PROJECT TOPIC- EFFECT OF WORKING CAPITAL MANAGEMENT ON FIRM PROFITABILITY IN SELECTED NIGERIAN QUOTED COMPANIES
Working capital management is a very important component of corporate finance since it affects the profitability and liquidity of a company. Its management may have both negative and positive impact on the firm‟s profitability, which in turn, has negative and positive effect on shareholders‟ wealth. This study aimed to provide empirical evidence on the effects of working capital management on firm profitability in selected Nigerian quoted companies for the period 2000 – 2009 by examining cash conversion cycle, liquidity, age and accounts receivables on profitability. The panel data methods were employed in order to analyse the mentioned effects. Four major hypotheses were formulated and all tested using multiple regression model at 5% significance level. Return on Assets which proxied profitability was adopted as the dependent variable. Sales growth, size, accounts payable and inventory were used as control variables. Pearson‟s correlation and regression analysis (general least square with cross section weight model) was used for analysis. The results showed that there is a strong negative relationship between cash conversion cycle and return on assets. This means that as cash conversion cycle increases, it will lead to decline in the profitability of firm and managers can create a positive value for the shareholders by reducing the cash conversion cycle to a possible minimum level. Liquidity had a positive and strong significant relationship with return on assets. Age also had a positive relationship with profitability while accounts receivable had a negative significant relationship with return on assets as to increase firms‟ profits. On the basis of these findings, we recommend among others that, managers and indeed organizations should concentrate on the proper management of each working capital components and keep them at optimal levels, as this will go a long way to enhance profitability and create value for their companies. The findings enhance the knowledge base of working capital management and will help companies manage working capital efficiently in our growing economy. The study contributes to the literature on the effects of working capital management on firm profitability in Nigerian companies in at least two ways. First, it focuses on Nigerian quoted companies where only limited research has been conducted on such firms recently. Second, this study validates some of the findings of previous authors by testing the effects and/or relationship between working capital management and the profitability of sample firms. Thus, the study adds substance to the existing theory developed by previous authors. It is suggested that further studies which would capture all non-financial companies listed in the Nigerian Stock Exchange or segregated these studies on industry basis, should be attempted. Also, further research can be conducted on the same topic in different countries for the comparison of working capital management policies of developing and developed countries as to determine the correct management policies.
1.1 BACKGROUND OF THE STUDY
Investors all over the world put their money into a business with a view to having some return on investment irrespective of whether it is in a proprietorship, partnership and corporations. In small and medium businesses, owners have direct or indirect control over the management of the business so, they themselves are responsible for the profit and loss. On the other hand, in the large multinational companies, the management of the company manages the affairs of the company on behalf of owners but owners want management to take such decisions which will give positive signal to market, increase the value of the firm, enhance profitability and maximize holding period return.
The heart of corporate finance literature is long term investment, capital structure and different valuation methods. These have been the focus of intention for many researchers in the past. In short it concerns the long term financial planning or decisions. On the other hand, it is believed that financial decisions of short term assets and short term liabilities management also influence the stock price. These decisions are vital because they demonstrate the financial stability of the firm and the market which develops perception about the firm accordingly (Afza and Nazir,2008). An efficient working capital management can create value for stakeholders while a deprived policy or inefficient management might affect the business in an appalling way and might cause a financial distress.
Working capital management involves planning and controlling current assets and current liabilities in a manner that eliminates the risk of inability to meet due short term obligations on the one hand and avoid excessive investment in these assets on the other hand (Eljelly, 2004). Lamberson (1995) argues that working capital management has become one of the most important issues in organizations, where many financial managers find it difficult to identify the important drivers of working capital and the optimum level of working capital. As a result, companies can minimize risk and improve their overall performance if they can understand the role and determinants of working capital. The relationship between current assets and current liability items is called working capital of the organization.
A business (also known as enterprise or firm) is an organization designed to provide goods, services, or both to consumers. Businesses are predominant in capitalist economies, in which most of them are privately owned and formed to earn profit as to increase the wealth of their owners. Businesses may also be not-for-profit or state-owned. A firm could also be looked at as a transformation unit concerned with converting factor inputs into valued intermediate and final goods or services.
The firm or business is the basic producing/supplying unit and is a vital building block in constructing a theory of market to explain how firms interact and how their pricing and output decisions influence market supply and price. It is an organization that employs resources to produce goods or services for profit and sometimes owns and operates one or more plants(Pass, Lowess and Davies, 2005). The organizational structure of firms are often complex and varied. Multiplant firms may be organized horizontally with several plants performing much the same functions. Examples are the multiple bottling plants of Coca-cola and many individual Wal-Mart Stores (Brue, 1987).
Firms may be vertically integrated, meaning they own plants that perform different functions in various stages of production process. Examples are oil companies like Shell, refineries, etc. A firm‟s growth is the expansion of the size of the firm over time. Typical measures of a firm‟s growth are the growth of assets or capital employed, turnover, profits or a number of employees. Some firms remain small by choice or circumstance, others expand or become large either in national or international context through either/or organic growth and external growth like mergers, takeovers, etc. The process of growth is initiated and facilitated by a combination of managerial, economic, financial and „chance‟ factors.
Even though firms traditionally are focused on long-term capital budgeting and capital structure, the recent trend is that many companies across industries focus on working capital management efficiency. Firms follow an appropriate working capital management approach that is favorable to their industry. Those that have less competition would focus on minimizing the receivables to increase cash flow, while firms where there are large number of suppliers of materials focus on maximizing the payable (Ganesan,2007).
The importance of working capital management cannot be denied in any given organization. Researchers all over the world focused on this issue and discussed it in detail in the perspective of many countries. Researchers from developing countries consider working capital as a life blood of any organization and for this reason, most of the research on this topic had been carried out in developing countries like Pakistan, India, Taiwan, etc. As we belong to a country where researchers consider working capital as the most important factor that determine the profitability, it was surprising that despite the importance of this topic, very little research has been carried out in Nigeria.
Nigerian firms as well as others the world over, utilize working capital for smooth operation. They plan for and manage their inventories, cash receivables and payables, to ensure that requirements in their items are met. The little working capital available to Nigerian firms is managed by them to avoid operational embarrassments. Raw material inputs, mostly imported, are affected by unstable foreign exchange market and monetary policies of the government. Raw materials inventory are thus affected by inadequate foreign exchange for importation, delays in clearing at the Nigerian ports, and poor transportation network. These affect the production runs of Nigerian firms and delivery of finished goods to customers. Local delivery of raw materials to firms by poor transport infrastructures in the country, high cost of debt/overdraft in Nigeria limited the short-term finance of Nigerian firms to collection on sales also hampers growth in the net working capital.
Firms (quoted and unquoted) in Nigeria are today facing challenges of adequate working capital and liquidity as to meet up their short-term maturing obligations as a result of inadequacy of working capital. The position of working capital of firms in Nigeria is not only an internal firm-specific matter, but also an important indicator of risk for creditors .Previous works on topics surrounding working capital management attempted to find out the best way to finance working capital as to achieve cost-effectiveness. Most studies were from developed economies like Britain, Russia and United States of America where pertinent information is costlessly available, with well developed financial institutions in which capital and money markets play a catalyst role in the sustenance of consistent and steady growth in all sectors of their economies.
The outcomes and recommendations of these studies could not be wholesomely adapted here in Nigeria because our economy is underdeveloped and characterized by crises emanating from socio-economic and political problems since independence. The Nigerian capital and money markets are not really helping to ameliorate the problem. Instead, more often than not, they compound the problem by creating bottlenecks with harsh conditions that could not be easily met by the companies that are at the verge of collapse. According to Olugbenga (2010), the mismanagement of working capital in firms has caused some promising investments, with high rate of return, to be failures and frustrated out of business. Many factories have either temporally or permanently been shut down due to illiquidity.
Many Nigerian workers have been forcefully thrown into unemployment market as a result of the aborted mission of their organization caused by the twin variables of working capital and profitability. Financial institutions like banks, are unwilling or reluctant to lend out money to these firms due to their poor credit position, while most firms are not willing to obtain available credits offered them due to high interest rates. Assets in commercial firms consist of two kinds: fixed and current assets. Fixed assets include land, building, plant, furniture, etc.
Investment in these assets represents that part of firm‟s capital, which is permanently blocked on a permanent or fixed basis and is also called fixed capital that generates productive capacity. The form of these assets does not change. Current assets consist of raw materials, work-in-progress, finished goods, bills receivable, cash, bank balances, etc. These assets are bought for the purpose of production and sales, like raw materials into semi-manufactured products, into finished products, into debtors which is turned over cash or bills receivable. The fixed assets are used in increasing production of a firm and the current assets are utilized in using the fixed assets for day to day working. Therefore, current assets, called working capital, may be regarded as the lifeblood of a business enterprise. It refers to that part of the firm‟s capital, which is required for financing short term. The management of this working capital is with the objective in ensuring that a satisfactory level is maintained. The working capital should neither be more nor less, but just adequate.
Working capital management plays an important role in a firm‟s profitability and risk as well as its value (Smith,1980). The current assets account for over half of its total assets for a manufacturing firm while they account for even more for a distribution company. Excessive levels of current assets can easily result in a firm‟s realizing a substandard return on investment. However, Van Horne and Wachowicz (2004) point out that the excessive level of current assets may have a negative effect on a firm‟s profitability, whereas a low level may lead to lower levels of liquidity and stock-out, resulting in difficulties in maintaining smooth operations.
Gitman (1976) has suggested that the goal of working capital management is to manage each of the firm‟s current assets and current liabilities in such a way that an acceptable level of net working capital is maintained. Ramamurthy (1978) has stated that the management of working capital is part of the total management process, focusing on the most effective choice of working capital and the most effective operating combinations and management of current assets. Efficient management of working capital plays an important role of overall corporate strategy as to create shareholder value.
Working capital is regarded as the result of the time lag between the expenditure for the purchase of raw material and collection for the sale of finished goods. The way working capital is managed can have a significant impact on both the liquidity and profitability of the firm (Shin and Soenen,1998). The main purpose of any firm is to maximize profit. But, maintaining liquidity of the firm also is an important objective. The problem is that increasing profits at the cost of liquidity can be serious problems to the firm.
Thus, strategy of firm must be a balance between these two objectives of the firms. Because the importance of profit and liquidity are the same, therefore one objective should not be at the cost of the other. If we ignore profit we cannot survive for a longer period. Conversely, if we do not care about liquidity, we may face the problem of insolvency. For these reasons, working capital management should be given proper consideration and will ultimately affect the profitability of the firm.
A firm may choose an aggressive working capital management policy with a low level of current assets as percentage of total assets, or it may also be used for the financing decisions of the firm in the form of high level of current liabilities (Afza and Nazir, 2009). Keeping an optimal balance among each working capital component is the objective of working capital management. Business success heavily depend on the ability of financial managers to effectively manage inventory, receivables and payables (Filbeck and Krueger, 2005).
Firms can decrease their financing costs and raise the funds available for expansion projects by minimizing the amounts of investment tied up in current assets. Lamberson (1995) indicated that most of the financial managers‟ time and efforts are consumed in the non-optimal levels of current asset and liabilities and bringing them to optimal levels. An optimal level of working capital is a balance between risk and efficiency. It requires continuous monitoring to maintain the optimum level of various components of working capital like cash, receivables, inventory and payables (Afza and Nazir,2009). A popular measure of working capital management is the cash conversion cycle, being defined as sum of days‟ sales outstanding and days‟ sale of inventory less payable days‟ outstanding (Keown et al, 2003). The longer this time lag, the larger the investment in working capital. Corporate profitability might also decrease with cash conversion cycle, if the costs of higher investment in working capital is higher and rises faster than the benefits of holding more inventories and granting more inventories and trade credit to customers (Deloof, 2003). Many firms have large investment in current assets like accounts receivables and inventories.
A survey by national bank of Belgium shows that all the non-financial business in Belgium has 17% of total assets invested in accounts receivables and 13% in inventories making a total of 30% current assets which is a large percentage. These figures do not show the true value of current assets because there are lots of other kinds of current assets in which a company can invest. Keeping this fact in mind, one can easily judge that the total current assets of non-financial firms are from 30% to 40% of total assets, which really shows the importance of working capital management (Deloof, 2003).
Firms may have an optimal level of working capital that maximizes their value. Also, large inventory and a generous trade credit policy may lead to higher sales. Larger inventory reduces the risk of a stock-out. Trade credit may stimulate sales because it allows customers to assess product quality before paying (Deloof,2003; Long ,Malitz and Ravid, 1993; and Deloof and Jegers 1996).
Because suppliers may have significant cost advantages over financial institutions in providing credit to their customers, it can also be an inexpensive source of credit for customers (Peterson and Rajan, 1997). Important theoretical development in finance during the past decade have provided a potential for improved decisions in business organizations. Unfortunately, developments have not been uniform across all areas of financial decision making within and between business organizations. Working capital appears neglected in spite of the fact that a high proportion of the business failures is due to poor decisions on the working capital of the firms (Smith,1980). Of interest in this study is the area of working capital management, which generally is made up of short-term investment and financing decision of firms.
Historically, working capital management has passed through different stages, mainly the control, optimization and value measurement. It originally started as a systematic approach of controlling the incoming, outgoing and to ensure that the remaining balances of working capital was not misappropriated for personal benefits of those entrusted with its management.
To this end, both researchers and practitioners developed various control measures over the receipts and collections of cash, receipts and issuance of inventories as well as the increase of receivables through cash collections. In a perfect world, working capital assets and liabilities would not be necessary due to certainty, no transaction costs, no scheduling costs of production or constraints of technology. The unit cost of producing goods will not change with the amount produced. Firms would borrow and lend at the same interest rate.
Capital, labour and product markets would reflect all available information and would be perfectly competitive. In such an ideal world of business, there would be little need to hold any form of inventory other than a limited amount of goods in process during production. But such an ideal business assumes that demand is exactly known in advance, that suppliers keep their due dates, production can be smoothed and orders executed directly without costs and delays. There would be no need of holding cash for working capital other than for initial costs, because it could be possible to make the payment from every receipt of sales.
There would be no need for receivables and payables if customers pay cash immediately and the firm also makes its payment promptly. However, problems of working capital exist because these ideal assumptions are unrealistic and therefore working capital level makes a significant part of a firm‟s investment in assets being financed, implying that investments may have benefits as well as costs. Generally, from the perspective of the Chief Financial Officer (CFO), working capital management is a simple and straightforward concept of ensuring the ability of the firm to fund the difference between the short-term assets and short-term liabilities (Harris, 2005).
However, a “Total‟ approach is desired as it can cover all company‟s activities relating to vendor, customer and product (Hall,2002). In practice, working capital management has become one of the most important issues in the organizations where many financial executives are struggling to identify the basic working capital drivers and an appropriate level of the working capital (Lamberson,1995). Understanding the role and drivers of working capital management therefore becomes necessary.
In general, current assets are considered as one of the important components of total assets of a firm. A firm may be able to reduce the investment in fixed assets by renting or leasing plant and machinery, whereas the same policy cannot be followed for the component of working capital. The high level current assets may reduce the risk of liquidity associated with opportunity cost of funds that may have been invested in long-term assets. Though the impact of working capital policies on profitability is highly important, only a few empirical studies have been carried out to examine the relationship. It is this lacuna that our study wants to correct by adding to the evidence and literature.
Specific research studies exclusively on the impact of working capital management on corporate profitability in developing countries, especially in poor Sub Saharan Africa (SSA) countries remained altogether an ignored area of empirical research (Falope and Ajilore, 2009). This discussion on the importance of working capital management, its different components and effects on profitability, leads us to the problem statement which will be analyzed in the next section. It is believed that this study will enable firms in Nigeria to decide on the working capital level that is optimal (optimal mix of working capital components) with a view to maximize shareholders‟ wealth without undermining other objectives of the firm.
Furthermore, the study will contribute to the literature on the relationship between the working capital management and firms‟ profitability focusing on Nigerian firms. The study will also validate some of the findings of previous authors by testing the relationship between working capital management and the profitability of sample firms. Thus, this study will add substance to the existing theory developed by previous authors.
PROJECT TOPIC- EFFECT OF WORKING CAPITAL MANAGEMENT ON FIRM PROFITABILITY IN SELECTED NIGERIAN QUOTED COMPANIES
1.2 STATEMENT OF THE PROBLEM
Inadequate working capital management has remained a problem for firms in Nigeria due to its negative impact on their profitability (Oluboyede ,2007). Mishra‟s (1975) identifies inventory, receivables, cash and working finance as the four problem areas of working capital confronting public enterprises and further pointed out the need for efficient and effective utilization of working capital, as it was a neglected area hitherto affecting profitability of firms. Smith (1973) also notices that a large number of business failures in the past has been blamed on the inability of financial managers to plan and control the working capital of their respective firms. Adegoke (2007) further observes that some firms in Nigeria with some promising investments, with high rate of return have turned out to be failures and frustrated out of business due to lack of or inadequacy of working capital.
The current squeeze on cash and credit is threatening the survival of many businesses globally, including Nigeria. Many companies, both in private and public sector irrespective of their age, size or product range, have been experiencing difficulties meeting short-term maturing obligations/liabilities. The Nigerian economy characterized by low capacity utilization of firms, infrastructural breakdown, unstable monetary policies, lack of raw materials input, unstable foreign exchange market, low level of disposable income and purchasing power of citizens, and high cost of finance, has negatively impacted on the working capital situation of Nigerian firms. Liquidity situation of these firms are negative due to the high interest charged on bank loans obtained by them to meet short-term financial obligations, also necessitated by failed trade credit policies to customers.
Multiple taxes by the three tiers of government have worsened the financial situations of Nigerian firms. High cost of debt/overdraft in Nigeria limited the short-term finance of Nigerian firms to collections on sales thereby hampering growth in net working capital. With the present harsh economic and competitive environment that has engulfed the business world, it becomes worrisome where a firm is overloaded with inventories and other marketable securities when cash is in short supply for payment (Nwankwo and Osho, 2010). These problem areas are still rearing their ugly heads in many Nigerian quoted companies in the past years resulting to illiquidity and reduction in profitability (or loss increases) declared by the affected firms. Many quoted companies are hardly declaring dividends or bonuses to their shareholders.
Instead, the executives often make promises to shareholders that when conditions improve, the returns will be shared. In trying to manage the working capital of their firms, some finance managers find difficulty in determining what optimal amounts of cash, accounts receivable and inventories that they should choose to maintain, given the level of sales and cost considerations. While a firm is trying to maintain liquidity in its daily operations as to meet its short-term obligations, the asset-liability mismatch often occurs which increase firm‟s profitability in the short-run but at the risk of bankruptcy (Anand and Gupta, 2002).
These factors have negatively affected the working capital positions, planning, management, and the operational efficiencies of Nigerian firms, exposing them to operational embarrassments. Though efficient management of the working capital is crucial for both profitability and prosperity of any firm, not many studies have been conducted on the issue in Nigeria (Akinlo, 2011). Insufficient evidences on the firms‟ performance and working capital management with reference to Nigeria, provide a strong motivation for evaluating the relationship between working capital management and firm performance in detail. Against this backdrop, the need to carry out a study on the topical issue becomes necessary. The focus is to exploit the possibility of coming out with feasible suggestions that will remove or cushion the attendant adverse effects of working capital, profitability and liquidity on the overall performance of the quoted Nigerian economy.
1.3 OBJECTIVES OF THE STUDY
This research focuses on the effects of working capital management on profitability of Nigerian firms. The specific objectives of this study are:
1. To examine the effects of cash conversion cycle on the profitability of Nigerian firms.
2. To determine the effects of liquidity on the profitability of Nigerian firms.
3. To examine the effects of Age on the profitability of Nigerian firms.
4. To examine the effects of Accounts receivable on the profitability of Nigerian firms.
1.4 RESEARCH QUESTIONS
1. What effect does Cash Conversion Cycle have on profitability of Nigerian firms?
2. How far does Liquidity have a positive significant effect on profitability of Nigerian firms?
3. What effect does Age have on profitability of Nigerian firms?
4. To what extent does Accounts Receivable have a negative significant effect on profitability of Nigerian firms.
1.5 HYPOTHESES OF THE STUDY
PROJECT TOPIC- EFFECT OF WORKING CAPITAL MANAGEMENT ON FIRM PROFITABILITY IN SELECTED NIGERIAN QUOTED COMPANIES