CHAPTER ONE

INTRODUCTION

1.1 Background of the study

The term working capital has several meanings in business and economic development finance. In accounting and financial statement analysis, working capital is defined as the firm’s short-term or current assets and current liabilities. Net working capital represents the excess of current assets over current liabilities and is an indicator of the firm’s ability to meet its short term financial obligations (Brealey & Myers, 2002). Effective working capital management consists of applying the methods which remove the risk and lack of ability in paying short term commitments in one side and prevent over investment in these assets in the other side by planning and controlling current assets and liabilities (Lazaridis & Tryfonidis, 2006). Working Capital Management is the administration of current assets and current liabilities. It deals with the management of current assets and current liabilities, directly affects the liquidity and profitability of the company (Deloof, 2003; Eljelly, 2004; Raheman and Nasri, 2007; Appuhami, 2008; Christopher and Kamalavalli, 2009; Dash and Ravipati, 2009). Current liquidity crisis has highlighted the significance of working capital management. Management of working capital has profitability and liquidity implications and proposes a familiar front for profitability and liquidity of the company. To reach optimal working capital management firm manager should control the tradeoff between profitability maximization and liquidity accurately (Raheman &Mohamed, 2007). An optimal working capital management is expected to contribute positively to the creation of firm value (Howorth & Weshead, 2003; Deloof, 2003; Afza &Nazir, 2007). 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. 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 Horne and Wachowicz, (2000). Efficient working capital management involves planning and controlling.

There must be a balance between current assets and current liabilities so as to eliminate the risk of inability to meet short term obligations on 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. 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 (Shin and Soenen, 1998). Therefore, there must be a trade- off between these two objectives of the firms. 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. Firms may have an optimal level of working capital that maximizes their value (Afza and Nazir, 2009).

Working Capital Management has its impact on liquidity as well as on profitability of the firm. The study analyzed the relationship between different variables of working capital management including the Average collection period, Inventory turnover in days, Average payment period, Cash conversion cycle and Current ratio and the gross operating profit. Debt ratio, size of the firm (measured in terms of natural logarithm of sales) and financial assets to total assets ratio were used as control variables

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