝑒𝑠 2 × 365 + !𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠

𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠2 × 365 − !𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 2 × 365

Buyers

Power ^!

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 2

Table 1. Summary of the independent variables.

IV.III.VI.IV CONTROL VARIABLES

Besides the variables mentioned above, the regression included a few control variables to try to isolate the effect of the independent variable on the dependent variable describes Bryman and Bell (2017). This thesis used control variables that, according to previous similar studies, probably have an impact on a firm’s profitability, which thereby was considered relevant to use in this study according to Deloof (2003) and Baños-Caballero, Garcia-Terual and Martinez Solano (2012)

IV.III.VI.IV.I SIZE

Previous similar studies have used size as a control variable, where it was operationalized by looking at the firm's turnover according to Park and Shin (2004), taken from retriever business. The argumentation behind that control variable was that a firm's size usually affects the firm's resources and possibilities to do business argues Isenberg (2019). Additionally, in theory, a larger firm has more power to shortening its payment times to suppliers and vice versa. This variable was transformed into a logarithmic variable because

2020-06-01 24 it was not normally distributed, with significant differences between the values and the variable had a right skew, which indicates the mean > median.

IV.III.VI.IV.II GROWTH

Deloof (2003) describes the importance of growth as a control variable in studies like this because a firm's growth often has an impact on the firm's choices and behavior. This study operationalizes growth by taking this year's sales minus the previous year's sales divided by the past year's sales, which is a common way of doing it in similar studies. The data set contained some firms with some observations with disproportionately high growth compared to others, which were detected by the use of boxplot and histogram. These observations were removed to get a relevant and credible result and in numbers, every growth observation that was higher than 200% or lower than - 100% were removed before the multiple regression. This was done by using the drop if command in Stata. Additionally, this variable was transformed into a logarithmic variable since the substantial differences between the values and that the variable had a right skew, which indicates that the mean > median.

Before that could be made, the variable needed to be adjusted since it is not possible to log-transform variable with negative values. This was done by adding a constant to all values, which in this case was 1, in order to receive only positive values.

IV.III.VI.IV.III AGE

As the abovementioned control variable, the variable age is a well-used control variable in studies regarding payment times and profitability argues Deloof (2003) and Baños-Caballero, Garcia-Terual and Martinez Solano (2012). The argument behind it is that firms usually have different strategies and behaviors depending on the phase in which a company operates. For that reason, this control variable was taken by looking into retriever business for the registration date. This variable was transformed into a logarithmic variable since the substantial differences between the values and that the variable had a right skew, which indicates that the mean > median.

IV.III.VI.IV.IV INDUSTRY

According to Deloof, 2003 and Baños-Caballero, Garcia-Terual and Martinez Solano (2012), industry is a well-used control variable in similar studies where the argumentation has been that there are distinct differences in the different sectors. For example, Anand (2005) states that one reason to include industry

2020-06-01 25 as a control variable is that various industries have different norms that affect firms' behaviors, which indicated that this was an important control variable.

This variable was operationalized by looking at which industry the firm is operating in and the variable was transformed into a dummy variable for each variable where 1 means that the firm is working in that specific industry and 0 means that the firm operates in another sector. The industry culture was omitted since it had the lowest value in order to make the random-effect regression with dummy variables. The information regarding which industries the firms operate in were taken from retriever business and the explanatory table down below displays the various industries that are categorized in the thesis as dummy variables. Since the industries are coded as dummy variables, their value is then given a 1 or a 0 where the 1 indicates that it is in line with the industry or a 0 if it is not in line with the industry. For example, if it is a company that is categorized as healthcare, only healthcare as a variable was given a 1 and the rest of the industries were given 0 as a variable value.

IV.III.VI.IV.V EXPLANATORY TABLE OF THE INDUSTRIES

Industry Dummy Variable Coding

Economics 1 0

Healthcare 1 0

Commerce 1 0

Manufacturing & Industry 1 0

Real Estate Business 1 0

Business Services 1 0

Hotel & Restaurant 1 0

Education, Research & Development 1 0

Culture 1 0

Table 2. Explanatory table of the industries.

2020-06-01 26 IV.III.VI.IV.VI SUMMARY TABLE OF THE CONTROL VARIABLES

Down below, all of the used control variables are presented in a table with the purpose of giving the reader a summary of all control variables and how they are measured in order to simplify for the readers in the latter parts of the study.

Control Variables Explanation of the control variables

Size Firms turnover for each year

Growth ("#$$%&' )%*$+ +*,%+ - .$%/01#+ )%*$+ +*,%+)

.$%/01#+ )%*$+ +*,%+

Age Number of days from registration date to 2019/01/01

Industry Type of industry the company operates in

Table 3. Summary of the control variables.

IV.III.VI.IV.VII EXPLANATORY TABLE OF THE VARIABLE NAMES

Down below, all of the variables used in this thesis are presented in a table with the purpose of giving the reader a summary of all variables and how they are measured in order to simplify for the readers in the latter parts of the study.

Dependent variable:

PRO Profitability

Independent variables:

CCC Cash Conversion Cycle

BP Buyers Power

Control variables:

SIZE Turnover

GROWTH Calculation on the difference between year xx and xx^-1

AGE The number of days from registration date to 2019-01-01

INDUSTRY Which industry do the company operate in?

Table 4. Explanatory table of the variable names.

2020-06-01 27 IV.III.VI.V P-VALUES AND CONFIDENCE INTERVAL

Down below, it is explained what p-values and confidence intervals are together with a brief explanation of how to interpret these values in the latter parts of the study. Bryman and Bell (2017) describe that the p-value states if the estimated coefficient is significant in comparison to the chosen significance level α. It could be said that if the significance level α that was chosen was larger than the estimated p-value, then the null hypothesis clearly must be rejected.

Furthermore, this study used confidence intervals when it comes to the accept or reject the formulated hypothesis. When it comes to this study’s finding whether a chosen variable was statistically significant or not, this paper used the 95% confidence interval. The interpretation of this is that if the estimated interval in the output has values from a negative to a positive value, the hypothesis cannot be accepted, and one could say that the variable in mind therefore is not statistically significant at 95% confidence interval.

IV.III.VII R^ANDOM-EFFECTS REGRESSION

Since panel data arise from a variety of different processes and categories it needs to be used and analyzed correctly, therefore, Hardy and Bryman (2009) argues that the panel data is used in two important ways. It is to both analyze the data over time and to control the unobserved explanatory variables and that there are two main approaches to satisfy these aspects, either the random effect or the fixed effect. The fixed effect has some advantages, but also some drawbacks and the major drawback that fixed effect has is the problem that it can only estimate the effects of variable x over time argues Hardy and Bryman (2009). Therefore, the random effect regression was used as the multivariate analyzes in STATA due to the fact that it existed a dummy variable that does not change over time which made it not possible to use the fixed-effect model and thereby the random effects-regression must be used in order to create credible and relevant results. The random effect model is displayed below.