DEPARTMENT OF BANKING AND FINANACE. ONYIMBA ROSELINE CHIZOBA REG. NO: PG/M.sc/12/61705

Transcription

1 ONYIMBA ROSELINE CHIZOBA REG. NO: PG/M.sc/12/61705 WORKING CAPITAL MANAGEMENT AND PROFITABILITY IN CHEMICAL AND PAINT SECTOR IN NIGERIA FACULTY OF BUSINESS ADMINISTRATION DEPARTMENT OF BANKING AND FINANACE Fred Attah Digitally signed by: Content manager s Name DN : CN = Webmaster s name O= University of Nigeria, Nsukka OU = Innovation Centre

2 WORKING CAPITAL MANAGEMENT AND PROFITABILITY IN CHEMICAL AND PAINT SECTOR IN NIGERIA BY ONYIMBA ROSELINE CHIZOBA REG. NO: PG/M.sc/12/61705 BEING A DESERTATION PRESENTED TO THE DEPARTMENT OF BANKING AND FINANCE, FACULTY OF BUSINESS ADMINISTRATION, IN PARTIAL FULFILLMENT FOR THE REQUIREMENTS FOR THE AWARD OF DEGREE OF MASTERS (M.sc) IN BANKING AND FINANCE, IN THE UNIVERSITY OF NIGERIA, ENUGU CAMPUS SUPERVISOR: ASSOCIATE PROF. NWUDE JUNE,

3 TITLE PAGE WORKING CAPITAL MANAGEMENT AND PROFITABILITY IN CHEMICAL AND PAINT SECTOR IN NIGERIA BY ONYIMBA ROSELINE CHIZOBA REG. NO: PG/M.sc/12/

4 DEPARTMENT OF BANKING AND FINANCE FALCULTY OF BUSINESS ADMINITRATION UNIVERSITY OF NIGERIA, ENUGU CAMPUS MAY,

5 CERTIFICATION This is to certify that the thesis prepared by Onyimba Roseline C., entitled: Working Capital Management and Profitability in Chemical And Paint Sector in Nigeria and submitted in partial fulfillment of the requirements for the degree of Degree of Master of Business Administration in Banking and Finance complies with the regulations of the university of Nigeria Nsukka and meets the accepted standards with respect to originality and quality ASSOCIATE PROF. NWUDE (SUPERVISOR) Date... ASSOCIATE PROF. NWUDE (HEAD OF DEPATRMENT) Date 5

6 DEDICATION This project work is dedicated to the Almighty God of Chosen whose love is endless towards me. 6

7 ACKNOWLEDGEMENTS I want to use this medium to express my profound gratitude to those who in one way or the other has contributed to the realization of this project work. My heartfelt gratitude goes to almighty God of the chosen whom his marvelous support has helped to make the accomplishment of this work possible and my brother whom his financial support has helped me a lot. I will not forget my supervisor Associate Prof. Nwude for his wonderful care and support during this work, including my other lecturers; Prof. J.U.J Onwumere, Dr. Mrs. Modebe, Dr Onah, and many others. I am also grateful to my family and to my friends for support during my studies and especially during the thesis project. May God almighty, bless, guide and protect them all Amen. Onyimba Roseline C. 7

8 ABSTRACT Working Capital Management plays an important role in financial decision making since it is a part of investment in assets and liabilities and it directly affects the profitability and liquidity of the firm. Firms can achieve optimal management of working capital by making the trade off between profitability and liquidity. Cash Conversion Cycle is one of the important measuring tools to calculate the efficiency of working capital management. The study tries to investigate the impact of working capital management on profitability of the selected Chemical and Paint firms listed in Nigeria Stock Exchange, using a sampled of 5 firms for the period of 14 years from , we had studied the effect of different variables of working capital management including the average collection period, inventory conversion period, average payment period cash conversion period and control for current ratio, debt ratio, size of the firm and financial assets to total assets ratio on the profitability measured by gross operating profitability of listed chemical and paint firms. The data is analyzed using descriptive and multiple regressions and the outcome shows that ACP had a positive and significant impact on the profitability, implied that firms can increase profitability measured by gross operating profit by lengthening collection period of account receivable as generous trade credit policy may lead to higher sales. A financial asset to total assets as a control variable has a significant positive relationship with firm s value and profitability of firms. This means, increasing in the level of financial assets to total assets will lead to increase in the profitability of the firm and the value of the firm, since they are brought for profitability purposes. 8

9 TABLE OF CONTENTS TITLE PAGE CERTIFICATION DEDICATION i ii iii AKNOWLEDGEMENT... iv ABSTRACT TABLE OF CONTENTS.. v vi CHAPTER ONE: INTRODUCTION 1.1: Background to the Study : Statement of the Problem Objective of the Study 5 1.4: Research Question : Research Hypotheses : Scope of the Research : Significant of the Study. 6 References...8 CHAPTER TWO: REVIEW OF RELATED LITERATURE 2.1: CONCEPTUAL FRAME WORK : Definition and Concept of Working Capital : Working Capital Cycle : Working Capital Policy : Factor Influencing Working Capital Requirement : Rationale for Working Capital : Working Capital and Liquidity : Rationale for Working Capital Management

10 2.2: THEORITICAL FRAME WORK : Theory of Working Capital Management : Impact of WCM on Company Profitability (Theoretical Base) : Measuring Working Capital Management (WCM) : Empirical Review : Summary Review : Major Trend (Consensus on Argument) : Critic of Literature : Research s Personal Contribution.. 46 References.. 45 CHAPTER THREE: RESEARCH METHODOLOGY 3.1: Research Design : Nature and Source of Data : Population and Sample size Explanation of the Variables : Specification of Models : Techniques of Analysis.. 59 References 61 CHAPTER FOUR: DATA PRESENTATION AND ANALYSIS 4.1 Data Presentation and Analysis : The Overall Analysis of Descriptive Statistics Test of Hypothesis Test of Hypothesis one Test of Hypothesis two Test of Hypothesis Three 70 10

11 4.3.4 Test of Hypothesis Four Implication of the Results Comparison of the Findings with the objective of the study Research Objective One Research Objective Two Research Objective Three Research Objective Four 76 References 77 CHAPTER FIVE: SUMMARY OF FINDING, CONCLUSION AND COMMENDATION Summary of Findings Conclusion Recommendation Area of further study Contribution to Knowledge 81 References 86 Bibliography. 82 APPENDIX 90 11

12 CHAPTER ONE INTRODUCTION 1.1 BACKGROUND TO THE STUDY The main objective of any business organization is to maximize the profit. But preserving liquidity of the firm is also an important objective too. A firm that did not make profit cannot survive in business for a long time and also firm with insufficient liquidity will be insolvent in a long-run which will disrupt the operational activities of the firm. In order words, effective and efficient management of profitability and liquidity are very important for firms survival. The management of working capital has a significant effect on firm s profitability and liquidity, irrespective of the nature and the size of the business. The management of working capital involves the determination of optimum level of working capital to keep, monitoring and controlling the level of individual component of working capital to ensure that the optimum level is not exceeded, and provision of funds to finance current assets (Nwude, 2004:628).Popularly known as trade-off between profitability and liquidity. Therefore the importance of working capital management cannot be over-emphasized. It is obviously critical for smooth operation of the firm, because it affects the profitability and liquidity of the firm. Working capital components (i e. account receivable period, account payable period, inventory period etc.) have implication for profitability among other variables. Hence, determining the amount of liquidity available for day to day business activities and as Nwude (2004) as posits: Working Capital is one of the most strategic assets holding of the firms. It is a Circulating capital which flows and changes form as the firm pursues its goals and performs its operation. It is a financial lubricant or life stream for the firm and maintains constant process of circulation throughout the firm (Nwude, 2004:627). Raheman & Nasr (2012) is of the view that if working capital management is not correct the sales and consequently the profit of the company might decrease and the company may be unable to pay its debt and commitment on time. However, the need for maintaining an adequate working capital can hardly be questioned. Just as the circulation of the blood is very important in human body to maintain life, the flow of fund is very necessary to maintain the business (Ebenezer & Asied, 2013). How profitable or non-profitable a business or a firm can be partly 12

13 depends on how it effectively and efficiently manages its working capital (Adarquah and Korankye 2013). The chemical and paint industry has been in existence for a number of years. The industry has gone through various based development from manual based process to more technologically advanced production methods (Adewole B., 2008). However, the level of development of the sector in Nigeria is still low when compare to other countries with more advanced technical know-how (Adewole B., 2008). The Nigeria chemical and paint industry is a highly competitive one. Unlike in other industries, many chemical and paint manufacturers do not have established relationship with financial institutions (Adewole B., 2008). This limits their ability for organic growth with many of the firms limiting their financial source to internal generated fund. Thus, this situation will compel the managers of the industry to device various strategies of managing their internal generated revenue to enhance their chance of making profit and meeting existing shareholders expectation. Strategies which can be adopted within the firm to improve liquidity and profitability include the management of working capital. In addition, the importance of working capital to manufacturing firms cannot therefore, be overlooked for not only do they significantly affect profitability but it concerns with the investment required for the purchase of raw materials and conversion of the raw materials to finished goods. It is a continuous circular process. For many manufacturing firms the current asset account for over half of their total asset (Raheman & Nasr, 2012). Along with fixed assets such as plant and equipment, working capital is generally the investment in current assets viz: inventory, account receivable, short term security and cash which are required to carry on the day to day operation of the firm. According to Barine: Fixed assets are the core tools for functioning the organization to produce goods and services to meet customers needs. Acquisitions of these fixed assets are not an end in itself. Input materials are needed, for running through these fixed assets to produce products and services that will meet the need of customers. Finance is also required to ensure that these input materials are available when needed. These input materials and finance for acquiring them regularly for firm use, ensure that fixed assets are in use and working. (Barine, 2012:216) Economic growth and development of many countries, especially the developing economies, rely heavily on extent the manufacturing sector is being developed. For instance despite its poor 13

14 natural resources, and the hurdles it faced from 1920s chronic inflation, Germany has effectively exploited the manufacturing sector and rose up to become the largest economy in Europe and the fourth largest in the world.(the World Bank 2012). In addition, Working Capital Management is of particular importance to both the small, medium and large enterprises, as it most needed to ensure profitability and increase expansion which is an essential prerequisite for solving the country unemployment problem. Also in this fast moving world, firms are highly competing among them, so a well designed working capital management is expected to contribute positively to creation of firm s value. Of interest to us is Chemical and Paint industry which are into the production of not only tertiary product but also secondary product (i.e. chemical) which is in turn used as a raw material in other industry. In view of this it has a major role to play in the system. 1.2 STATEMENT OF THE PROBLEM The working capital management has an important role for the firm s existence because of its effect on firm s profitability and liquidity in order words, liquidity management and profitability are very important issues in the growth and survival of business and the ability to handle the trade-off between the two are source of concern for financial managers. Reason because the decisions that tend to maximize profitability tend to minimize liquidity and vice versa. Profitability does not translate to liquidity in all cases, a company may be profitable without necessarily being liquid (Owolabi & Obida, 2012). Liquidity should be managed in order to obtain an optimal level, that is, a level that avoid excess liquidity which may incurs unnecessary additional cost to the firm. Liquidity level should not fall below minimum requirement as it will lead to the inability of the organization to meet short term obligation that are due. The main problem facing all organizations is how to maintain the trade-off between profitability and liquidity. For managers of firms there are two main objectives concerning the management of their firms (Telwolde 2002). First they want to maximize the profitability of the firm, maximizing the value for the shareholders of the firm. Second they want to minimize the liquidity risk of the firm. Liquidity risk is the risk that firms do not have enough cash or other short-term assets to satisfy mostly their short-term financial obligation, which can cause difficulties for firms in maintaining their operating activities. 14

15 Though, the ultimate objective of any firm is to maximize the profit. But, preserving liquidity of the firm is also an important objective too. The problem is that increasing profit at the cost of liquidity can invites serious problem to the firm. Therefore, there must be a trade-off between these two objectives of the firms (Muhammad, Jan & ullah, 2012). Also the desire of all business organizations is to be going concern, but achieving this basic idea also requires business organizations to be simultaneously profitable and solvent irrespective of the profit-orientation, size and the nature of business, all firms require an optimum level of working capital management ( Jayarathne 2014). Inefficiency of working capital management leads the capital into a pitfall (Niresh, 2012). Optimal working capital management positively contributes to the creation of firm value. On one hand, cost of liquidity brings a serious problem and stands against profitability (Dong, & su, 2010). On the other hand, a firm cannot survive without sufficient liquidity because the firm may face the problem of insolvency. Therefore, a balance between profitability and liquidity must always be maintained. Poor management of working capitals results to liquidity problems which might lead to bankruptcy in very severe cases (Nwude, 2004:628). When organization has insufficient working capital, it will be difficult for them to survive in a competitive environment because they cannot be able to meet the needs of their customers and also their short term creditors and it also makes difficult the implementation of operating plans and achievements of profit targets. While excessive working capital results in idle funds being unnecessarily tied down resulting in a loss of profitability for the organization since idle funds can be invested elsewhere to earn returns for the organization,(nwude, 2004:628). Excessive working capital as well results in unnecessary accumulation of inventories which in turn increases the dangers of obsolescence, deterioration, and pilferage, mishandling, high insurance and carrying costs, idle assets, which are barren of income accounts receivable, poor profitability (Nwude, 2004: ). Therefore, there is need for effective working capital management which aims at an optimum working capital level. The optimum working capital level is that level of working capital which avoids both insufficient and excessive working capital taking the nature of the firm s business and the level of operations into consideration (Nwude, 2004:628). In addition Kaur, & Singh, (2012) states that this working capital policy is an important issue in any organization because without the proper management of working capital component it will be difficult for the organizations to run its operation smoothly. Many financial managers are finding it difficult to identify the important drivers of working capital management that can 15

16 enhance their company profitability (Huynh, 2012).If we do not care about profit; we cannot survive for a longer period. On the other hand, if we do not care about liquidity, we may face the problem of insolvency or bankruptcy (Raheman & Nasr, 2007). Therefore it is clear that, if organization at any point in time does not have the enough funds to meet its short-term obligations such as creditors, salaries, and the day-to-day expenses, then it is likely to become technically insolvent. Conversely if the business or firm is so conservative it may have a surplus of working capital, which will adversely, affects profits. Therefore, the trade-off between profitability and liquidity is the key to working capital management (Aminu, 2012:55). 1.3: OBJECTIVE OF THE STUDY General objective In respect of the above quest, our general research objective aims at finding out whether Working Capital Management can impact on profitability of selected firms in the chemical and paints sector listed in Nigeria Stock Exchange and if so, whether it is positively or negatively affected. Specific objectives To achieve the general objective, the following specific objectives were used; I. To determine whether Average Collection Period has a positive and significant impact on Profitability of selected firms in the chemical and paints sector in Nigeria. II. To assess whether Inventory Conversion Period has a positive and significant impact on Profitability of selected firms in the chemical and paints sector in Nigeria. III. To ascertain whether Average Payment Period has a positive and significant impact on Profitability of selected firms in the chemical and paints sector in Nigeria. IV. To examine if Cash Conversion Period has a positive and significant impact on Profitability of selected firms in the chemical and paints sector in Nigeria. 1.4: RESEARCH QUESTION Our research questions for this study are as follows: i. What is the impact of Average Collection Period on the profitability of the selected firms? 16

17 ii. iii. iv. What is the impact of Inventory Conversion Period on the profitability of the selected firms? What is the impact of Average Payable Period on the profitability of the selected firm? What is the impact of Cash Conversion Period on the Profitability of selected firms in the chemical and paints sector in Nigeria? 1.5: HYPOTHESES OF THE STUDY Our hypotheses for the study are as follows: Ho1: Average Collection Period (ACP) has no positive and significant impact on Profitability of selected firms. Ho2: Inventory Conversion Period (ICP) has no positive and significant impact on Profitability of selected firms. Ho3: Average Payment Period (APP) has no positive and significant impact on Profitability of selected firms. Ho4: Cash Conversion cycle (CCC) has no positive and significant impact on Profitability of selected firms in chemical and paints sector in Nigeria. 1.6: SCOPE OF THE STUDY The research covers the five reputable firms in the Chemical and Paint sector in Nigeria, viz: African Paint Plc, Berger Paints Plc, CAP Plc, DN Meyer Plc, and premier Paint plc. The sample represent 71 percent of total of Chemical and Paint companies listed in Nigeria Stock Exchange based on fourteen fiscal years (i.e.5 out of the total of 7 chemical and paint companies listed in N.S.E.). With the availability of annual reports, the period of was chosen and it covers the particular part for preparing our data for statistical analysis. 1.7: SIGNIFICANCE OF THE STUDY The significance of this study can be viewed from two major standpoints- Practical and Academic. 17

18 (a) Practical Significance: The study will assist in broadening understanding of the following or the scope of knowledge of the following: To manufacturing firms in general, it will expose the relationship existing between our relevant variables, which will be of interest to them in their respective firms. Specifically to the manufacturers in the sector under study, it will expose to large extent the activities or things going-on in their organizations with regard to our relevant variables and a comparative analysis of their actions over some relevant years. More so, to policy makers, economic and business researchers, it will help to guide them on future research, re-appraise current business practices and provide basic guideline for policy makers in rapid changing of business environment. To management of the firm; among other things, the findings of the study may guide managers of firms under study and other similar firms to understand how working capital management affect their profitability which may enhance their short-term financial decision making. To government, the important of efficient working capital management by manufacturing firm in Nigeria cannot be over-emphasized as this is extremely needed to boost profitability and increase expansion, which can help in solving the countries unemployment issues and ensuring economic stability. Buttressing this point, the World Bank Annual Report (2007) observes that developing countries can considerably resolve their socio-economic challenge when they take significant step to revive and develop their manufacturing base. (b) Academic Significance In the academic arena, this study will prove to be significant in the following ways: It will contribute to the enrichment of the literature on working capital management and profitability It will throw more light on the relationship between profitability and such other variables apart from working capital management component. It will also contribute to the enrichment of the literature on profitability and liquidity management. The study will serve as a body of reserved knowledge to be referred to by researchers. 18

19 REFERENCES Abdul, R. and Nasr, M. (2007), Working Capital Management and Profitability: Case of Pakistani Firms, International Review of Business Research Papers, Vol.3, No. 2, pp Adarquan, R. S. and Korankye, T. (2013) Empirical Analysis of Working Capital Management and Its Impact on the Profitability of listed Manufacturing Firms in Ghana, Research Journal of Finance and Accounting, Vol.4, No. 1, pp Aminu, Y. (2012) A Nexus between Liquidity/ Profitability Trade-Off for Working Capital Management in Nigeria s Manufacturing Sector, International Journal of Arts and Commerce, Vol. 1, No. 6, pp Akoto, R. K., Vitor, D. A. and Angmar, P. L. (2013) Working Capital Management and Profitability: Evidence from Ghanaian Listed Manufacturing Firms. Journal of Economics and International Finance, Vol. 5, No. 9, pp Alavinasab,S. M. and Davoudi, E. (2013) The Relation between Working Capital Management and Profitability of listed Companies in Tehran Stock Exchange. Business Management Dynamics, Vol. 2, No. 7, pp. 1-8 Barine, M. N. (2012) Working Capital Management Efficiency and Corporate Profitability: Evidence from Quoted Firm in Nigeria, Journal of Applied Finance and Banking, Vol.2, No. 2, pp Dong, H. P. and Jyh S. (2010) The Relationship between Working Capital Management and Profitability: A Vietnam Case International Research Journal of Finance and Economics, Vol. 49, Ebenezer, A. B. and Asiedu M. K. (2013) The Relationship between Working Capital Management and Profitability of listed Manufacturing Companies In Ghana, International Journal of Business and Social Research, Vol.3, No. 2, pp Harsh, V. K. and Sukhdev, S. (2013) Managing Efficiency and Profitability through Working Capital, Asian Journal of Business Management, Vol. 5, No. 2, Jayarathne, T.A.N.R. (2013) Impact of Working Capital Management on Profitability: Evidence from Sri Lanka, Proceeding of the 3 rd International Conference on Management and Economics, Oral Presentation. Pp Kaul, H. V. and Singh S. (2012) Managing Efficiency and Profitability through Working Capital: An Empirical Analysis of BSE 200 Companies, Asian Journal of Business Management, Vol. 5, No. 2, pp

20 Leon, S. A. J. (2013) The Impact of Working Capital Management on Profitability of the Listed Firms in Sri Lanka, Global Journal of Commerce and Management Perspective, Vol. 2, No. 6, pp Melita, S. C. (2010) The Effect of Working Capital Management on Firm s Profitability: Empirical Evidence from an Emerging Market, Journal of Business and Economic Research, Vol. 8, No. 12, pp Mobeen, U. R and Naveed, A. (2013) Determination of the Impact of Working Capital Management on Profitability: AN Empirical Study From the Cement Sector in Pakistan. Asian Economic and Financial Review, Vol. 3, No. 3, pp Mohammed, N. E. A. B and Saad, N. B. M. (2010) Working Capital Management: The effect of Market Valuation and Profitability in Malaysia, International Journal of Business Management Vol. 5, No. 11, pp Muhammad, M., Jan W.U. & Ullah k. (2011) Working Capital Management and Profitability: An Analysis of Firms of Textile Industry of Pakistan, Journal of Management Sciences, Vol.4, No.2.pp Nwude, C. E. (2004) Basic Principles of Financial Management Second Edition, Enugu: Chuke Nwabude Nigeria Onwumere, J.U.J (2009), Business and Economic Research Methods, Enugu: Vougasen Ltd Owolabi, S. and Obida, S. (2012), Liquidity Management and Corporate Profitability: A Study of Selected Manufacturing Companies, Business Management Dynamics, Vol.2, No. 2, pp Raheman, A.and Nas,r M. (2007) Working Capital Management and Profitability: Case of Pakistani Firms, International Review of Business Research Papers, Vol.3, No.1, pp Rekha, G. (2014) Effect of Working Capital Management on Firms Profits: Evidence from the Pharmaceutical Sector, International Journal of Management and Social Science Research, Vol. 3, No. 1, pp Sarbapriya, R. (2012) Evaluating the Impact of Working Capital Management Components on Corporate Profitability: Evidence from Indian Manufacturing Firms. International Journal of Economic Practice and Theories, Vol. 2, No. 3, pp Solabomi, O. A. (2013) Working Capital Management and Financing Decision: Synergetic Effect on Corporate Profitability, International Journal of Management, Economics and Social Science, Vol. 2, No. 4, pp

21 Tewolde, S. (2002) Working Capital Management: The Case Of Government Owned, Transnational and Privatized Manufacturing Firms in Eritrea, University of Groningen, Faculty of Management and Organization. Ullah, K. (2011) Working Capital Management and Profitability: An Analysis of Firms of Textile Industry of Pakistan, Journal of Management Science, Vol.6, No.2, pp Zubair, A. and Muhammad Y. G. (2013) Impact of Working Capital Management on Profitability: A Case of the Pakistan Cement Industry, Journal of Contemporary Research in Business, Vol. 5, No. 2, pp

22 CHAPTER TWO REVIEW OF RELATED LITERATURE INTRODUCTION This chapter reviews some of the related literature on impact of working capital management on firms profitability among different countries. The theoretical point is divided into many sub chapters concerning the subject of the thesis. For this point, much background information has been collected from different articles and literature. 2.1: CONCEPTUAL FRAME WORK 2.1.1: Definition and Concept of Working Capital The term working capital is that portion of total funding needed for day to day operation of an entity (Nwude, 2004:627). Adarquah (2013) sees it as basically short-term resources available to a company for financing its day-to-day activities. Ani, Okwo and Ugwunta (2013) is of the view that working capital is the stock stored that has a conversion or resale value in order to gain profit. On their part, Vallalnathan and Joriye (2012) equally view it as the flow of ready funds necessary for the working concern. Sarbapriya (2012) sees it as the result of the time lag between the expenditure for the purchase of raw material and the collection for the sale of finished goods. Again Muhammad, Ullah Jan and Ullah (2011) see it as a financial metric which represents the amount of day to day operating liquidity available to a business. Working capital is needed every day until the on-going project is completed (Kumarel et al. 2002). Richards & Laughlin (1980) discovered that working capital is needed in every step of the process but it changes after certain steps. It is a circulating capital which flows and changes forms as the firm pursues its goal and performs its operations (Nwude, 2004:627). Also according to Nwude, (2004:627) it is a financial lubricant or life stream for firm and maintain constant process of circulation throughout the firm. A narrow definition for the working capital is inventory plus account receivable minus account payable. Working capital meets the short term financial requirement of a business enterprise (Loen, 2013). The major concepts of working capital are the gross working capital and the net working capital. Gross working capital is the totality of firms investment in current assets such as inventory, accounts receivable, short term marketable securities and cash. Net working capital is the totality 22

23 of firms investment in current assets less the totality of the firm s current liabilities. Current liabilities includes items such as accounts payable, notes payable, accruals, customers deposit (i.e. prepayment) deferred taxes and short- term deposit obligation : Working Capital Cycle working capital cycle is the length of time it take a firm, from the time it paid cash for the raw material purchases to the time the firm collect cash from its sales ( Nwude, 2004). It is also defined as the amount of time it takes to turn the net current asset and current liabilities into cash. The longer the cycle is, the longer a business is tying up capital in its working capital without earning a return on it ( According to mysafaribooksonline, working capital or operating cycle refers to the period that an enterprise takes in converting the cash back into the business from the cash initially invested in various operating activities of the enterprise. The said cycle starts from the cash blocked by the way of purchase of raw materials and ends with the realization of cash out of sales. Therefore, the said cycle is the time lag between the cash investment in purchase of raw materials and the recovery of cash by the way of sales of goods. In the mean period, the cash engaged in operation is being gradually converted into different forms of working capital till its recovery from sales. The working capital cycle can be seen from the figure 1 Cash Raw materials Receivable Work-in Progress Finished goods Figure 1, the working Capital Cycle (Nwude, 2004, pp.632) 23

24 The basic activities of companies are purchasing, production, sales and collection of payment. The cash is invested to the production cycle when resources are purchased. The tied up cash is back to use after company has collected payment from the sales. The cash that is invested in working capital cannot be invested to some profitable targets (Talonpoika, 2012). The four keys dates in product cycle that influence the firm s investment in working capital are as follows; Account Payable Period: The firm starts the cycle by purchasing raw materials, but does not pay for them immediately. This delay is the account payable period. Inventory Period: the firm processes the raw materials and then sells the finished goods. The delay between the initial investment in inventories and the sale date is the inventory period. Account Receivable Period: sometimes after the firm has sold the goods to its customers pay their bills. The delay between the date of sales and the date at which the firm is paid is the account receivable period. Cash Conversion Cycle: The sum of the inventory period and account receivable period gives the length of time it takes the purchased raw materials to transform into cash. The cash conversion cycle can be calculated using the working capital ratio as shown below; 1. Inventory period = Average Inventory/ Annual cost of goods sold *365/1 2. Account Receivable Period = Average Account Receivable/ Annual sales*365/1 3. Account Payable Period/ Annual cost of goods sold*365/1 Cash Conversion Cycle = Inventory period + Receivable period (Payable period). Inventory Period = Raw materials period + work-in-progress + finished good period. Raw Materials Period is the number of days raw materials are heed in store before they are converted into worn-in-progress. Work- In-Progress Period is the number of days the raw materials are in the process before conversion into finished goods. Finished Good Period is the number of days the finished goods held before they are sold 24

25 2.1.3: Working Capital Policy A company needs to closely monitor its working capital levels in order to keep its cash requirements formally in check. Lack of attention to the investment in working capital (account receivable, inventory and payables) may result in a runaway need of cash, especially when sales are growing. A business can do this most effectively by instituting and enforcing a number of policies. Working capital policy involve decision about company s assets and liabilities- what they consist of, how they are used, and their mix affect the risk versus return characteristics of the company (Soyemi and Olawale, 2014). However, it is basically about how much working capital the company should maintain. According to Pieterson, (2012) Working capital policy involves decision about company s asset and liabilities-what it consist of, how they are used, and their mix affect the risk versus return characteristics of the company. Through their effect on the firms expected return, ultimately have an impact on shareholder wealth. Thus, an efficient working capital management is critical for the long-term survival of a business (Padachi & Howorth, 2014). These policies have been divided into two categories by Weinraub and Visscher (1998) they are; 1. Aggressive working capital policy 2. Conservative working capital policy Aggressive: An aggressive working capital policy is one in which you try to squeeze by with a minimal investment in current asset coupled with an extensive use of short-term credit. Your goal is to put as much money to work as possible to decrease the time needed to produce products, turnover inventory or deliver services. Speeding up your business cycle grows your sales and revenues, you keep little money on hand, cut slow- moving inventory and unnecessary supplies to the bone and stretch out your bill payments for as long as possible. The one payment you cannot delay is interest- your creditors can sue you, force you into bankruptcy and liquidate your assets. You could also want to avoid missing tax payments. Conservative working capital policy is good for companies in volatile or seasonal industries such as tourism; farming or construction might adopt conservative working capital policy to buffer against risk. If you employ a conservative working capital policy, there is plenty of cash in 25

26 the bank, your warehouse are full of inventory and your payables are all up to date. If you compute the working capital ratio- current asset/ current liabilities a conservative policy might yield a ratio above 2:0 that is, you have more than $2 in current asset for every dollar of shortterm liabilities. Conservative managed working capital will help lower your risk of short-term cash shortages but might hurt your long-term profitability, because excess cash doesn t earn much of a return. Generally, efficient working capital management depends on working capital policy adopted, distinguished as conservative or aggressive policies. The conservative working capital policy implies a higher investment in working capital accounts, such as higher level of inventories, extending more trade credit to customers and reducing supplies financing, resulting in lower profitability and lower risk (Gomes, 2013). In contrast, aggressive working capital policy implies lower investment in working capital accounts, through lower level of investment in inventories, shortening trade credit to customers and postponing payment to suppliers, resulting in an increase of profitability & risk for firm (Blinder & Maccini, 1991).Therefore, more aggressive working capital policies are associated with higher return and higher risk while conservative working capital policies are concerned with the lower risk and return (Carpenter and Johnson, 1983; Gardner, et al., 1986; Weinraub and Visscher, 1998) : Factor Influencing Working Capital Requirement According to Nwude, (2004:629) they are as follows; 1. Production Cycle Production cycle is the period of time needed for a production process to produce a finished product. It starts with the procurement of the relevant raw materials to the end of the production. The time period includes the time it takes to procure the raw materials onto production arena plus the time it takes to return the raw materials into finished product ready for sale. The longer the productions cycle the longer the working capital requirement. 2. Nature of Business Manufacturing, trading (whether wholesale or retail), service delivery and so on, each has its influence on working capital requirements. If a business engaged in stock-piling inventories with the hope of selling them during the season s large working capital will be in stocks. If it is a manufacturing concern, heavy working capital will be invested in raw materials to ensure continuity in production. Therefore the nature of business has substantial influence on working capital requirements. 26

27 3. Size of Business The level of activity also influences the working capital needs. A higher level of activity requires additional stock of raw materials or finished goods to meet higher production or sales request. Additional investment in account receivable will be needed, as a result of increase in sales, which will equally attract increment in receivables. Equally a lower level of activity will attract a lower level of investment in working capital. 4. Fluctuations in Business Boom increases the scale of operation of a firm. Recession decreases the scale of operation of the firm. Levels of stocks and debtors increase during boom thereby necessitating additional investment in assets while the reverse is the case under recession. 5. Credit Policy A conservative credit policy is expected to lead to low investment in receivables and by extension lower working capital requirements. A liberal credit leads to increase in receivables and by extension a higher working capital needs. 6. Credit Availability A firm that enjoys liberal credit terms from its suppliers or bankers will operate with less working capital than a firm without such facility. 7. Dividend Policy Dividend is the portion of the earnings available to common shareholders that is share among the common shareholders as reward for their ownership stake in the business. Cash is one of the current assets or working capital items payment of cash dividend depletes cash and thus reduces the working capital to that extent. If all earnings are retained or ploughed back in the business, working capital position will be improved. 8. Efficiency in Operations Efficiency in operation means optimal resources utilization at minimal operating costs. Optimal utilization of resources improves profitability and by extension improve the earnings ability of the firm. The enhanced earning capacity results in improved an retained earnings which helps in increasing working capital. 9. Price Changes In a period of rising price levels, cost of things will rise, and companies that need to maintain the same level of current assets will need more working capital. The same level of the current assets will need lower working capital when prices decrease. 27

28 2.1.5: Rationale for Working Capital Every business needs adequate working capital in order to maintain day to day cash flow. It needs enough cash to pay wages & salaries as they all due and to pay creditors if it is to keep its workforce and ensure its supplies. Maintaining adequate working capital is not just important in the short-term because sufficient liquidity must be maintained in order to ensure the survival of the business in the long-term as well. Working capital as the life blood of every business concern for this reason, no business can be run successfully without adequate amount of working capital. The advantages of maintaining adequate working capital are as follows; Continuous production: Adequate working capitals ensure regular supply of raw materials and continuous production. Solvency and Goodwill: adequate working capital enables prompt payment to creditors. This help in creating and maintaining goodwill. Easy loans: a concern having sufficient working capital enjoys high liquidity and good credit standing. Hence it can secure loan from bank and other easy and favorable terms. Cash Discount: adequate working capital enables a concern to avail cash discount on the purchases, leading to a reduction in cost. Regular payment of Expenses: a company which has ample working capital can make regular payment of salaries, wages and other day to day commitment. Such prompt payment raises the morale of the employees and increases their efficiency. As a result costs are minimized and profit increases. Exploitation of the Market Conditions: a concern with adequate working capital can exploit favorable market conditions. It can buy its requirements of raw materials in bulk when the market price is lower. Similarly, it can hold stock of finished goods to realize better prices. Adequate working capitals enable a concern to face business crisis such as depression because during that period there is much pressure on working capital. High Return on Investment: adequate of working capital facilitates continuous production and effective utilization of fixed assts. Because of this, the concern is able to generate more profits and ensure higher return on investment. 28

29 2.1.6: Working Capital and Liquidity Working capital is a common measure of company liquidity, efficiency and overall wealth. Because it include cash, inventory, account receivable and account payable, the portion of debt due within one year and other short-term account. It also can be looked at as the excess of total current assets over total liabilities. Thus the larger the amount of working capital the stronger the liquidity position of the business organization (Almazari, 2014). Nzioki et al., (2013) is of the view that corporate liquidity is influenced by the cash cycle because cash cycle measures the average amount of time that cash is tied up in operations process. Therefore a firm with a short term cash cycle is expected to have high level of cash and marketable securities, all else being equal. Working Capital is an indication of company s operating liquidity. Having enough working capital means that companies should be able to pay for all its short-term expenses and liabilities. According to Smith (1980) there is a trade-off between liquidity and profitability, which are the dual goal of working capital management. These goals imply that decisions that tend to maximize profitability tend to minimize liquidity and vice versa. Conversely, focusing almost entirely on liquidity will tend to reduce the potential profitability of the firm (Eljelly, 2004). Managing current assets directly affects the liquidity of the firm, so efficient management of current assets leads to better liquidity position for the firm. The better the liquidity position of the firm, the easier it becomes for the firm to manage its expenses and obligations. Firms have to determine the individual and joint impact of the levels of short-term investment and financing on the dual objectives of working capital management. According to Mohammed (2011) Liquidity has so far been define as a pyramid of current assets in descending order of realizability which cash holding at the top position and inventories the last. As it is clear by now, liquidity is one of the most important goals of working capital management and central task of cash management (Lamberg & Valmngm, 2009). Almazari (2014) sees it as the average time period required to convert non-cash current assets into cash; the shorter the period required the stronger the liquidity position of the business organization. Liquidity of firm can be measure with the following liquidity ratios; Current ratio = current assets/ current liabilities Quick ratio = current asset- inventory/ current liabilities 2.1.7: Rationale for Working Capital Management Working capital management is a very important component of corporate finance because it directly affects the liquidity and profitability of the company (Raheman & Nasr, 2007). It can be 29

30 expected that the way in which working capital is managed will have a significant impact on the profitability of the firm (Deloof, 2003). Working capital management is important due to many reasons; Every organization needs proper management of working capital in order to avoid the problem of illiquidity. Poor management of working capital results to liquidity problems which might lead to bankruptcy in severe cases (Nwude, 2004). Proper working capital management helps to improve sale and consequently the profit of the company. Working capital management increases cash flow speed, decreasing irrecoverable receivables and decreasing the costs to create opportunities to maximize the wealth of the shareholders. Effective working capital management consists of applying the methods which remove the risk and lack of ability in paying short term commitments in one side and prevents over investment in these assets the other side by planning and controlling current assets and liabilities (Lazaridis, & Tryfonidis, 2006). For one thing, the current assets of a typical manufacturing firm account for over half of its total assets. For a distribution company, they account for even more (Raheman & Nasr, 2007). 2.2: THEORETICAL REVIEW 2.2.1: THEORY OF WORKING CAPITAL MANAGEMENT The interaction between current assets and current liabilities is the main theme of the theory of working capital management, is concerned with the problem that arises in attempting to manage the current assets, the current liabilities and the inter-relationship that exit between them. The goal of working capital management is to manage a firm s current assets and liabilities in such a way that a satisfactory level of working capital is maintained. a Conservative theory This approach suggests that the estimated requirement of total funds should be met from long term sources, the use of short term funds should be restricted to only emergency situations or there is unexpected outflow of funds. 30

31 b Hedging theory Hedging approach is more risky in comparison to conservative approach. There are two reasons for this. First, there is, as already observed, no NWC with the hedging approach because no long term funds are used to finance short term seasonal needs, that is, current assets are just equal to current liabilities. On the other hand, the conservative approach has a fairly high level of NWC. Secondary, the hedging plan is risky because it involves almost full utilization of the capacity to use short term funds and in emergency situations it may be difficult to satisfy the short term needs. Comparison of hedging approaches with conservative approach; a comparison of the approaches can be made on the basis of (i) cost considerations, and (ii) risk considerations. Cost considerations: the cost of these financing plans has a bearing on the profitability enterprise. c Trade off theory A Tradeoff between the Hedging and Conservative Approaches. It has been shown that the hedging approaches are associated with high profits as well as high risk, while the conservative approach provide low profits and low risk. Obviously, neither approach by itself would serve the purpose of efficient WCM. A trade off between these two extremes would give an acceptable financing strategy. The third approaches strikes a balance and provides a financing plan that lies between these two extremes. The exact trade off between risk and profitability will differ from case to case depending on risk perception of the decision makers. One possible trade off could assume to be equal to maximum monthly requirements of funds during a given period manage. This level of requirement of fund may be financed through long run source and for any additional financing need short term fund may be used : Impact of Working Capital Management on Company Profitability: Theoretical base When the cash conversion cycle shortens, cash becomes free for other usages such as investing on equipment and infrastructure or innovating manufacturing and selling process or lowering the total investment in current assets (Huynh, 2012). It accordingly brings company with higher operating profitability. In contrast, when the cash conversion cycle lengthens cash is tied up in firm s operation activities, leaving little chance for other investments of this cash flow. Company profitability is decreased as a result. In those cases cash conversion cycle is said to have a negative relationship with company profitability. On the other hand, cash conversion cycle can also have positive influence on company profitability. It could be interpreted through a chain of positive impact of inventory periods and account receivable period with a negative impact of accounts payable period on the company profitability. The longer the inventory, the lower the cost involved in procrastinating of goods and/ or service supplied. 31