CHAPTER ONE

INTRODUCTION

1.1       Background to the Study

The corporate finance literature has traditionally focused on the study of long-term financial decisions, particularly investments, capital structure, dividends or company valuation decisions. However, short-term assets and liabilities are important components of total assets and need to be carefully analyzed. Management of these short-term assets and liabilities warrants a careful investigation since the working capital management plays an important role in a firm’s profitability and risk as well as its value (Smith, 1980). Efficient management of working capital is a fundamental part of the overall corporate strategy in creating the shareholders’ value. Firms try to keep an optimal level of working capital that maximizes their value (Deloof, 2003; Howorth and Westhead, 2003 and Afza and Nazir, 2007).

Short term assets and liabilities 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. Short term assets and liabilities management is important due to many reasons (Peel, Wilson and Howorth, 2000). For one thing, the current assets of a typical manufacturing firm accounts for over half of its total assets. For a distribution company, they account for even more. Excessive levels of current assets can easily result in a firm’s realizing a substandard return on investment. However firms with too few current assets may incur shortages and difficulties in maintaining smooth operations (Van Horne and Wachowicz, 2000).

Efficient Short term assets and liabilities 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. Short term assets and liabilities 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 short term assets and liabilities of a firm in part affect its profitability.

The ultimate objective of any firm is to maximize the profit; however, preserving liquidity of the firm is also an important objective. The problem is that increasing profits at the cost of liquidity can bring serious problems to the firm. Therefore, there must be a tradeoff between these two objectives of the firms (Hall, 2002). 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 (see, Raheman and Nasr, 2007).

Maxwell, Gitman and Smith (1998) argue that firms 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 these short-term assets and liabilities popularly called working capital is accounts payable (Dong and Su, 2010). 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 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 (Howorth and Westhead, 2003). 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.

Studies in corporate finance is, customarily, considered as the study of long term financial decisions, provision of long term assets and share and dividend policies. However topics of short term assets and liabilities finance are not less significant in developing an efficient corporate financial strategy not only in Nigeria but all over the world. To the best of my knowledge this area of  finance  considering the vital role short term assets and liabilities management play in increasing the shareholders’ value of a firm. Hence,  relatively  to western knowledge  to provide an empirical analysis on the impact of short term assets and liabilities management on the profitability of manufacturing firms in Nigeria.

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