Working Capital Management and Firms Performance a Study of Manufacturing Companies in Nigeria
Chapter
One
Introduction
1.1
Background to the Study
Working
Capital management of a firm, which deals with the management of current assets
and current liabilities, has been recognized as an important area in financial
management. Working capital (WC) refers to the firm’s investment in short-term
assets. Pandey, (2005) classified working capital into gross and net concepts.
He defined gross working capital as the firm’s investment in current assets.
Current assets are the assets which can be converted into cash within an
accounting year and these include; cash, short-term securities, debtors, bills
receivables and stocks. He described net working capital as the difference
between current assets and current liabilities. Current liabilities are those
claims of outsiders, which are expected to mature for payment within an
accounting year. These include trade creditors, bills payable, bank overdraft
and short- term loan. Home van, (2000) described working capital management as
involving the administration of these assets namely cash, marketable
securities, receivables and inventories and the administration of current
liabilities. Management of these short-term assets and liabilities is important
to the financial health of business of all sizes. This importance is hinged on
the fact that the amounts invested in working capital are often high in
proportion to the total assets employed and therefore warrants a careful
investigation (Smith, 1980). Working Capital therefore, should neither be more
nor less, but just adequate for the smooth running of a firm. While excess
amount of working capital results in the reduction of firm’s profitability,
holding of inadequate amount of it leads to lower levels of the firm’s
liquidity and stock outs resulting in difficulties in maintaining smooth
operation (Krueger, 2002).
Business
success, therefore, heavily depends on the ability of the financial managers to
effectively manage accounts receivable, inventory and account payable (which
are component of working capital) (Filbeck and Krueger, 2005). Firm can reduce
their financing costs and or increase the funds available for expansion of
project by minimizing the amount of investment tied up in current assets (Home
Van Wachowicz, 2004). For this reasons, most of the financial manager’s time
and efforts are spent in identifying the non-optimal levels of current assets
and liabilities and bringing them to optimal levels (Lamberson, 1995). An
optimal level of working capital is the one in which a balance is achieved
between risk and efficiency. To maintain the optimal level of various
components of working capital, continuous monitoring is required (Afza and
Nazir, 2009). A poor or inefficient working capital management leads to tie up
funds in idle assets and reduces the liquidity and profitability of a company
(Reddy & Kameswar, 2004). Siddart & Das (1993), states that the major
reason for slow progress of an undertaking is shortage or wrong management of
working capital. Deloot (2003: 573), states that “there is a significant
relationship between gross operating income and number of days of account
receivable, inventories and accounts payables”. The relationship between
accounts payable and profitability is consistent with the view that less profitable
firms wait longer to pay their bills. Considering the importance of Working
Capital Management therefore, the researcher focused on evaluating the Working
Capital Management and profitability relationship like other similar works such
as Uyar, 2009; Samiloglu and Demirgune 2008; Vishnani and Shah, 2007; Tervel
and Solano, 2007; Lazaridis and Tryfonidis, 2006; Padachi, 2006; Shin and
Soenen, 1998; Smith et al, 1997 and Jose et al, 1996. However, there are a few
studies with reference to
Nigeria
in respect of the subject. Like Akinsulire, 2005, Falope,, 2009, Ajilore,, 2009
etc. Most of these studies focused on the Working Capital Management financing
policies. Shah and Sana (2006) concentrated on the oil and gas sector and
estimated the relationship using small sample of 7 firms. Raheman and Masr
(2007) analyzed profitability and Working Capital Management performance of 94
firms listed on Karachi Stock Exchange for the period 1999-2004 by using
ordinary least square and generalized least square. However, this study ignored
the fixed effect of each firm as each firm has its unique characteristics and
also ignores sector-wise analysis of Working Capital Management performance of
manufacturing firms. Insufficient evidences on the firm’s performance and
Working Capital management with reference to Nigeria therefore, provide a
strong motivation for evaluating the relationship between working capital
management and firm’s performance in detail. This study therefore, explores the
various way of measuring Working Capital components and relates them to the
performance of the Nigerian manufacturing sector.
1.2
Statement Of The Problem
There
has been a growing number of studies that examined the relationship between
working capital and corporate profitability in the recent time (Shin and
Soenen, 1998; Deloof, 2003; Fildbeck and Krueger, 2005; Falope, 2009; .Jinadu,
2010). Justification for this common efforts centered on the relationship between
efficiency in working capital management and firms profitability and its
implications on shareholder’s value. Most of these studies were however,
centered on large firms operating within well developed money and capital
market of developed economies and did not consider the fact that the amount of
working capital required varies across industries and indeed firms depending on
the nature of business, scale of operation, production cycle, credit policy,
availability of raw materials etc (Ghosh and Maji; 2004). It is regrettable to
note that in spite of these huge literatures in this area, many firms had
crashed, more especially manufacturing sector of the Nigerian economy in which
application of working capital is more pronounced (Jinadu, 2009). In addition,
some promising investments with high rate of return are failing and being
frustrated out of business because of inadequacy of working capital. Many
factories had been either temporarily or completely shot down because they
could not meet their financial obligations as at when due because they were not
liquid. Many Nigerian workers had been forcefully thrown into unemployment
market and frustratingly became dependent on relations as a result of the
aborted mission of their organization caused by poor attention given to the
management of working capital . Unfortunately, Nigeria capital and money
markets are not really helping to ameliorate the problem, instead, more often
than not; they compound the problem by creating bottleneck with harsh
conditions that could not be easily met by the companies that are at the verge
of collapse. The problem then arises as to how managers of these manufacturing
organization could be encouraged to pay more attention to the management of
their working capital. In other words, how could working capital be managed in
order to impact positively on firms performance.
Working Capital Management and Firms Performance a Study of Manufacturing Companies in Nigeria
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