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Wednesday 16 June 2021

Effects of Working Capital Management on Profitability of Manufacturing Firms in Nigeria

Effects of Working Capital Management on Profitability of Manufacturing Firms in Nigeria

Chapter One

Introduction

1.1 Background to the Study

The sustainability of a firm heavily depends on the ability and success of its financial management function (Karaduman, H. A., Akbas, H. E., Caliskan, A. O., & Durer, S. 2011). Traditionally, corporate finance involves capital budgeting, capital structure and working capital management. However, working capital management is also a very important field of corporate finance, because of its considerable effects on the firms profitability and liquidity (Nazir and Afza, 2009 and Alshubiri; 2011) In order to maintain its activity, firms typically need two types of assets: fixed assets and current assets. Fixed assets which include, building, plant, machinery, furniture, fixture and fitting among others are not only purchased for the purpose of resale, but also for operational purposes (Singh and Pandey, 2008). On the other hand, current assets are seen as key components of the firm’s total assets. The economic theory of firm requires that firm resources should be utilized efficiently in order to achieve economic successes. Moreover, the competitive modern business environment makes financial managers irrespective of the nature of their business to ensure efficient utilization of firm resources. 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, the 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 a firm, workings capital management has direct consequences on the liquidity position and the ultimate profitability of a firm (Burt and Abbate, 2009). Working capital connotes the funds locked up in materials, work in progress, finished goods, receivables and cash. Therefore, working capital is one of the most important measurements of the financial position, which according to Guthmann (2008) is the life-blood and nerve centre of any business entity. This necessitated the need for the careful management of working capital in every business organization with the value maximization objective.

Therefore, 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 level of working capital is maintained. In essence, the goal of working capital management is to promote a satisfying profitability and maximizes shareholders’ value (Li and Han-Wen, 2006). In essence, managing working capital is necessary because of its’ directs effects on the profitability and liquidity of a corporate entity. Rehn (2012) asserts that working capital usually refer to net working capital, the difference between current assets and current liabilities. Thus, it involves minimizing the timing of collecting receivables, deferring the period of payables, cash management and keeping the minimal inventory.

However, optimal efficient working capital management is usually achieved through the management of receivables, payables, inventory, cash conversion cycle and the operating cycle as a whole. A firm therefore needs to set an optimal level of stock to hold. Working capital management is considered as a very sensitive area in the field of financial management (Joshi, 1994); because it involves the decision of the amount and composition of current assets and the financing of these assets. However, most firms do not hold the correct amount of working capital and this has been a major obstacle to their overall profitability (Stephen, 2012). This together with the current liquidity crisis has highlighted the significance of working capital management. Because management of working capital has profitability and liquidity implications, which requires the firm manager to reach optimal working capital by controlling the trade-off between profitability maximization and liquidity accurately (Raheman and Mohamed, 2007).

This study is motivated by the recent global financial crises which significantly affect the liquidity position and the overall business activities across the world. In Nigeria, where credit is either not available or expensive to obtain, there are corporate issues across almost all the firms that, has to do with liquidity problem and consequently their operating performance. Researchers do conduct studies to examine the relationships among the firms’ working capital components and profitability using different methodologies. However, several effects particularly from foreign agencies and governments are in place to improve the manufacturing industry in Nigeria.

 

1.2 Statement of the Problem

Many companies had been either temporarily or completely shutdown. Many Nigerian workers had been thrown into unemployment market and frustratingly became dependent on relations and friends. Some Nigerian manufacturing firms that are still in business cannot pay dividend to shareholders in their companies. All these led to the study of working capital management in the recent past. Some of these companies are still shaking inspite of their being quoted on the NSE. Some manufacturing firms were acquired by another because they could not stand alone, example Savannah Sugar Company limited was acquired by Dangote industries limited in 2002. It is in the light of this crisis that the researcher had deemed it necessary to examine the impact of working capital management on the profitability of Nigerian petroleum trading companies. Working capital requires that the way it is managed will to a large extent determine whether such enterprise can survive or not. The management decides the best proportion of its investment in both fixed and current assets and finally her liability level to enable improvement and correction of imbalances in the liquidity position of the firm. However, the inability to make payments as at when due may definitely have serious consequences on the organizations financial growth (profitability). Therefore, it seems important to look into the above problem to know how to encourage managers so that their companies can stand the test of time, however, (Van Home and Wachobvics, 2004) pointed out that excessive level of current assets may have a negative effect on a firm’s profitability whereas a low level of current assets may lead to lowers of liquidity and stock-out, resulting in difficulties in maintaining smooth operations.

One of the major objectives of working capital management is to ensure that corporate entities have sufficient, regular and consistent cash flow to fund their activities. Therefore, efficient working capital management could enable firms in sustaining growth which, in turn leads to strong liquidity and profitability for ensuring effective and efficient customer services. Stephen (2012) documents evidence that most business organizations do not hold the right amount of stocks, debtors and cash; as a result of which the firms are unable to meet there maturing short term obligations and its upcoming operational needs. However, working capital management has been empirically examine in many different ways, while some authors studied the impact of an optimal inventory management; others have studied the optimal way of managing accounts receivables that leads to profit maximization (Lazaridis and Tryfonidis, 2006; Besley and Meyer, 1987). Other studies have focused on how reduction of working capital improves a firm’s profitability (Shin and Soenen, 1998; Deloof, 2008; Raheman and Nasr, 2007; Samiloglu, 2008; Zariyawati, 2009; Falope and Ajilore, 2009; Dong and 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 economy, where the market mechanisms and the business environment significantly differ from Nigeria.


Effects of Working Capital Management on Profitability of Manufacturing Firms in Nigeria


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