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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