Effects Of Free Cash Flow On Profitability Of Firms Listed In Pakistan Stock Exchange

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I. Introduction:

Companies that have high free cash flow are likely to attract investors that look for efficient opportunities to invest their additional resources in the market. Creditors and investors are willing to invest in companies that have high free cash flows because the strength of debt kickback and the definition of financial flexibility of the company are the means for assessing these companies. In addition, cash profits and debts reduction are not possible without possession of cash paying. The free cash flows theories were introduced in 1986 for the first time by Jensen and it gradually evolved, as one of the new topics in the financial literature which describes the behaviour of companies that is not justifiable with previous economic theories (Griffith & Carroll, 2001).

Free cash flows is one of the key tools for measuring the financial performance of business unit and shows the cash that company has after performing the necessary costs for maintenance or development of assets (Habib, 2011).Free cash flows can have important applications for shareholders in assessing the financial soundness of the business unit. The managers who invest free cash flows in projects with positive net present value (NPV) as a result of efficient use from their owned resources contribute to the increase of the firm value. Firms have a choice between internal and external sources to finance their investments. Internal sources include retained earnings and depreciation, while external sources refer to debt and equity (Jensen & Smith, 2005).

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II. Research Question:

· What is the effect of free cash flow on profitability by firms listed on the Pakistan Stock Exchange?

III. Significance:

Here in this research, the researchers tried to find the influence of free cash flow, firm size, cash liquidity on profitability of firms listed in Pakistan stock exchange (PSE). Free cash flow is the volume of cash retained in the entity after deducting and disbursing money for all the capital type and current type of overheads of the firm (Habib, 2011). Free cash flow is the cash acquired through firm’s operating activities deducted from cash components of investment (Zerni et al., 2010). Profitability can be the tendency of firm to earn profit generated by all its business accomplishments (Maheshwari, 2002). It is a reflection of the efficiency of management to earn revenue, employing all the possible means accessible in the marketplace. Hubbard (1998) shows that the relationship between free cash flows and profitability is positive as well as significant, a rise in the level of cash flow of a firm leads to a corresponding increase in profits of the firm. The firm should consider making key investment decisions to make use of additional cash flows. For example, the firms that hold excess cash might use it in buying overpriced firms rather than paying out dividends to the shareholders.

IV. Value of Study:

The findings of this study would be beneficial for foreign and local investors because they would be able to get deep insights on the effect of free cash flow on investment while considering investment decisions and diversification for portfolios to increase profitability. Financial analysts and consultants stand to benefit from the findings of this study; it would enable them to provide improved financial services especially on investment decisions in order to achieve increased profitability.

V. Objective of the study:

The objective of this study is to determine the effect of free cash flow on the profitability on firms listed at the Pakistan stock Exchange.

VI. Literature Review:

  • Free Cash Flow:

Richardson (2006) defined free cash flow (FCF) as the net cash the firm earns from operating activities after making deduction from development costs; this cost is then added to R&D expenditures and finally investment expenditures of new projects are deducted from that. This notion of free cash stream can have more than one explanation; for example, Hackel, Livnat and Rai (2000) suggested that the free cash flows can be explained in following two manners (1) the conventional definition where one needs to deduct the paid funds for a company’s investment from operating cash flow. (2) The more recent method of computing Free Cash Flow requires the addition of discretionary cash outlays (DCO) and discretionary capital expenditure (DCAPEX) to the traditional free cash flows FCF. On the cash flow statement, the operating Cash Flows reflect the ability of a firm to generate future cash flows. Nevertheless, most of the financial analysts suggest two uses for cash flows generated from operating activities: firstly they feel that these funds from operating activities of firm should be used to purchase new fixed assets so that the firms should be able to maintain the same level of operating activities and earnings in the future, secondly a proportion of the income from operations can either be bestowed as a dividend or used for rebuying of stock in order to delight the shareholders. According to Jensen (1988) free cash flow is defined as “after deducting the necessary cash expenses from cash flow generated from operating activities, the left over cash flow is actually free cash flow”.

The formula to calculate Free Cash Flow is given as:

FCF=EBIT (1- corporate Tax) + Depreciation ± Change in Working capital- Capital Expenditure

  • Profitability:

Realistically speaking, the firms always have some profit targets, sometimes even the managers are given additional compensation to reach those targets but the ultimate objective of the business units are much broader than relying on profits alone. Profitability might be ‘the tendency of any given investment to generate revenue from its usage (Srivastava & Srivastava, 2006). The most commonly used tool from financial ratio analysis is profitability ratios. Such ratios can often be used to determine the company’s net worth, its performance & efficiency and its payoff to its stakeholders. Profitability ratios can generally be categorized into two major types namely margin and returns (Fazzari et al., 1988). Margin Ratios are used in measuring the profitability of a firm for instance gross profit margin ratio simply expresses the costs of goods that a company sells as a percentage of sales revenue. One other measure is operating profit margin also known as EBIT which measures the overall efficiency of the manufacturing firm (Maheshwari, 2002). Another measure of profitability in manufacturing firms is return on assets ROA which depicts the efficiency of company’s management in utilizing all resources/ assets of the firm to procure earnings. It is a computation of how many dollars as income the company will generate for every dollar invested in firm’s assets.

A higher ROA means a more money-spinning company. Another measure of profitability is return on equity ratio ROE, this measure of profitability is significant in measuring how much dollar income each dollar of the shareholder’s investment will earn. ROE is calculated as ratio of net income divided by stockholders equity. Profitability can also be calculated as return on capital employed ROCE. ROCE is calculated as EBIT/ capital employed. It helps us to measure how much returns a company can generate from all it available resources.

VII. Methodology:

This research adopted a research design of descriptive survey that aimed at analysing the effect of free cash flow on the profitability of firms listed at the PSE. Statistical research (Descriptive statistics) serves to describe data and characteristics about population or phenomena being studied (Singh & Nath, 2010). A discipline that gives quantitative explanation of the major characteristics of an assortment of information, or it is a quantitative explanation in itself is known as descriptive statistics. This study aimed at evaluating the possible influence of free cash flow on the profitability of companies listed at the PSE. Mugenda and Mugenda (2003) described target population as the complete set of individual’s cases or objects that are being investigated. The population for this study consisted of 580 companies listed in PSE as on December 25th, 2019.

  • Sample Description:

A stratified sampling method was used to select a study sample of 35 companies listed at PSE. A practice of probability sampling in which the whole population is divided into several subgroups named as strata, then arbitrarily a choice of final sample is made consisting of subjects proportionally selected from different subgroups (Strata). This technique is knows as stratified sampling. This was used because the population (580 companies) is heterogeneous but certain similar or homogeneous sub population (company sectors) can be isolated. A sample size of 35 is usually considered statistically significant.

Four variables were included in this study. There were three independent variables: free cash flows, capital liquidity and the size of the firm. Profitability was used as a dependent variable. Secondary data were extracted from audited annual reports and financial statements of companies listed at PSE.

  • Time Span:

Time span is five years (2015 – 2019). The annually prepared financial report includes: income statement, balance sheet and the statement of cash flows.

VIII. References:

  1. Griffith, J. M., & Carroll, C. (2001). Free Cash Flow, Leverage and Investment Opportunities. Journal of Business and Economics 1(2), 1-5.
  2. Habib, A. (2011). Growth opportunities, earnings permanence and the valuation of free cash flow. Australasian Accounting, Business and Finance Journal, 5(4), 101-122.
  3. Jensen, M. C., & Smith, C. W. (2005). Stockholder, manager, and creditor interests: Applications of agency theory. Theory of the Firm, 1(1).
  4. Zerni, M., KALLUNKI, J. P., & Nilsson, H. (2010). The entrenchment problem, corporate governance mechanisms, and firm value. Contemporary Accounting Research, 27(4), 1169-1206.
  5. Maheshwari, S. (2002). Principles of Management Accounting. New Delhi: Sultan Chand & Sons.
  6. Hubbard, R. G. (1998). Capital-market imperfections and investment. Journal of Economic Literature 36, 193-225.
  7. Hackel, K. S., Livnat, J., & Rai, A. (2000). A free cash flow investment anomaly. Journal of Accounting, Auditing & Finance, 15(1), 1-24.
  8. Jensen, M. C. (1988). Takeovers: Their causes and consequences. The Journal of Economic Perspectives, 2(1), 21-48.
  9. Srivastava, K., & Srivastava, K. (2006). Managing Product Returns for Reverse Logistics. International Journal of Physical Distribution and Logistics Management 36(7), 524-546.
  10. Fazzari, S. M., Hubbard, R. G., Petersen, B. C., Blinder, A. S., & Poterba, J. M. (1988). Financing constraints and corporate investment. Brookings papers on economic activity, 1988(1), 141-206.
  11. Singh, Y. K., & Nath, R. (2010). Research methodology. New Delhi: APH Publishing Corporation.
  12. Mugenda, O., & Mugenda, A. (2003). Research Methods, Qualitative & Qualitative approaches. Nairobi: Acts Press African Center for Technology studies.

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