This chapter provides an overview of working capital management and its relationship with profitability and an introduction to industry background. It also looks into the research objectives and aims which will lead to the research question for the purposed study.
1.1 Overview
This research work aims to investigate the relationship between Working capital management and profitability in listed Nigerian manufacturing companies. A sample of 11 listed manufacturing companies on the Nigerian Stock Exchange was used, over a five-year period from 2007 to 2011. Working Capital Management is an important aspect of corporate finance as it has a direct significant impact on profit. The lack of understanding about the impact of working capital requirements on profitability, the lack of clarity about its determinants, and the lack of management's ability to plan and control its components may lead to insolvency and bankruptcy (Gill, 2011). If we remember correctly, to arrive at Gross Profit in our conventional Trading Account, we have to deduct Cost of Sales from actual Sales. The cost of sales comprise of Opening stock, purchases and closing stock. Sales and all the cost of sales variables are directly guided by the Working Capital Management Policy adopted by an entity. As much as this research involves establishing a relationship between working capital management and profitability, it is noteworthy to state that Working capital also directly affects liquidity in any organisation that wants to remain a going concern. Efficient management of working capital plays an important role of overall corporate strategy in order to create shareholder value (Ray, 2012).
The Lack of empirical evidence on the working capital management and its impact on firm's profitability in the case of manufacturing companies in Nigeria has necessitated this comprehensive research into this subject. Working Capital management has been examined by different researchers in various ways. The literature review section would attempt to extensively explore as many literatures as possible, in an attempt to analyse various thoughts and opinions as well as findings on this very crucial and important subject area.
1.2 Industry background
Ajayi (2007) explained that industrial development in the country involved considerable artisanal crafts firms in the early stages and grew progressively in number over the years to large-scale manufacturing. The Nigeria manufacturing sub-sector comprise of large scale manufacturing companies (including the basic principal industrial projects, promoted by government), the intermediate goods produced by companies sponsored by transnational corporations, the small and medium scale manufacturing units financed by foreign and local entrepreneurs and the cottage industries located in urban and rural areas. The large-scale manufacturing outfits and main industrial projects include iron and steel, fertilizers, pulp, paper, machine tools cement vehicles assembly, petrol chemical plants and petroleum refineries. Among intermediate and consumer goods industries are chemicals, paints, tyres etc., while food, beverages textiles, plastics, soaps detergents and furniture belonging to small and medium scale manufacturing units. The solid minerals sub-sector consists of a wide range of minerals which include gold, limestone, columbite, marble cassiterite and so on (Awe & Ajayi, 2009). The Nigerian economy is highly dependent on oil hence the few amount of existing manufacturing companies. In this research work, 11 listed manufacturing companies would be used to establish this cause and effect relationship between working capital management and profitability. The manufacturing sector in Nigeria is considered very important as it is expected to be one of the key sectors absorbing the surplus agricultural labour as they are released from the rural sector in the development process (Ogunrinola & Osabuohien, 2010). There has been a growing concern on the decline of the output of the manufacturing sector in Nigeria in recent times, despite the fact that the government embarked on several strategies aimed at improving industrial production and capacity utilization of the sector (Obamuyi, et al., 2012).
Manufacturing companies are highly dependent on inventory in other to be able to continue production and meet demand, and demand would usually translate into receivables before turning into cash. On the other hand, they require some form of short term financing to fund inventory such as payables. A trade- off between these components is what the finance function is responsible for in any organisation to ensure liquidity and profits.
1.5 Research aim
Over the years a variety of in-depth research has been carried out in previous literatures to investigate the relationship between working capital management and profitability in different sectors of the economy. Most notably of this research are in developed economies and in Asia. This piece of work seeks to bridge the gap that exists in Nigerian listed manufacturing.
1.3 Research Objective
The main objective of this research work is
To investigate the relationship that exists between Working Capital and Profitability in manufacturing companies listed on the Nigerian Stock Exchange using financial data from 2007 to 2011. However, the secondary objectives of this research are
To address the issue on the literature of working capital management which is perceived to be lacking?
To synchronise the tripartite relationship between working capital, liquidity and profitability and to increase the awareness of the perception of readers to working capital management, liquidity and profitability in case of Nigerian listed companies
To assess the relationship between Working Capital Management and Return on Capital Employed of the manufacturing companies.
1.4 Research question
What is the relationship between working capital and profitability for Nigerian manufacturing companies?
In answering the question above the researcher also aims to find out the relationship between Liquidity and profitability for the Nigerian firms.
To answer the questions above the Following HYPOTHESES for listed manufacturing companies in Nigeria was propounded
Ho There is no relationship between Working Capital Management and Profitability (ROA and ROE).
H1 There is a relationship between Working Capital Management and Profitability (ROA and ROE)
Ho There is no relationship between Liquidity and Profitability (ROA and ROE)
H1 There is a relationship between Liquidity and Profitability (ROA and ROE)
1.6 Significance of Study
This study adds to the literature on the relationship between the working capital management and the Profitability of companies. First, it focuses on Nigerian manufacturing firms where only limited research has been conducted on such firms recently. Secondly, this study validates some of the findings of previous authors by testing the relationship between working capital management and the profitability of the selected companies. Very importantly, to bridge the gap that exists for Nigeria by serving as a continuum for further research. Thus, this study adds validity to the existing theory developed by authors in previous research, intends to look at the effects of working capital management on the profitability of the 11 listed manufacturing companies in Nigeria. It is believed that the result findings of this research will enable manufacturing firms in Nigeria to decide on the working capital level that is optimal with a view to maximizing returns and shareholders wealth without diverting from other objectives of the company. Specifically, this study seeks to determine the extent to which working capital management affects companies' profitability.
1.7 Research Methodology
The theoretical framework has been developed through secondary data from related source; the theoretical frame work addresses issues such as independent variables such as the components of Working capital (i.e. receivables, inventory, and payables) and how they relate with dependent variables such as liquidity and most importantly profit. Quantitative and qualitative approach was considered very useful for this research work.
1.8 Structure of the Study
This piece of research work has been designed to contain five chapters.
Chapter one contains introduction, industry background, research objective; furthermore, it highlights the research questions and the research methodology.
Chapter two contains the literature review. This section is further discussed and categorised into: nature and importance of working capital management, the management of working capital which comprises of inventory management, receivables management, payables management, and cash conversion cycle/liquidity. The remainder of this section of this research work is a comprehensive review of the findings from related literatures.
CHAPTER TWO
LITERATURE REVIEW
2.1 Introduction
This chapter contains the review of literature which begins with an exploration of the nature and importance of working capital management, its definition and why it is vital to every organisation and in the field of financial management as a whole. This chapter also contains an exposition of working capital management and its core components which are; inventory management, receivables management, payables management and cash conversion cycle, working capital policies like the aggressive and conservative policy would also be dealt with. Lastly, a review of the findings and outcomes of various research works was dealt with in the review of literature section. This will serve as a frame work for this research work.
2.2 Nature and Importance of Working Capital Management
Working capital management is important to companies because it provides profit
through sales that gives rise to growth. It provides liquidity through cash flow that gives
rise to corporate stability and existence (Nwankwo & Osho, 2010). Working Capital is the flow of ready funds necessary for the working of a concern. It comprises funds invested in Current Assets, which in the ordinary course of business can be turned into cash within a short period without undergoing diminishing in value and without disruption of the organization (Ramachandran & Janakiraman, 2009). It is simply the net result when current liabilities are deducted from current assets. A positive net result means an organisation is able to meet its short term obligations as and when they fall due, and a negative net result means potential liquidity problems. 'Working capital proposes a familiar front for profitability and liquidity management. To reach optimal working capital management firm manager should control the trade-off between profitability and liquidity accurately. An optimal working capital management is expected to contribute positively to the creation of firm value' (Bhunia, et al., 2012).
The importance of working capital management cannot be over emphasised, especially in this period of global financial meltdown. This is because illiquidity is prevalent worldwide necessitating that effective and efficient management of any available cash will be needed to ensure that company breaks even and survives this distressed time since credit is not easily come by (UREMADU, et al., 2012). In developing countries like Nigeria that requires the emergence of Small and Medium Scale enterprises (SMEs) to serve as an economic catalyst, long term financing are not easy to come by. This leaves a preponderant reliance on working capital which is a short-term form of funding (Olufisayo, 2011). Manufacturing companies more than service organisations heavily require a sound working capital policy management (Raheman, et al., 2012), because inventory is required in other to further production, payables could come in handier than cash to finance the purchase of inventory, and to achieve speedy turnover, receivables could be the quicker option compared to cash receipt. A sound Working capital Policy Management would seek to balance these various components in other to avoid liquidity problems, idle funds and make profits.
The recent financial turmoil and the recession that struck harder through 2008 have necessitated more emphasis on the investment that firms make in short-term assets, and the resources used with maturities of under one year which represent the main share of items on a firm's balance sheet (Abuzayed, 2012). Abuzayed (2012), further suggested that successful management and utilisation of an organisation's resources whether long-term or short-term would have a direct and significant impact on profitability. Given that management success might be measured by market value we argue in this study that efficient working capital management should bring more shareholders market value. Businesses must constantly be creative and transform themselves to stay ahead of competition in this rapid growing world. An efficient working capital management system has to be structured to run the business and make profits in the long run. As costs are continuously increasing, companies have to make efficient use of funds in managing the purchase, inventory, processing and distribution of finished product to the existing customers, and it is common in many business decision-making situations that certain goals or objectives of the firm can only be met at the expense of other goals (DASH & HANUMAN, 2012). Having the correct level of working capital at the appropriate time is important for efficient day to running of a business. It is essential that firms commit resources to manage working capital, especially during recession period when access to credit is very limited. It is reasonable to assume that economy-wide fluctuations that are exogenous to the operations of the firm play an important role in the demand for the firm's products and any financing decision (Enqvist, et al., 2012). Working capital is seeing as the life-blood of a business. If a business has some favourable levels of working capital then it is always getting the return on any favourable opportunity. Working capital can be used to pay the payroll of the employees and petty expenses, it can also be used to pay utility bills and very importantly pay creditors and suppliers (Sial, 2011).
In general, current assets are considered as one of the vital components of total assets of an organisation. An organisation may be able to reduce the investment in fixed assets by renting or leasing plants and machineries, but the same policy cannot be adopted for the components of working capital (Nazir & Afza, 2009). Hussain et al (2012) concluded in their research that an aggressive investment policy approach to working capital resulted in increased organisation's profitability. They carried out their research on listed Pakistan manufacturing companies within a time frame of 2005 to 2010.
2.3 THE MANAGEMENT OF WORKING CAPITAL
Working capital structure refers to the elements of WC and it shows which of the possible components is responsible for investment in WC. Working capital structure is encapsulated in the concept of working capital management (WCM), which refers to the financing, investment and control of the net current assets within the policy guidelines. Working Capital can be regarded as the lifeblood of the business and its effective provision can do much to ensure the success of the business, while its inefficient management or neglect can lead to the downfall of the enterprise (Padachi, et al., 2012) .Nyamao et al (2012) suggested that the management of working capital entails efficiency of cash management, efficiency of receivables management and efficiency of inventory management as determinants of financial performance model. Financial performance could therefore be enhanced if efficiency levels of cash, receivables and inventory management practices are increased. They further concluded that the efficiency in working capital management practices as measured by efficiency in cash management, efficiency in receivables management and efficiency in inventory management has an impact on the growth rate of businesses' revenue, market share, profits and total assets. Optimising the components of Working capital is an indication of a Working capital Policy that is headed in the right direction. As earlier discussed, working capital is a trade-off between current assets and current liabilities. Its components comprise of: cash, inventory, receivables and payables. Working capital has been managed, using various strategies by different finance managers. While some have approached it from the impact of proper or optimisation of inventory management, others have looked at it from the stand-point of accounts receivables trying to develop a postulate that its optimisation will translate into profit maximisation (Gill, et al., 2010). Gill et al (2010) also suggested that a popular measure of working capital management is the cash conversion cycle, which is given, as the time span between the expenditure for the purchases of raw materials and the collection of sales of finished goods. The shorter the Cash Conversion Cycle, the more liquid the company is and the profitable as well. Working capital management is comprised of many important decision makings. Management of cash, accounts receivables, accounts payables, inventories which involves policy decisions in the areas of policy of credit terms of sales, inventory management etc. The appropriate levels of working capital for firms in variety of industries are a very important consideration. These issues are dealt by almost all the managers and researchers in financial studies (Alam, et al., 2011). Efficient management of working capital plays an important role of overall corporate strategy in order to create shareholder value. Working capital is considered as the result of the time difference between the expenditure for the purchase of raw material and the collection for the sale of the finished goods (Dong & Su, 2010). The definition is considering working capital from the cash conversion cycle point of view.
The amounts of funds invested in working capital are often high in proportion to the total assets employed and so it is important that these amounts are used in an efficient and effective manner (Padachi, 2006). The management of current assets and liabilities is essentially what working capital management entails (Adediran, et al., 2012). The optimisation of the components would not only guarantee liquidity, but also profitability. So many businesses are profitable but go burst because they are technically insolvent, which means they are illiquid and are not able to meet their short-term obligations. Adediran et al (2012), suggested that the two main aspects of working capital management are ratio analysis and management of individual components of working capital, and that a few key performance ratios of working capital management are working capital ratio, inventory turnover and the collection ratio. A proper ratio analysis would aid management in identifying areas such as cash management, inventory management, receivables management and payables management. Nazir & Afza (2009) suggested that Managers can create value if they adopt a conservative approach towards working capital investment and working capital financing policies. The effectiveness of working capital management includes planning and controlling the current assets and debts by avoiding overinvestment of the current asserts and avoiding inappropriate flow of the working assets for fulfilling the responsibilities. Cash conversion cycle is known as a criterion indicating the effectiveness of working capital management (Valipour & Jamshidi, 2012).
A study on the relationship of working capital management and profitability was carried out by Hassan et al (2011); they considered working capital management as a determining factor in creating value in firms. An examination of selected companies from the Turkish Stock Exchange market from 2005-2009, as well as cash conversion cycle as a criterion for the effectiveness of working capital management and the efficiency of assets as a criterion for profitability and found that a reduction in cash conversion cycle had a positive and significant relationship with the efficiency of assets (Hassan, et al., 2011). The greater the relative size of near cash assets, the lesser the risk of running out of cash, all other things being equal. All individual components of working capital including cash, marketable securities, account receivables and inventory management play an important part in the performance of any organisation (Raheman, et al., 2010). Inventory Management is a very important aspect of Working Capital Management. Manufacturing companies without a proper inventory policy would definitely face a stock out situation, and would lead to inability of the manufacturing concern to continue production because of lack of materials to further production.
2.3.1 Inventory Management
The amount of inventory requirement is dependent on the type of organisation in question. For example, in a just-in time manufacturing environment, inventory is considered a waste, whereas in organisations where there exists a poor cash flow or the lack of strong control over electronic transfer among all divisions and all important suppliers, lead times and quality of materials received, inventory plays important roles (Muller, 2011). Muller (2011), further stated that valuation of inventory in necessary for its management, and the valuation methods are LIFO (Last In First Out), FIFO (First In Firs Out), Average Cost Method of Inventory, Specific Cost Method of Inventory and Standard Cost Method. All these methods would aid financial managers eradicate obsolescence in stock and proper valuation to ensure that profit is not over stated or under stated.
To effectively manage inventory, a manager must have access to three fundamental sets of information: information about demand such as forecasts; information about assets such as the inventory available for sales, on order and where they are located; and finally information about replenishment lead times (Ozer, 2011). Ozer (2011) further suggested that information technology serves as a veritable tool which aids managers with the means to obtain better and timely information regarding, for example, demand, lead times, available assets, supplier information and capacity. Technology has also enabled customers to obtain vast amounts of information about a product, such as its physical attributes and availability. Xiwen et al (2012) analysed inventory management using the system dynamic theory, it was postulated in their work that the system dynamics model of managing inventory can link all relevant factors which have an impact on inventory management, can forecast the inventory situation when the market demand is changing continuously and also can regulate enterprises' business activities in accordance with the prediction. In such a manner, that it can dynamically and correctly carry out the management of inventory, and achieve the objective of reducing costs, increasing profits and improve overall performance.
2.3.2 Receivables Management
All efforts the financial manager makes in setting credit standard, credit terms and credit collection periods are geared towards establishing an optimal credit policy for the firm (UREMADU, et al., 2012). Gunny (2010), explains receivables management from the point of view of Earnings management. He classified earnings management as comprising of accruals management and real activities manipulation (RM). Gunny explained that accruals management (receivables management) is not attainable by changing the underlying operating activities of an organisation, but through the choice of accounting methods used to represent those activities. However, he explained that this type of earnings management attempts to increase/decrease earnings. This leads us to the argument that profits are affected by receivables management which is a component of working capital management. Cash collection is one of the most important functions of a company, it is considered second only to generation of revenue. Thus, accounts receivable risk management is a very important tool for every company. The accounts receivable collection risk cannot be fully avoided, and cannot be completely reduced by the full amount. However, it can be reduced to a tolerable, reasonable and acceptable measure that does not adversely affect the business success and long-term business goals (Biswal, et al., 2012). Account receivable is one of the major components of working capital. It acts as a conduit fight between the sales and the cash recovery from the credit customers. It is made up of credit sales and bills receivable. Any lapses in this aspect will lead to requirement of additional working capital. The unwarranted working capital requirement due do effective management will always attract an additional interest commitment. The additional interest commitment will erode the current earning of the organization (Prabhakar, 2011). Hartmann-Wendels & Stöter (2012) explained that accounts receivable constitute a significant portion of companies' balance sheets, highlighting the importance of the management and financing of this type of asset. They further stressed that management of accounts receivable can either be organized within the firm or delegated to a specialized financial intermediary, such as a factor. The study basically looked at the decision between internally managing receivables as opposed to factoring receivables. Every firm has to determine credit policy and credit standard for efficient Receivable Management. The determination of credit policy involves a trade-off between the profit on extra sales that arise due to the credit being extended to its customers on the one hand and the cost of carrying those losses suffered on account of bad debts on the other hand. The credit standard refers to the minimum quality of credit worthiness of a credit applicant that is acceptable to the firm. In other words, they explained that the quality of the trade accounts to be accepted is called as Credit Standard (Nageswari, et al., 2011).
Michalski (2012) suggested that the decision whether to extend the trade credit terms, is a compromise between limiting the risk of allowing for the payment postponement from unreliable purchasers and gaining new customers by way of a more liberal organization trade credit policy. This decision shapes the level and quality of accounts receivable. He basically established the need for a sound working capital management policy and liquidity position, in relation to achieving the primary objective of non-profit organisations which is to deliver a service as opposed to making profits. It was referred to as the realization of the mission that cause the donors support for the organization.
Providing customers with an instalment option to purchase is a widely-used instrument to increase turnover and patronage. For the firm implementing this instrument, instalment payment is a sale on credit with special conditions, especially including an extended credit period and an instalment plan fixing the due dates for payments to be made by the customer. Credit sales as one part of a selling concept directly incorporate a conflict between marketing and financial objectives - between gaining patronage from customers and controlling the credit risk involved by extended, more customer-oriented payment conditions. The operative control of these credits is the core function of accounts receivable management whose key functions are to record and manage payments, to configure terms of payment and trading conditions, to induce collection procedures and to bring loan securities under control, if available (Schwarz, 2011). Quazi et al (2011) suggested that Inventory is the main part of the working capital. Increase in the inventory will give reduction in the risk of stock out. Inventory is done for meeting the demand of the public. Inventory is the liability of the company to sell it. Biswal et al (2012) again suggested in their research that the problem of accounts receivable is not an easily solvable task because of its complexity and size, the solution they proffered was that a corporate system of receivables collection risk management should be constituted in India's system of payments that could guard lenders from debtor's default. They also suggested that the created model is optimal in Indian context as it is based on datasets from financial reports of Indian pharmaceutical companies. (Biswal, et al., 2012).
2.3.3 Payables Management
Accounts Payable management is a very critical and important component of working capital management. A high accounts payable could mean two things. It is either the organisation has a good relationship with its suppliers and is also able to renegotiate an extension of payment, which is good from a cash flow perspective. It could also mean that an organisation lacks sufficient cash flow, too much funds tied up in inventory and receivables which would lead to failure to honour payment obligations. This in itself is symptomatic of liquidity crisis. A payables management method suggested by Arno Grbac et al (2011) is that organisations should firstly invest its time and energy to determine what funds are available to pay its suppliers and other short term obligations, and then the business must then review all its invoices from suppliers and/or other vendors by a way of critical analysis, and then prioritise these invoices. They suggested that it is often in the best interest of businesses to pay their vendors invoices as late as possible in order to collect interest on the funds for as long as possible. The existence of a firm's negative working capital is confirmed to influence strongly the reduction of the trade credit obtained from suppliers in Western Europe countries in parallel with a joint contribution of short and long term bank financing as a substitute from trade debt. Firm characteristics related to negative working capital and fixed assets level, jointly or alone, give more importance to the role of short term bank financing on substituting or reducing the volume of trade credit obtained from suppliers (Manuel, 2010). Shakkarwar et al (2011) approached the management of working capital from a system and methods perspective. Their invention is an automated system that provides a computer-implemented method for generating a first accounts payable financial product that is configured to be used for one or more payment transactions. The method includes receiving a selection of a core account for providing financial backing for the first accounts payable financial product; receiving a selection of a first recipient payee to which the first accounts payable financial product is to be distributed; generating the first accounts payable financial product based on one or more control parameters that define use restrictions for the first accounts payable financial product; and causing the first accounts payable financial product to be distributed to the first recipient payee.
Flynn et al (2011) in their invention on the management of payables, provided a systematic approach that should be employed in payables management by stratifying payables according to their age through the process of recording credit data, validating this data, publishing the validated credit data as a claim batch data, managing the claims data and invoicing the managed claim data. Below is a process flow developed by the inventors.
Source: (Flynn & Jraige, 2011)
Wilson et al (2012) invented an automated system that relates to data processing, and in particular to an accounts payable tax rules processing system and method that allows an accounts payable processing system to be configured to verify that the tax rules for multiple jurisdictions have been properly applied.
2.3.4 Cash Conversion Cycle/Liquidity
Several researchers have approached working capital or net working capital as cash conversion cycle when attempting to establish a relationship between company performance and profitability. According to Duggal & Budden (2012) the theory of working capital management, ceteris paribus, emphasizes minimizing the firm's cash conversion cycle (CCC), which is defined as the time interval between cash disbursements and cash collections.
Cash conversion cycle is estimated as follows: Cash conversion cycle=Inventory/ (One day's cost of goods sold) +Accounts receivable/ (One day's sale)-Accounts payable/ (One day's cost of goods sold).
They explained that the first term on the right hand side is called Days Inventory Held (DIH). The second term is called Average Collection Period or Days Sale Outstanding (DSO), which is a measure of how quickly a firm collects from its customers. All other things being equal, the higher the values for DIH and DSO, the higher the firm's investment in its net working capital. The last term is called Days Payable Outstanding (DPO), a measure of vendor financing. A higher value for this term denotes a greater amount of vendor financing, all else being equal. A firm that minimizes its cash conversion cycle also minimizes its needs for net working capital, which, as already stated, is costly and affects the firm's cost of capital (Duggal & Budden, 2012). Ding et al (2012) suggested that cash conversion cycle is a more comprehensive indicator of working capital management efficiency and defined it as follows CCC = {[(inventories-accounts payable)/cost of goods sold]+(accounts receivable/sales)}*365
This indicator measures the time elapsed from the moment the firm pays for its inputs to the moment it receives payment for the goods it sells. It combines the cycles of inventories, accounts
Receivable, and accounts payable. The lower the CCC, the more efficiently the firm is able to manage its working capital. The term, cash conversion cycle, first was propounded by Hager in 1976, and it has been utilised by many researchers. Usually the companies first have credit transactions trading goods and services on credit and then recover accounts receivables which are referred to as cash conversion cycle. Proper working capital management policy is achieved by minimising the time lag between expenses for getting Inventory and the cash received that result from its sale. It is calculated as: (Inventory turnover in Days+ Average Collection Period-Average Payment Period) (Alipour, 2011). The correlation between working capital and profitability of firms is analysed for the management of cash cycle management. Working capital is made by the three important factors, debtor, creditor and stock. When we include cash conversion cycle (CCC) to working capital then it becomes working capital management (WCM) (Qazi, et al., 2011).
The cash conversion cycle is a dynamic measure of on-going operating liquidity representing the number of days a firm takes to go from cash outlay back to cash receipt, rather than the ability to cover short term liabilities with liquid assets. (Lancaster, et al., 2011).
A useful way of assessing the liquidity of firms is with the cash conversion cycle (CCC) (Moss & Stine, 1993). Liquidity is simply the ability of an organisation to meet its short-term obligations as and when they fall due. On the other hand, cash conversion cycle. Cash
