CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
The Nigerian Economy is faced with several factors which could impede the speed of having a huge return on the resources employed by the firms and companies. As a result, however, proper initiative and capital (resource) management is required. It is worthy to note that out of every resource that an organization has, working capital is the most important or the basic. Working capital is a vital element in any organizational setting that requires cogent attention, proper planning and management. Again it is an essential resource required by every firm to achieve its goals and objectives. One factor that is deduced to influence firm profitability grossly is the firm’s working capital. Dougall and Guthmann (1984) define working capital as excess of current assets over current liabilities. This view was elaborated by Gladson and Park (1963) when they defined working capital as the excess of current assets of a business (cash, accounts receivables, inventories, for example) over current items owed to employees and others (such as salaries and wages payable, accounts payable, taxes owed to government). Gole (1959) also holds more or less the same view. Working capital is the stock stored that has a conversion or resale value in order to gain profit. It represents the largest cost of a firm especially the manufacturing firms. In normal circumstances, working capital consists of about 30% – 40% of a firm’s total investment. Investment in working capital to a large extent determines the returns earned by a firm.
Nevertheless, excessive levels of current assets can easily result in a firm realizing a substandard return on investment while firms with too few current assets may incur shortages and difficulties in maintaining smooth operations (Van Horne & Wachowicz, 2000). As a result, working capital management is a very important component of corporate finance as it directly affects the liquidity and profitability of a firm. It centers on current assets and current liabilities of a firm. Jagongo and Mogaka (2013) define working capital management as the ability to control effectively and efficiently, the current assets and current liabilities in a manner that provides the firm with maximum return on its assets and minimizes payments for its liabilities.
Working capital management has been considered as an important component of firm’s financial decision process, occupying a major portion of manager’s time and resources (Richard & Laughlin, 1980). Similarly, Onwumere, Ibe, and Ugbam (2012) stated that efficient management of working capital is thus a fundamental part of the overall corporate strategy of the firm in creating the shareholder’s value, keeping in mind that an optimal level of working capital will maximize the firms value.
Efficient working capital management involves planning and control of current assets and current liabilities in a manner to strike a balance between liquidity and profitability. Harris (2005) pointed out that 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. The ultimate objective of any firm is to maximize shareholders wealth and maximizing shareholders wealth can be achieved by a firm maximizing its profit. A firm that wishes to maximize profit must strike a balance between current assets and current liabilities and hence keeping abreast of the liquidity and profitability trade-off. Preserving liquidity and profitability of the firm is an important objective as increasing profit at the expense of liquidity can bring serious problems to the firm and vice-versa.
Working capital management is considered to be a very important element to analyze the firm’s performance while conducting day to day operations. There are chances of imbalance of current assets and current liability during the life cycle of a firm and profitability will be affected if this occurs. This is why the study of working capital on firm’s profitability is drawing scholar’s attention in this recent times.
The goal of working capital management is to manage the firm’s current assets and liabilities in such a way that a satisfactory level of working capital is maintained. This is so because if the firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and may even be forced into bankruptcy. The current assets should be large enough to cover its current liabilities in order to ensure a reasonable margin of safety. Each of the current assets must be managed efficiently in order to maintain the liquidity of the firm while not keeping too high a level of any one of them.
Two benefits are usually associated with working capital management. Firstly, working capital management is important with regard to its direct effect on firm liquidity (Chiou & Cheng 2006; Moss & Stine 1993). The short-term effects of working capital management on liquidity are straight forward to derive (Richards & Laughlin, 1980). Stocks lead to cash outflows to suppliers and cash inflows from customers. Therefore, if payments to suppliers are postponed, payables increase but the cash outflows materialize at a later point in time. Inversely, if a firm’s trade credit policy allows its customers late settlements, the cash inflow is delayed. This interdependency was highlighted in the financial crisis (2008–2009) when external funding became unattractive or even unavailable, leading firms to tighten their trade credit policies, reduce stocks, and delay payments to compensate for the external financing constraints (Enqvist, Graham, & Nikkinen, 2012). Longer-term effects of working capital management on liquidity are less clear. For instance, a strict trade credit policy might deter potential customers and thereby reduce future cash inflows.
Secondly, working capital management is important for managing firm value (Pass & Pike 1987; Smith, 1980). Evidence from US corporations reveals that investors value working capital investments with a discount compared to cash (Kieschnick, Laplante, & Moussawi, 2011). This can be ascribed to the fact that working capital management is linked to companies’ profitability. Working capital management can affect companies’ profitability in two ways. On the one hand, working capital management influences firm sales and hence profits. On the other hand, working capital management impacts the capital employed and thus the cost of capital. Assuming it is feasible to increase sales without increasing the capital employed would lead to a disproportionately high increase in profitability. A firm can be very profitable if it can translate cash from operations within the same operating cycle, otherwise the firm would need to borrow to support its continued working capital needs.
In Nigeria, studies on working capital have centered on aggressive conservative working capital practices, liquidity level (Jide, 2010) and policies of firms on profitability (Onwumere et al., 2012). However, no attempt has been made to use the traditional proxies to empirically investigate the working capital-performance nexus on profitability of consumer goods companies, it is against this backdrop that this study sought to empirically investigate the impact of working capital management on profitability of quoted consumer goods companies in Nigeria.
1.2 Statement of the Problem
Working capital management is essential to company’s survival because of its effects on firm’s profitability, risk and value. Some promising investments with high rate of return had turned out to be failures and were frustrated out of business (Salaudeen, 2001).Smith (1973) in Egbide (2009) discovered that large number of business failures in the past has been blamed on the inability of the financial manager to plan and control the working capital of their respective firms. This reported inefficient management of working capital among financial managers are still practiced today in many organizations in the form of high bad debts, high inventory costs etc., which adversely affect their operating performance (Egbide, 2009). Many companies in Nigeria had been either temporarily or completely shot down due to their inability to manage efficiently their working capital, example, Nigeria paper mills ltd, Jebba, Nigeria sugar company, Bacita, Kastina steel rolling mill Co. Ltd., among others.
Many Nigerian workers had been thrown into unemployment market and frustratingly became dependent on relations and friends, example, Premier Breweries plc. reduced its staff from 5000 to 1000 in 2007. Some Nigerian companies that are still in business cannot pay dividend to shareholders in their companies, (example, Champion Breweries has not paid dividend since 1988, Golden Guinea Breweries has not paid since 1997) among others (Salandeen, 2001). Some of these companies are still shaking in spite of their being quoted on the NSE. Some consumer goods companies were acquired by another because they could not stand alone, example Savannah Sugar Company limited was acquired by Dangote Sugar 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 quoted consumer goods companies in Nigeria Stock Exchange. Working capital is the life wire of any business enterprise. It therefore 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.
1.3 Objectives of Study
The general objective of this study is to investigate the impact of working capital management on profitability of quoted consumer goods companies in Nigeria. To achieve the above objective, the study will strive to accomplish the following specific objectives:
- to investigate the impact of cash conversion cycle on profitability of quoted consumer goods companies in Nigeria.
- to show the impact of accounts receivable on profitability of quoted consumer goods companies in Nigeria.
- to ascertain the impact of accounts payable on profitability of quoted consumer goods companies in Nigeria.
- to show the impact of inventory turnover period on profitability of quoted consumer goods companies in Nigeria.
1.4 Research Questions
The research questions will be as follows:
- to what extent has cash conversion cycle affected the profitability of quoted consumer goods companies in Nigeria.
- how does accounts receivable impact on the profitability of quoted consumer goods companies in Nigeria.
- how does accounts payable influence the profitability of quoted consumer goods companies in Nigeria.
- to what extent does inventory turnover period influence the profitability of quoted consumer goods companies in Nigeria.
1.5 Research Hypotheses
The research hypotheses, in line with the research objectives and stated in null form, will be as follows:
- Cash conversion cycle does not have a negative and significant impact on profitability of quoted consumer goods companies in Nigeria.
- Accounts receivable does not have a negative and significant impact on profitability of quoted consumer goods companies in Nigeria.
- Inventory turnover period does not have a negative and significant impact on profitability of quoted consumer goods companies in Nigeria.
- Accounts payable does not have a positive and significant impact on profitability of quoted consumer goods companies in Nigeria.
1.6 The Scope of the Study
The scope of the study comprises 10 quoted consumer goods companies that are consistent with their annual reports with the Nigeria Stock Exchange. The essence of selecting this 10 companies was to avoid missing variables. The researcher borrows extensively from secondary data and makes use of journals, quoted consumer goods company’s annual reports for the periods, the Nigerian stock exchange fact books and the Nigeria Stock Exchange Daily Official list. The researcher also made use of return on assets as a proxy for the profitability of consumer goods companies in Nigeria.
The research study 10 consumer goods companies listed on the Nigeria Stock Exchange for a 10-year period covering 2005 – 2014, forming a panel data for the 10-year period. The researcher choose this period to study the impact of working capital management on profitability of quoted consumer goods companies in Nigeria because it is the years that the manufacturing companies in Nigeria faced the problem caused by the restrictions that banks implemented on short – term loans, which lead to financial constraint on manufacturing firms. Ivashina and scharfstein (2008) found that banks indeed scaled back lending during the financial crisis of 2008 resulting in a 36% decline of consumer product, in those years. This decline caused financial constraints for firms and companies all over the world.
1.7 Significance of the Study
Short term financing which working capital is the major part plays a vital role in the economic position of the firms. The results of this study wasl most likely be useful in understanding the dynamics of and thus, in improving WCM practices for raising or maximizing the profitability. It could help guide the financial managers towards more specialized handling of day to day operations and achieving optimal level for increased efficiency.
Among other things, this study was specifically significant to Managers, Economist/Policy maker and Academics/Researchers in a number of respects.
- Managers
This study will serve as a guide to managers of consumer goods companies in Nigeria because it will help them to efficiently manage their working capital in order to become profitable. As according to Deloof (2003) efficient working capital management is fundamental for maximizing profitability. Therefore, maximizing profit is the main objective for companies; however, companies need at the same time to focus on liquidity to prevent insolvency (Raheman & Nasr, 2007).
- Economist/Policy Maker
The economist/policy maker will get to understand how working capital management impacts on profitability, which may enhance their short term financial decision making. Working capital investment involves a trade- off between profitability and risk, decisions that focus entirely on maximizing liquidity decreasing profitability (Smith, 1973).
- Academics/ Researchers
This study will help enlighten the issues on working capital policies and also serve as a resource material for further works and studies.
1.8 Limitations of the Study
The study was conducted on only the 10 consumer goods companies in Nigeria Stock Exchange. Accordingly the result could not be generalized for all the quoted consumer goods companies operating in Nigeria due to unavailability of data for some of these firms.
1.9 Operational Definition of Terms
Working capital: Working capital is the cash needed to pay for the day-to-day operation of the business. It is calculated as the difference between the current assets of a business and its current liabilities.
Current assets: These are those assets that are held in cash form or that can easily be turned into cash. Examples are receivable, inventory and cash. While current liabilities are money owned by a business which will need to be paid within one year.
Working capital management: It is the regular adjustment and control of the balance of current assets and current liabilities of an organization are made and the fixed assets are properly serviced.
Accounts receivable are customers who have not yet made payment for goods or services, which the company has provided. The objective of the debtor management is to minimize the time-lapsed between completion of sales and receipts of payment. In this respect account receivable is divided by sales. It represents the firm’s payment from its customers.
Inventories: Inventories are list of stocks raw materials, work-in- progress or finished goods waiting to be consumed in production or to be sold. Inventory is calculated as inventory/purchase. It reflects the stock held by the firm.
Accounts payable: Accounts payable is suppliers whose invoices for goods or services have been processed but who have not yet been paid. Organization often regards the amount owing to the creditors as a source of free credit. Account payable is calculated as payables divided by purchases. The longer the value, the longer firms take to settle their payment commitment to their suppliers.
Cash conversion cycle (CCC): The cash conversion cycle (CCC) is a proxy for working capital management efficiency. Cash conversion cycle is the flow of cash from suppliers to inventories to accounts receivable and back into cash. It is therefore calculated as inventories and receivables less payables. It has been interpreted as a time interval between the cash outlays that arise during the production of output and the cash inflows that results from the sale of the output and collection of the account receivable. CCC is calculated by subtracting the payables the sum of the inventory conversion period and the receivable.
Sales growth: The sales growth is the increase or decrease of the annual sales measured as a percentage. In this study a positive effect from sales growth on the performance is assured.
Debt: This is measured by relationship of long-term debt to total assets and is proxy leverage. It is assumed that when external funds are borrowed e.g. from banks at the fixed rate, they can be interested in the company and gain a higher interest paid to the bank.
Consumer Goods Companies: These are companies that relate to items purchased by individuals rather than by manufacturers and industries. This companies involved with food production, packaged goods, clothing, beverages, automobiles and electronics