1.1 Background to the Study
The economic theory of firm requires that firm resources should be utilized efficiently in order to achieve economic successes. Moreover, the competitive modern business environment makes financial managers irrespective of the nature of their business to ensure efficient utilization of firm resources. Firm resources are broadly classified into two, longterm assets (non-current assets) and short-term assets (current assets). Therefore, there are two major decisions in the theory of corporate financial management, that is, the long-term or capital budgeting decision and the short-term or working capital management decision (Pandey, 2009). Although long-term capital decisions are of critical importance to the going concern of a firm, workings capital management has direct consequences on the liquidity position and the ultimate profitability of a firm (Burt & Abbate, 2009).
Working capital connotes the funds lock up in materials, work in progress, finished goods, receivables and cash. In this regard, Khan and Jain, (2005) state that current assets are those assets, which can be converted into cash within a short period of time, and the cash received is again invested into these assets; hence, it is constantly receiving or circulating. Therefore, working capital is one of the most important measurements of the financial position, which according to Guthmann (2008) is the life-blood and nerve centre of any business entity. This necessitated the need for the careful management of working capital in every business organization with the value maximization objective.
Therefore, working capital management involves the application of strategies and policies in the use of firm’s current assets and liabilities in such a way that an optimum level of working capital is maintained. In essence, the goal of working capital management is to promote a satisfying profitability and maximizes shareholders’ value (Li & Han-Wen, 2006). They further lament that profitability is affected by the choices that companies make regarding their working capital policies. Thus, if a firm cannot maintain an optimum level of working capital, it is likely to become insolvent and may even be forced into bankruptcy. However, the need for working capital to run day-to-day business activities effectively cannot be overemphasized.
In essence, managing working capital is necessary because of its’ directs effects on the profitability and liquidity of a corporate entity. Rehn (2012) asserts that working capital usually refer to net working capital, the difference between current assets and current liabilities. Thus, it involves minimizing the timing of collecting receivables, deferring the period of payables, and keeping the minimal inventory. Moreover, working capital management includes cash management, that is, how to invest idle cash without compromising liquidity.
Consequently, extant literature on firm profitability and efficiency documents different resulting effect of sub-optimal working capital management on performance and value of firm (Deloof, 2003). According to him, efficient working capital have many effects, which include speeds payment of short-term commitments on firms; facilitating owner financing and it reduces working capital as a cause of firms’ failure. In addition, Osisioma, (1997) and
Wignaraja and O’Neil (1999) revealed that working capital ensures a sound liquidity for assurance of long-term economic growth and attainment of profit generating process, and also ensures acceptable relationship between the components of firms’ working capital for efficient mix which guarantee capital adequacy. On the contrary, Peel and Wilson (1996), Shin and Soenen (1998), Eljielly (2004) and Appuhami (2008) are of the view that inefficient working capital induces firms’ failures, overtrading signs, inability to propel firm liquidity and profitability, and loss of business due to scarcity of products.