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Euro-Asian Journal of Economics and Finance

Volume 4, Issue 4
e-ISSN: 2310-4929
Pages: 113-122 p-ISSN: 2310-0184
October 2016

Impact of Free Cash Flow on Profitability of Firms Listed in

Karachi Stock Exchange
Sadaf Ambreen1*& Junaid Aftab1

*1COMSATS Institute of Information Technology, Islamabad, Pakistan

The discourse objective of this research was to determine the impact of free cash flows on
the profitability of firms listed at the Karachi Stock Exchange (KSE). The population
consisted of 580 companies listed in KSE as on March 7th, 2015. A stratified sampling
method was used to pick a sample of 30 companies listed at KSE. Data were collected from
financial statements and published accounts. The amount of free cash flows that was
available per year was used. Secondary data were extracted from audited annual reports
and financial statements of firms sourced from KSE for a period of five years (2010 2014).
Data were sorted, cleaned and coded, and then entered into statistical package for social
science (SPSS). Data was of quantitative nature. So, data analysis was done by using
correlation and regression model. The results revealed that free cash flow and size of firm
influence firms profitability while capital liquidity does not influence much on dependent
variable profitability. This research will be useful since it will add more knowledge on the
influence of excess cash on profitability of those firms which are listed at the KSE. Foreign
and local investors 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.

Keywords: Profitability, Free cash flow, Capital liquidity, Banking sector, KSE Pakistan
INTRODUCTION
Companies that possess excess free cash flow are
perceived to be more rewarding for any financiers
who are always on their toes to find out great
investment projects, so that they can invest their
extra finances in marketplace. Potential financiers
and lenders are all the time very eager to invest in
businesses with very high surplus cash streams as
they mostly appraise any business on the basis of
two criteria: How much financially flexible a firm
is? How easily a firm can pay off its credits and
loans? If a business is unable to pay its cash loans
then profit earnings and credit reduction cannot be
materialized. The very first theory about cash flow
was put forth by Jensen in 1986. In the literature on
finance, such theories were welcomed as fresh
themes and they began to evolve steadily as new
concepts of literature. Old financial theories could
not cope with new financial behaviors of the
multinationals (Griffith & Carroll, 2001). One
important mean to measure the economic
achievements of any entity is its free cash stream.
This free stream can be explained as the left over

________________________
*
Corresponding author: Sadaf Ambreen
COMSATS University, Department of Management Sciences, Pakistan.
E-Mail: Sambreen16@yahoo.com

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Euro-Asian j. econ. financ.
ISSN: 2310-0184 (print); 2310-4929 (online)
Volume: 4, Issue: 4, Pages: 113-122
cash within an entity after deducting and
disbursing cash for all the obligatory expenses of
repairs, purchases, maintenance and expansion of
an entitys assets (Habib, 2011). Free cash streams
of a firm are a reflection of commercial robustness
of a business so a financier uses this figure for a
number of different benefits. They can be of
substantial significance for lender, creditor and
potential stakeholders. Any business will be able
to enhance its wealth and value if it can put the
surplus cash into some promising use or
undertake a profitable project. For this, the
managers of the company really need to work hard
as they have to put the firms interest above their
own interest and honestly and competently invest
the free cash stream of the business to exploit the
profitable ventures with positive net present value
that will add value to the entity. Two types of
fundraising are possible for the firms so that they
can bear the expenses of their new investments:
inner type and outer type. Inner type of fund
collection makes use of earnings retained in the
firm and non-cash expense like depreciation while
from the outer side, finance is available in the form
of bonds and stock (Jensen & Smith, 2000).
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 Karachi
stock exchange (KSE). 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
firms 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.
This is possible even when the firms have a low
financial capacity after making acquisitions since
they invest in non-profitable investment projects
(Griffith & Carroll, 2001). The objective of this
research was to measure the influence of excess
cash flow on the profitability of firms that are
listed at the Karachi stock exchange.
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.
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
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Volume: 4, Issue: 4, Pages: 113-122
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. This FCF is at the firms
discretion to be used for undertaking the
investments with positive net present value.
Dechow and Ge (2006) said that cash flows from
operations together with the cash flows from
investment activities are in actual fact the free cash
flows. Managers are often quite inclined and
tempted to hold large proportion of firm assets as
cash and cash equivalents so that they can invest
them to purchase some other Capital assets, give
away dividends to stockholders and keep cash
retained in the firm (Hann, Ogneva & Ozbas,
2010). Free cash flow is the spare cash flow that a
firm puts aside to undertake projects having
positive NPV (Jensen, 1988). Free cash flow can
also depict that some sort of agency problems exist
within a firm since the excess cash might not be
used by the managers to pay shareholders
dividends.
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 companys 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 firms 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
shareholders 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.
Relationship between the Free Cash Flow and
Profitability:
Free cash flow is the quantity of cash flow
obtainable for resource providers after paying all
the expenses and requirements of business which
are necessary for keeping it in an operational form.
Proper management of working capital
components enables the firms to hold excess free
cash flows which can in turn be invested in
profitable ventures to generate profits for the firm.
Free cash flows not only impact the revenues and
profitability of the firm but also the value of firms
balance sheet. If a firm fails to manage its net
working capital properly then free cash flows
might be lower than the net earnings 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. This is possible
even when the firms have a low financial capacity
after making acquisitions since they invest in non-
profitable investment projects (Griffith & Carroll,
2001). Firms can decide to hold free cash flows for
speculative purpose as they wait for profitable
ventures that can promise better returns in future.
The firm can also decide to invest in risky
investments that have higher payoffs so that these
investments may later yield better returns which
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Volume: 4, Issue: 4, Pages: 113-122
could be profitable to the firm. On the other hand,
the poorly invested free cash flows can negatively
impact the profits of the firm if the firm engages in
risky investments and the firm ends up losing
everything (Griffith & Carroll, 2001).
Research Hypotheses
Keeping all above discussion in mind, this research
has attempted to verify these three hypotheses in
order to check the objectives of the study.
FIGURE 1 HERE
H1: There is significant impact of free cash flow on
profitability of the firm.
H2: There is significant impact of capital liquidity
on profitability of the firm.
H3: There is significant impact of size of the firm
on profitability of the firm.
METHODOLOGY
This research adopted a research design of
descriptive survey that aimed at analyzing the
effect of free cash flow on the profitability of firms
listed at the KSE. Descriptive research (also called
statistical research) 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 KSE.
Mugenda and Mugenda (2003) described target
population as the complete set of individuals
cases or objects that are being investigated. The
population for this study consisted of 580
companies listed in KSE as on March 7th, 2015.
Sample Description
A stratified sampling method was used to select a
study sample of 30 companies listed at KSE. 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
30 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 KSE for a time span of five
years (2010 2014). The annually prepared
financial report includes: income statement (or
profit and loss statement), balance sheet (the
statement of financial position) and the statement
of cash flows.
DATA ANALYSIS TECHNIQUES
The techniques used in this research study were
quantitative in nature.
Data were sorted, cleaned and coded first and then
this data were entered into statistical package for
social science (SPSS). As data used were of
quantitative nature, correlations and regression
analysis model were used for data analysis.
Descriptive Statistics
The table 1 reveals the statistical analysis of
variables. The minimum value for profitability was
-0.087 while the maximum value of profitability
was 3.619. The mean value of profitability for the
listed firms of KSE was 0.297 with a standard
deviation of 0.652.
The free cash flows had a minimum score of
0000.00 billion rupees and its maximum score was
30068965.00 billion rupees. Likewise, the mean
score of free cash flows for listed firms of KSE was
3641598.27 billion rupees with a standard
deviation of 6293039.09.
TABLE 1 HERE
When it comes to capital liquidity, the maximum
value was 91.197 and its minimum value was
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Volume: 4, Issue: 4, Pages: 113-122
0.0159. The standard deviation for capital liquidity
was 16.593 while the average capital liquidity for
the KSE listed firms was 3.350.
With respect to size of the firm, the minimum
score was 3.958 and the maximum score was 8.652.
The average size for the listed firms was 7.006 with
a standard deviation of 0 .954.
Correlations
Pearson correlation was used to establish the
strength of association between any two variables.
Cohns Coefficient was used to estimate the size
effect. The sample for this study consisted of 30
firms for whom the annual observations for the
period 2010-2014 were taken. Pearson correlation
scale was used to describe the strength or degree
of association between two variables. The results
revealed the existence of a significant and positive
relationship between predictor variables free cash
flows, capital liquidity & firms size and dependent
variable profitability of KSE listed firms as shown
in table 2
TABLE 2 HERE
We can conclude that when the amount of free
cash flow increases, the profitability of listed firms
of KSE also increases (r=0.809). Profitability is
positively correlated with capital liquidity having
a correlation of 0.344. Profitability is moderately
but positively correlated with size of the firm
having a correlation of 0.599. All are significant at
p <0.01.
Regression Analysis
To establish the association between independent
and dependent variables, a multiple regression
analysis was conducted.
The model summary was used to summarize the
association of free cash flows, capital liquidity &
firms size to profitability of listed firms by
determining the correlation and R2, the coefficient
of determination for the regression model as
shown in table 3
TABLE 3 HERE
The R-square (coefficient of determination) for the
model was 0.766, meaning that the regression
model used for this study is a very good predictor.
The independent variables explained 76.6% of the
variation in profitability of listed firms.
From the ANOVAs results, F-test outcome tells us
about the absolute fit of the regression model to
the data analyzed. Here, the outcome of F-test is
lower than 0.001, as seen in the very last column of
the table. The model fits the data very well as the
F-value is statistically significant as shown in table
4
TABLE 4 HERE
The p value 0.000 implies that the regression
model significantly predicts the association of
independent variables with the dependent
variable. The significance between the variables
less than =0.05. By use of the F-table, the F (5%, 3,
26) tabulated was 2.98 which was less than F=
28.386 which reinforced that fact that the model
was statistically significant. This result indicates
that the overall regression model is statistically
significant and is useful for prediction purposes at
5% significance level.
Regression coefficients reflect the mean value of
change in the regression or dependent variable
(profitability) for a unit change in the regression or
independent variable while all other regression in
the model are held constant. Such kind of
statistical control is compulsory in a regression
model because the role of one variable is isolated
from the rest of the variables in the statistical
model.
The independent variable for capital liquidity in
the above model is insignificant since it has t-
value= -1.836 at p-value greater than 5% as shown
in table 5
TABLE 5 HERE
The independent variables free cash flow and size
of the firm are significant since they have the value
7.449 and 2.387 at p-value less than 5%. The
hypothesis H1 is verified by the study as the p-
value is 0.000, so there is significant impact of free
cash flow on profitability of the firm. The
hypothesis H2 is not supported by this study as it
p value is 0.078, so there is no significant impact of
capital liquidity on profitability of the firm. The
hypothesis H3 is verified by the study as the p-
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Volume: 4, Issue: 4, Pages: 113-122
value is 0.025, thus there is significant impact of
size of the firm on profitability of the firm.
DISCUSSION AND CONCLUSION
One of the most important financial measures is
free cash flow since it reveals whether a firm is
financially healthy or not and whether or not it is
able to undertake new investment opportunities.
Investors also take interest in knowing about
firms free cash flow so that they can have an idea
of the gains, they will be able to procure as
dividends. Excessive cash flows are attractive not
only for the firms themselves but also for the
potential investors. The firms with free cash flows
are able to secure the loans and debts quite easily
from their investors.
The growth of the business has a major impact on
free cash flows of a firm. A firm in the growth and
expansion phase will have most of its cash locked
up as receivable accounts and inventory thereby
lowering the amount of free cash flow for the firm.
Whereas when a business is dwindling or
shrinking, it liquidates its inventory and converts
its working capital back to cash and cash
equivalents, thereby adding to its reservoirs of free
cash of the firm.
Profitability is impacted by the degree of
competition faced by the firm, strength of product
demand (high demand for fashionable products),
elasticity of product demand, state of economy,
success of advertising campaign, availability of
substitutes, price discrimination policy of the firm,
bargaining power of suppliers, bargaining power
of buyers and amount of fixed cost for a firm.
Investors need to take into account the general and
strategic situations of the firms for computing the
free cash flows and profitability of the firms while
making the investment decisions. Free cash flow is
not the same as profitability. Profitability of a firm
is based upon accrual basis of accounting while
free cash flow is based upon cash basis of
accounting. Even a profitable company can be
bankrupt at the same time because of its cash flow
problems. Being profitable doesnt always means
that you are conducting business well.
This research adopted a research design of
descriptive survey. The population for this study
consisted of 580 companies listed in Karachi stock
exchange (KSE) as on March 7th, 2015. A stratified
sampling method was used to select a study
sample of 30 companies listed at KSE. Four
variables were used 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 KSE for
a time span of five years (2010 2014). Data were
sorted, cleaned and coded first and then this data
were entered into statistical package for social
science (SPSS). As data used were of quantitative
nature, correlations and regression analysis were
used for data analysis. The association between
independent and dependent variables was
established using a multiple regression model.
Statistical package for social sciences (SPSS) was
used to conduct the multiple regression and
correlation analysis. Descriptive statistics were also
computed for each of the four variables.
A significant positive correlation is existent
between profitability of firms listed at KSE and
their free cash flows. The higher the free cash flow,
the more profitable will be the firm. The regression
results reveal that the hypotheses H1 and H3 are
fully supported by the findings of this study.
While the hypothesis H2 was not supported to our
finding.
This study can be seen as a demonstration of the
fact that in order to achieve profitability, a firm
needs to rely directly upon its free cash flows.
Although, there are other factors as well that
contribute to any firms profitability. This
conclusion in turn is supplemented by the findings
of Kessides (1990) who stated that a firms
profitability should be seen as an outcome of its
income and expense combination reported in the
profit and loss statement. Profit and loss statement
is a comprehensive record of all the income and
expenses incurred by a firm during an accounting
period. The existence of a direct positive
relationship between free cash flow and profits is
therefore verified in the sense that profits are
calculated by deducting the cost of sales from sales
revenue. The resulting gross profit is generated as
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Volume: 4, Issue: 4, Pages: 113-122
a result of the firms operating activities. Thus the
importance of free cash for profitability becomes
very clear.
In real life situations also, it is inevitable for any
firms survival that both its profitability and cash
flow must be positive and firms need to maintain a
fine balance between both of them. If a company is
low or deficient in any of these two, it will be
unable to survive the competition and soon will be
forced to shut down. Therefore, a company must
be very vigilant about its profitability and cash
flow status if it is to succeed and grow in long run.
Limitations and Future Direction
Although, every attempt was made to choose a
representative sample of listed firms, but still this
goal may not be realized fully as the firms under
study were of extremely diverse nature,
operational in various sectors of economy and too
many in number. Also, the study was conducted
by using data for a period of five years (2010-2014).
These findings might not hold true in the next five
years since there are many macro-economic factors
in play that have the probable effect upon the
profitability of the listed firms in Karachi Stock
Exchange. The factors comprise political factors,
changes in government regulations and
technology.
The study implemented a multiple regression
model using four variables: three independent
variables (free cash flows, capital liquidity and the
size of the firm) and one dependent variable
(profitability). Future researchers can adopt a
similar model but they can explore other variables
also having probable effect on the profitability of
listed firms at Karachi Stock Exchange.
REFERENCES
Dechow, P., & Ge, W. (2006). The Persistence of
Earnings and Cash Flows and the Role of
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Anomaly. Review of Accounting Studies 11
(2-3), 253-296.
Fazzari, S. M., Hubbard, R. G., Petersen, B. C.,
Blinder, A. S., & Poterba, J. M. (1988).
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investment. Brookings papers on economic
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Griffith, J. M., & Carroll, C. (2001). Free Cash Flow,
Leverage and Investment Opportunities.
Journal of Business and Economics 1(2), 1-5.
Habib, A. (2012). Growth opportunities, earnings
permanence and the valuation of free cash
flow. Australasian Accounting, Business and
Finance Journal, 5(4), 101-122.
Hackel, K. S., Livnat, J., & Rai, A. (2000). A free
cash flow investment anomaly. Journal of
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Hubbard, R. G. (1998). Capital-market
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Jensen, M. C. (1986). Agency cost of free cash flow,
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Jensen, M. C., & Smith, C. W. (2000). Stockholder,
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Kessides, I. N. (1990). Market concentration,
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Maheshwari, S. (2002). Principles of Management
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Richardson, S. (2006). Over-investment of free cash
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Singh, Y. K., & Nath, R. (2010). Research

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APPENDIX

Table 1: Descriptive Statistics

Variables N Minimum Maximum Mean Std. Deviation
Free Cash Flow
(Billion Rs.) 30 00000.00 30068965.0 3641598.27 6293039.09
Capital Liquidity 30 0.0159 91.197 3.350 16.593
Size of Firm 30 3.958 8.652 7.006 0.954
Profitability 30 -0.087 3.619 0.297 0.652

Table 2: Correlations
Variables 1 2 3 4
Profitability (1) 1
Capital Liquidity (2) 0.344** 1
Size of Firm (3) 0.599** -0.182* 1
Free Cash Flow (4) 0.809** -0.341 0.514** 1
**. Correlation is significant at the 0.01 level (2-tailed).

Table 3: Model Summary

Model R R Square Adjusted R Square Std. Error of the Estimate
1 0.875a 0.766 0.739 0.308
a. Predictors: (Constant), Size of Firm, Capital Liquidity, Free Cash Flow

Table 4: ANOVA
Model Sum of Squares Df Mean Square F Sig.
Regression 571.9 3 190.6 28.386 .000b
1 Residual 174.6 26 6.716
Total 746.5 29
a. Dependent Variable: Profitability
b. Predictors: (Constant), Size of Firm, Capital Liquidity, Free Cash Flow

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Table 5: Coefficients
Model Unstandardized Standardized t Sig.
Coefficients Coefficients
B Std. Error Beta
(Constant) -8213674.46 3806569.41 -2.158 .040
Free Cash Flow 0.630 0.085 0.781 7.449 .000
1
Capital Liquidity -57090.383 31102.940 -0.187 -1.836 0.078
Size of Firm 1311311.11 549282.732 0.247 2.387 0.025
a. Dependent Variable: Profitability

Figure 1

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