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Full Project – The effect of working capital management on the performance of manufacturing firms

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CHAPTER ONE

1.0 INTRODUCTION

1.1 THE BACKGROUND OF THE STUDY

Many researchers have studied working capital from different views and in different environments. The following ones were very interesting and useful for our research: (Eljelly, 2004) elucidated that efficient liquidity management involves planning and controlling current assets and current liabilities in such a manner that eliminates the risk of inability to meet due short-term obligations and avoids excessive investment in these assets. The relationship between profitability and liquidity was examined, as measured by current ratio and cash gap (cash conversion cycle) on a sample of joint stock companies in Saudi Arabia using correlation and regression analysis. The study found that the cash conversion cycle was of more importance as a measure of liquidity than the current ratio that affects profitability. The size variable was found to have significant effect on profitability at the industry level. The results were stable and had important implications for liquidity management in various Saudi companies.

First, it was clear that there was a negative relationship between profitability and liquidity indicators such as current ratio and cash gap in the Saudi sample examined.

Second, the study also revealed that there was great variation among industries with respect to the significant measure of liquidity. (Deloof, 2003) discussed that most firms had a large amount of cash invested in working capital. It can therefore be expected that the way in which working capital is managed will have a significant impact on profitability of those firms. Using correlation and regression tests he found a significant negative relationship between gross operating income and the number of days accounts receivable, inventories and accounts payable of Belgian firms. On basis of these results he suggested that managers could create value for their shareholders by reducing the number of days’ accounts receivable and inventories to a reasonable minimum. The negative relationship between accounts payable and profitability is consistent with the view that less profitable firms wait longer to pay their bills.

(Ghosh and Maji, 2003) in this paper made an attempt to examine the efficiency of working capital management of the Indian cement companies during 1992 – 1993 to 2001 – 2002. For measuring the efficiency of working capital management, performance, utilization, and overall efficiency indices were calculated instead of using some common working capital management ratios. Setting industry norms as target-efficiency levels of the individual firms, this paper also tested the speed of achieving that target level of efficiency by an individual firm during the period of study. Findings of the study indicated that the Indian Cement Industry as a whole did not perform remarkably well during this period. (Shin and Soenen, 1998) highlighted that efficient Working Capital Management (WCM) was very important for creating value for the shareholders. The way working capital was managed had a significant impact on both profitability and liquidity. The relationship between the length of Net Trading Cycle, corporate profitability and risk adjusted stock return was examined using correlation and regression analysis, by industry and capital intensity. They found a strong negative relationship between lengths of the firm’s nettrading Cycle and its profitability. In addition, shorter net trade cycles were associated with higher risk adjusted stock returns.

(Smith and Begemann 1997) emphasized that those who promoted working capital theory shared that profitability and liquidity comprised the salient goals of working capital management. The problem arose because the maximization of the firm’s returns could seriously threaten its liquidity, and the pursuit of liquidity had a tendency to dilute returns. This article evaluated the association between traditional and alternative working capital measures and return on investment (ROI), specifically in industrial firms listed on the Johannesburg Stock Exchange (JSE). The problem under investigation was to establish whether the more recently developed alternative working capital concepts showed improved association with return on investment to that of traditional working capital ratios or not. Results indicated that there were no significant differences amongst the years with respect to the independent variables. The results of their stepwise regression corroborated that total current liabilities divided by funds flow accounted for most of the variability in Return on Investment (ROI). The statistical test results showed that a traditional working capital leverage ratio, current liabilities divided by funds flow, displayed the greatest associations with return on investment. Wellknown liquidity concepts such as the current and quick ratios registered insignificant Raheman & Nasr associations whilst only one of the newer working capital concepts, the comprehensive liquidity index, indicated significant associations with return on investment.

Effective working capital management on the profitability of organizations involve two closely related approached. Firstly, basic policy must be set regarding the desired levels of each asset component. Secondly, on administrative frame work must be set up for managing and controlling these within the policy of guidelines. Different firms approach the problem of working capital differently. Typically, management relies on the use of ratio analysis and similar rules of thumbs to determine the efficiency with which working short term resources are allocated. The advent of computer and the increasing use of financial models such as economic order quantity (EOQ), optimum cash level (OCL) has allowed firms to apply more formal method to gauge the effectiveness of their working capital management strategy.

Optimum cash level (OCL) refers to the level of cash a company can hold to balance the holding cost of carrying cash (i.e. interest forgone on marketable securities) against fixed cost of transferring marketable securities to cash or vice versa (Lucey, 1999). In managing working capital of corporate organizations, there is the need to segregate current assets into components units for policy formulation and exception. This is because these assets are of different nature which makes it imperative that they should be considered and managed under unique approaches though with an objective.

However, manufacturing firms either new or old must first and foremost plan for the short term survival of the business before making the long term survival as their priority. Therefore, the survival of business entities depends on the availability of adequate working capital management as well as the need for its effective management to enhance optional use.

However, there are number of manufacturing firms that have either not doing well or at the verge of collapse, some of the problems are either dues to bad management of resources or lack of ability to maintain sufficient working capital for their business. Working capital is the most important assets for the operations of the business. Working capital are the basic inputs to keep business running on a continuous basis. It is also the ultimate output expect to be realized by selling the service or product manufactured by the firm. The firm should keep sufficient working capital neither more or less. Working capital shortage according to will disrupt the firm’s operation. While excess working capital will simply remain idle, without contributing anything toward the firm’s profitability.

Sometimes even if the profitability or profit from operations is higher, the firm may face liquidity problems due to the fact that the current representing the profit may be in the form of either in fixed assets like plant, buildings, etc or in the form of current assets like inventory, debtors other than in the form of cash and bank balances. In situations where the firm faces the liquidity problems will hamper the working capital of the company which results in lower profitability of the firm. If, more assets of the firm are held in the firm of highly liquid assets of will reduce the profitability of the firm. Lack of liquidity may lead to lower rate of return, loss of business opportunities in the manufacturing firms.

1.2 THE STATEMENT OF THE PROBLEM

Although many factors are responsible to the ineffective and inefficient working capital management of manufacturing firms. Some of these problems includes: poor management of working capital which adversely affects the profitability of manufacturing firms; under-utilization of working capital resources and non optimization of organization working capital. Lack of definite business organization of the manufacturing company, excessive profit maximization on the survival of manufacturing firms, illiquidity and cash mis-management of manufacturing firms.

THE OBJECTIVES OF THE STUDY

The general objective of this study is to investigate the effect of working capital management on the performance of manufacturing firms.

Other objectives of the study include:

To determine working capital management of manufacturing firms and its corporate objectives.
To identify the components of working capital management of manufacturing firms.
To determine the roles of working capital management on the performance of organization.
To evaluate the effect of working capital management on the profitability of manufacturing firms.
To examine the problems of working capital management on the profitability of organization like the manufacturing firms.
To proffer solutions to the problems of working capital management on the profitability of organization like manufacturing firms.
To determines the effectiveness of management of working capital on the profitability of manufacturing firms.
To ascertain the relationship between profitability index and working capital management of manufacturing firms.

RESEARCH QUESTIONS

What is working capital management of manufacturing firms?
What roles does working capital management play on the performance of organization?
What are the effects of working capital management on the profitability of effect of working capital management on the performance of manufacturing firms?
What are the problems of working capital management on the profitability of organization like manufacturing firms?
What are the solutions to the problems of working capital management on the profitability of organization like manufacturing firms?

What determines the effectiveness of management of working capital on the profitability of manufacturing firms?

What is the relationship between profitability index and working capital management of manufacturing firms?

THE STATEMENT OF HYPOTHESIS

H₀₁: Working capital management is not a determinant of the liquidity ratio of manufacturing firms.

H₀₂: There is no significant relationship between working capital and the profitability of manufacturing firms.

H₀₃: Working capital does not play a significant role in the operations of the firms.

H₀₄: The level of working capital does not have any significant impact on the corporate objective of manufacturing firms.

1.6 THE SIGNIFICANCE OF THE STUDY

The study will be of immense importance to effect of working capital management on the performance of manufacturing firms namely private limited companies, partnership.

The research work when accomplished will assist some of the banks to reappraise their present existing policy on management of their working capital and profitability with the aim of improving organizational performance and prudent management of their financial resources. It is also hoped that the finding of the study will increase the level of knowledge on the optimum management of working capital and profitability in most organization.

Therefore profitability index is indispensable with the level of working capital management in every organization. The impact of working capital management will enhance optimum increase in profitability measurement of manufacturing firms.

The study will pose great challenges to other researchers who will like to carryout research in related area. It will act as a database and reference material for students in related discipline.

THE STATISTICAL TOOLS TO BE USED IN THE STUDY

This chapter highlights the research methods of gathering relevant information from the respondents. It involves various research tools required to be used in gathering data for this research study. The research design includes , population of study, sample size and sample techniques, research instruments, procedure for data collection, and data analysis. Adequate data is needed to accomplish the aim of the work. Therefore, both the primary and secondary sources of data will be used to gather responses from the members of staff in Lagos.

The simple ratios and percentages was used for data presentation and analysis. Then the chi-square statistical tool (c²) Will be used for the test of research hypotheses. The decision rule for chi-square is that if the calculated c² is greater than the table of c² at a given level of significance and degrees of freedom, then reject the null hypotheses, if not, we then accept the null hypothesis. The administered questionnaire will be analysed using simple percentage statistics and Chi – Square statistical tool for testing the hypothesis under 5% level of significant.

The Chi – square formula is stated below:

² = (O – E)²

Where c² = Chi- Square

O = Observation Frequency

E = Expected frequency

1.8 DEFINITION OF TERMS

i) Working Capital: this refers to the term for that part of the capital of the company that is continuously circulating. It also refers to the assets such as, cash debtors and liabilities such as shot-term creditors of the firm.
ii) Financial Management: it refers to the effective and efficient raising and utilization of fund.

Liquidity: this refers to the degree at which assets can be readily converted into cash.

Permanent Working Capital: it refers to the minimum level of current asset which is continuously required by the firm to carry out its business operation.
Assets: Assets can be defined as the resources owned and used by a business organization for the purpose of generating income.
Profit: Excess of income over expenditure in the operations of manufacturing firms.z

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Full Project – The effect of working capital management on the performance of manufacturing firms

Full Project – The effect of working capital management on the performance of manufacturing firms

CHAPTER ONE

1.0 INTRODUCTION

1.1 THE BACKGROUND OF THE STUDY

First, it was clear that there was a negative relationship between profitability and liquidity indicators such as current ratio and cash gap in the Saudi sample examined.

1.2 THE STATEMENT OF THE PROBLEM

Full Project – The effect of working capital management on the performance of manufacturing firms

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