ABSTRACT
Working capital management is a vital issue in financial decision making since it is a part of investment in asset and it directly affects the liquidity and profitability of the company. Cash conversion cycle ‘one of the most commonly used method in management of working capital is an important financial metric used to determine efficiency of how a company can convert its inventory into sales and then into cash. Past studies have found out that there is a negative relationship between the duration of the cash cycle and profitability and management need to achieve a tradeoff between profitability and liquidity so as to maximize shareholders wealth. From the past studies suggestions the study will investigate the relationship between cash conversion cycle a component of working capital management and the profitability of a sample of Kenyan manufacturing firms using a sample of 10 Kenyan manufacturing firms for a period of 7 years from 2004-05 to2011-12 financial years , the effect of different variables of working capital management including the average collection period, inventory turnover in days, average payment period, cash conversion cycle and current ratio, debt ratio, size of the firm and financial assets to total assets ratio on the net operating profitability of the firms. The result suggests a strong negative relationship between the measures of working capital management including the number of days accounts receivable and cash conversion cycle, financial debt ratio with corporate profitability. Previous studies regarding the average days of accounts payable reported negative correlation of this variable and the profitability of the firm. Finally, the study found insignificant negative relationship between firm size and its net operating profit ratio.
Key words: Working capital management, corporate profitability, Manufacturing Firms.
SECTION ONE
1.0 INTRODUCTION
1.1 BACKGROUND OF THE STUDY
Financial management tools are important aspects during financial decision making since they require firms commitment and managerial support. Most commonly used financial management tools are working capital management and capital budgeting. Working capital management is concerned with the matching of current assets and current liabilities, and it represents the portion of investment that circulates from one form to another in the ordinary conduct of the business. This idea embraces a recurring transition from to inventories to receivables and back to cash that forms operating cycle of the firm (Gitman.L.J, 2001).The difference between current assets and current liabilities represent the net working capital which depicts liquidity position of a firm. Most financial managers face the difficulty of matching current assets and current liabilities. It is important for a firm to sustain their short-term investments to ensure its stability in longer period and also flexibility to carry out their business plans (Ellely 2004). This is not an easy task since managers must ensure that business operations are running in efficient and profitable manner. At this stage there are possibilities to mismatch current assets and current liabilities. If this happens and firm managers cannot manage it properly then it affects firm growth and earnings .This might lead to further financial distress and in the long run a firm can go bankrupt.
Financial Managers faces a strong challenge in management of inventory to satisfy operations needs and minimizing inventory handling cost which is a primary goal in cost management. This goal is not met without careful planning and analysis of inventory management. Analyzing a company’s inventories and receivables is a reliable means of helping to determine whether it is a good investment play or not. Companies stay efficient and competitive by keeping inventory levels down and speeding up collection of what they are owed. The cash conversion cycle (CCC) is one of several measures of management effectiveness. It measures how fast a company can convert cash on hand into even more cash on hand. The CCC does this by following the cash as it is first converted into inventory and accounts payable (AP), through sales and accounts receivable (AR), and then back into cash. Generally, the lower these number the better for the company. Although it should be combined with other metrics (such as return on equity and return on assets) it can be especially useful for comparing close competitors because the company with the lowest CCC is often the one with better management. (http://www.investopedia.com/articles/06/cashconversioncycle.asp)
If the company sells what people want to buy, cash cycles through the business quickly. If management cannot figure out what sells, the CCC slows down. For instance, if too much inventory builds up, cash is tied up in goods that cannot be sold – this is not good news for the company. In order to move out this inventory quickly, management might have to slash prices, possibly selling its product at a loss. If Accounts Receivables is handled poorly, it means that the company is having difficulty collecting payment from customers. This is because Accounts Receivables are essentially a loan to the customer, so the company loses out whenever customers delay payment. The longer a company has to wait to be paid, the longer that money is unavailable for investment elsewhere. On the other hand, the company benefits by slowing down payment of Accounts Payable to its suppliers, because that allows the company to make use of the money for longer. Although companies normally increase inventory levels when they are introducing a new product in the market or ahead of a busy sales period this should be matched with the forecasted demand. Therefore management will strive to achieve a balance on the duration of accounts receivables and accounts payable so as to increase profitability and maintain liquidity position of the firm. This will also influence discount policy of the firm in that for
1.2 STATEMENT OF THE PROBLEM
The dilemma in most of financial management decision making is to achieve the tradeoff between liquidity and profitability. In relation to risk and return on investment, a good firm’s liquidity can be achieved by utilization of effective capital management tool as measured by C.C.C. 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).
The challenge most financial managers’ face in decision making is to determine the inventory levels they should hold in their stock, their collections period and reinvestment of cash inflows in order to optimize the firm’s profit and maximize the shareholders’ wealth. The challenge most financial managers’ face in decision making is to determine and assess the impact of working capital management tool on its profitability. The current assets of a typical manufacturing firm accounts for over half of its total assets so the study has chosen Kenyan Manufacturing Companies because most of their assets are current assets and deals with accounts receivables and accounts payables which are important aspects of Cash Conversion Cycle.
The study will assess the Cash conversion cycle as a tool used in decision making in these organizations. The main objective of the study is to seek to conclusion on the relationship of cash conversion cycle period and profitability and the optimum duration that will maximize profits.
1.3.1General objective
To draw conclusion on the relationship of cash conversion cycle and profitability.
1.3.2 Specific objectives
1. To establish a relationship between cash conversion cycle and Profitability.
2. To determine the optimum duration of Cash Conversion Cycle which maximizes profits.
3. To establish a relationship between liquidity and profitability.
1.4 Research questions
1. What is the relationship between cash conversion cycle and profitability?
2. What is the optimal duration of Cash Conversion Cycle that maximizes profits?
3. What is the relationship between profitability and liquidity?
1.5 IMPORTANCE OF THE STUDY
The study is framed to help manufacturing firms improve on their financial decision making that optimizes shareholders value through maintenance of optimal inventory levels. The study will try to point out the significances of Cash Conversion Cycle and to generate data that can be used for further studies and researches on other related topics.
1.6 SCOPE AND JUSTIFICATION OF THE STUDY
The scope of the study will be the employment of cash conversion cycle in financial decision making by manufacturing firms in Kenya from data collected from questionnaires and financial reports between 2004-05 to2011-12 financial years. With the cash conversion cycle playing a major role in financial stability of different corporations, its efficient utilization is necessary in achieving the goal of financial stability. The purpose of the study is to find an appropriate way in which cash conversion cycle can be more effectively utilized in financial decision making to improve firm’s profitability and increase shareholders wealth
1.7 DELIMITATIONS AND LIMITATIONS OF THE STUDY
The study will be delimited to five most performing manufacturing firms based on their share prices and listed operating in Kenya and listed at the Nairobi Stock Exchange. This leaves out other firms which are not listed in the stock exchange or their share prices are not among the top five. The study will also be delimited to Annual financial reports of 2004-05 to2011-12 financial years containing financial statements from 2004-05 to2011-12 financial years. The sampling of data will be from the finance department.
The study faces challenges in data collection where annual reports are to be used. This is because accuracy on the data from financial statements cannot be verified since there might have been bias on how they were collected and analyzed. Due to time and financial constraints, data collection will only be restricted to companies listed in Nairobi Stock Exchange .This might influence the quality of data collected since data from other manufacturing firms are excluded.
1.8 DEFINITION OF TERMS AND VARIABLES
1.8.1 Cash Conversion Cycle (CCC) ‘ Measures how long a firm will be deprived off cash if it increases its investment in resources in order to expand customer sales. It measure liquidity risk entailed by growth.
1.8.2 Financial Management ‘ This is the management activity which is concerned with the planning and controlling of the firm’s recourses.
1.8.3 Capital Budgeting ‘ This is firm’s decision to invest its current fund most effectively in the long term assets in anticipation of an expected flow of benefits over a series of years.
1.8.4 Liquidity ‘ This is firm’s continuous ability to meet maturing obligations.
1.8.5 Liabilities ‘ This are debts payable in future by the firm to its creditors. They represents economic obligation to pay cash or provide goods or services in some future period.
1.8.6 Assets ‘ Represents economic resources. They are the valuable possessions owned by the firm.
1.8.7 Hurdle Rate ‘ The rate of return/yield an investor is willing to accept in an investment. It’s also known as Internal Rate of Return.
1.8.8 Working Capital ‘ It is the sum of all current assets used in the operations of the company. This includes, cash, marketable securities, inventories and receivables.
1.8.9 Ratios ‘ Refers to the indicated quotient of two mathematical expressions and sa the relationship between two or more things. They are used as a benchmark for evaluating the financial position and performance of the firm.
1.8.10 Efficiency ‘ It is the ability to complete a job with minimal expenditure or competence in performance.
1.8.11. Effectiveness ‘ Adequate to accomplish a purpose, producing the intended or expected result.
1.8.12 Accuracy ‘ Is a Condition of quality being true. Zero defects i.e free from error.
1.8.13. Independent Variable ‘ The variable that is to be manipulated to provide an effect on the dependent variable. In this case, it’s the Financial Management Tools
1.8.14 Dependent variable ‘ The variable whose result depends on the independent variable. In this case, it’s Financial Decision Making.
1.8.15 Moderating Variables – Effectiveness of Financial Management Tools
SECTION TWO
2.0 LITERATURE REVIEW
The study reviewed the relationship between the length of the CCC and corporate profitability. Most of the studies examined the empirical relationship between these variables that show a significant and negative relation. There has been a traditional focus in the field of corporate finance on the long term financial decisions including capital budgeting, capital structure, and dividends. There has been, however, an increasing researcher’s focus on the WCM practices for the last two decades. As a matter of efficiency, the essential point of the WCM practices lies in reducing the CCC period by speeding up collections and slowing down disbursements, as much as possible. The idea of CCC was pioneered by Richards and Laughlin (1980) as a powerful tool for measuring how well a firm is employing its WCM practices. Gentry et al. (1990) concluded that a firm’s market worth was invariably associated with the CCC. The efficient cash management on the part of the firm invariably increases the net present value (NPV) of the cash flows, and eventually the market value of the company. Similarly, a shorter CCC period eventually results in a high profitability of the firm because due to the efficient WCM practices the cost of using the funds in decreased. In other words a shorter CCC period implies any one or all of the following situations:
1. A reduced inventory turnover period in days- quicker processing of materials.
2. A reduced receivables’ turnover in days- speedy collections from credit customers.
3. A reduced payables’ turnover in days- slow payments to creditors.
As a result, the efficiency of internal operations of the company eventually results in an increase in the firms’ returns on investment, a rise in the NPV of associated cash flows, and higher market value of a firm (Gentry et al, 1990).
Moss and Stine (1993) found that the CCC is associated with small business because small businesses need to better manage their cash availability due to lack of credit. Shortening the CCC enhances profitability because the longer the CCC the greater the need for external borrowing. Deloof (2003) also found a significant negative relationship between gross operating income and number of days of inventory, accounts receivable and accounts payable of Belgian firms. These results suggest to managers to create value for their shareholders by reducing the number of days accounts receivable and inventories to a reasonable minimum. The negative correlation between accounts payable and profitability are contrary with the vision that the less profit-making firms make late payments of their bills.
A study of all non-financial corporations in the United States by Nobaneee (2006) suggested that CCC is the measure of the effectiveness of WCM that considers all cash flows associated with inventory, accounts receivable and accounts payable. He investigated that to attain optimal levels of inventory, receivables and payables will reduce the cost of handling and opportunity costs of holding inventories, debtors and creditors, and direct to an most favorable length of the cycle cash conversion. (Journal of Emerging Issues in Economics, Finance and Banking (JEIEFB))
Another study conducted on Spanish small and medium size firms (SMFs) in Span by Teruel& Solano (2007) also confirmed the negative association between the profitability and the number of days accounts receivable and inventory days. He added that SMEs should be worried about the Working capital management, as it can help by minimizing its CCC at a minimum (Teruel and Solano 2007). Vishnani and Shah (2007) measured the impact of policies of Working Capital Management on the firm performance in the Indian electronic industry. They find that stock holding period and debtors’ collection period has a negative correlation with firm performance while the average payment has positive correlation. At the same time Teruel and Solano (2007) found a strong negative link between the measures of WCM (Liquidity) and financial performance. Thus, managers can generate revenue for their firms by managing the CCC and keeping the accounts of receivables, payables and inventory to an optimal level.
Uyar (2009) examined the impact of CCC with firm size and performance for firms listed at Istanbul Stock. The Results showed that there is a considerable negative association between CCC and the firm performance. Gill et al.(2010) found out that there is a significant association between the CCC and performance calculated through gross operating profit. They found out that there is negative correlation between performance and average days of accounts receivable and a positive correlation between CCC and performance.
Raheman et al. (2010) concluded that WCM has a significant negative impact on operating
Profitability of the firms and plays a vital role to generate value for shareholders. Mohamad and
Saad (2010) found a significant negative links between WC variables with firm’s profitability of
Malaysian listed companies. Dong and Su (2010) also found a negative relationship between CCC and corporate performance in Vietnam and a positive link between number of days accounts payable and performance. The study ascertains that managers can enhance profits by minimizing the number of days accounts receivable and inventories and more profitable firms wait longer for payment of their bills.
Nobanee et al. (2011) also concluded that there is a strong negative link between the CCC and Return On Assets for all industries except for consumer goods and services in Japan. Karaduman et al. (2011) in Turkey found out that CCC influences the performance of the firms measured in terms of ROA, listed in the ISE(Istanbul Stock Exchange). The results advocate that it may be possible to enhance performance by improving efficiency of WC. A study conducted by Hayajneh and AitYassine (2011) found out that the link between the WC efficiency and performance of Jordanian manufacturing firms had a strong negative correlation between average receivables collection period, average conversion inventory period, average payment period and the performance measures. Gill (2011) finds the negative link between firm size and WC requirements as bigger firms have lower WC requirements than the smaller firms in Canada and efficient WCM is vital to create the higher profits.
Vijayakumar (2011) observed the link between liquidity and performance is one of the areas of performance of corporate enterprise. Empirical outcomes of the studies found a strong negative correlation between performance and Accounts Receivable Period (ARP), Inventory Conversion Period (ICP) and Cash Cycle (CCC) for a sample of Indian automobile industry.
These results recommend that managers can generate value for their shareholders by minimizing the number of days of accounts receivable and inventories to a reasonable minimum. Additionally, firms are capable of attaining sustainable competitive advantage by means of effective and efficient utilization of the resources of the organization through a careful decline of the CCC to its minimum. The study also observed that there is positive link between accounts payable period and profitability. This finding holds that more profitable firms wait longer to pay their bills. These conclusions are consistent conclusions drawn by Shin and Soenen (1998), Eljelly (2004), Lazaridis and Tryfonidis (2006) and Garcia et al.(2007).
Zubairi (2010) examined that the firm performance and cash cycle can be influenced by firm size in Pakistan. He added that larger firms can be predictable as efficient in collecting receivables due to their power. He found that the firm size has a considerable straight effect on performance of automobile firms and liquidity has a positive link with the performance. In the case of micro and small enterprises, managing the CCC is of vital importance as these firms usually operate with a low financial base. As a matter of fact, reduction the CCC period is invariably a valuable source of small firm finance. It can be safely argued that every firm whether having business operations over a micro scale, small scale, or medium size market, or over a large or even a global level, must maintain and ensure efficient cash management practices in order to get maximum return on its highly precious capital invested in the business. As for instance, the most appropriate WCM practices are considered and valued by Dell and Wal-Mart as an important competitive advantage (Ruback and Sesia 2000). Shin and Soenen (1998) have pointed out towards an important evidence of the impact of efficient management of CCC turnover. They show that in 1994, while the Wal-Mart and Kmart were almost similar with respect to their debt equity ratios, the CCC period of Kmart was of about sixty one days, and that of Wal-Mart forty days. This resulted in an additional annual financing cost of $198.3 million to Kmart and later on it’s inefficient WCM practices contributed to its bankruptcy (Moussawi et al, 2006). The WCM was found to have a significant impact on both the profitability and liquidity in previous studies in the context of different countries (Uyar, 2009). Uyar, (2009) examined the sample of 166 corporations from seven industries of merchandising and manufacturing sector listed in Istanbul Stock Exchange (ISE), Turkey, and concluded that the larger the firm size, the shorter the CCC or the smaller the firm size, the longer the CCC and the firms with shorter CCC were more likely to be more profitable than the firms with longer CCC. Conversely, a poor cash management may well land the firm into troubles as it couldn’t be able to pay its current obligations on time and eventually the firm may have to face the technical insolvency in the short run, or even the ultimate bankruptcy if such state of poor cash management persists and remains unresolved for excessively long period of time. So it can be established that liquidity management is important to maintain adequate profitability as well as the survival of the firm (Uyar, 2009). The Corporate liquidity can be assessed in the context of two different aspects: static or dynamic (Farris and Hutchison, 2002; Moss and Stine, 1993and Uyar, 2009). The first static aspect based view relates to the use of conventional ratios like working capital ratios and liquidity ratios. These various ratios are deployed to gauge or measure the liquidity of the firm at a specific point in time whereas the dynamic view takes into account the firm’s ongoing or concurrent liquidity position based on firm’s operations. So the CCC days are the very outcome of this dynamic view of cash management on the part of the firm. Moss and Stine (1993) found firm size to be an important factor towards the CCC days. They showed that the larger the size of the firms; the shorter is the CCC turnover in days. They also found a significant a positive relationship of the CCC when compared to the working capital ratios. The previous researchers have found a significant and negative relationship between profitability and the length of CCC (Jose et al., 1996; Eljelly, 2004; Uyar 2009). Deloof (2003) studied the impact of WCM practices on earning efficiency of 1009 companies for a period of 5 years data using the CCC period as the efficiency tool for good WCM practices. He concluded with a strong negative association between the CCC period and profitability. Samiloglu and Demirgunes (2008) analyzed the effect of WCM practices on firms’ profitability. They found a negative relationship between the profitability and the debtors’ turnover days, sock turnover days and the financial leverage, with the exception of sales growth which had a positive impact on firm’s earnings.
In another study, Karaduman and et al (2010) analyzed the impact of WCM practices on the firm’s earnings regarding a four years data of the listed firms in ISE, Turkey. On the basis of their strong evidence, they regarded the efficient WCM practices as a fundamental driver of thereby arguing the necessity to create a balance between the profitability and risk associated with the ultimate outcomes of the financial decision making. Lyroudi and Lazaridis (2000) analyzed the food industry in Greece for the relationships and found the evidence of a significant positive relationship between the CCC and the current and quick ratios. Koumanakos (2008) and Padachi (2006) also found a negative association between the stock turnover days and the return on investment- that high level of inventories was associated with low profitability. Singh and Pandey (2008) also analyzed association between WCM practices and performance in the context of the Hindalco Industries for an eighteen years data. Lazaridis and Tryfonidis (2006) also analyzed association between WCM practices and performance and found a strong relationship between the WCM ratios and firm performance, and their results from regression analysis showed strong association between profitability (gross operating profit) and CCC. It was also argued by them that an efficient and optimal CCC management was vital for increasing the shareholders worth. The research by Eljelly (2004) also found a strong negative association between the WCM measures and the firm performance. Gill and Biger and Mathur, (2010) also reported a very strong relationship between slow recoveries and low profitability. Mathuva (2009) also analyzed the impact of working capital management practices with the same conclusion that there exist strong relationships between average collection period (ACP) and profitability, between the inventory turnover period and profitability, and between payables turnover period (APP) and the firm’s profitability. In their studies on the same subject matter, Dong and Su (2010) and Hutchison et al. (2007) showed a strong relationship between CCC length and the company’s returns on investment. According to Schilling (1996), the decision to segregate the capital employed between the current assets and fixed assets and both the returns on investment in current assets and fixed assets are to be considered. He proves that if the CCC length/turnover days are increased, the minimum liquidity required in the business increases; and if the CCC turnover decreases, there also occurs a fall in the volume of cash needed by the business. He argues that as the return on total capital employed turns out to be lesser than the return on fixed assets, investment in current assets must be done very cautiously maintaining a minimum of liquidity In Pakistan’s context Raheman and Nasr, (2007) analyzed the effect of components of WCM on liquidity and profitability by selecting a sample of 94 Pakistani firms listed on Karachi Stock Exchange ( KSE) for a period of 6 years from 1999 ‘ 2004. They reported significant negative correlations between WCM components and profitability, and between liquidity and profitability. Afza and Nazir (2009) studied relationship between WCM practices and a firm’s profitability by taking 204 non-financial companies listed on KSE for years 1998-2005. They used regression analysis and found a strong positive association of low profitability and aggressive WCM, and recommended a conservative approach towards WCM and related financing policies.
Noreen, Khan and Abbas, (2009) examined the international WCM of MNCs in Pakistan. They studied three major areas namely the international cash management operations, international sales and foreign exchange activities of one hundred and fifty companies of the banking, telecommunication, and related service providers. Their study is envisaged to be helpful to the
Policy makers and decision making authorities to better consider and adopt efficient ways of WCM practices.
SECTION THREE
3.0 RESEARCH METHODOLOGY
3.1 Research Design
This research will be undertaken to analyze the effects of cash conversion cycle on profitability. Descriptive design is most suitable for the purpose of accomplishing this research objective. This is because through descriptive design the study will be able to explain the relationship between cash conversion cycle and profitability, and liquidity. Cross sectional studies will be used since financial reports used are samples from seven financial years and questionnaires will be issued once to the relevant respondents.
3.2 Population
This study will target manufacturing firms listed in Nairobi Stock Exchange and will analyze data obtained from their financial reports for the past seven year. For a firm to be part of this it has to be listed in the stock exchange and also ranked among the top five in terms of current share price. The restriction is due to share price which is a measure of shareholders wealth in an entity, since the study seeks to find the relationships between cash conversion cycle, profitability and liquidity, firms with high share price are considered profitable and hence need to study the relationships using the firm’s data.
3.3 Sampling and sampling design
The study will adopt the stratified sampling design where the respondent shall be the personnel in the finance department. In addition, the study will use the financial report of 2005-2012 financial years so as to calculate the firm’s cash conversion cycle. The durations for each year will be compared to its respective profits. A relationship will be established between these components which can be used in decision making so as to forecast future profits.
3.4 Data collection tools
The study will gather data using both primary and secondary data sources. The primary data source will employ the use of direct interview with the overall financial manager and the use of questionnaire. The two methods were chosen because ; both methods are free from bias , it’s a quick method of data collection from large population and on the part of questionnaire ; its question are standardized and hence minimizes the degree of variance brought about by personal opinion. The secondary source of data will be from the annual report of the company of 2005 to 2012 financial years. These reports shall enable the study to save time in data collection; they are cost effective and contain data that could be gathered by use of primary data.
3.5 Data Analysis Technique
In establishing the relationship between financial management tools employed, its effectiveness in decision making on performance of the firm, the study will utilize descriptive statistical techniques in data analysis. An analysis of Liker scale will be used to establish the effectiveness of financial management tools and T test will be used in testing hypothesis..
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