Published on International Journal of Economics & Business
Publication Date: April 17, 2019
OGUNMAKIN Adeduro Adesola
Department of Accounting, Ekiti State University
Ado Ekiti, Ekiti State, Nigeria
This study examined the effect of working capital management on the profitability of selected quoted firms in Nigeria. Secondary method of data collection was adopted. Simple random sampling technique was used in selecting three industries out of the seventeen quoted industries in Nigeria and two firms each from the sampled industries. Variables tested for working capital management (WCM) were average collection period (ACP); average payment period (APP); inventory turnover in days (ITID) and cash conversion cycle (CCC). Return on asset (ROA) and return on equity were proxy for profitability. Data gathered from the financial statement of the selected firms were analyzed with pairwise correlation and the results indicate a significant relationship between cash conversion circle and return on assets. The study concluded that there is an existence of trade off between working capital management policies adopted by firms and their level of profitability.
Keywords: Profitability, Working Capital, Management, Firms, Return on Asset, Return on Equity, Cash Conversion Cycle, Current Ratio, Debt Ratio Sales Growth.
Working capital management has been described as the management of current assets and current liabilities (Agyei & Yeboah, 2011; Tauringana & Afrifa, 2013; Mbawuni, Mbawuni & Mimako, 2016). The concept of working capital management addresses companies management of their short-term capital, which is an important component of corporate financial management Working capital directly affects the profitability and liquidity of both small and large companies. The need for firms to maintain optimum working capital and creating sustainable working capital is becoming ever more important. Consequently, proper working capital management will enable firms sustain business growth, which in turn will lead to maximisation of owners wealth (Mbawuni, Mbawuni & Mimako, 2016).
Working capital management is measured by the cash conversion cycle (CCC), which is defined by Keown, Martin, Pretty, & Scott, (2003); Adolphus, (2014) as the sum of daily sales outstanding (average collection period) and days of sales in inventory less days of payables outstanding. The longer this time lag, the larger the investment in working capital. A longer cash conversion cycle might increase profitability because it leads to higher sales. Also, cash management is essential to every business that desires to meet up with its short-term financial obligations (Akinyomi, 2016). He stated further that cash represents the basic input necessary to start and keep a business running. A firm needs to maintain sufficient cash to keep its business running. Cash shortage will disrupts the firm’s operation and can even lead to insolvency. Excessive cash will tie down capital which will lead to low return on capital employed. A firm most maintained a healthy cash position.
Many research works have been carried out in the area of working capital management and how it affect or enhance profitability of the firms. For example, Akinyomi, (2016) investigated the effect of Cash Management on Profitability of Nigerian Manufacturing Firms; Agyei, and Yeboah (2011) empirically studied working capital management and profitability of banks in Ghana and Mbawuni, Mbawuni and Mimako, (2016) analysed the impact of working capital management on Profitability of petroleum retail Firms. The problem of this study then, is that most of the reviewed literature paid attention to a single industry and few of the existing study have been able to do cross-sectional analysis. To this end, this research work critically examined the effect of working capital management on the profitability of selected quoted firms across industries in Nigeria.
Specifically, it examined the relationship between working capital management and return on equity and return on asset of the selected quoted firms in Nigeria.
2. Literature Review
Working capital management is one of the most important areas while making liquidity and profitability comparisons among firms. It’s involves decision of amount and composition of current assets and the financing of these assets, the greater the relative proportion of liquid assets, the lesser the risk of running out of cash (Eljelly, 2004). The components of working capitals are inventories, trade receivables and trade payables, the proportion of the working capital components can change from time to time during the trade cycle, the working capital components will be based on the objective of the firm and maximisation of profits (Lamberson, 1995).
The study derived its theoretical framework directly from the trade-off theory. The trade-off, theory according to Bhattacharya, (2001) and Mwanahamisi, (2013), proposes that there is a trade-off between liquidity and profitability; gaining more of one means giving up some of the other. At one end of the spectrum, there are highly liquid firms which are not very profitable, while at the other end, and firms which are highly profitable but are not very liquid. The basic challenge therefore is to determine the middle ground where the firm should reside. Proponents of the trade-off approach are focusing their efforts mainly on developing dynamic structural trade-off models. An attractive feature of these models is that they try to provide a unified framework that can simultaneously account for many facts (Mwanahamisi, 2013).
A well-managed working capital promotes a firms well-being on the market in terms of liquidity and it also acts in favor for the growth of shareholders value (Jeng-Ren & Han-Wen, 2006; Mwanahamisi, 2013). Investment in working capital involves a balance/tradeoff between risk and profitability because investment decision, which leads to increase in profitability will be inclined to increase risk and vice versa. Efficiency in managing working capital also increases cash flow of the firms which in turn increase the growth opportunities for the firms and return to the shareholders (Mwanahamisi, 2013).
This study reviewed some empirical studies in relations to working capital management and firm’s profitability’s; Akinyomi, (2016), examined the relationship between cash management and profitability in the Nigerian manufacturing firms. Correlation and regression analysis were carried out. The results reveal a positive and significant relationship between cash conversion circle and return on equity on one hand and a non significant negative relationship between cash conversion circle and return on assets. From the results of the study, it is recommended that future researchers should expand the scope of their studies to include multiple sectors of the economy.
Mwanahamisi, (2013) investigated the effects of working capital management on the performance of firms in Kenya. A descriptive research was undertaken to guide the study. From a target population of 33 included the Head of Departments, the Principals and Head of sections of the finance division of Kenya Ports Authority. A stratified random sampling technique was employed in selecting the sample of 30 respondents at 5 percent level of confidence. In order for the relevant information to be collected, both primary and secondary data collection methods were used. He used Statistical Package for Social Science (SPSS Version 20.0) for data analysis. The finding of the study shows that firm performance gets affected by working capital management. He recommended that further research should focus on other components of working capital management such as company size, sales growth, and current ratios.
Also, Ngwenya, (2012) investigated the relationship between working capital management and profitability and sampled 69 companies listed on the Johannesburg stock exchange for the period of 1998 to 2008. The study analyzed data using regression analysis and Pearson correlation. The results showed a significant negative relationship between profitability and cash conversion cycle, and a positive significant relationship between accounts payable and profitability.
This research work focused at obtaining consistent estimate of fixed effect models for panel data regression applied to data from selected quoted firms. The population of the study is all the quoted firms in Nigeria which were segregated into seventeen industries. Simple random sampling techniques was used in selecting three industries; Consumers goods; Brewing and Agricultural sub-sector and same technique was also used to select two firms each from the sampled industries; Consumers: PZ and Glaxo; Brewing Industry: Nigerian Brewery and Guinness and Agric: Presco and Okomu. The study covered 2006 – 2014. Based on the require information on the financial variables consider for this study. Information was obtained from the financial statement of the selected quoted firms. The selected firms serve as cross-sectional units and number of years as the time series. The Generalized least square panel with White Heteroskedasticity-Consistent Standard Errors and Covariance was used as estimation technique.
3.1 Specification of Model
Akinyomi, (2016) put up a model to capture relationship between cash management and profitability in the Nigerian manufacturing firms;
ROA= Return on assets
ROE= Return on equity
CCC= Cash conversion cycle
CR= current ratio
DR= Debt ratio
SG= Sales growth
ε = Error Term
Following this model, with modifications, this study put up a model to capture the effect of working capital management on the profitability of the selected quoted firms in Nigeria. However, the data gathered could be modeled using panel regression.
The adopted model will be specified in functional form as follows:
ROA= Return on Assets
ROE= Return on Equity
ACP= Average Collection Period
APP= Average Payment Period
ITID= Inventory Turnover in Days
CCC= Cash Conversion Cycle
4. Analysis and Interpretation of Results
4.1 Multicollinearity Test
Adopting Ahsan, Abdullah, Gunfie, and Alam (2009) approach, the three major methods used in determining the presence of multi-co linearity among independent variables in this study were pairwise correlation matrix, tolerance test and Variance Inflation Factor (VIF). This study utilized a pair-wise correlation matrix shown at 5% level of significance. It shows the relationship among the individual variables. As evidence in table1 below, there exist an inverse relationship between ACP and ROE, ACP and ROA, CCC and ROA, CCC and ROE, CCC and APP, with the lowest correlation of -0.5420 between average collection period and return on equity, which implies that there is a 54.2 % inverse relationship between ACP and ROE and depicts that the higher the period used in the collection of the respective companies receivables the lower their profitability, vice verse, while a positive relationship exist between ROA and ROE, ROA and APP, ROA and ITID, APP and ROE, APP and ACP, ITID and ROE, ITID and ACP, ITID and APP, CCC and ITID however, the highest correlation of 73.06% occurred between ROA and ROE followed by 72.19% relationship between cash conversion cycle (CCC) and Inventory Turnover in Days (ITID).