Research Project Table 11

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THE EFFECT OF WORKING CAPITAL MANAGEMENT ON THE

COMPANYS PERFORMANCES A SELECTION OF VARIOUS

MANUFACTURING COMPANIES IN NAIROBI

BY

CATHERINE CHEBET BIRIR

BBM/2757/10

THE RESEACH PROJECT IS APARTIAL FULLFILLMENT OF A

REQUIREMENT FOR THE AWARD OF BACHEROR IN BUSINESS

MANAGEMENT DEGREE, SCHOOL OF BUSINESS AND

ECONOMICS, MOI UNIVERSITY.

OCTOBER 2010


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DECLARATION

DECLARATION BY THE CANDIDATE

This research project is my original and has not been presented for degree in any other

university or institution. No part of this project may be reproduced without prior

permission of the author and or Moi University.

Signature; Date;

Name; Catherine Chebet Birir

Reg No.BBM/2757/10

DECLARATION BY SUPERVISIOR

This research project has been submitted for examination with our approval as university

SUPERVISIOR

Signature; Date;

Name; George NChembere

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MOI UNIVERSITY, NAIROBI KENYA

ACKNOWLEDGEMENT

I wish to express my heartfelt appreciation to all those who contributed either directly or

indirectly to the success of my research

I wish to thank my mother Monica Birir, brothers Kevin, Ruben and my sweet sister

Irene for giving me encouragement to go on.

Special thanks go to my beloved husband Augustine for moral and financial support

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DEDICATION

This research is dedicated to my husband Augustine and my sons Ethan and Jayden for

their patient, understanding and support.

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ABSTRACT

The overall objective of the study was to examine the effect of working capital

management on the company performances but with specific references on Nairobi.

Manufacturing have been faced with many problems.

The study population was to assess effect of investment in cash on companys

performances, the effect of holding stock on the companys performances, the effect of

giving credit on the companys performances, the effect of having creditors and the

effect of delaying payment of creditors on the performances of the firm.

The study population was 20 manufacturing companies in Nairobi. A sample of 200

manufacturing companies was picked The respondents were managers finance and

treasures. Closed and open ended questionnaires were administered to 20 targeted

respondent using a drop and pick method. Finance data was targeted was analyses at

Nairobi central A and B district office. The data was analyses using descriptive statistics

with the help of SPSS and excess worksheet and presented in the table and figures.

The findings of the study are that working capital management is an important part in

firm financial management decision. An optimal working capital management is

expected to contribute positively to the creation of firm value. To reach optimal working

capital management firm manager should control the trade off between profitability and

liquidity accurately. The purpose of this study is to investigate the relationship between

working capital management and firm profitability. Cash conversion cycle is used as

measure of working capital management.

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It is recommended that that reducing cash conversion period results to profitability

increase. Thus, in purpose to create shareholder value, firm manager should concern on

shorten of cash conversion cycle till accomplish optimal level.

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TABLE OF CONTENT

DECLARATION ................................................................................................... ii

ACKNOWLEDGEMENT ...................................................................................... iii

DEDICATION .................................................................................................... iv

ABSTRACT ........................................................................................................ v

TABLE OF CONTENT ........................................................................................ vii

CHAPTER ONE .................................................................................................. 1

INTRODUCTION ............................................................................................. 1

Background ................................................................................................ 1

Overview of the context scope ................................................................... 3

Statement of the problem .......................................................................... 3

Objectives of the study .............................................................................. 4

Hypotheses Testing .................................................................................... 5

Scope of the study ..................................................................................... 6

Significance of the Study ........................................................................... 6

CHAPTER TWO .................................................................................................. 7

LITERATURE REVIEW ..................................................................................... 7

Introduction ............................................................................................... 7

The concept of working capital management .......................................... 10

Conceptual framework ............................................................................. 10

CHAPTER THREE ............................................................................................. 12

METHODOLOGY ........................................................................................... 12

Introduction .............................................................................................. 12

Research design ....................................................................................... 12

Sampling design ...................................................................................... 13

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Descriptive Analysis ................................................................................ 13

Quantitative Analysis ............................................................................... 13

Data collection process ............................................................................ 14

Data analysis and presentation ................................................................ 14

Limitation of study ................................................................................... 15

REFERENCES ........................................................................................... 16

APENDICES ............................................................................................... 18

Appendix 1; Time plan ............................................................................. 18

Appendix 2; Proposal research budget .................................................... 19

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CHAPTER ONE

INTRODUCTION

BackgroundWorking capital management is a very important component of corporate finance

because it directly affects the liquidity and profitability of the company. It deals with

current assets and current liabilities. Working capital management is important due to

many reasons. For one thing, the current assets of a typical manufacturing firm accounts

for over half of its total assets. Excessive levels of current assets can easily result in a

companys realizing a substandard return on investment. However companys with too

few current assets may incur shortages and difficulties in maintaining smooth operations

(Horne and Wachowicz, 2000).

Efficient working capital 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). Many surveys have indicated that managers spend

considerable time on day-to-day problems that involve working capital decisions. One

reason for this is that current assets are short-lived investments that are continually being

converted into other asset types (Rao 1989). With regard to current liabilities, the firm is

responsible for paying these obligations on a timely basis. Liquidity for the ongoing firm

is not reliant on the liquidation value of its assets, but rather on the operating cash flows

generated by those assets (Soenen, 1993). Taken together, decisions on the level of

different working capital components become frequent, repetitive, and time consuming.


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Working Capital Management is a very sensitive area in the field of financial

management (Joshi, 1994). It involves the decision of the amount and composition of

current assets and the financing of these assets. Current assets include all those assets that

in the normal course of business return to the form of cash within a short period of time,

ordinarily within a year and such temporary investment as may be readily converted into

cash upon need. The Working Capital Management of a firm in part affects its

profitability. The ultimate objective of any firm is to maximize the profit. But, preserving

liquidity of the firm is an important objective too. The problem is that increasing profits

at the cost of liquidity can bring serious problems to the firm. Therefore, there must be a

trade off between these two objectives of the companys. One objective should not be at

cost of the other because both have their importance. If we do not care about profit, we

cannot survive for a longer period. On the other hand, if we do not care about liquidity,

we may face the problem of insolvency or bankruptcy. For these reasons working capital

management should be given proper consideration and will ultimately affect the

profitability of the firm.

Companys may have an optimal level of working capital that maximizes their value.

Large inventory and a generous trade credit policy may lead to high sales. Larger

inventory reduces the risk of a stock-out. Trade credit may stimulate sales because it

allows customers to assess product quality before paying (Long, Maltiz and Ravid, 1993,

and Deloof and Jegers, 1996). Another component of working capital is accounts

payable. Delaying payments to suppliers allows a firm to assess the quality of bought

products, and can be an inexpensive and flexible source of financing for the firm. On the

other hand, late payment of invoices can be very costly if the firm is offered a discount


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for early payment. A popular measure of Working Capital Management (WCM) is the

cash conversion cycle, i.e. the time lag between the expenditure for the purchases of raw

materials and the collection of sales of finished goods. The longer this time lag, the larger

the investment in working capital (Deloof 2003). A longer cash conversion cycle might

increase profitability because it leads to higher sales. However, corporate profitability

might also decrease with the cash conversion cycle, if the costs of higher investment in

working capital rise faster than the benefits of holding more inventories and/or granting

more trade credit to customers. This discussion of the importance of working capital

management, its different components and its effects on profitability leads us to the

problem statement which we will be analyzing.

Overview of the context scope

The city of Nairobi is located in the southern region of Kenya on the banks of Nairobi

River. Besides having the largest population in Africa, Nairobi claims to be the fourth

largest city in the continent. Some of the major cities of Kenya that are located nearby

Nairobi include Kileleshwa, Chiromo, and Kilimani Estate in the west and Pangani in the

north.

Statement of the problem

Does Working Capital Management Affect Profitability of manufacturing Companys? To

analyze this problem statement, we have developed objectives of our research, which will

hopefully contribute towards a very important aspect of financial management known as

working capital management. This research is focusing on working capital management

and its effects on profitability for a sample of manufacturing companys.


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Objectives of the study

The main objectives are:

To establish a relationship between Working Capital Management and

Profitability.

To find out the effects of different components of working capital management on

profitability of manufacturing companies.

To establish a relationship between the two objectives of liquidity and

profitability of the manufacturing companies.

To find out the relationship between profitability and size of the manufacturing

companies.

To find out the relationship between debt used by the Manufacturing companies

and its profitability

To analyze the Operating profit margin of manufacturing industry.

To analyze the Working Capital of manufacturing industry.

To investigate the impact of Working Capital Management on profitability of

manufacturing Companies.

To draw conclusion about relationship of working capital management and

profitability of the Manufacturing companies.

To achieve these objectives, this study is organized as follows:

Section two reviews the literature for the relevant theoretical and empirical work on

working capital management and its effect on profitability. Section three presents the

methodology and framework used in the empirical analysis.


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Hypotheses Testing

Since the objective of this study is to examine the relationship between profitability and

working capital management, the study makes a set of testable hypothesis {the Null

Hypotheses H0 versus the Alternative ones HA}.

Hypothesis 1

The first hypothesis of this study is as follows:

H01: There is no relationship between efficient working capital management and

profitability of manufacturing companies.

HA1: There is a possible positive relationship between efficient working capital

management and profitability of manufacturing companies. Companies more efficient in

managing their working capital is expected to pose high level of profitability and vice

versa.

Hypothesis 2

The second hypothesis of the study is as follow:

H02: There is no relationship between liquidity and profitability of manufacturing

companies.

HA2: There may exist a negative relationship between liquidity of Manufacturing

companies and profitability. Companys with high level of liquidity are expected to post

low level of profitability and vice versa.

Hypothesis 3

The Third hypothesis of the study is as follow:

H03: There is no relationship between size of manufacturing companies and profitability.


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HA3: There may exists a positive relationship between the company size and its

profitability. This may be due to the ability of large companies to reduce liquidity levels

and cash gaps.

Hypothesis 4

The Fourth hypothesis of the study is as follow:

H04: There is no relationship between debt used by manufacturing companies and

profitability.

HA4: There is a possible negative relationship between debt used by manufacturing

company and profitability. Companies with high level of debt usage are expected to post

low level of profitability and vice versa.

Scope of the study

The study assessed the working capital management within the selected manufacturing

companies in Nairobi focusing on small, Middle level and giant manufacturing

companies whose turnover do not exceed Kshs 2 billion.

Significance of the Study

The results of this study shall be useful to managers in manufacturing companies in

Kenya. Information from this study shall inform companies on the importance of working

capital management. The results shall inform shareholders on the current practice of

working capital management, on the underlying risks that currently exist and ways these

risks would be mitigated. The results of the study will also be useful to members who are

interested to know how safe there investment are in term of working capital management,

what practices would be they proposed to e adopted by the managers to ensure financial

viability of these institution.


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CHAPTER TWO

LITERATURE REVIEW

Introduction

This chapter covers the review of related literature in regards to working capital

management concept, perception and practices in financial institution. It also portray the

conception framework that attempts to show the assets liquidity management liability

measure of liquidity information system.

In intention to discover the relationship between efficient working capital management

and companys profitability(Shin & Soenen, 1998) used net-trade cycle (NTC) as a

measure of working capital management. NTC is basically equal to the CCC whereby all

three components are expressed as a percentage of sales. The reason by using NTC

because it can be an easy device to estimate for additional financing needs with regard to

working capital expressed as a function of the projected sales growth. This relationship is

examined using correlation and regression analysis, by industry and working capital

intensity, in all cases; they found, a strong negative relation between the length of the

companys net-trade cycle and its profitability. In addition, shorter NTC are associated

with higher risk-adjusted stock returns. In other word, (Shin & Soenen, 1998) suggest

that one possible way the firm to create shareholder value is by reducing companys

NTC.

The study of (Shin & Soenen, 1998) consistent with later study on the same objective that

done by (Deloof, 2003) by using sample of 1009 large Belgian non-financial companys

for the period of 1992-1996. However, (Deloof, 2003) used trade credit policy and

inventory policy are measured by number of days accounts receivable, accounts payable


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and inventories, and the cash conversion cycle as a comprehensive measure of working

capital management. He founds a significant negative relation between gross operating

income and the number of days accounts receivable, inventories and accounts payable.

Thus, he suggests that managers can create value for their shareholders by reducing the

number of days accounts receivable and inventories to a reasonable minimum. He also

suggests that less profitable companys wait longer to pay their bills.

In other study, (Lyroudi & Lazaridis, 2000) use food industry Greek to examined the cash

conversion cycle (CCC) as a liquidity indicator of the companys and tries to determine its

relationship with the current and the quick ratios, with its component variables, and

investigates the implications of the CCC in terms of profitability, indebtness and firm

size. The results of their study indicate that there is a significant positive relationship

between the cash conversion cycle and the traditional liquidity measures of current and

quick ratios. The cash conversion cycle also positively related to the return on assets and

the net profit margin but had no linear relationship with the leverage ratios. Conversely,

the current and quick ratios had negative relationship with the debt to equity ratio, and a

positive one with the times interest earned ratio. Finally, there is no difference between

the liquidity ratios of large and small companys

The management of working capital is important to the financial health of

businesses of all sizes. The amounts invested in working capital are often high in

proportion to the total assets employed and so it is vital that these amounts are used in an

efficient and effective way. (Padachi, 2006)

Working capital starvation is generally credited as a major cause if not the major

cause of small business failure in many developed and developing countries (Rafuse,


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1996). The success of a firm depends ultimately, on its ability to generate cash receipts in

excess of disbursements. The cash flow problems of many small businesses are

exacerbated by poor financial management and in particular the lack of planning cash

requirements (Jarvis, 1996).

The management of working capital is important to the financial health of

businesses of all sizes. The amounts invested in working capital are often high in

proportion to the total assets employed and so it is vital that these amounts are used in an

efficient and effective way. (Padachi, 2006). Working capital starvation is generally

credited as a major cause if not the major cause of small business failure in many

developed and developing countries (Rafuse, 1996). The success of a firm depends

ultimately, on its ability to generate cash receipts in excess of disbursements. The cash

flow problems of many small businesses are exacerbated by poor financial management

and in particular the lack of planning cash requirements (Jarvis, 1996).

Despite the fact that business performance is relying on efficient working capital

practices, this area has been neglected for research for a long time period. Even in the

developed countries like

Although abundant research and theoretical development has been done in the

area of investment and long-term finance but this gray area of short-term finance, in

particular working capital management has been neglected for a very long time. Such

neglect might have been acceptable, if working capital had a relatively little importance

to the firm, but effective working capital management has a crucial role to play in

enhancing the profitability and growth of the firm. Indeed, experience shows that

inadequate planning and control of working capital is one of the more common causes of


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business failure. (Pass and Pike 1984).

This knowledge gap has led the researcher to find out that how management of working

capital management in general and cash management in particular is being addressed in

Nairobi kenya.

The concept of working capital management

The principal activities of manufacturing companies are production and sales and

distribution of products. Basically manufacturing companies will be interested in

maintaining a good working capital management to ensure that manufacturing flow

smoothly therefore financial performance of manufacturing companies will be concerned

with the rate of current assets/ current liabilities.

Conceptual framework

All the variables stated below have been used to test the hypotheses of our study. They

include dependent and independent variables:

Net Operating Profitability (NOP) which is a measure of Profitability of the firm is used

as dependant variable. It is defined as Operating Income plus depreciation, and divided

by total assets minus financial assets.

Average Collection Period (ACP) used as proxy for the Collection Policy is an

independent variable. It is calculated by dividing account receivable by sales and

multiplying the result by 365 (number of days in a year).

Inventory turnover in days (ITID) used as proxy for the Inventory Policy is also an

independent variable. It is calculated by dividing inventory by cost of goods sold and

multiplying with 365 days.


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Average Payment Period (APP) used as proxy for the Payment Policy is also an

independent variable. It is calculated by dividing accounts payable by purchases and

multiplying the result by 365.

The Cash Conversion Cycle (CCC) used as a comprehensive measure of working capital

management is another independent variable, and is measured by adding Average

Collection Period with Inventory Turnover in Days and deducting Average Payment

Period.

Current Ratio (CR) which is a traditional measure of liquidity is calculated by dividing

current assets by current liabilities.

INDEPENDENT VARIABLE DEPENDENT V

Net profitability

Avarage collection period

Inventory Turnover in days Influence

Avarage payment period

Cash Conversion Cycle

Financial Perf


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CHAPTER THREE

METHODOLOGY

Introduction

This chapter covers the research design, target population, sample size, data collection

method, data analysis and presentation. This was achieved by developing a similar

empirical framework first used by Shin and Soenen (1998) and the subsequent work of

Deloof (2003).

Research design

The most difficult issue faced by the authors was to decide about the sample and the

methodology. Although manufacturing companies are dispersed in the main cities of

Kenya, it was decided to take the data from industrial area cities. Hence, results can be

generalized. Personal interviews and telephone surveys were deemed infeasible due to

high cost and geographical dispersion of the firms. It was decided to use the tool

previously used by Ricci and Vito in 2000 in their paper to identify working capital

management practices in Nairobi. While this method allows for easier analysis of the data

due to standardized questions, its limitation is that it allows the researcher to determine

only what the respondents are doing, not how or why they are doing it. Again the

researchers have tried to overcome this limitation by adding few open ended questions in

order to get the picture closer to the reality.


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Sampling design

In this research we have provided two types of data analysis; descriptive and

quantitative.

Descriptive Analysis

Descriptive analysis is the first step in our analysis; it will help us describe relevant

aspects of phenomena of cash conversion cycle and provide detailed information about

each relevant variable. Research has already been conducted in our area of study anda lot

of information is already on hand, and SPSS software has been used for analysis of the

different variables in this study.

Quantitative Analysis

In quantitative analysis we applied two methods: First: we used correlation models,

specifically Pearson correlation to measure the degree of association between different

variables under consideration. Second: we used Regression analysis to estimate the causal

relationships between profitability variable, liquidity and other chosen variables. We have

used Pooled Ordinary Least Squares and Generalized Least Squares (cross section

weights) methods for analysis. We used panel data in a pooled regression, where time-

series and cross-sectional observations were combined and estimated. In other words,

several cross-sectional units were observed over a period of time in a panel data setting.

For this purpose of analysis the E - views software was used to analyze financial data and

especially in case of pooled data.


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Data collection process

The data used in this study was acquired from internet and web sites of different

companies. The period covered by the study extends to six years starting from 2003 to

2009. The reason for restricting to this period was that the latest data for investigation

was available for this period. The sample is based on financial statements of the 20

manufacturing companies, including firms from different sectors of our economy.

Because of the specific nature of their activities, companies in financial sector, banking

and finance, insurance, leasing, business services, renting and other services are excluded

from the sample. Finally, the firm with data of the number of days accounts receivable,

number of days inventories, number of days accounts payable and operating income are

included in sample.

Data analysis and presentation

The first part of data analysis, profile of the respondents and results of open ended

questions is being discussed. A total of 10 responses were received comprising 83%

response rate. These responses represent four broad industries mainly service sector

(covering banks and financial institutes, petroleum gas, telecommunication and service

providers). When analyzed the total respondent pool about the working capital decision

making, it was revealed that 65.8 % of the respondents confirmed it at the corporate level.

This result is closer to the Ricci and Vito study who had reported it as 57.3%. The

regional level value was 32.1% and only 1.6% of the respondents were taking decisions

at local level. Overall, it may be concluded that most of the companies tend to make it at

corporate level which shows the centralized approach for making working capital

decisions. Response rate was 76.3% when inquired about the firms percentage of


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overseas sales, it was discovered that 71% of the respondents replied it between 1-50%.

However 29% of the respondents answered that it was between 51-100%.

About relationship with foreign banks, the results of the survey indicate that almost

68.7% of the firms have relationship with 1-20 foreign banks. This result is quite parallel

with Ricci and Vito study which show that 74.1% of the firms have relationship with 1-

25 foreign banks. Response rate for this question was 77.3%. 71% of the respondents

claimed that overseas demand deposit account were between 1-20. More surprisingly it

was revealed that 3.2% firms confirmed between the numbers 10,000-50,000.

Limitation of study

Like any other study, this survey is not without limitations. First, the scale used was just

taken as teacher made instrument and was not without loop wholes. For example, some

of the questions were answered by the respondents based on their own understanding.

Second, some concepts specially related to foreign exchange activities are relatively

novel and the respondents had not enough knowledge about it.

Third, response rate was somewhat low for open ended questions which might reflect in

generalizing the results. Last, but not least there is a lack of fundamental research in the

area of working capital so enough literature was not available which could provide a

strong foundation for proper research design


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REFERENCES

Deloof, M and Jegers, M. 1996. Trade credit, product Quality, and Intra Group Trade:

Some European Evidence,Financial Management, Vol 25 No 3 pp. 33-43

Eljelly, A. 2004. Liquidity-Profitability Tradeoff: An empirical Investigation in an

Emerging Market,International Journal of Commerce & Management, Vol 14

No 2 pp.48 - 61

Joshi, P. V. 1995. Working Capital Management under Inflation, 1st Ed. Anmol

Publishers, pp. 20 - 93Long, Michael. S, Malitz. Lleen. B, and Ravid, S.Abraham, (1993) Trade Credit,Quality Guarantees, and Product Marketability

Financial Management,pp. 117 127

Rao, R. K. S. 1989. Fundamentals of Financial Management, 3rd Ed. Macmillan

publishers, pp 550-644

Ricci, C. and Vito, N. D. 2000. International Working Capital Practices in the UK,European Financial Management, Vol 6 No 1 pp. 69-84

Richard, V. D. and Laughlin, E. J. 1980. A Cash Conversion Cycle ApproachtoLiquidity Analysis,Financial Management, Vol 9 No 1 pp. 32-38

Shin, H.H and Soenen, L. 1998. Efficiency of Working Capital Management andCorporate Profitability,Financial Practice and Education, Vol 8 No 2, pp 37-4

45 Smith, M. Beaumont, Begemann, E. 1997 Measuring Association

Soenen, L. A. 1993. Cash conversion cycle and corporate profitability,Journal of

Cash Management, Vol 13 No 4 pp. 53-58

Eljelly, A. 2004. Liquidity-Profitability Tradeoff: An empirical Investigation in anEmerging Market, International Journal of Commerce & Management, Vol 14

No 2 pp.48 61

Long, Michael. S, Malitz. Lleen. B, and Ravid, S. Abraham, (1993) Trade Credit,

Quality Guarantees, and Product Marketability Financial Management, pp. 117 -

127

Rao, R. K. S. 1989. Fundamentals of Financial Management, 3rd Ed. Macmillan

publishers, pp 550-644

Ricci, C. and Vito, N. D. 2000. International Working Capital Practices in the UK,

European Financial Management, Vol 6 No 1 pp. 69-84


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Shin, H.H and Soenen, L. 1998. Efficiency of Working Capital Management and

Corporate Profitability, Financial Practice and Education, Vol 8 No 2, pp 37-45

Smith, M. Beaumont, Begemann, E. 1997 Measuring Association between Working

Capital and Return on Investment, South African Journal of Business

Management, Vol 28 No 1

Soenen, L. A. 1993. Cash conversion cycle and corporate profitability, Journal of

Cash Management, Vol 13 No 4 pp. 53-58

Van Horne, J. C. & Wachowicz, J. M. 2000. Fundamentals of Financial Management,

11th Ed. Prentice Hall Inc


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APENDICES

Appendix 1; Time plan

Jan Feb Mar Aprl May Jun Jul Aug Sept Oct

Groundwork xx xx

Literature review xx xx xx xx xx

Defining Methods xx xx

Data collection xx xx xx

Progress Seminar 15th

Data Analysis xx xx xx

Write first draft xx xx xx xx xx xx xx

Write second draft xx xx xx

Write Final draft xx x

Thesis Due


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Appendix 2; Proposal research budget

N Description Unit Unit Cost Quantity

1 Per diem allow ances Month 750 82

2

Miscellaneous travel

expenses Trip 150 40

3 Insurance Month 265 85

4 Accommodation Month 3500 36 1

5 Security Month 2250 36

6 Communication Month 1250 36

7

Printing, stationery,

drafting, reproduction of

reports 2 Month 500 36

8

omputers an o ce

equipment4 Lump

9Local transport andvehicle running costs Month 750 144 1

10 Off ice running costs4 Month 1250 36

11 Workshops & seminars Unit 1000 12

12 Study Tours Unit 20000 3

Total Costs

Documents

Research Project Table 11