e-sRC

CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
Working Capital Management refers to a company‟s managerial accounting strategy designed to
monitor and utilize working capital components (current assets and current liabilities) to ensure
the most financially efficient operation of the firm (Investopedia. 2018). Working capital
management involves planning and controlling current assets and current liabilities in a manner
that eliminates the risk of inability to meet short term obligations when due and to avoid
excessive investment on current assets which leads to idle cash (Eljelly, 2004). Working capital
management involves decisions on the amount which constituted the composition of net current
assets and the financing of these assets (Samson, et al, 2012).
Working Capital Management can also be defined as the controlled process of current assets less
current liabilities (Lukarris & Eero, 2011). Weston & Bringham (2015), defined working capital
management as investment in short term assets. We have observed that most researchers see
working capital management through the prism of working capital and they try to define working
capital as follows: Cheng, Frank and Wu (2009) and Guthman & Dougall (1948) defined
working Capital as receivables plus inventory minus payables. Working Capital are short term
balance sheet items which are attributable to current assets on the assets side and current
liabilities on the liabilities side of the balance sheet (Brealey, Meyers & Allen, 2011, p.856). The
main elements of working capital should include cash, marketable securities, receivables and
inventories which are important for the management of the company (Ali & Ali, 2012).
Working Capital Management is important as it has direct impact on the profitability of firms
(Ray, 2012). To maintain liquidity and profitability of an organization, its working capital should
be managed efficiently (Nazir & Afza, 2009). This entails planning and controlling current assets
and current liabilities of firms with the view to reduce the risk of inadequate and non-availability
of cash (Adeniji, 2008).
Deloof (2003) posited that working capital management directly affects the liquidity and
profitability of firms, the study argues that firms in a given large sample must vary in terms of
size, age and Technology among others; that liquidity settings will also vary greatly depending
on the risk appetite of the firm. Also, that firms will have different credit ratings that determines
the way in which these firms make their purchases. According to Raheman and Nasr (2007)
“Excessive level of current assets account can easily result in a firm realizing a substandard
return on investment”, hence the need to manage working capital. The working capital
management variables considered by this study are; account receivables, inventories turnover,
account payable and cash conversion cycle (Lukkaris & Eero, 2011).
Working capital management involves planning and controlling current assets and current
liabilities in a manner that eliminates the risk of inability to meet short term obligations when
due and to avoid excessive investment on current assets which leads to idle cash (Eljelly, 2004)
and looking at the nature of working capital and its components which are short lived, there is
the need to manage working capital in order to attain profitability. “Current assets are short-lived
investments that are continually being converted into other asset types” (Rao, 1989). When a
firm maintain excessive current asset, it ends up tying down firm resources and that can affect
profitability (Rahem & Nasir, 2011). Also, large inventory and a generous trade credit policy
may lead to high sales, but that does not translate in to profitability (Rahem & Nasir, 2011).
Efficient working capital management is necessary for achieving both liquidity and profitability
of a company (Nazir & Afza, 2009). A poor and inefficient working capital management leads to
tying up funds in idle assets and reduces the liquidity and profitability of a company (Reddy &
Kameswari, 2004). Working capital management became important and necessary during the
financial crisis up to 2008 because the cost of long term debt increases and the new cost levels
become difficult to attain, hence the need to manage working capital, especially when it can
influence firm profitability and risk (Smith, 2018).
Keeping larger inventory by a firm reduces the likely risk of a stock-out (Rahem & Nasr, 2007),
even at that, inventories are not to be kept at an arbitrary level, there is the need for deliberate
planning and continuous check on the inventory. Given that Inventories can save the firm from
the risk of losing an important customer by meeting up with their unexpected demand; however,
keeping too much idle stock may create unnecessary liquidity shock to a firm thereby affecting
firm profitability, hence the need for tradeoff between liquidity and profitability which is
ultimately working capital management (Shin & Soenen, 1998).
Firms sometimes bought goods on credit from its suppliers meant to be payable in the near
future, delaying payment to suppliers allows a firm to assess the quality of products bought, and
can be an inexpensive and flexible source of working capital for the firm (Perri, 2008). This in
essence allows firms to utilize the available cash that ought to be used for paying for supplies to
another profitable investment opportunity. However, late payment of invoices can be very costly
if the firm is offered a discount for early payment (Rahem & Nasr, 2007).This decision process
need to be taken by top management and is considered as payables management and as a
component of working capital, it can be seen as working capital management (Cannon, 2008).
Cash conversion circle is a fundamental tool applied in the assessment of the efficiency of
working capital management (Richard & Laughlin, 1980). The common measure of working
capital management (WCM) is the cash conversion cycle (CCC), this is the time between making
payment for the raw materials purchased and the receipts of proceeds of sales of finished goods
(Deloof, 2003). The more days a company‟s money is tied up in inventory, the longer the cash
conversion cycle and the longer the number of days creditors must wait for their money (Jason &
Kasozi, 2017). It is usually recommended that firms should have shorter cash conversion cycle
for them to be profitable and remain credit worthy (Bibi & Ajmad, 2017).
A longer CCC may translate into poor profit as inventories are either not converted into goods on
time or they are converted, sold and yet the debtors have delayed payment or we have delayed
paying our creditors (Billie, 2014). Hence, when CCC is shortened, it is expected to improve
firm‟s profitability. Longer CCC results to a greater need for expensive external financing as
cash are tied down on inventories or because we have lost our credit worthiness as such we have
to look elsewhere to finance that which ordinarily would have been made available to us by our
creditors (Nordmeyer, 2015). Longer CCC ultimately suggest that the firm is less likely to obtain
credit when needed and less likely to continue in business as it is cash trapped (Jason & Kasozi,
2017). When there is a reduction in the time cash are tied up in working capital, it tends to
improve on the efficient operations of the firm. The CCC is a useful way of assessing the firm‟s
cash flow as it is the measure of time that the funds were invested in working capital (Pratap,
Kumar & Colombage, 2017). CCC is often regarded as the powerful and more comprehensive
measure of WCM than using the current ratio and the quick ratio which focus on statistical
balance sheet values (Quang, 2017). The CCC includes the time dimension of liquidity which
measures the overall ability of firms to manage cash (Pratap, Kumar & Colombage, 2017).
There are two major measurement of firm‟s performance commonly put to use, these are return
on asset (ROA) and return on equity (ROE) (Meena & Reddy, 2016). The impact of working
capital management on the financial performance of industrial goods firms is often measured
using the return on asset (ROA) and not return on equity (ROE) because of timing and value
issues against ROE (Falope & Ajilore, 2010). Often, net operating income and gross operating
income are also used as the measure of financial performance. Also, the use of operating income
to sales and operating cash flow to sales is beginning to gaining currency as a measure of firm‟s
performance (Enow & Brijlal, 2014). The operating income is often used as a measure of firm‟s
earnings power from ongoing operation and it is regarded as the difference between revenues and
operating expenses. However, for the purpose of this work, return on assets (ROA) will be
adopted as the proxy of firm profitability because in manufacturing companies, the firm is being
financed mostly by the proceeds from the assets of the company (Falope & Ajilore, 2010).
On the basis of the above background, the study attempts to evaluate the impact of working
capital management on the profitability of industrial goods firms in Nigeria. What motivate this
study is that, working capital management has been regarded as part of the financing
considerations that a finance manager of a corporation needs to determine apart from capital
structure and budgeting. Recently, companies have been putting more emphasis on maximizing
profitability from their business operation (Akoto, Vitor & Angmor, 2013), hence the need to
manage their working capital. Consequently, in determining the firm‟s profitability, finance
managers need to take account of the firm‟s working capital management which basically means
managing the firm‟s current assets and current liabilities (Park & Gladson, 1963). In a balance
sheet, current assets consist of account receivables, cash and bank balances which are short term
in nature and are used for production and sales; that can be converted in to cash within the year
(Raheman & Nasr, 2007). Similarly, current liabilities refer to obligations that need to be paid
within the year or not beyond the business operating cycle, whichever is earlier (Ross,
Westerfield & Jaffe, 2010). Hence, current liabilities comprises of accounts payable, accrued
wages, taxes, short term debt and other expenses payable (Ali & Ali, 2012).
Managing working capital efficiently, increases firm‟s profitability and shareholder value (Dong
& Su, 2010). In addition, the benefits of having an efficient working capital management is that
the firms would be able to meet its short term obligations and maintain adequate liquidity
position in order to continue the operation of the firms (Dalayeen, 2017). In line with this,
working capital management decision is an important factor as it determines the firm‟s value
maximization and shareholders wealth (Dong & Su, 2010).

1.2 Statement of the Problem
Empirical study on the relationship between Working Capital Management and profitability
dwelling on Industrial Goods Firms in Nigeria must be ubiquitous to enable industrialist have
information at the snap of their finger. These should be the material that will drive their firms
forward by sustaining firms operation so that Nigeria will be positioned in the community of
industrialized nations. Nigeria has in its Vision of becoming one of the 20th Industrialized
Economy in the World by year 2020 and a leading Economy in Africa; Nigerian Industrialist
need to know the importance of managing their Working Capital and the relationship that exist
thereto with profitability for Nigeria to sustain the tide. Adequate knowledge on Working Capital
Management in the Industrial Goods Firms will help in solving the Country‟s developmental
challenges such as unemployment, poverty and other related problems; as its industries will
flourish as they become profitable. Many Industries earlier established have either folded or are
performing very low due to their improper management of working capital which results in lack
of appropriate financing and access to trade credit (Masocha & Dzamonda, 2016, Enow &
Brijlal, 2014).
It has been found that there are a lot of research work on working capital management and
profitability but there is none that dwell on the Industrial Goods Firms in Nigeria. This has
created a gab in the body of knowledge in the Industrial Goods Firms in Nigeria. With this
research, material will be made available that dwells on the Industrial Goods Firms in Nigeria.
The research shall make materials available which inevitably bridge the gap that exits from the
paucity of materials dwelling on Working Capital Management and Profitability in the Industrial
Goods Firms in Nigeria. With this material, there is no need for extrapolation of information that
will suffice for knowledge in the Industrial Goods Firms in Nigeria.
This gab in knowledge is to be filled by conducting a study on the Impact of Working Capital
Management on the Profitability of Industrial Goods Firms in Nigeria. The Variables to be
deployed for the study consist of Account Receivable Days, Inventory Turnover Days, Accounts
Payable Days and Cash Conversion Circle as Proxies for the Independent Variable and Return on
Assets as Proxy for the Dependent Variable. This work will look at the impact of managing
Account receivable days (ARD), Inventory turnover days (ITO), Account payable days (APD)
and cash conversion cycle (CCC) on profitability of industrial goods firms in Nigeria. Failure to
investigate this relationship will be an issue for concern because there is no specific study that
cover the Industrial Goods Firms in Nigeria as far as the Impact of Working Capital
Management on Profitability is. This work will serve as material that will cover the knowledge
gab that exist as a result of deficit of research materials on the Industrial Goods Firms in Nigeria.
1.3 Research Questions
Based on the problem statement highlighted, the following questions were formulated:
i. To what extent does Accounts Receivable Days (ARD) affect the Return on Asset (ROA)
of Industrial Goods Firms in Nigeria?
ii. To what extent does Inventories Turnover Days (ITO) affects the Return on Asset (ROA)
of Industrial Goods Firms in Nigeria?
iii. To what extent does Accounts Payable Days (APD) affects the Return on Asset (ROA)
of Industrial Goods Firms in Nigeria?
iv. To what extent does Cash Conversion Circle (CCC) affect the Return on Assets (ROA) of
Industrial Goods Firms in Nigeria?