COMPLETE SCHOOL PROJECT TOPICS & MATERIALS :
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CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND OF THE STUDY
Investors all over the world put their money into a business with a view to having some return on investment irrespective of whether it is in a proprietorship, partnership and corporations. In small and medium businesses, owners have direct or indirect control over the management of the business so, they themselves are responsible for the profit and loss. On the other hand, in the large multinational companies, the management of the company manages the affairs of the company on behalf of owners but owners want management to take such decisions which will give positive signal to market, increase the value of the firm, enhance profitability and maximize holding period return. The heart of corporate finance literature is long term investment, capital structure and different valuation methods. These have been the focus of intention for many researchers in the past. In short it concerns the long term financial planning or decisions. On the other hand, it is believed that financial decisions of short term assets and short term liabilities management also influence the stock price. These decisions are vital because they demonstrate the financial stability of the firm and the market which develops perception about the firm accordingly (Afza and Nazir,2008). An efficient working capital management can create value for stakeholders while a deprived policy or inefficient management might affect the business in an appalling way and might cause a financial distress.
Financial management involves planning and controlling current assets and current liabilities in a manner that eliminates the risk of inability to meet due short term obligations on the one hand and avoid excessive investment in these assets on the other hand (Eljelly, 2004). Lamberson (1995) argues that working capital management has become one of the most important issues in organizations, where many financial managers find it difficult to identify the important drivers of working capital and the optimum level of working capital. As a result, companies can minimize risk and improve their overall performance if they can understand the role and determinants of working capital. The relationship between current assets and current liability items is called working capital of the organization.
A business (also known as enterprise or firm) is an organization designed to provide goods, services, or both to consumers. Businesses are predominant in capitalist economies, in which most of them are privately owned and formed to earn profit as to increase the wealth of their owners. Businesses may also be not-for-profit or state-owned. A firm could also be looked at as a transformation unit concerned with converting factor inputs into valued intermediate and final goods or services. The firm or business is the basic producing/supplying unit and is a vital building block in constructing a theory of market to explain how firms interact and how their pricing and output decisions influence market supply and price. It is an organization that employs resources to produce goods or services for profit and sometimes owns and operates one or more plants(Pass, Lowess and Davies, 2005).
The organizational structure of firms are often complex and varied. Multiplant firms may be organized horizontally with several plants performing much the same functions. Examples are the multiple bottling plants of Coca-cola and many individual Wal-Mart Stores (Brue, 1987). Firms may be vertically integrated, meaning they own plants that perform different functions in various stages of production process. Examples are oil companies like Shell, refineries, etc. A firm‟s growth is the expansion of the size of the firm over time. Typical measures of a firm‟s growth are the growth of assets or capital employed, turnover, profits or a number of employees. Some firms remain small by choice or circumstance, others expand or become large either in national or international context through either/or organic growth and external growth like mergers, takeovers, etc. The process of growth is initiated and facilitated by a combination of managerial, economic, financial and „chance‟ factors.
Even though firms traditionally are focused on long-term capital budgeting and capital structure, the recent trend is that many companies across industries focus on working capital management efficiency. Firms follow an appropriate working capital management approach that is favorable to their industry. Those that have less competition would focus on minimizing the receivables to increase cash flow, while firms where there are large number of suppliers of materials focus on maximizing the payable (Ganesan,2007).
The importance of working capital management cannot be denied in any given organization. Researchers all over the world focused on this issue and discussed it in detail in the perspective of many countries. Researchers from developing countries consider working capital as a life blood of any organization and for this reason, most of the research on this topic had been carried out in developing countries like Pakistan, India, Taiwan, etc. As we belong to a country where researchers consider working capital as the most important factor that determine the profitability, it was surprising that despite the importance of this topic, very little research has been carried out in Nigeria. Nigerian firms as well as others the world over, utilize working capital for smooth operation. They plan for and manage their inventories, cash receivables and payables, to ensure that requirements in their items are met. The little working capital available to Nigerian firms is managed by them to avoid operational embarrassments. Raw material inputs, mostly imported, are affected by unstable foreign exchange market and monetary policies of the government. Raw materials inventory are thus affected by inadequate foreign exchange for importation, delays in clearing at the Nigerian ports, and poor transportation network. These affect the production runs of Nigerian firms and delivery of finished goods to customers. Local delivery of raw materials to firms by poor transport infrastructures in the country, high cost of debt/overdraft in Nigeria limited the short-term finance of Nigerian firms to collection on sales also hampers growth in the net working capital.
Firms (quoted and unquoted) in Nigeria are today facing challenges of adequate working capital and liquidity as to meet up their short-term maturing obligations as a result of inadequacy of working capital. The position of working capital of firms in Nigeria is not only an internal firm-specific matter, but also an important indicator of risk for creditors .Previous works on topics surrounding working capital management attempted to find out the best way to finance working capital as to achieve cost-effectiveness. Most studies were from developed economies like Britain, Russia and United States of America where pertinent information is costlessly available, with well developed financial institutions in which capital and money markets play a catalyst role in the sustenance of consistent and steady growth in all sectors of their economies. The outcomes and recommendations of these studies could not be wholesomely adapted here in Nigeria because our economy is underdeveloped and characterized by crises emanating from socio-economic and political problems since independence. The Nigerian capital and money markets are not really helping to ameliorate the problem. Instead, more often than not, they compound the problem by creating bottlenecks with harsh conditions that could not be easily met by the companies that are at the verge of collapse.
According to Olugbenga (2010), the mismanagement of working capital in firms has caused some promising investments, with high rate of return, to be failures and frustrated out of business. Many factories have either temporally or permanently been shut down due to illiquidity. Many Nigerian workers have been forcefully thrown into unemployment market as a result of the aborted mission of their organization caused by the twin variables of working capital and profitability. Financial institutions like banks, are unwilling or reluctant to lend out money to these firms due to their poor credit position, while most firms are not willing to obtain available credits offered them due to high interest rates.
Assets in commercial firms consist of two kinds: fixed and current assets. Fixed assets include land, building, plant, furniture, etc. Investment in these assets represents that part of firm‟s capital, which is permanently blocked on a permanent or fixed basis and is also called fixed capital that generates productive capacity. The form of these assets does not change. Current assets consist of raw materials, work-in-progress, finished goods, bills receivable, cash, bank balances, etc. These assets are bought for the purpose of production and sales, like raw materials into semi-manufactured products, into finished products, into debtors which is turned over cash or bills receivable. The fixed assets are used in increasing production of a firm and the current assets are utilized in using the fixed assets for day to day working. Therefore, current assets, called working capital, may be regarded as the lifeblood of a business enterprise. It refers to that part of the firm‟s capital, which is required for financing short term. The management of this working capital is with the objective in ensuring that a satisfactory level is maintained. The working capital should neither be more nor less, but just adequate.
Financial management plays an important role in a firm‟s profitability and risk as well as its value (Smith,1980). The current assets account for over half of its total assets for a manufacturing firm while they account for even more for a distribution company. Excessive levels of current assets can easily result in a firm‟s realizing a substandard return on investment. However, Van Horne and Wachowicz (2004) point out that the excessive level of current assets may have a negative effect on a firm‟s profitability, whereas a low level may lead to lower levels of liquidity and stock-out, resulting in difficulties in maintaining smooth operations.
Gitman (1976) has suggested that the goal of working capital management is to manage each of the firm‟s current assets and current liabilities in such a way that an acceptable level of net working capital is maintained. Ramamurthy (1978) has stated that the management of working capital is part of the total management process, focusing on the most effective choice of working capital and the most effective operating combinations and management of current assets. Efficient management of working capital plays an important role of overall corporate strategy as to create shareholder value. Working capital is regarded as the result of the time lag between the expenditure for the purchase of raw material and collection for the sale of finished goods. The way working capital is managed can have a significant impact on both the liquidity and profitability of the firm (Shin and Soenen,1998). The main purpose of any firm is to maximize profit. But, maintaining liquidity of the firm also is an important objective. The problem is that increasing profits at the cost of liquidity can be serious problems to the firm. Thus, strategy of firm must be a balance between these two objectives of the firms. Because the importance of profit and liquidity are the same, therefore one objective should not be at the cost of the other. If we ignore profit we cannot survive for a longer period. Conversely, if we do not care about liquidity, we may face the problem of insolvency. For these reasons, working capital management should be given proper consideration and will ultimately affect the profitability of the firm.
A firm may choose an aggressive working capital management policy with a low level of current assets as percentage of total assets, or it may also be used for the financing decisions of the firm in the form of high level of current liabilities (Afza and Nazir, 2009). Keeping an optimal balance among each working capital component is the objective of working capital management. Business success heavily depend on the ability of financial managers to effectively manage inventory, receivables and payables (Filbeck and Krueger, 2005). Firms can decrease their financing costs and raise the funds available for expansion projects by minimizing the amounts of investment tied up in current assets. Lamberson (1995) indicated that most of the financial managers‟ time and efforts are consumed in the non-optimal levels of current asset and liabilities and bringing them to optimal levels. An optimal level of working capital is a balance between risk and efficiency. It requires continuous monitoring to maintain the optimum level of various components of working capital like cash, receivables, inventory and payables (Afza and Nazir,2009). A popular measure of working capital management is the cash conversion cycle, being defined as sum of days‟ sales outstanding and days‟ sale of inventory less payable days‟ outstanding (Keown et al, 2003). The longer this time lag, the larger the investment in working capital. Corporate profitability might also decrease with cash conversion cycle, if the costs of higher investment in working capital is higher and rises faster than the benefits of holding more inventories and granting more inventories and trade credit to customers (Deloof, 2003).