THE IMPACT OF WORKING CAPITAL MANAGEMENT ON THE PROFITABILITY OF MANUFACTURING FIRMS LISTED ON THE NIGERIAN STOCK EXCHANGE

ABSTRACT

This study examined the impact of working capital management on profitability of firms listed on the Nigerian Stock Exchange(NSE). Twenty (20) companies were selected through simple random sampling and the study was for a period of eleven (11) years (2006-2016). Data were collected through secondary sources, from annual reports and financial statements of selected firms. Panel data regression model was employed as the estimation technique, using fixed effect and random effect model technique. Hausman test statistics were used to determine which model was appropriate to explain the impact of the independent variable on the dependent variable. The findings of this study revealed that, debtor’s conversion period (DCP) has negative and non-significant impact on return on asset (ROA); inventory conversion period (ICP) has positive but non-significant impact on return on asset (ROA); creditor’s conversion period (CCP) has negative but significant impact on return on asset (ROA) and cash conversion cycle (CCC) has positive and significant impact on return on asset (ROA). Based on the research findings, it is recommended that managers can increase profitability of manufacturing firms by shortening debtors conversion  period  (DCP),  creditor’s  conversion  period  (CCP)  and  optimizing inventory conversion period (ICP) and cash conversion cycle (CCC).

CHAPTER ONE

INTRODUCTION

1.1       BACKGROUND TO THE STUDY

Maximization  of firm  value and  profit  to  the benefit  of shareholders is  the main objective of the financial manager. Schultz and Shultz (1971) in Nwude (2004) reaffirmed that firm value maximization is one of the main objectives of   financial management.  In  maximizing  the  firm’s  value  through  earnings,  the  intention  of financial managers is to maximize cost attached to each operation.  Though cost can respond to the control efforts of financial management, revenue may not, due to the fact that tastes and wants of customers are much more difficult to anticipate and satisfy.

The economic theory of firm states that profit is maximized at a point where marginal cost and marginal revenue are equal.  Hence, the purpose of financial management is to maximize average cost and organize the firm to operate efficiently so as to generate adequate  profits  which  will  reflect  in  the  payment  of  enhanced  dividends  to shareholders and enhance market value of the firm. Consequent upon the foregoing, the competitive modern business environment makes financial managers irrespective of the nature of their business to ensure efficient utilization of firm resources (Ojeani 2014). Firm resources are broadly classified into two: long term assets (non-current assets) and short term assets (current assets).

Therefore, there are two major decisions in the theory of corporate financial management, that is, long-term or capital budgeting decision and the short-term or working capital management decision (Pandey, 2009).   Although long-term capital decisions are of critical importance to the going concern of the firm, working capital management has direct consequences on the liquidity position and profitability of a firm (Burke & Abbate, 2009).

Working capital are funds used in day to day running of the business.  According to Nwude (2004), working capital is that portion of total funding needed for the day to day operations of an entity.  Khan and Jain (2005) state that those assets that can be converted to cash within a short period of time without significant loss of value is referred to as current assets. Working Capital is one of the most strategic asset holding of firms.  It is a circulating capital which flows and changes form as the firm pursues

its goals and performs its operations. One of the yard stick used in measuring the financial health of a firm is working capital because it is the blood that runs through the veins of every business entity (Guttmann 2008). It is a financial lubricant and life stream of the firm and maintains constant process of circulation throughout the firm. This     necessitates  the  need  for  careful  management  of working  capital  in  every business organization with the value maximization objective.

According to Ross, Westerfield and Jordan (1993), “the phrase working capital refers to a firm’s short term assets, such as inventory, and its short term liabilities, such as money owed to suppliers.  Managing the firm’s working capital is a day-to-day activity that ensures the firm has sufficient resources to continue its operations and avoid costly interruptions. This involves a number of activities all related to the firm’s receipts and disbursement of cash.” Some of the questions about working capital that must be answered include: how much cash and inventory should we keep on hand?  Should we sell on credit? If so, what term will we offer, and to whom will we extend them? How will we obtain needed short term financing?  Will we purchase on credit, or will we borrow short term and pay cash?  If we borrow short term, how and where should we do  it?  Working  Capital  Management  on  the  other  hand  is  the  management  of investments/divestments in current assets and increases/decreases in current liabilities (Nwude 2004). Working Capital Management involves the application of strategies and policies in the use of firm’s current assets and liabilities in such a way that an optimum working capital is achieved.   In essence, the goal of working capital is to promote a satisfying profitability that maximizes shareholder’s value (L1 & Han-Wen,

2006).   They further stated that profitability is affected by choices that companies make regarding their working capital policies. Thus, “if a firm cannot maintain an optimum level of working capital, it is likely to become insolvent and may even be forced into bankruptcy.   However, the need for working capital to run day-to-day business activities cannot be overemphasized.”

The management of working capital involves the determination of optimum level of working  capital  to  keep,  monitoring  and  controlling  the  levels  of  individual components of working capital to ensure that optimum level is not exceeded and provision of funds to finance current assets Nwude (2004). Poor management of working capital results in liquidity problem which might lead to bankruptcy in very

severe cases. When an organization has insufficient working capital, it is said to be undercapitalized or over trading.  Symptoms of over trading include rapid growth in sales, current and fixed assets, high stock turnover, low average collection period and liquidity ratios, stretching payables exceeding old limits, high debt-equity ratio.

Excessive Working Capital results in idle funds being unnecessarily tied down and in loss of profitability for the organization since the idle funds can be invested elsewhere to earn returns for the organization.  When a firm has excess working capital, it is said to be under trading or over capitalized.   Symptoms of under trading include high working capital turnover and liquidity ratios, low stock turnover and creditors payment period, high average collection period. Effective Working Capital Management therefore aims at ensuring that working capital is at optimum levels.   The optimum working capital level is that level of working capital which avoids both overcapitalization and undercapitalization taking the nature of the firm’s business and the level of operations into consideration.

Excessive Working Capital results in unnecessary accumulation of inventories which in turn increases the danger of obsolescence, deterioration, pilferage, mishandling, high insurance and carrying costs, idle assets, which are barren of income, accounts receivables, poor profitability. It indicates a defective credit policy which can lead to higher incidence of bad debts and loss of profits. Insufficient working capital, on the other hand, makes difficult the implementation of operating plans and achievement of profit  targets.    Other  demerits  include  stunted  growth  or  growth  stagnation  and sluggish rate of return on investment as a result of non-availability of working capital to undertake profitable investments.   The organization also loses its reputation, trust and confidence If it fails to meet up with short term obligations. Operating plans suffer due to insufficient resources and this can result in operating inefficiency. Again, poor returns on investments can result from inefficient utilization of fixed assets due to insufficient working capital to oil the fixed assets.

Because of its impact on the profitability and liquidity of corporation, management of working  capital  is  very  crucial.  Rehn  (2012)  asserts  that  “the  difference  between current assets and current liability is net working capital.” According to Nwude (2004), to the accountant, working capital is usually defined as current assets less current liabilities,  that is,  net working  capital.    To  the financial  analyst,  the accountant’s

definition is regarded as net working capital.   That is, the financial analyst defines working capital  as current assets of the firm,  that is gross working capital.   The necessity of working capital management or managing firm’s working capital involves minimizing the timing of collecting receivables, deferring the period of payables and keeping the optimum inventory.  Moreover, working capital management includes cash management, that is, how to invest idle cash without compromising liquidity.

Consequently,  extant  literature  on  firm  profitability  and  efficiency,  documents different results on the effects of working capital management on performance, and value of firm (Deloof, 2003).  According to him, efficient working capital has many effects, which include: speeds payment of short-term commitments of firms, enhances owner financing and minimizes failure of firms on account of working capital. Wignaraja and O’ Neil (1999) revealed that “working capital ensures a sound liquidity for  assurance  of  long  term  economic  growth  and  attainment  of  profit  generating process, and also ensures acceptable relationship between the components of firm’s working capital for efficient mix which guarantee capital adequacy.”  Peel and Wilson (1996), Shin and Soenen (1998), Eljielly (2004) and Appuhami (2008) find that inefficient working capital management leads to company’s failures, overtrading, liquidity crises, low profitability, and loss of business due to scarcity of products.

However, optimal and efficient working capital management is usually achieved through management of account receivables, account payables, inventory, cash conversion cycle and operating cycle as a whole. In this regard, Van Horne (1995) states that account receivable management involves achieving an optimal credit cycle. Moreover, since profit maximization is the goal of providing credit, debt collection cost should not exceed the amount recovered.

Accounts or trade payables management focuses on the period of time taken by companies to pay its creditors (suppliers).   It is the current liabilities and all other obligation maturing    within one year, such as overdraft, short term bank loan, bills payable, creditors, income tax liabilities (Uyer, 2009).  “Moreover, accounts payables management revolves around how much credit time received by the firm from its trade creditors;  it  therefore  shows  the  breathing  time  received  by  the  firm  in  terms  of payment for credit purchase.   Hence, the effectiveness lies in whether the firm is enjoying  the  actual  credit  period  promised  by  suppliers.”Cash  conversion  cycle

according to Wang (2002) is used in measuring cash management and it shows the relationship between cash flows within a firm and the components of working capital. Similarly, it can also be used to determine the amount of cash needed for any sales level, it is therefore a period of time between the outlay of cash on raw materials and the flow of cash from the sale of finished goods.

Inventory Management according to Stephen (2012) especially in a manufacturing firm “consists of three components: raw materials, work-in-progress and finished goods.” He further explains that “the holding of inadequate stock may lead to stock out costs such as lost profitability and goodwill from customers.  A firm, therefore, needs to set an optimal level of stock to hold and order: the “Economic Order Quantity (EOQ) is usually used”. In view of the foregoing discussions, working capital management is considered  a very important area in the field  of financial management  because it involves  the  decision  on  the  amount  and  composition  of  current  assets  and  the financing of these assets (Joshi, 1994). Moreover, the decisions with regard to “the level of different working capital components become frequent, repetitive, and time consuming” (Joshi, 1994).

One  of  the  major  challenges  to      overall  profitability  is  that  most  firms  hold inadequate working capital (Stephens, 2012). The importance of    working   capital management is  highlighted by  liquidity crises and its effect on  profitability. Because management of working  capital  has  profitability  and  liquidity  implication,  which requires the firm manager to reach optimal working capital by controlling the trade- off between profit  maximization and liquidity, accurately (Raheman, & Mohammed, 2007).

This work is motivated by the growing importance of working capital management and its significant effect on the liquidity and profitability of businesses across the world. The paucity of credit in Nigeria and the stringent conditions given by lenders to borrowers has negatively impacted on firms.  This negative impact affects not only the liquidity of firms, but also their profit performance.   It is the responsibility of financial managers to examine the current assets and current liabilities, when firm encounters liquidity challenges, with a view to making informed decisions with regard to the profitability of their entity.   In the same vein, researchers have carried out studies to find how profitability is related to working capital using different methodologies. This study focuses on randomly selected manufacturing firms listed on the floor of Nigerian Stock Exchange (NSE).   There are studies by many researchers outside Nigeria on working capital management and  firm profitability, however, the few research work in this particular area in Nigeria are industry or sector specific.  Some studies focused on brewery industry, while others have focused on pharmaceutical industry, food and beverage and some agriculture based industry. We have not only brought  this  research  home to  examine and  study  the impact  of  working  capital management on profitability of firms in Nigeria, we have deviated from the course of other researchers who focused on specific industry in Nigeria.  This study, therefore, examines  randomly  selected  manufacturing  firms  across  different  industries  in Nigeria. This study will provide empirical evidence on the effectiveness of financial management   of   these   firms   selected   through   simple   random   sampling   of manufacturing firms listed on the floor of Nigerian Stock Exchange (NSE) in line with effort at improving these companies. It is against this background that this study attempts to determine the Impact of Working Capital Management on the Profitability of Listed Manufacturing Firms in Nigeria.

1.2  STATEMENT OF THE PROBLEM

Firms,  both  within     and  outside  Nigeria  contend  with  several  challenges  and problems.  Some of these challenges that are external include: competition, regulation, availability of demand for the product, availability of credit facilities, security and inadequate power supply, to mention a few.  Others like capital adequacy, liquidity, and profitability are internal.

One of the major objectives of Working Capital Management is to ensure that corporate entities have adequate, regular and consistent cash flow to fund their activities.   Therefore, efficient working capital management can help firms sustain growth by ensuring strong liquidity and profitability. Consequently, efficient working capital management is very vital for business survival, for instance, too much cash signifies inefficiency whereas cash crunch is an indication that the business survival is in doubt. Stephen (2012) documents evidence that many businesses do not hold off appropriate mix e.g. stock, debts and cash, consequently, companies can not honor

their short term maturing obligations. In the same vein inadequate working capital means that a firm cannot expand and increase its sales thereby, hindering the growth and profitability of the business.

Other challenges faced by firms in Nigeria incudes; low capacity utilization, undercapitalization, weak financial base, high production cost and unstable demand among others.   While efforts have been made by previous researchers to proffer solutions to these, little or no effort has been made to investigate the short term liquidity problems with respect to working capital management.  Moreover, how far profitability of the firms is determined by the working capital management has not been well researched in Nigeria, hence, the need for this study. However, working capital management has been empirically examined in many ways and in many countries. Why some researchers studied “the impact of optimal inventory management”, others studied “the optimal ways of managing accounts receivables in order   to   drive   profitability   and   maximize   shareholders   value”   (Lazaridis   & Tryfornidis, 2006; Besley & Meyer, 1987).   Other studies have focused on “how reduction of working capital improves firm’s profitability” (Shin & Soenen, 1998; Zariyawati, 2009; Falope & Ajilore, 2009; Dong & Su, 2010; Sharma and Kumar,

2011).

In  summary,  most  of  these  studies  concentrated  on  a  single  working  capital component and the study are mostly from the developed economies, where market mechanisms and the business environment significantly differ from Nigeria.   This provided a gap for this study to fill.  Similarly, this study used all the working capital components like, debtors conversion period, inventory conversion period, creditor conversion period, cash conversion cycle, and examined their impact on the profitability of firms, measured by return on asset. Finally, the scope of study covered period, 2006-2016 making this work a very current one.

1.3       OBJECTIVES OF THE STUDY

The main objective of this research work is to examine “the impact of working capital management on the profitability of randomly selected manufacturing firms listed on the floor of Nigerian Stock Exchange (NSE)”. The specific objectives of this research work are to determine the impact of:

1.          Debtors conversion period on profitability of selected manufacturing firms.

2.           Inventory conversion period on the profitability of selected manufacturing firms.

3.           Creditors payment period on the profitability of selected      manufacturing firms.

4.          Cash conversion cycle on the profitability of selected manufacturing firms.

1.4      RESEARCH QUESTIONS

As a result of the objectives stated above, the following research questions will guide the study. The questions are to what extent does:

1.         Debtors conversion period affect profitability of the manufacturing firms listed on the Nigerian Stock Exchange.

2.         Inventory conversion period impact profitability of the manufacturing firms listed on the Nigerian Stock Exchange.

3.         Creditors payment period influence profitability of the manufacturing firms listed on the Nigerian Stock Exchange.

4.         Cash  conversion  cycle  determine  profitability  of  the  manufacturing  firms listed on the Nigerian Stock Exchange.

1.5         RESEARCH HYPOTHESES

This study will be guided by the following proposals which will be tested based on the      strength of the evidences from the estimated parameters of the model.

1.         Debtor’s conversion period does not  have positive and significant impact on the profitability of  selected manufacturing firms listed on the floor of Nigeria Stock Exchange.

2.         Inventory conversion period does not have positive and significant impact on the profitability of selected manufacturing firms listed on the floor of Nigerian Stock  Exchange.

3.        Creditors payment period does not have positive and significant impact on the profitability of selected manufacturing firms listed on the floor of Nigerian Stock Exchange.

4.          Cash Conversion Cycle does not have positive and significant impact on the profitability of selected manufacturing firms listed on the floor of Nigerian Stock Exchange.

1.6       SCOPE OF THE STUDY

This study aims at evaluating the impact of working capital management and its major components on the profitability of twenty(20) manufacturing firms listed on the floor of Nigerian Stock Exchange (NSE) for the period of eleven(11) years period (2006 to

2016). A simple random sampling technique was used to select listed firms on the Nigerian Stock Exchange. The study used information available on the audited annual report and financial statements of the firms for the period under review.

1.7       SIGNIFICANCE OF STUDY

This work reveals the effect of working capital management on the profitability of selected manufacturing  firms listed on the floor of the Nigerian Stock Exchange (NSE). The findings of this research work will benefit the following group of persons:

1. SHAREHOLDERS

Shareholders as business owners could be the primary beneficiaries of the findings of this research paper as anything affecting the value of their investments is of great importance to them. Working Capital Management has the potentials of improving profitability and the overall  value of the firm.

2. MANAGERS

Managers of selected firms listed on the floor of Nigerian Stock Exchange as well as other firms will benefit from the findings of this research study. This is because managers are usually interested in understanding the effects of their performance on the profitability and firm value. This study will enable managers make accurate, precise, and favourable economic decisions toward the firms growth.

3. CREDITORS

The findings of this research study will enable businesses measure the level of safety in being able to discharge obligations in order to attain profitability and be prepared for unforeseen events by providing cushion for such occurrences. This study will also be of importance to creditors, because they are interested in the credit worthiness of the firms in meeting their obligations, which could only be possible with efficient management of firm’s working capital.

4. ACADEMIA

This research work will again add to the stock of knowledge in the academic community.   Students and researchers will find this study useful in that they are interested in how theoretically related variables empirically affect each other.   This study will serve as source of knowledge for students and a point of reference for researchers.

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