THE RELATIONSHIP BETWEEN WORKING CAPITAL MANAGEMENT AND PROFITABILITY OF SMALL AND MEDIUM ENTERPRISES IN NAIROBI COUNTY, KENYA MAUREEN OGANGA

Transcription

1 THE RELATIONSHIP BETWEEN WORKING CAPITAL MANAGEMENT AND PROFITABILITY OF SMALL AND MEDIUM ENTERPRISES IN NAIROBI COUNTY, KENYA BY MAUREEN OGANGA D61/78151/2012 A RESEARCH PROJECT SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE AWARD OF THE DEGREE OF MASTER OF BUSINESS ADMINISTRATION, UNIVERSITY OF NAIROBI NOVEMBER, 2015

2 DECLARATION I declare that this research project is my original work and has not been submitted for a degree any other institution/ college for academic award. Signature Date:... Maureen Oganga D61/78151/2012 This research project has been submitted for examination with my approval as the University supervisor Signature Date:... Mr. Herick Ondigo Lecturer, Department of Finance and Accounting School of Business, University of Nairobi ii

3 ACKNOWLEDGEMENTS It has been an exciting and instructive study period in the University of Nairobi and I feel privileged to have had the opportunity to carry out this study as a demonstration of knowledge gained during the period studying for my master s degree. My sincere gratitude goes to all those who in one way or another, directly or indirectly, have played a role in the realization of this research project. Let me, therefore, thank them all equally. First, Above all am indebted to the all-powerful GOD for all the blessings and strength He gave unto me and for being with me throughout the study. I am deeply obliged to my supervisor Mr. Herick Ondigo for his exemplary guidance and support without whose help; this project would not have been a success. I also take this opportunity to express my deep gratitude to my loving family, and friends who have been a constant source of motivation and support during this project. iii

4 DEDICATION The research is dedicated first to my dear Husband Mr. Laban Omondi Onono, my sons Greg Jerry Omondi and Castro Onyango Omondi who have been a great source of inspiration to my education and without his foresight, sacrifice and support I would not have gone this far. Secondly, to my special friends and colleagues whose encouragement kept me going through to the end. iv

5 TABLE OF CONTENTS DECLARATION... ii ACKNOWLEDGEMENTS... iii DEDICATION... iv LIST OF TABLES... viii LIST OF FIGURES... ix LIST OF ABBREVIATIONS... x ABSTRACT... xi CHAPTER ONE... 1 INTRODUCTION Background of the Study Working Capital Management Profitability Effects of Working Capital Management on Profitability SMEs in Nairobi County Research Problem Objective of Study Value of the Study... 6 CHAPTER TWO... 8 LITERATURE REVIEW Introduction Theoretical Review Cash Conversion Cycle Theory Tradeoff Theory The Miller- Orr Model Determinants of Profitability Cost of Credit v

6 2.3.2 Size Culture Gross profit margin Empirical Review Summary of the Literature Review CHAPTER THREE RESEARCH METHODOLOGY Introduction Research Design Population of Study Sample Data Collection Data Analysis Analytical Model Operationalization of the Variables Test of significance CHAPTER FOUR DATA ANALYSIS, RESULTS AND INTERPRETATION Introduction Demographic information Firms business activities Period the firm has been in operation Form of ownership of the enterprise Descriptive Statistics Inferential statistics Pearson s Correlation Coefficients Analysis Regression analysis Analysis of Variance Interpretation of the Findings vi

7 CHAPTER FIVE: SUMMARY, CONCLUSIONS AND RECOMMENDATIONS Introduction Summary Conclusion Recommendations of Policy And Practice Limitations of the study Suggestions for Further Research REFERENCES APPENDICES Appendix I: Data Collection Form Appendix II: List of SMEs to be included in the Sample Appendix III: Descriptive Data vii

8 LIST OF TABLES Table 4.1: Descriptive Statistics Table 4.2: Correlation analysis Table 4.3: Model's Goodness of Fit Statistics Table 4.4: Analysis of Variance (ANOVA)..29 Table 4.5: Regression Coefficients viii

9 LIST OF FIGURES Figure 4.1: SMEs business activities Figure 4.2: Period the Firm has been in operation Figure 4.3: Form of ownership of the enterprises.. 24 ix

10 ABC ANOVA - Activity Based Costing - Analysis of Variance LIST OF ABBREVIATIONS BAT Model - The Baumol-Allais-Tobin Model CCC - Cash Conversion Cycle EOQ Model - The Economic Order Quantity GDP GPM ICP JIT MRP PCA PCP RCP ROA SMEs WC WCC WCM - Gross Domestic Product - Gross Profit Margin - Inventory Conversion Period - Just-in-Time Inventory - Materials Requirement Planning - principal component analysis - Payable Conversion Period - Receivables Conversion Period - Return on Assets - Small and Medium enterprises - Working capital - Working capital cycle - Working capital management x

11 ABSTRACT Working capital is the most crucial factor for maintaining liquidity, survival, solvency and profitability of business. The theory of working capital management suggests that to have higher profitability the firm has to sacrifice solvency and maintain a relatively low level of current assets. Studies have focused on the relationships of the various WCM measures and survival within this sector and not profitability levels, which is also important for sustainability. The objective of the study was to establish the relationship between working capital management and profitability of small and medium enterprises in Nairobi County. The study adopted both descriptive and quantitative research design. The population of interest constituted SMEs in Nairobi County and a sample of 150 SMEs was used. The coefficient of determination as measured by the adjusted R-square presented a strong relationship between dependent and independent variables given a value of This depicted that the model accounted for 72.9% of the total observations while 27.1% remains unexplained by the regression model. Durbin- Watson test was used as one of the preliminary test for regression to test whether there was any autocorrelation within the model s residuals. Given that the Durbin -Watson value was close to 2 (1.901), there was no autocorrelation in the model s residuals. A number of small and medium enterprises in Nairobi County have failed to grow due to huge amounts of money, usually tied up in different components of working capital which are ill managed with lack of credit policies in some cases due to lack of proper overall working capital management. These results from the regression showed that when acting jointly, accounts receivable period, accounts payable period, inventory conversion period, cash conversion cycle and the number of years would increase the profitability of SMEs in Nairobi County. xi

12 CHAPTER ONE INTRODUCTION 1.1 Background of the Study Working capital management is concerned with the challenges that a firm encounters in managing the current assets, current liabilities and the interrelationships that exist between current assets and current liabilities. Current assets are defined as cash and other assets that are expected to be converted to cash within one year; these include cash, marketable securities, accounts receivable and inventory. Current liabilities are those liabilities which are to be paid within one year out of the current assets or earnings of the firm and include accounts payable, bills payable, bank overdraft and outstanding expenses (Ross, Westerfield, & Jordan, 1991). Working capital management (WCM) is considered a fundamental element of an organization s financial health as it aims at maintaining an optimal balance between each of the working capital components which are made up of the current assets and current liabilities. The level of current assets is a key factor in a company s liquidity position, and hence a company must be able to generate enough cash to meet its short term needs if it is to be a going concern, therefore working capital management is a key factor in the company s long term success (Watson & Head, 2007). Dong & Su (2010) noted that working capital management reflects the time interval between actual cash expenditures on a firm s purchase of productive resources and the recovery of cash receipts from sales during operations. The most important issue in working capital management is the maintenance of liquidity in the day to day operations of the firm so as to prevent creditors and suppliers whose claims may fall due in the short term from exerting unwarranted pressure on the management and to ensure the smooth running of the firm. Whereas maintaining liquidity is a key factor in working capital management, it directly affects the profitability of the firm since liquid assets give the lowest returns thus inconsistent with the goal of shareholders wealth maximization. Therefore working capital management is an essential part of financial management and contributes significantly to a firm s wealth creation as it directly influences Organizational profitability and liquidity (Akoto et al 2013). Profitability 1

13 refers to the ability of a firm to earn profit and liquidity is the precondition to ensure that firms are able to meet their short-term obligations. Makori & Jagongo (2013) in their research stated that the conflict in the working capital management objectives of profitability and liquidity requires working capital (WC) to be managed efficiently and effectively in order to provide the firm with maximum returns on assets and minimize payments for its liabilities. Omesa et al (2013) stated that in order to improve the effectiveness of working capital, it is important to shorten the working capital cycle (WCC). The cycle measures the time for paying for the goods supplied by creditors to receiving cash from the debtors after sale. Agha (2014) stated that there is a strong linear relationship between profitability of the firm and its working capital efficiency and effectiveness. The ability of financial managers to effectively and efficiently manage their receivables, inventories and payables has a significant impact on the success of the business and on profitability as well. A firm needs to have working capital policies on the management of stocks, debtors, cash and short term investments in order to minimize the possibility of managers making decisions which are not in the company s best interest. The policies should take into consideration the nature of the business because different businesses will have different working capital requirements Working Capital Management Working capital management (WCM) is a process that involves planning and controlling current assets and liabilities in a manner that eliminates the risk of inability to meet short term obligations and avoid excessive investment in these assets (Lamberson, 1995). Working capital represents the source and use of short-term capital. Working capital can be Gross working capital which refers to the firm s investment in current assets. Current assets are assets which can be easily converted into cash within the shortest period usually one year and include cash, short term securities, debtors and stock (Power et al, 2005). To effectively manage working capital a firm needs to direct its attention to three main working capital proxies accounts receivables, accounts payable and inventory management. The accounts receivables collection period should be determined through credit management, collection policy and credit analysis, this is determined at any given time by volume of trade 2

14 receivables and sales revenue time the days in a year. Similarly the accounts payable period should be determined for a firm to decide whether it should take advantage of discounts offered and pay less, or not take the discount and finance additional cost from other sources of finance. Accounts payable forms the largest category of short term finance (Njoroge, 2012). Inventory measures involve determination of the inventory turnover period and inventory holding costs Profitability Profitability refers to the ability of a business organization to earn profit and liquidity is the precondition to ensure that firms are able to meet their short term obligations. Niresh (2012) in his study stated that while the immediate survival of the business anchors on liquidity, its long term survival and growth depends on profitability. Generally the profit refers to a positive gain from an investment or business operations after subtracting all expenses. Net operating profit refers to the amount of money that a firm has earned after the cost of goods sold and operating expenses have been deducted. This normally indicates whether the firm is making more than it spends or spending more than it makes The most important goal in operating a firm is to earn an income for its owners; a business that is not profitable cannot survive (Pandey, 2010). Profitability is a measure of the amount by which a firm s revenues exceed its relevant expenses, investors are interested in dividends and appreciation in market price of stock and therefore pay more attention to profitability ratios. Managers on the other hand are interested in measuring the operating A return is determined by assessing earnings relative to the level and sources of financing, the key measures of profitability are return on capital employed, return on assets and return on investments Effects of Working Capital Management on Profitability Working capital management is a vital function in financial management decision of any firm. Inefficient or efficient management of working capital has profitability and liquidity implications. Working capital can be seen as a metric for evaluating a company s operating liquidity. A positive WC position indicates that a company can meet its short term obligations, and on the other hand a company s WC position signals its operating efficiency. The management of a firm s liquidity is necessary for all businesses small or large. When a firm does not manage its liquidity well, it will have cash shortages and as a result experience 3

15 problems paying its obligations when they fall due. The relationship between the current liabilities and current assets determines the liquidity position of firms (Dong and Su, 2010). Smith (1980), states that WCM is important because of its effects on the firm s profitability and risk and consequently its value. An efficient working capital management can enable a firm to react quickly and genuinely to unexpected changes in economic environment and gain competitive advantages over its rivals (Alshubiri, 2011). An optimal working capital aims to ensure a balance between profitability and liquidity, to achieve this objective finance managers have to play the critical role of continuous monitoring of working capital components such as accounts receivables and accounts payables SMEs in Nairobi County In Kenya classification of enterprises is primarily by the number of employees engaged by firms (Republic of Kenya, 1986). The firms that employ 5 to 49 and 50 to 99 workers are classified as small scale and medium scale enterprises respectively. Nairobi County is home to the SME sector which consists of a mixture of dynamic enterprises involved in an array of activities that are concentrated in the urban areas. The contribution of SMEs is more than double that of large manufacturing sector which stands at 7% of the gross domestic product (Republic of Kenya, 2003). According to the Central Bureau of Statistics (1999) SMEs generate 75% of all new jobs annually. SMEs in Nairobi County tend to find a wide array of opportunities because of the concentration of government departments, large companies and local and foreign organizations which require diverse goods and services which the SMEs can cater for. The threat to SMEs survival and longevity problems are of a financial nature (Jindrichovska, 2013). A number of small medium enterprises in Kenya have over the years failed to grow to large enterprises as envisaged in their conceptual plans mainly due to improper structures especially regarding liquidity and working capital (Ministry of Planning and National development, 2003). Most SMEs are faced with huge amounts of money usually tied up in different components of working capital which are ill managed with poor, or lack of credit policies in some cases due to lack of financial management capacity (Njoroge, 2012) 4

16 1.2 Research Problem Working capital is the most crucial factor for maintaining liquidity, survival, solvency and profitability of business. The theory of working capital management suggests that to have higher profitability the firm has to sacrifice solvency and maintain a relatively low level of current assets (Hill, 2013). Management of working capital is an essential task to the finance manager who has to ensure that the amount of WC available is neither too large nor too small for its requirement. Sunday (2011) established that most SMEs do not engage their working capital in such a way as to enjoy maximum profit and their combination of debtors management strategy, cash management, account payable (or creditors) and stock management strategy are largely suboptimal for efficient operations and future growth. Abdul and Afza (2010) analyzed the impact of working capital management on firms profitability in Pakistan for 204 manufacturing firms listed in Karachi Stock Exchange over the period The findings of the study was that net operating profitability is negatively associated with inventory turnover in days, average payment period, cash conversion cycle and net trade cycle. This is in contrast to Mathuva (2010) who examined the influence of working capital management components on corporate profitability on a sample of 30 listed firms in Nairobi Securities Exchange for the period and established that a positive relationship exists between Inventory Conversion Period, Average Payment Period and Profitability. However the researcher s findings were similar in conclusion that overall in manufacturing sector WCM has a significant impact on profitability and play an important role in the creation of shareholder value and in order to be more profitable firms should take shortest time to collect cash from customers. Makori & Jagongo (2013) analyzed the effect of Working Capital Management on Firm s Profitability using balanced panel data of five manufacturing firms and five construction firms listed on the Nairobi Securities Exchange for the period and found a negative relationship between profitability, number of day s accounts receivable and cash conversion but a positive relationship between profitability and number of days of inventory and number of day s payable. 5

17 Kiio (2014) assessed the effect of working capital on financial performance of 43 manufacturing firms in Nairobi County from a population of 424 manufacturing firms in the 12 sectors as categorized by Kenya Association of Manufacturers in Nairobi County. The study established that there is a significant effect of working capital management on financial performance of manufacturing firms in Nairobi County. Notably, most studies have concentrated on the manufacturing sector in Kenya and particularly firms listed in the Nairobi Stock Exchange. The manufacturing sector contributes about 10% of Kenya s GDP and so using results of studies focusing on this sector to generalize for all other sectors may not be representative. The researches that have been conducted in both developed and emerging markets on the relationship between working capital proxies and profitability of firms have provided varied results and therefore it is noteworthy to conduct to a study on the possible outcomes of the levels of the working capital components on the profitability of the SMEs as opposed to only identifying factors influencing the practices. The studies have also focused on the relationships of the various WCM measures and survival within this sector and not profitability levels, which is also important for sustainability. It is the mixed results between working capital measures and profitability in diverse sectors of the economy that has motivated this study to seek to answer the following question: What is the relationship between working capital management and profitability of the small and medium enterprises in Nairobi County? 1.3 Objective of Study To establish the relationship between working capital management and profitability of small and medium enterprises in Nairobi County 1.4 Value of the Study The research findings will be of importance to the government in the formulation of regulations concerning working capital management for the various sectors which contribute to economic growth of the country. In particular, the SMEs have been critical in job creation and driving economic growth. The findings from the study will be useful to companies which invest substantial amount in working capital and therefore face challenges with working capital management practices and techniques. The information from the study will assist the Chief Executive Officers of companies in the designing of competitive strategies with regard to 6

18 working capital management and simultaneously improve their profitability and create more value for their shareholders. The findings of the study will also be useful to other researchers and academicians since it will trigger a need to conduct further research in the same subject matter or related topics in order to add knowledge to the existing body with regard to working capital management and profitability. 7

19 CHAPTER TWO LITERATURE REVIEW 2.1 Introduction The chapter focuses on the concepts of working capital management and the relationship with liquidity in SMEs. It highlights Concepts, Ideas, Theories and empirical studies and findings. 2.2 Theoretical Review This chapter reviews literature relating to working capital management and profitability. The section will highlight concepts, theoretical and empirical literature of working capital management and profitability Cash Conversion Cycle Theory The CCC represents the interaction between the components of working capital and the flow of cash within a company, and can be used to determine the amount of cash needed for any sales level. The focus is on the length of time between the acquisition of raw materials and other inputs and the inflows of cash from the sale of finished goods and represents the number of days of operation for which financing is needed. Richard and Laughlin (1980) argued that traditional ratios such as current ratio, quick acid test and cash ratios has not been able to provide accurate information about working capital and insisted on using dynamic liquidity measures in WCM, where dynamic refers to the inflows and outflows of cash as a product of acquisition, sales payment and collection process done over time. According to Arnold (2008) the shorter the CCC the fewer are the resources needed by the company whereas the longer the cycle the higher was the investment in the WC, but in turn the longer cycle would increase sales which could lead to profitability. At the same time this longer cycle which will lead to a higher investment could also rise faster than the benefits of the higher profitability. Shin and Soenen (1998) have argued that it is important for firms to shorten the CCC as managers can create value for their shareholders by reducing the cycle to a reasonable minimum. 8

20 They further argued that a longer conversion cycle might indicate that company sales are rising and that the company can compete by having relaxed credit policies or high inventories. A higher CCC on the contrary can actually hurt a company s profitability by increasing the time that cash is tied to non interest bearing accounts such as accounts receivables; by shortening the CCC the company s cash flow will have a higher net present value because cash is received quicker. This is consistent with the observation made by Gill et al (2006) that a well managed working capital promotes a company s well being on the market in terms of liquidity and also acts in favor of growth of shareholder s value Tradeoff Theory The theory postulated by Smith (1980), indicated the importance of trade off between the dual goals of working capital management which are Profitability and Liquidity. Niresh (2012) in his study stated that while the immediate survival of the business anchors on liquidity, its long term survival and growth depends on profitability. The level of working capital in a firm affects both the profitability of the firm as well as risk levels. Profitability refers to the ability of the firm to earn profit and risk is the probability that a firm may not able to meet its obligation as and when they fall due. The greater the working capital the more liquid a firm was and therefore the lesser the risk of insolvency and consequently decrease in profitability of a firm while on the other hand, the lower the working capital the less liquid a firm is and hence the greater the risk of recording a loss The Miller- Orr Model The Miller-Orr model developed by Miller and Orr (1966) assumes that net cash flows are normally distributed with a zero value of mean and standard deviation. The model provides for two control limits- the upper control limit and the lower control limit as well as a return point. If the firm s cash flows changes randomly and hit the upper limit, then it takes appropriate corrective action to come back to a normal level of cash balance and when the firm s cash flows decreases below the lower limit, it also takes the appropriate corrective control measures. A firms cash must be maintained at an ideal level, it may also result to increased cost due to mishandling, theft or waste; too much or inadequate level of cash balance for instance can lead to stopping in business operations (Padachi, 2006). 9

21 A firm will sale marketable securities to return to the correct cash levels and will purchase marketable securities if above the required limit. Firms set lower limits (L) depending on how much risk of cash shortfall the firm is willing to tolerate. The return point is the cube root of the square root of 3 multiply by conversion cost multiply by variance of daily net cash flows divided by 4 times daily opportunity cost. A company may be profitable but with no liquid cash which can result to operation interruptions, the company can also be forced into winding up by its creditors. 2.3 Determinants of Profitability Velmugurun and Annalaksmi (2015) noted that liquidity management is a very important issue in the growth and survival of a business and the ability to handle the tradeoff between the two is a source of concern for financial managers. Therefore for firms to achieve the desired liquidity and maintain profitability, financial managers need to strike a balance unto the factors affecting liquidity and profitability Cost of Credit Ndagijimana and Okech (2014) found out that SMEs are normally perceived to be riskier than larger corporates. In most cases, SMEs do not have adequate collateral to provide to mainstream banking institutions to enable them access credit. Additionally, the lack of proper structures and book keeping become a challenge in assessing the operations of SMEs. Consequently, majority of the SMEs get their finances from friends, micro financing institutions as well as shy-locks that unfortunately charge very high interest with a number of clauses not revealed at the time of advancing the financing support. This affects SMEs negatively in the process due to high interest rates charged since it becomes expensive to service thereby causing a liquidity problem Size Velmuguran and Annalaksmi (2015) found out that size of a firm positively influences liquidity and that a unit increase in size shall increase liquidity by units.whereas an increase in company assets leads to higher level of profitability. Monika (2013) found out that achieving desired liquidity for a firm requires structures and qualified personnel to manage the systems. SMEs generally do not have the capacity to hire and maintain such staff. If the SME survives and graduates to the next level with increased resources, it was able to put in place requisite 10

22 structures which would then enhance the ability to monitor and control liquidity appropriately. Large companies have the ability to set up adequate policies and to employ qualified staff to ensure success in maintaining optimal liquidity positions Culture Graham and Coyle (2000) noted that sometimes national culture creates credit risk within a specific country. In some countries there is an acceptance that debts can be paid late and only after persistent demands from the supplier. Customers who pay late are simply conforming to what is normally expected, and would not see such as being improper. Hall and Silva (2005) further state that cultures vary in the extent that attitudes are relaxed towards late payment of bills or, indeed, the observance of formal contracts. SMEs are always managed by small teams or family members and it could be expected that decision-making in these companies is more affected by national culture than in huge multinationals which have many standardized protocols Gross profit margin Firms with a higher Gross Profit Margin (GPM) have more incentives to use trade credit as a form of price discrimination in order to increase sales and consequently their profit, which was previously confirmed by García-Teruel and Martínez-Solano (2010), and Petersen and Rajan (1997). Preve and Sarria-Allende (2010) should keeping optimal inventory levels be especially important for those whose profits are largely based on asset rotation rather than margin on sales. Besides, it could be that for firms with a higher GPM the costs of holding extra inventories are smaller than the extra profits they could make by ensuring that they are always able to sell when getting an unexpected rush order. Furthermore, it is not unlikely that a SME that is able to earn a high GPM produces special or high quality products which makes it an attractive customer. This gives such a SME negotiation power, which for example means that suppliers are willing to grant longer payment terms. Finally, the combined effect of the increased inventory levels and accounts receivable are larger than the increase of the accounts receivable leading to a longer CCC in firms with a higher GPM. 11

23 2.4 Empirical Review There are several researchers, both local and international, who have carried out studies on the relationship between working capital, its measures and financial performance, profitability or liquidity and they have provided their evidence to support the various findings. Internationally, Eljelly (2004) tested the relationship between profitability and liquidity measures for 27 Saudi companies, from three non-financial sectors, over the period The independent variables used in the regression models as measures of liquidity were the current ratio and the CCC. Size was included as a control variable. The dependent variable was measured using net operating income before depreciation deflated by sales. The overall results showed that liquidity measures are significant and have negative relationship with profitability, and the importance of those measures differ across industries. Raheman and Nasr (2007) studied the effects of selected WCM and liquidity measures on the profitability of 94 Pakistani companies listed on Karachi Stock Exchange over the period They ran pooled least squares and generalized least squares regression models with cross section weights to test the relationship between profitability; the dependent variable, measured as the net operating income deflated by total assets and the following independent variables; the RCP, the ICP, the PCP, the CCC, and the current ratio. They also used size, leverage, and the ratio of financial assets to total assets as control variables. The results showed significant and negative relationships between profitability and all WCM and liquidity measures. Furthermore, size showed a significant and positive relationship with profitability, leverage and the ratio of financial assets to total assets showed significant and negative sign with profitability. Abdul and Afza (2010) analyzed the impact of working capital management on firm s profitability in Pakistan for 204 manufacturing firms listed in Kerachi Stock Exchange for the period The researchers used Net Operating Profitability to measure performance whereas the variables for working capital management used included Average Collection Period, Inventory Turnover in Days, Average Payment Period, Cash Conversion Cycle and Net Trade Cycle. Balanced Panel Data method was used and the results indicated that Net Operating 12

24 Profitability is negatively associated with average collection period, inventory turnover in days, average payment period, cash conversion cycle and net trade cycle. In addition, the study showed a significant negative correlation between financial debt ratio, current liabilities to total assets ratio and profitability. However, the size of the firm was found to have a positive relation to profitability. The researchers concluded that overall in manufacturing sector, working capital management has a significant impact on profitability and play an important role in the creation of shareholders value. They recommended that in order to create value for shareholders, firms must try to lower the number of days in inventory, cash conversion cycle and net trade cycle to a reasonable level. Arshad & Gondar (2013) examined the relationship between working capital management and profitability of Pakistan Cement Sector. The study adopted quantitative research method to test the research hypothesis. The study used data of 21 listed cement companies in Karachi Stock Exchange for a period of 7 years The dependent variable of the study was return on assets whereas the independent variables were the current ratio, quick ratio, net current assets to total assets ratio, working capital turnover ratio and inventory turnover ratio. The study established that current ratio and net current ratio on total ratio have significant positive effect on firm profitability whereas quick ratio has a negative significant effect on firm s profitability. The research also established that working capital turnover ratio and inventory turnover ratio have no statistical significant effect on profitability. The study recommended that profitability of firms may be increased by shortening of the inventory period. Akoto, Awunyo and Angmor (2013) examined the relatioship between working capital management practices and profitability of listed manufacturing firms in Ghana from the secondary data of all the 13 listed manufacturing firms for the period Using panel data methodology, they found a significant negative relationship between profitability and accounts receivable days. The study also established that there exist a significant positive relationship between profitability and cash conversion cycle, current assets ratio, firm size and current assets turnover. The study concluded that managers can create incentives in order to reduce their accounts receivable to 30 days and in addition recommended enactment of local laws to protect indigeneous firms by restricting imports of cheaper commodities in order to promote demand for locally manufactured goods. 13

25 Velmuguran and Annalaksmi (2015) studied the determinants of liquidity of the select Indian Tractor companies over the period The sample size was restricted to six companies out of the ten tractor companies in operation owing to lack of non availability of financial statement for a continuous period of They employed correlation analysis to find the variables associated with liquidity; current ratio was introduced as dependant variable and size of firm, age, return on investment, inventory turnover ratio, dividend payout ratio, growth, leverage and asset turnover ratios are measured as the independent variables. The findings were that out of the eight independent variables only three variables namely age, inventory turnover ratio and leverage were found to be significant at one percent the rest at less than one percent level. The study also established by multiple regression size, return on investment, inventory turnover ratio, growth in sales, leverage and asset turnover ratio collectively influence liquidity. Locally, Mathuva (2010) examined the influence of working capital management components on corporate profitability on a sample of 30 listed firms in Nairobi Securities Exchange for the period The sampled companies included 4 Agricultural companies, 6 Commercial and service companies, 13 Industrial and allied companies and 7 Alternative investment segment. The study used Net Operating Profit to measure Profitability whereas Accounts Collection Period, Inventory Conversion Period, Average Payment Period and Cash Conversion Cycle were used as proxies to working capital. Other Variables used included Company Size, Leverage, Fixed Financial Assets, Variability, GDP Growth rate, Age and Industry. The results indicated that a negative relationship exists between Accounts Collection Period, Cash Conversion Cycle and Profitability. A positive relationship exists between Inventory Conversion Period, Average Payment Period and Profitability. Similarly, the study also established that the coefficients on the other variables were significant such as net operating income increases with the company size, financial fixed assets, increase in company s age and increase in variability of net operating profit. However, the study found out that increase in leverage and use of debt resulted to decrease in net operating profit. The study concluded that more profitable companies take the shortest time to collect cash from their customers; the longer the company takes to pay its creditors the more profitable it is since by delaying payment to creditors, the company was able to effectively acquire a cheap and 14

26 flexible source of financing which can be used to generate additional profits for the company and lastly, shortening the cash conversion cycle improves profitability of the company. Mutungi (2010) carried out a study on the relationship between working capital management and financial performance of oil marketing companies in Kenya. The study noted the fact that working capital in any firm is critical and requires conscious balance between the components on the working capital namely cash receivables, payables and inventory. The objectives of the study was to establish the working capital management policies among oil marketing firms in Kenya and to examine the relationship between working capital management and profitability in oil marketing firms in Kenya. From the correlation analysis the study concluded existence of aggressive working capital policy in the oil sector. Makori & Jagongo (2013) analyzed the effect of Working Capital Management on Firm s Profitabilty using balanced panel data of 5 manufacturing firms and 5 construction firms listed on the Nairobi Securities Exchange for the period The researchers used Pearson s Correlation and Ordinary Least Square Regression models to establish the relationship between working capital management and firm s profitability. The study found a negative relationship between profitability, number of day s accounts receivable and cash conversion but a positive relationship between profitabilty and number of days of inventory and number of day s payable. They also found out that control variables such as financial leverage, sales growth, current ratio and firm size have significant effect on the firm s profitabilty. They concluded that Management can create value for their Shareholders by reducing the number of day s accounts receivable and increasing inventories to a reasonable level. The researchers suggested that to increase the profitability of the firms, firms can take longer to pay their creditors in as far as they do not strain their relationships with the creditors and effective and efficient utilization of organization s resources through a careful reduction of cash conversion cycle to its minimum. Nyabwanga,, Ojera and Nyakundi (2013) carried out a financial diagnosis of the SMEs financial performance by focusing on their liquidity, solvency and profitability positions using ratio analysis. Data for the study covered the period and was obtained from the financial statements of three SMEs which were purposively sampled from the SMEs operating in Kisii Municipality. The sampled SMEs were those which had financial statements for the years under consideration. Data collected through the analysis of key ratios were analyzed using the 15

27 mean, standard deviation, coefficient of variation, Student-t test and through the use of the Altman s Z-score model. The findings of the study showed that the liquidity position of the SMEs was on average low; their solvency was low and their financial Health was on average not good. Further, the results show that there is a significant impact of current ratio, quick ratio and Debt to Total Assets ratio on Return on Assets (ROA). The results of the study demonstrate that the liquidity position of the SMEs was well below the acceptable global norm of 2 for current ratio and 1 for quick ratio. Further, the results indicated that the financial health of the SMEs needed to be improved hence the recommendation that SMEs make liquidity, solvency management and financial stability an integral driver of their policy frameworks. Ndagijimana and Okech (2014) undertook a study on the determinants of working capital management practices in small and medium enterprises in Nairobi County. The study specifically examined how management of accounts receivables, accounts payables and cash conversion cycle affect working capital management practices in the SMEs. The study adopted the descriptive research design and data was analyzed by use of regression analysis to obtain both descriptive and inferential statistics. The findings showed that there was a positive relationship between accounts receivables, accounts payables and working capital management practices in SMEs. The study further concludes that there is cash conversion cycle also affect working capital management practice in small medium enterprises. Kiio (2014) assessed the effect of working capital on financial performance of manufacturing firms in Nairobi County. Stratified random sampling method was used to select 43 manufacturing firms from a population of 424 manufacturing firms in the 12 sectors as categorized by Kenya Association of Manufacturers in Nairobi County. The researcher relied on secondary data from audited financial statements to obtain data relating to the research question the data was analyzed through the use of regression and correlation analysis. The study established that there is a significant effect of working capital management on financial performance of manufacturing firms in Nairobi County. 16

28 2.5 Summary of the Literature Review Several studies stressing on the importance of effective WCM have been carried out. The studies from developed and emerging markets indicate that firms should adopt a familiar front for liquidity and profitability management to reach optimal working capital and to reach optimal WCM firms should control the tradeoff between profitability and liquidity accurately. Moreover, with the help of Cash Conversion Cycle theory and the Miller- Orr Model and tradeoff theory WCM is well aligned to existing theories in finance. The theories seek a balance between two extremes; aggressive and conservative WCM policies in order to reduce the costs and maximize the benefits associated with both extremes. Past empirical studies provide useful information of what has so far been determined by other researchers in this topic and the gaps that remain unresolved. A review of most of these studies reveals a relationship between WCM and profitability of firms in general with the exception of small and medium enterprises. However the differences in the variables tested and the context of the various studies makes it difficult to generalize. The other notable gap is that most studies have looked at WCM in terms of financing and investing policies and seem to have ignored or given less emphasis to the effect of WC policies such as inventory policy, AR policy, cash management policies and their possible influence on Stock return of firms. Broadly speaking, not much research is available that directly compares the WCM policies; aggressive and conservative policies on one side and profitability as the dependent variable. The study will seek to address this gap by specifically investigating the various policies adopted by firms to control their working capital and how these have impacted their overall value and growth over a period of time. 17

29 CHAPTER THREE RESEARCH METHODOLOGY 3.1 Introduction This chapter covers the research methods that the study was adopted to satisfy the study objective. These include research design, population of study, sample design, data collection instrument, and data analysis. 3.2 Research Design Research design determines the general research approach or strategy to be adopted by a study. This study adopted a descriptive research design whose data was derived from investigation results generated from questionnaires which was administered to the selected participants. According to Mugenda and Mugenda (2003) a descriptive survey research is probably the best method in collecting original data for the purpose of describing a population which is too large to observe. Further, Ndagijimana and Okech (2014) posits that this approach yields the best results as participants would provide the necessary feedback without undue inconvenience and therefore facilitates coverage of the desired sample in a timely manner. 3.3 Population of Study Population refers to the entire group of people or elements of interest that the researcher wishes to investigate, According to Ngechu (2004), a population is a well-defined or set of people, services, elements, and events, group of things or households that are being investigated. The units of analysis were the members or elements of the population. The target population for this study was 1500 SMEs registered in Nairobi, acquired from the Nairobi County government records. However for the purpose of this study only SMEs that have been in operation for five years and above was considered to form the target population since it is assumed that this length of time could provide meaningful measures of performance. This reduces the number of SMEs to 1500; the period 2009 to 2013 was used for the purpose of this study. 18

30 3.4 Sample The study used probability sampling techniques to create a sampling frame for SMEs. Stratified sampling techniques were adopted to ensure that SMEs engaged in different activites are represented. Orodho (2003) states that stratified sampling are applicable if a population from which a sample is to be drawn does not constitute a homogenous group. According to Mugenda and Mugenda (2004) a sample size of between 10% and 30% is a good representative of a target thus, 10% of the accessible population is enough for the sample size, therefore, for this study a sample of 150 SMEs was used. To realize this research for ease of administration the strata for this study constituted divisions into manufacturing, information and communications technology, trading, service and other firms. 3.5 Data Collection Creswell (2003) defines data collection as a means by which information is obtained from the selected subjects of an investigation. The data was collected from both secondary and primary source through self-administered data sheets. The study used a data collection form to collect both the dependent and independent variables data. Independent variables used, the Accounts receivables period, Accounts payable period, Inventory conversion Period, and Cash conversion Cycle while dependent variable was firms profitability. Data was collected for the period 2009 to Data Analysis Both quantitative and qualitative approaches were applied to process and analyze the data. Quantitative analysis was with the listing and coding open-ended data, which together with precoded quantitative data was digitalized using the Statistical Package for Social Sciences (SPSS). The data was cleaned, verified and run using SPSS to generate descriptive statistics, and significance tests. In the qualitative dimension, data was listed and organized under various thematic areas based on the research objectives. The qualitative data was analyzed on the basis of the thematic areas and interpretation of the data drawn. 19

31 3.6.1 Analytical Model The study conducted a simple regression analysis so as to establish how the dependent variable profitability relates to the independent variables. The researcher applied the regression model to elucidate the strength of independent variables the accounts receivables period, accounts Payable Period, Inventory conversion period, cash conversion cycle, sales growth influence on the dependent variable profitability. The regression equation was of the form: Y = +β1x1+β2x2+β3x3+β4x4 +β5 X 5+B6 X6+ɛ Y= profitability as measured by Net operating profit α = represent the model Constant (intercept) β1 β5 = regression coefficient which measures unit changes included in Y for each unit change in X variables X1 = The Accounts receivables period, X2 = Accounts payable period, X3 = Inventory conversion Period, X4 = Cash conversion Cycle X5 = Number of years X6 = Sales growth ɛ = Error term. 20

32 3.6.2 Operationalization of the Variables Variable Measurement Profitability was measured by Net operating profit Net profit before taxes x 100% Net sales Accounts Receivable Period Inventory Conversion Period Accounts Payables Period Cash conversion Cycle Sales growth Age of Firm Control variable Accounts Receivables x365 Credit Sales Inventory x365 Cost of Sales Accounts Payables x365 Credit purchases ACP+ICP-APP ROI No of years in operation Source: Research findings Test of significance Inferential statistics which include analysis of variance (ANOVA) was used to test the significance of the overall model at 95% level of significance. According to Mugenda (2008) analysis of variance is used because it makes use of the F test in terms of sums of squares residual. Coefficient of determination (R 2 ) was used to predict the effect of independent variables to the dependent variables. The model made use of regression and analysis of variance (ANOVA) to reveal the relationship between independent variables and dependent variable. 21

33 CHAPTER FOUR DATA ANALYSIS, RESULTS AND INTERPRETATION 4.1 Introduction This chapter is a presentation of results and findings obtained from field responses and data, broken into two parts. The first section deals with the background information, while the other section presents findings of the analysis, based on the objectives of the study as explored by the data collection form where both descriptive and inferential statistics have been employed. 4.2 Demographic information The demographic data seeks to establish the general information of the participants. From the data collection form, the following demographic statistics were established, firms business activity and the period the firm has been in operation. They are explained in the subsections below Firms business activities. The study sought to determine the business activities that the SMEs operated in Nairobi County. The figure 4.1 shows the findings on activities which the small and medium enterprises operated in Nairobi County. Figure 4.1: SMEs business activities Source: Research Findings 22

34 From the responses in the data collection form it was noted that majority of the participants(39.4%) indicated that they businesses operated in the trading operations. This was closely follewed by respondents who stated that businesses were operational in the information and communication technology activities. This covered a frequency of 33 respondents and was about 25.0% of the total respondents. Participants who stated that their small and medium enterprises was in the service activities followed closely after with a frequency of 29 participants which calculated to 22% of the total respondents. 13.6% of the participants indicated that their businesses operated in manuucturing activities while none of the respondents indicated thar their firms operated in any other form of activity from the ones provided Period the firm has been in operation The study sought to determine the number of years the small and medium enterprises had been in operations. The findings are shown in the figure 4.2 below Figure 4.2: Period the firm has been in operation Source: Research findings From the study it was noted that majority of the respondents (52%) indicated that their firms had been in operation for a period of over 10 years. This was closely followed by respondents who 23

35 stated that their small and medium enterprises had been in operation for a period of 1-5 years and this was noted to cover 25% of the total respondents. It was noted from the findings that 23% of the respondents stated that their firms had been in operation for a period of 5-10 years. It was therefore noted that majority of the SMEs had been in operation long enough for the respondents to provide sufficient and relevant data on the relationship between working capital management and profitability of SMEs in Nairobi County Form of ownership of the enterprise The study also sought to determine the forms of ownership of the firms. The results from the analysis of the findings is discussed in the figure 3 as shown Figure 4.3: Form of ownership of the enterprises Source: Research Findings From the analysis of the findings it was noted that majority of the respondents (58%) indicated that their firms were private enterprises. This was closely followed by respondents (33%) who indicated that their firms were limited companies. The least frequency was of the respondents indicated that they operated in joint ventures carrying 9% of the total respondents. 24