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The Effect of Working Capital Management On The Manufacturing Firms' Profitability
The Effect of Working Capital Management On The Manufacturing Firms' Profitability
ARSI UNIVERSITY
COLLEGE OF BUSINESS AND ECONOMICS
DEPARTMENT OF ACCOUNTING AND FINANCE
POSTGRADUATE STUDIES
March 2021
Asella, Ethiopia
1. INTRODUCTION
Finance theories are discussed under three main out fits as capital budgeting,
capital structure and working capital management. As a result, the first two
are mostly related to financing and managing long term investments.
Management of working capital refers to management of current assets and
current liabilities (Ross et al., 2010).
According to Padachi K. (2006) the standard measure of working capital
management is the cash conversion cycle that is the time interval between the
expenditure for the purchase of raw materials and the collection of sales of
finished goods. Therefore, the stretched this time delay, the bigger the
investment in working capital will be. The inadequate of working capital leads
the firm to liquidation. Inversely, unnecessary investment in working capital
results in wasting cash and ultimately leads to lower profitability or even loss
(Gill A, Biger N and Mathur N 2010). Management strategy aimed at
maintaining a balance between liquidity and profitability has far-reaching
consequences on the growth and survival of the firm. Thus, the manager of a
business entity is in a dilemma of achieving desired tradeoff between liquidity
and profitability in order to maximize the value of a firm.
Deloof (2003) found that the longer the time lags, the larger the investment in
working capital, and also a long cash conversion cycle might increase
profitability because it leads to higher sales.
To sum up; one of the most important factors for a firm to consider is the
management of working capital. The components inside WCM consist of
current assets and current liabilities. The difference in current asset to
current liabilities also reflects a firm’s liquidity (Mathuva, 2010). It is
important to have a good assessment of a company's liquidity because a
decline in liquidity can lead to a greater risk of bankruptcy. WCM is essential
for any firm to survive because of its effects on a firm’s profitability and
consequently its value. The effective working capital management is very
important because it affects the performance and liquidity of the firms (Taleb,
G.A., Zoued, A.N., Shubiri, and F.N., 2010). The main objective of working
capital management is to reach optimal balance between working capital
management components (Gill, 2011). The efficient management of working
capital is a fundamental part of the overall corporate strategy to create
shareholders value (Nazir and Afza, 2008). Therefore firms try to keep an
optimal level of working capital that maximizes their value (Deloof, 2003).
The field of working capital management is given attention by researchers
because of its continued relevance and centrality to the success of a going
concern. To corroborate this assertion, Enyi (2011) asserts that a business is
as strong as its unencumbered capital base, as liquid as its working capital
volume, and as dynamic and viable as its managerial decisions, working capital
is the centre of existence of any business. In effect, without working capital,
business cannot operate successfully (Nor Edi and Noriza, 2010).
Hence, however investment and working capital management is common in
any nations of the world; in developing countries like Ethiopia with less
experience in manufacturing industry, it attracted attention of the researcher
in this untouched area, Gelan industrial zone as per the researcher knowledge.
Moreover, working capital management is not only increasing profitability in
today’s cash - Strapped and uncertain economy, but it is the question of
meeting firm’s day to day operation. Therefore, the issues uttered above
vindicate the need to thoroughly investigate the problem; and hence, the need
to study the effect of working capital Management on firm’s profitability in
Gelan City manufacturing companies.
Having this, the study will be aimed at examining the overall effect of Working
Capital Management on the Profitability of manufacturing companies in Gelan
City.
Considering of the above points, aim of the study will be to examine the effect
of working capital management on the profitability of manufacturing
companies found in Gelan city.
The study will be delimited in its title to examine the effect of working capital
management on the profitability of manufacturing companies found in Oromia
Special Zone Gelan city. The total sample size of the study will be 38
manufacturing companies. Of which, a total of 78 factories, the researcher will
select only 38 companies as a sample through stratified random sampling
technique in order to avoid bias. Finally, the study will incorporate five years
data starting from 2014-2018.
2.1. INTRODUCTION
This Chapter contains the methodology that will be used to conduct the
research. It describes the research design, the population, sample, model
specification, data collection and data analysis method.
According to Kothari (2004) the formidable problem that follows the task of
defining the research problem is the preparation of the design of the research
project, popularly known as the “research design”. A research design is the
arrangement of conditions for collection and analysis of data in a manner that
aims to combine relevance to the research purpose with economy in
procedure.”
Stratified sampling method has the following advantage which leads the
researcher to use it. First, it improves the accuracy of the sample, i.e. it
ensures that any differences between the strata are controlled by making sure
that each stratum is proportionately represented. Second, Stratified sampling
is one tool to reduce selection bias. However, if from stratum’s one group is
either overrepresented or underrepresented in a sample, selection bias has
occurred and the sample will not accurately reflect the larger population.
Accordingly, six (6) types of manufacturing companies will be chosen for this
study based on their nature. The study will make the sample representative of
the population manufacturing companies in Gelan City. Proportionate
stratified sampling design will be used.
Table1. Table showing sample size
STRATA Total population Sample sizes
Metal 26 13
Garment 10 5
Food 10 5
Paper 5 2
Construction 6 3
Other 21 10
Total 78 38
The sampling fraction will be based on the number of population for each of
the six strata that form the sample size of 38. This will ensure that all the
manufacturing sectors will be represented in the sample size in the
proportions in which they will occur in the total population. Since the total
population is 78 and the sample size will have 38 elements, the uniform
sampling fraction for all activity type will be 38/78=49%
The reason for using five year data will be in order to include some factories
emerged recently in Gelan City at which their life span is not less than five (5)
years for investigation components of working capital and control variables.
2.6. RATIONALE BEHIND THE SELECTION OF LOCATION
Firstly, the choice of Gelan City was made because, Gelan City recently being
identified as an Industrial Zone even as a country due to many companies
confined there and found nearest of Addis Ababa, the Commercial Capital
City of Ethiopia with a good trading. Second best, while searching on internet
and simple survey made, the researcher believed that, the problem is almost
untouched in the area.
2.7. DATA ANALYSIS AND PRESENTATION
In order to analyze the effect of working capital management on the firms’
profitability, quantitative research approach to analysis the finding,
Descriptive statistics to describe and summarize the behavior of the variables
and inferential tests (Correlation and regression) has been be applied to test
the effect of variable(s) on profitability of firms. The analysis will cover the
period from 2014 to 2018. The researcher will use SPSS and E- view9 for
different purpose.
Simple Descriptive Statistics
Descriptive statistics will be used as the first step in the analysis and it will be
used to describe relevant aspects of observable facts about the variables and
provide detailed information about each relevant variable. At this stage, mean,
standard deviation, maximum and minimum values of the required variables
will be computed.
Inferential Test
Regression tries to estimate or predict the average value of one variable on the
basis of the fixed values of other variables. A pooled regression will be
conducted, since the data has both time series and cross-sectional dimensions.
Time series data are data that have been collected over a period of time on one
or more variables. Cross-sectional data are data on one or more variables
collected at the same point in time (Brooks, 2008).
εi = error
i = 1, 2, 3&, 38 firms
t = Time from 1, 2…, 5 years
α = Estimated value of Y when all the other variables are Zero
εi = error term
The Coefficient of determination
Coefficient of determination (R2) test will use to analyze how well the line of
goodness of fit represents the data; i.e., R2 (multiple regression) is a summary
measure that tells how well the sample regression line fits the data.
The t–test
The t–test takes two sets of data and then examines whether the average of the
two group are statistically different from each other. For example this can be
used to analyze, the increase in profitability is mainly caused by working
capital components or control variables of the firm. The test carried out at 5%
or10% significance level. The result significant if the ‘P’ value is 5% or less.
2.9. DEFINITION OF VARIABLES
The aim of this thesis is to empirically investigate the effect of working capital
management on the profitability of selected manufacturing companies during
the period 2014 to 2018. Since, the researcher wants to find relationships
between working capital components and its effect on the profitability of
selected manufacturing firms, the best choice will be to do regression analysis.
Therefore, the researcher will divide the variables into two groups, which are
dependent and independent & control variable.
Return on asset
Dependent variables are variables that are used to measure the profitability of
firms based on the independent variables. In order to examine the effect of
working capital components on the profitability of manufacturing companies
in Gelan, profitability will be measured by return on assets (ROA).
ROA is a widely used financial tool to determine the level and intensity of
returns that a firm has generated by employing its total assets.
ROA = Net income/total assets
Independent Variables
This study will make use of the following: the explanatory and control
variables.
Cash conversion cycle (CCC)
Cash conversion cycle is a time span between the payments for raw material
and the receipt from the sale of goods. The cash operating cycle is the amount
of time between the companies’ purchasing raw materials, converting to a
finished goods and the receiving of cash from the sale of the goods. (Arnold,
2008 pp.454) mentioned that companies take a cycle in which companies
purchase inventory, sell goods on credit, and then collect the amounts
due. It can be calculated as follows;
Cash Conversion Cycle
= (Number of Days Inventory)
+ (Number of Days Accounts Receivable)
− (Number of Days Accounts Payable)
Inventory days
The inventories in the form of raw materials, work in progress, and finished
goods. This is one of the major parts of assets for manufacturing companies.
However higher level of inventory days is not always good sign for the company
as it can increase the storage cost and obsolescence stock. It can be calculated
as follows;
Inventory days = [inventories*365]/cost of sales.
The less number of days sales in inventory indicates that inventory does not
remain in ware houses or on shelves but rather turns over rapidly from the
time of acquisition to sale (Ross et al, 2003).
Receivable days
Payable days
The amounts payable to the suppliers for the goods and services purchased is
represented as trade payable. When the suppliers offer credit periods to the
firm it gives the flexibility to manage the finance with other expenses. Further
the credit period also allows the firm to measure the quality of the supplied
product and services. The payable days can be calculated as follows;
Payable days = [accounts payables*365]/cost of goods sold.
Current Ratio
Liquidity affects profitability of firms so to keep its effect neutral the researcher
have used current ratio as control variable. It is a measure of general liquidity
and it is the most widely used to make the analysis for short term financial
position or liquidity of a firm (Fabozzi and Peterson, as cited in Wobshet, 2014).
It is calculated as follows;
Current Ratio
= Current Asset
Current Liabilities
Size of the firm can influence the firm’s performance in several ways. Firstly if
a firm is large player in the market it gives the bargaining power to strike good
deals with supplier. Further the lenders will be happier to provide the loans
(Samiloglu and Demirgunes, 2008). Size of the firms can be calculated as
logarithm of Total Asset and the formula is given below;
Size of the firm = log of Asset
2.10. Description of Variables, Scale of Measurement
References