Project Topic – IMPACT OF WORKING CAPITAL ON THE PROFITABILITY OF MANUFACTURING FIRMS (STUDY OF SOME SELECTED MANUFACTURING FIRMS)

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CHAPTER ONE

INTRODUCTION

1.1         Background to the Study

Working capital management is managing and regulating current assets and liabilities in such a way that removes the danger of being unable to fulfill short-term commitments as they become due and avoids excessive investment in current assets, which results in idle cash (Eljelly, 2004). Working capital management entails determining the composition of net current assets and financing these assets (Samson, et al, 2012).

Additionally, working capital management may be described as the systematic accumulation of current assets minus current obligations (Lukarris & Eero, 2011). Working capital management, as described by Weston and Bringham (2015), is the investment in short-term assets. We have seen that the majority of researches approach working capital management via the lens of working capital and attempt to describe it as follows: Working Capital was described by Cheng, Frank, and Wu (2009) and Guthman & Dougall (1948) as receivables plus inventories minus payables. Working capital is a word that refers to short-term balance sheet items that are related to current assets on the asset side and current liabilities on the liability side of the balance sheet (Brealey, Meyers & Allen, 2011, p.856). Working capital should consist primarily of cash, marketable securities, receivables, and inventory, all of which are critical for the administration of the business (Ali & Ali, 2012).

Working Capital Management is important as it has direct impact on the profitability of firms (Ray, 2012). To maintain liquidity and profitability of an organization, its working capital should be managed efficiently (Nazir & Afza, 2009). This entails planning and controlling current assets and current liabilities of firms with the view to reduce the risk of inadequate and non-availability of cash (Adeniji, 2008).

Deloof (2003) posited that working capital management directly affects the liquidity and profitability of firms, the study argues that firms in a given large sample must vary in terms of size, age and Technology among others; that liquidity settings will also vary greatly depending on the risk appetite of the firm. Also, that firms will have different credit ratings that determines the way in which these firms make their purchases. According to Raheman and Nasr (2007) “Excessive level of current assets account can easily result in a firm realizing a substandard return on investment”, hence the need to manage working capital. The working capital management variables considered by this study are; account receivables, inventories turnover, account payable and cash conversion cycle (Lukkaris & Eero, 2011).

Working capital management involves planning and controlling current assets and current liabilities in a manner that eliminates the risk of inability to meet short term obligations when due and to avoid excessive investment on current assets which leads to idle cash (Eljelly, 2004) and looking at the nature of working capital and its components which are short lived, there is the need to manage working capital in order to attain profitability. “Current assets are short-lived investments that are continually being converted into other asset types” (Rao, 1989). When a firm maintain excessive current asset, it ends up tying down firm resources and that can affect profitability (Rahem & Nasir, 2011). Also, large inventory and a generous trade credit policy may lead to high sales, but that does not translate in to profitability (Rahem & Nasir, 2011). Efficient working capital management is necessary for achieving both liquidity and profitability of a company (Nazir & Afza, 2009). A poor and inefficient working capital management leads to tying up funds in idle assets and reduces the liquidity and profitability of a company (Reddy & Kameswari, 2004). Working capital management became important and necessary during the financial crisis up to 2008 because the cost of long term debt increases and the new cost levels become difficult to attain, hence the need to manage working capital, especially when it can influence firm profitability and risk (Smith, 2018).

Keeping larger inventory by a firm reduces the likely risk of a stock-out (Rahem & Nasr, 2007), even at that, inventories are not to be kept at an arbitrary level, there is the need for deliberate planning and continuous check on the inventory. Given that Inventories can save the firm from the risk of losing an important customer by meeting up with their unexpected demand; however, keeping too much idle stock may create unnecessary liquidity shock to a firm thereby affecting firm profitability, hence the need for tradeoff between liquidity and profitability which is ultimately working capital management (Shin & Soenen, 1998).

Firms sometimes bought goods on credit from its suppliers meant to be payable in the near future, delaying payment to suppliers allows a firm to assess the quality of products bought, and can be an inexpensive and flexible source of working capital for the firm (Perri, 2008). This in essence allows firms to utilize the available cash that ought to be used for paying for supplies to another profitable investment opportunity. However, late payment of invoices can be very costly if the firm is offered a discount for early payment (Rahem & Nasr, 2007).This decision process need to be taken by top management and is considered as payables management and as a component of working capital, it can be seen as working capital management (Cannon, 2008).

Cash conversion circle is a fundamental tool applied in the assessment of the efficiency of working capital management (Richard & Laughlin, 1980). The common measure of working capital management (WCM) is the cash conversion cycle (CCC), this is the time between making payment for the raw materials purchased and the receipts of proceeds of sales of finished goods (Deloof, 2003). The more days a company‟s money is tied up in inventory, the longer the cash conversion cycle and the longer the number of days creditors must wait for their money (Jason & Kasozi, 2017). It is usually recommended that firms should have shorter cash conversion cycle for them to be profitable and remain credit worthy (Bibi & Ajmad, 2017).

A longer CCC may translate into poor profit as inventories are either not converted into goods on time or they are converted, sold and yet the debtors have delayed payment or we have delayed paying our creditors (Billie, 2014). Hence, when CCC is shortened, it is expected to improve firm‟s profitability. Longer CCC results to a greater need for expensive external financing as cash are tied down on inventories or because we have lost our credit worthiness as such we have to look elsewhere to finance that which ordinarily would have been made available to us by our creditors (Nordmeyer, 2015). Longer CCC ultimately suggest that the firm is less likely to obtain credit when needed and less likely to continue in business as it is cash trapped (Jason & Kasozi, 2017). When there is a reduction in the time cash are tied up in working capital, it tends to improve on the efficient operations of the firm. The CCC is a useful way of assessing the firm’s cash flow as it is the measure of time that the funds were invested in working capital (Pratap, Kumar & Colombage, 2017). CCC is often regarded as the powerful and more comprehensive measure of WCM than using the current ratio and the quick ratio which focus on statistical balance sheet values (Quang, 2017). The CCC includes the time dimension of liquidity which measures the overall ability of firms to manage cash (Pratap, Kumar & Colombage, 2017).

Statement of the Problem

Adequate knowledge on Working Capital Management in the Industrial Goods Firms will help in solving the Country‟s developmental challenges such as unemployment, poverty and other related problems; as its industries will flourish as they become profitable. Many Industries earlier established have either folded or are performing very low due to their improper management of working capital which results in lack of appropriate financing and access to trade credit (Masocha & Dzamonda, 2016, Enow & Brijlal, 2014).

It has been found that there are a lot of research work on working capital management and profitability but there is none that dwell on the Manufacturing firms. This has created a gab in the body of knowledge in the Manufacturing firms. With this research, material will be made available that dwells on the Manufacturing firms. The research shall make materials available which inevitably bridge the gap that exits from the paucity of materials dwelling on Working Capital Management and Profitability in the Industrial

Goods Firms in Nigeria. With this material, there is no need for extrapolation of information that will suffice for knowledge in the Manufacturing firms. This gab in knowledge is to be filled by conducting a study on the Impact of Working Capital Management on the Profitability of Manufacturing firms. The Variables to be deployed for the study consist of Account Receivable Days, Inventory Turnover Days, Accounts Payable Days and Cash Conversion Circle as Proxies for the Independent Variable and Return on Assets as Proxy for the Dependent Variable. This work will look at the impact of managing Account receivable days (ARD), Inventory turnover days (ITO), Account payable days (APD) and cash conversion cycle (CCC) on profitability of manufacturing firms. Failure to investigate this relationship will be an issue for concern because there is no specific study that cover the Manufacturing firms as far as the Impact of Working Capital Management on Profitability is.

1.3         Research Questions

Based on the problem statement highlighted, the following questions were formulated:

1. To what extent does Accounts Receivable Days (ARD) affect the Return on Asset (ROA) of Manufacturing firms?
2. To what extent does Inventories Turnover Days (ITO) affects the Return on Asset (ROA) of Manufacturing firms?
3. To what extent does Accounts Payable Days (APD) affects the Return on Asset (ROA) of Manufacturing firms?
4. To what extent does Cash Conversion Circle (CCC) affect the Return on Assets (ROA) of Manufacturing firms?

1.4         Objectives of the Study

The main objective of the study is to examine the effect of working capital management on the profitability of quoted manufacturing firms. The specific objectives are as follows;

1. To evaluate the impact of Accounts Receivable Days (ARD) on Return on Asset (ROA) of Manufacturing firms.
2. To investigate the impact of Inventory Turnover Days (ITO) on Return on Asset (ROA) of Manufacturing firms.
3. To examine the impact of number of days Accounts Payable Days (APD) on Return on Asset (ROA) of Manufacturing firms.
4. To evaluate the impact of cash conversion cycle (CCC) on return on asset (ROA) of Manufacturing firms.

1.5         Hypotheses of the Study

In line with the objectives of the study, the following hypotheses were formulated in a null form:

H0₁: Accounts Receivable Days (ARD) has no significant impact on the Return on Asset (ROA) of Manufacturing firms.

H0₂: Inventory Turnover Days (ITO) has no significant impact on the Return on Asset (ROA) of Manufacturing firms.

H0₃: Accounts Payable Days (APD) has no significant impact on the Return on Asset (ROA) of Manufacturing firms.

H0₄: Cash Conversion Cycle (CCC) has no significant impact on the Return on Asset (ROA) of Manufacturing firms.

1.6         Scope of the Study

The study examines impact of working capital on the profitability of manufacturing firms (study of some selected manufacturing firms). The research focused on twenty-one (21) Industrial Goods Firms listed on the Nigeria Stock Exchange (NSE) for the period of Eight (8) years (2009-2016). The variables of the study were restricted to: Accounts Receivable Days (ARD), Inventories Turnover Days (ITO), Accounts Payable Days (APD) and Cash Conversion Cycle (CCC). These variables were chosen because they are the basic components of working capital and they are the major constituents of working capital of Industrial Goods Firms.

1.7         Significance of the Study

Conducting this study will be of immense importance to firm managers, for it will help expand their learning curve and help reduce the possibility of default, especially in turbulent time. It is believed that the outcome of the study will be of immense benefit to the mangers of quoted Manufacturing firms by opening new doors for improvement, growth and excellence in their operations. The findings will assist them in taking long lasting decisions on the area of financing working capital.

Also, it will be of benefit to existing and potential investors of quoted Manufacturing firms in identifying potential portfolios. It will assist them in assessing the financial performance of the quoted Manufacturing firms, as they will be able to view the working capital of these firms from the statement of financial positions of the firms and factor it as to whether they are managed efficiently or not. Development Finance bodies like the Bank of Industry will find this as a handy manual for assessing Industries that approach them for financing. The findings of this research will hopefully contribute to knowledge and add to the literatures on the effects of working capital management on profitability of quoted Manufacturing firms. This study will also be valuable for practitioners, policy makers, firm managers and academician with regards to issues associated with Working Capital Management and Profitability of Firms.

The regulatory authorities such as Nigerian Stock Exchange (NSE), Security and Exchange Commission (SEC) will find this study valuable as it will enable them assess the performance of Industrial Goods Firms by taking relevant decision in respect of the companies, based on the indices and information made available here.

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Project Topic – IMPACT OF WORKING CAPITAL ON THE PROFITABILITY OF MANUFACTURING FIRMS (STUDY OF SOME SELECTED MANUFACTURING FIRMS)