CHAPTER ONE INTRODUCTION 1
1.1 Background to the Study
In the present business environment, firms require effective management of working capital that provides a financial metric which signifies effective liquidity accessible to the firm for the purpose of improving various aspects of its financial performance (Azeez, Abubakar, & Olamide, 2016). A combination of working capital and fixed assets such as equipment and plant are all considered working capital. For instance, when a firm is endowed with assets and profitability, and the assets cannot be turned into cash then it is short of liquidity and therefore it is paramount for the firms to have a positive working capital so as to fulfil both maturation of the short term debt and forthcoming operational expenses (Kasiran, Mohamad, & Chin, 2016).
According to Azeez, Abubakar, and Olamide, (2016), the most significant subject in financial decision making is working capital as all asset investment entails suitable financing, however WC is overlooked in when making financial decision because it is always involved in investment and financing in short term periods. According to Kimeli (2014), working capital affects financial performance of a firm by failing to contribute return on equity. Firms that achieve maximum value return always have an ideal level of working capital. Owele & Makokeyo, 2015) argue that a firm with larger inventory helps them to reduce stock-out risks since the trade credits stimulates firm sales by letting the customers to assess the quality of product before doing the payments. The accounts payable is another constituent of working capital, firms delaying payments of the suppliers, the get the opportunity to evaluate the quality of supplied products thus making them financial flexible. Shah, & Sana, (2005) argue that when invoices payments are done late, increases the cost of the firm incase where discount was to be given for early payment.
According to Owolabi et al., (2012) the primary goal of any business firm is to capitalize on the profitability as well as increase the wealth of firm shareholders or owners, balancing between firm liquidity and profitability during the daily operation of the firm facilitates the smooth running as well as meeting the company’s obligation. Uremandu, Ben-Caleb, ; Enyi, (2012) argue that firm profitability, liquidity and growth is directly affected by the working capital management, thus the amount of money invested in a firm as working capital should be similarly high compared to the total assets employed.
Financial performance is measured using financial matrices like profitability, liquidity, solvency, repayment capacity, short-term financial management, financial efficiency and firm over capacity. Profit means the wealth that a company has created from the utilization of its available resources (Valentine, 2014). The liquidity of a business determines its ability to maintain its liquid cash and cash equivalents to meet its debt obligation on a timely basis using the quick ratio and current ratio. Solvency is used to a measure the ability of a business to clear its debt obligations if all its assets are sold together with its ability to recover from financial turmoil (Woodruff, 2014).
A company’s financial performance can also be measured by how well it manages its short term financial goals for example WCM and inventory management (Purdue, 2013). The firm’s financial activities can be measured in monetary terms to provide an insight in the performance of an organization as a whole. This measurement can also be used to determine the firm’s overall wealth over a given time horizon. Tippins & Sohi, (2003) argue that the most familiar measures of financial performance are ROE and ROA.
The ROE measures earnings over a period of time on shareholders equity investment. It is also the measurement for the amount of income generated by the investment mad by an organization’s owners (equity holders). The return of asset ROA measured the return on total assets after interest and taxes. It provides the management with information on the level of efficiency with which assets are financed by either equity or debt are generating after tax profits to firm (Orlitzky, Schmidt, ; Rynes, 2003).
1.1.1 Global Perspective of Working Capital Management
In Pakistan, the WCM is viewed as an integral process of enhancing financial performance (Bagh et al., 2016). Firms maintaining appropriate level of WC will be able to improve its financial performance. According to Bagh et al., 2016, the financial performance of manufacturing firms in Pakistan is influenced by WCM. Bagh et al., (2016) argue that some the WCM practices that influence firm performance through ROA, ROE and EPS include cash conversion cycle and average payment period.
Baveld (2012) in Netherland carried a study on the association between firm’s gross operating profit and accounts receivables. The study findings revealed that during non-crisis period, the relationship between the account receivables and gross operating profit was significant but negative, while during crisis period the relationship between the account receivables and gross operating profit had no significant association. The study recommended that during the crisis the firms in Netherland association between accounts receivables and firm’s profitability changes by minimizing their accounts receivables so as to maximize their profitability during crisis periods.
Mohamad and Saad (2010) argue that the association between current ratio and financial performance among listed Malaysian firms was negative and significant. The study results revealed that the profitability and market value of the firm were greatly affected by WCM. Furthermore, Eljely, (2004) also asserted that the current ratio and profitability of the Saudi Arabia firms was negative.
1.1.2 Regional Perspective of Working Capital Management
According to Louw, Hall and Brummer (2016), decreasing the investment of inventory and trade receivables whereas increasing the trade payables improved the profitability of South African retail firms; inventory management has a strong substantial effect on a firm’s profitability. Louw, Hall and Brummer (2016) recommended that retail firms to implement innovative inventory management systems so as enhance inventory levels and profitability. Akoto et al., (2013), also asserted that correlation between profitability and accounts receivable days of retail firms in South Africa was significant but negative.
Luqman, (2014) in Nigeria analyzed the working capital management of all brewery firms and revealed that cash balances, receivable management and payables and inventories and debtors had a major effect on profitability of breweries firms in Nigeria. The level of leverage affects the corporate profitability negatively and insignificantly. The growth rate in earnings affects the dividend payout ratio negatively while the profitability and net trade cycle affects the dividend payout ratio is affected positively (Oladipupo & Okafor 2013).
In Ghana, the correlation between CCC and bank profitability is positive and significant, but the size, exchange risk, credit risk and capital structure insignificantly affects the bank profitability (Adjei & Yeboah, 2011). The firms listed at Ghana Stock Exchange performed poorly than unlisted firms. Akoto et al., (2013), argue that managers can advance shareholder’s capital by setting in measures that to reduce the accounts receivable days to 30 days. In Ghana the domestic regulations were established to safeguard native firms and to prevent them from importers activities at the same time promoting an increase in demand for the local manufactured goods.