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PROJECT TOPIC: EFFECTS OF WORKING CAPITAL MANAGEMENT ON THE PROFITABILITY OF MANUFACTURING COMPANY

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CHAPTER ONE

 

INTRODUCTION

1.1       Background to the Study

The working capital of a company has a major role in making it profitable or non-profitable. Most of the potential investors and other sanalyze position statement to evaluate the management of working capital. Net Working capital consists of current assets less Short term obligations. Positive working capital explain that the corporation is in a fine condition to reimburse it’s short-term debt whereas negative working capital explain that the most liquid assets of the corporation are not sufficient to fulfill its current monetary commitments. Any finance manager must sustain a most favorable point of investment in the most liquid assets of the company. Working capital for any business is the amount of capital to carry out its daily basis operations. In manufacturing concerns, it is the investment required for the conversion of raw material into ready to sell products for the company. The most important items inside determination of working capital are inventories of the corporation, its accounts receivables and payables. The management of working capital frequently considered a tool to maintaining competence of the business inside their operations. Working capital is often assessed by lenders to judge the financial short term paying back ability in difficult financial periods. One of the key determinants of survival and sustainable business growth of modern organisations is the effectiveness of accounting and finance department or function (Eljielly, 2004). One area of accounting and finance that affects the efficient operations of business organisations in general is working capital management (WCM), among other things (Eljielly, 2004; Shin & Soenen, 1998; Tauringana & Afrifa, 2013). WCM has been described as the management of current assets and current liabilities (Agyei & Yeboah, 2011; Tauringana & Afrifa, 2013). The concept of WCM addresses companies’ management of their short-term capital, which is an important component of corporate financial management, directly affects the profitability and liquidity of both small and large firms (Agyei & Yeboah, 2011; Tauringana & Afrifa, 2013). It has been well noted that small scale industries contribute immensely to providing job opportunities, nurturing a society of entrepreneurs and opening up new business avenues for the development of a country. The current scarcity of cash and credit is threatening the survival of many businesses in all over the world primarily in Nigeria as its considered the sources of company’s working assets and liabilities referred to as working capital, it is a fact that corporations could not exist without working capital and this is undeniable. Eventually, the management of working capital (WCM) necessitates short term decisions in working capital (WC) and financing of all aspects of both firms short term assets and liabilities. This explains the fact that firms with inadequate working capital are in financial strait jacket. As the name implies, working capital refers to the funds that are required for the day to day running of the activities of a firm, it is the excess of current assets over current liabilities. Working capital management involves the relationship between a firms short term assets and its short term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short term debt and upcoming operational expenses. In view of that, working capital management has become one of the most important issues in the organizations where many financial executives strive to identify the basic working capital drivers and the appropriate level of working capital (Lamberson 1995). The management of working capital involves managing inventories, account payables, account receivables and cash. Large numbers of business failure has been attributed to the inability of financial managers to plan and control the current assets and current liabilities of their respective organizations. This explains why working capital management is vital to firms with limited access to the long term capital market. The working capital measures both a company’s efficiencies and its short term financial health. It also gives investors an idea of the companies underlying operational efficiency. The working capital shows a company’s efficiency, financial strength and cash flow health which also helps in determining the profitability and risk as well as its value (Smith 1980). The significant of working capital had been highlighted in most of the literature of WCM i.e. EljeUy (2004) described that the efficient WCM are engaged with planning and controlling current assets and liabilities in such a way that eliminates the risk of inability to meet short term obligations in hands with the avoidance of excessive investments in these assets. Siddiquee and khan (2009) indicate that the inefficient management of WC not only reduces profitability but ultimately may also lead a concern to financial crisis thus every organization irrespective of its profit orientation, size and nature of business needs requisite amount of WC. Consequently, the efficient WCM is the most crucial factor in maintaining survival, liquidity, solvency and profitability of the concerned business organization. Thus, we could say that approach in managing working capital has enormous influence to the firms performance. The importance of working capital in the day to day running of the business activities of a firm are stated in the books. Having said that working capital is the live wire of a business, it is expected that effective provision of it will ensure greater success of a company while in — effective management of it will lead to ultimate downfall of what otherwise might be considered as a prosperous concern. Working capital is important to the operations of a firm but the maintenance of a working capital is more crucial. This is because excessive working capital means holding costs and idle funds which earns no profits for the firms is dangerous while inadequate working capital which means not having sufficient funds only limits the firm’s profitability but also results in production interruptions and inefficiencies and sales disruptions. Over the last five to ten years, the world brewery market has become increasingly concentrated with a wave of business combinations among brewery giants as well as diversification of investments outside their geographical location. All these are in the quest to dominate the market as well as the maximization of shareholders wealth. Increasing market domination that will enhance the maximization of shareholders wealth depends largely on certain firm specific factors such as persistent profitability. Profit maximization for any firm depends on efficient management of cost and process of production as well as increases in sales resulting from firm’s market domination. One factor that is deduced to influence firm profitability grossly is the firm’s working capital. Working capital is the stock stored that has a conversion or resale value in order to gain profit. It represents the largest cost of a firm especially the manufacturing firms. In normal circumstances, working capital consists of about 30% – 40% of a firm’s total investment. Investment in working capital to a large extent determines the returns earned by a firm. Nevertheless, excessive levels of current assets can easily result in a firm realizing a substandard return on investment while firms with too few current assets may incur shortages and difficulties in maintaining smooth operations (Van Horne and Wachowicz, 2000). As a result,working capital management is a very important component of corporate finance as it directly affects the liquidity and profitability of a firm. It centers on current assets and current liabilities of a firm. For one thing, the current assets of a typical manufacturing firm accounts for over half of its total assets (Abdul and Mohamed, 2007). One reason why managers spend considerable time on day-to-day management of working capital is that current assets are short-lived investments that are continually being converted into other asset types (Rao, 1989). Liquidity for the on-going firm is not reliant on the liquidation value of its assets, but rather on the operating cash flows generated by those assets (Soenen, 1993). Working Capital Management is therefore a 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. Efficient working capital management involves planning and control of current assets and current liabilities in a manner to strike a balance between liquidity and profitability. Harris (2005) pointed out that working capital management is a simple and straightforward concept of ensuring the ability of the firm to fund the difference between the short term assets and short term liabilities. The ultimate objective of any firm is to maximize shareholders wealth and maximizing shareholders wealth can be achieved by a firm maximizing its profit. A firm that wishes to maximize profit must strike a balance between current assets and current liabilities and hence keeping abreast of the liquidity and profitability trade-off. Preserving liquidity and profitability of the firm is an important objective as increasing profit at the expense of liquidity can bring serious problems to the firm and vice-versa. Working capital management is considered to be a very important element to analyze the firm’s performance while conducting day to day operations. There are chances of imbalance of current assets and current liability during the life cycle of a firm and profitability will be affected if this occurs. This is why the study of influence of working capital on firm’s profitability is drawing scholars’ attention in recent times. Numerous studies on the drivers and financial impact of working capital management for different manufacturing firms for different countries of the world have been published in recent times. However, inter-country studies of world leading firms in a given industry are spare.


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