Effect of Working Capital Management on the Profitability ... · Working capital management is...

International Journal of Economics & Business ISSN: 2717-3151, Volume 3, Issue 2, page 255 - 261

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Zambrut.com. Publication date: April 17, 2019.

Ogunmakin, A. A. 2019. Effect of Working Capital Management on the Profitability of ................ 255

Effect of Working Capital

Management on the

Profitability of Selected

Quoted Firms (Study in Nigeria)

OGUNMAKIN Adeduro Adesola

Dr. OGUNMAKIN Adeduro Adesola

Department of Accounting, Ekiti State University

Ado Ekiti, Ekiti State, Nigeria

1. Introduction

Working capital management has been described as the management of current assets and current

liabilities (Agyei & Yeboah, 2011; Tauringana & Afrifa, 2013; Mbawuni, Mbawuni & Mimako, 2016).

The concept of working capital management addresses companies management of their short-term

capital, which is an important component of corporate financial management Working capital directly

affects the profitability and liquidity of both small and large companies. The need for firms to maintain

optimum working capital and creating sustainable working capital is becoming ever more important.

Consequently, proper working capital management will enable firms sustain business growth, which in

turn will lead to maximisation of owners wealth (Mbawuni, Mbawuni & Mimako, 2016).

Abstract: This study examined the effect of working capital management on the profitability of

selected quoted firms in Nigeria. Secondary method of data collection was adopted. Simple

random sampling technique was used in selecting three industries out of the seventeen quoted

industries in Nigeria and two firms each from the sampled industries. Variables tested for

working capital management (WCM) were average collection period (ACP); average payment

period (APP); inventory turnover in days (ITID) and cash conversion cycle (CCC). Return on

asset (ROA) and return on equity were proxy for profitability. Data gathered from the financial

statement of the selected firms were analyzed with pairwise correlation and the results indicate

a significant relationship between cash conversion circle and return on assets. The study

concluded that there is an existence of trade off between working capital management policies

adopted by firms and their level of profitability.

Keywords: Profitability, Working Capital, Management, Firms, Return on Asset, Return on

Equity, Cash Conversion Cycle, Current Ratio, Debt Ratio Sales Growth.

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Working capital management is measured by the cash conversion cycle (CCC), which is defined

by Keown, Martin, Pretty, & Scott, (2003); Adolphus, (2014) as the sum of daily sales outstanding

(average collection period) and days of sales in inventory less days of payables outstanding. The longer

this time lag, the larger the investment in working capital. A longer cash conversion cycle might

increase profitability because it leads to higher sales. Also, cash management is essential to every

business that desires to meet up with its short-term financial obligations (Akinyomi, 2016). He stated

further that cash represents the basic input necessary to start and keep a business running. A firm needs

to maintain sufficient cash to keep its business running. Cash shortage will disrupts the firm’s operation

and can even lead to insolvency. Excessive cash will tie down capital which will lead to low return on

capital employed. A firm most maintained a healthy cash position.

Many research works have been carried out in the area of working capital management and how

it affect or enhance profitability of the firms. For example, Akinyomi, (2016) investigated the effect of

Cash Management on Profitability of Nigerian Manufacturing Firms; Agyei, and Yeboah (2011)

empirically studied working capital management and profitability of banks in Ghana and Mbawuni,

Mbawuni and Mimako, (2016) analysed the impact of working capital management on Profitability of

petroleum retail Firms. The problem of this study then, is that most of the reviewed literature paid

attention to a single industry and few of the existing study have been able to do cross-sectional

analysis. To this end, this research work critically examined the effect of working capital management

on the profitability of selected quoted firms across industries in Nigeria.

Specifically, it examined the relationship between working capital management and return on

equity and return on asset of the selected quoted firms in Nigeria.

2. Literature Review Working capital management is one of the most important areas while making liquidity and

profitability comparisons among firms. It’s involves decision of amount and composition of current

assets and the financing of these assets, the greater the relative proportion of liquid assets, the lesser the

risk of running out of cash (Eljelly, 2004). The components of working capitals are inventories, trade

receivables and trade payables, the proportion of the working capital components can change from time

to time during the trade cycle, the working capital components will be based on the objective of the

firm and maximisation of profits (Lamberson, 1995).

The study derived its theoretical framework directly from the trade-off theory. The trade-off,

theory according to Bhattacharya, (2001) and Mwanahamisi, (2013), proposes that there is a trade-off

between liquidity and profitability; gaining more of one means giving up some of the other. At one end

of the spectrum, there are highly liquid firms which are not very profitable, while at the other end, and

firms which are highly profitable but are not very liquid. The basic challenge therefore is to determine

the middle ground where the firm should reside. Proponents of the trade-off approach are focusing their

efforts mainly on developing dynamic structural trade-off models. An attractive feature of these models

is that they try to provide a unified framework that can simultaneously account for many facts

(Mwanahamisi, 2013).

A well-managed working capital promotes a firms well-being on the market in terms of liquidity

and it also acts in favor for the growth of shareholders value (Jeng-Ren & Han-Wen, 2006;

Mwanahamisi, 2013). Investment in working capital involves a balance/tradeoff between risk and

profitability because investment decision, which leads to increase in profitability will be inclined to

increase risk and vice versa. Efficiency in managing working capital also increases cash flow of the

firms which in turn increase the growth opportunities for the firms and return to the shareholders

(Mwanahamisi, 2013).

This study reviewed some empirical studies in relations to working capital management and

firm’s profitability’s; Akinyomi, (2016), examined the relationship between cash management and

profitability in the Nigerian manufacturing firms. Correlation and regression analysis were carried out.

The results reveal a positive and significant relationship between cash conversion circle and return on

equity on one hand and a non significant negative relationship between cash conversion circle and

return on assets. From the results of the study, it is recommended that future researchers should expand

the scope of their studies to include multiple sectors of the economy.


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Mwanahamisi, (2013) investigated the effects of working capital management on the

performance of firms in Kenya. A descriptive research was undertaken to guide the study. From a

target population of 33 included the Head of Departments, the Principals and Head of sections of the

finance division of Kenya Ports Authority. A stratified random sampling technique was employed in

selecting the sample of 30 respondents at 5 percent level of confidence. In order for the relevant

information to be collected, both primary and secondary data collection methods were used. He used

Statistical Package for Social Science (SPSS Version 20.0) for data analysis. The finding of the study

shows that firm performance gets affected by working capital management. He recommended that

further research should focus on other components of working capital management such as company

size, sales growth, and current ratios.

Also, Ngwenya, (2012) investigated the relationship between working capital management and

profitability and sampled 69 companies listed on the Johannesburg stock exchange for the period of

1998 to 2008. The study analyzed data using regression analysis and Pearson correlation. The results

showed a significant negative relationship between profitability and cash conversion cycle, and a

positive significant relationship between accounts payable and profitability.

3. Methodology

This research work focused at obtaining consistent estimate of fixed effect models for panel data

regression applied to data from selected quoted firms. The population of the study is all the quoted

firms in Nigeria which were segregated into seventeen industries. Simple random sampling techniques

was used in selecting three industries; Consumers goods; Brewing and Agricultural sub-sector and

same technique was also used to select two firms each from the sampled industries; Consumers: PZ and

Glaxo; Brewing Industry: Nigerian Brewery and Guinness and Agric: Presco and Okomu. The study

covered 2006 – 2014. Based on the require information on the financial variables consider for this

study. Information was obtained from the financial statement of the selected quoted firms. The selected

firms serve as cross-sectional units and number of years as the time series. The Generalized least square

panel with White Heteroskedasticity-Consistent Standard Errors and Covariance was used as estimation

technique.

3.1 Specification of Model

Akinyomi, (2016) put up a model to capture relationship between cash management and

profitability in the Nigerian manufacturing firms;

ROE= b0 + b1CCCt + b2CRatiot + b3DRatiot + b4SGt + ε …… (3.1)

ROA= b0 + b1CCCt + b2CRatiot + b3DRatiot + b4SGt + ε...…... (3.2)

Whereas;

ROA= Return on assets

ROE= Return on equity

CCC= Cash conversion cycle

CR= current ratio

DR= Debt ratio

SG= Sales growth

ε = Error Term

Following this model, with modifications, this study put up a model to capture the effect of

working capital management on the profitability of the selected quoted firms in Nigeria. However, the

data gathered could be modeled using panel regression.

The adopted model will be specified in functional form as follows:

ROAit= f (ACP it,, APP it,, ITID it,, CCC it,, 𝓐I, 𝓑t , µ)………… (3.3)

ROEit= f (ACP it,, APP it,, ITID it,, CCC it,, 𝓐I, 𝓑t . µ)………… (3.4)

Where;

ROA= Return on Assets

ROE= Return on Equity

ACP= Average Collection Period

APP= Average Payment Period


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ITID= Inventory Turnover in Days

CCC= Cash Conversion Cycle

𝓐i = unobserved cross sectional effect

𝓑t = unobserved time series effect

i=s; t = y

Panel data with three regressors

S = numbers of entities (states) Y = number of years

f = Functional Notation

µ = Proxy for the Disturbance variable

4. Analysis and Interpretation of Results

4.1 Multicollinearity Test Adopting Ahsan, Abdullah, Gunfie, and Alam (2009) approach, the three major methods used in

determining the presence of multi-co linearity among independent variables in this study were pairwise

correlation matrix, tolerance test and Variance Inflation Factor (VIF). This study utilized a pair-wise

correlation matrix shown at 5% level of significance. It shows the relationship among the individual

variables. As evidence in table1 below, there exist an inverse relationship between ACP and ROE, ACP

and ROA, CCC and ROA, CCC and ROE, CCC and APP, with the lowest correlation of -0.5420

between average collection period and return on equity, which implies that there is a 54.2 % inverse

relationship between ACP and ROE and depicts that the higher the period used in the collection of the

respective companies receivables the lower their profitability, vice verse, while a positive relationship

exist between ROA and ROE, ROA and APP, ROA and ITID, APP and ROE, APP and ACP, ITID and

ROE, ITID and ACP, ITID and APP, CCC and ITID however, the highest correlation of 73.06%

occurred between ROA and ROE followed by 72.19% relationship between cash conversion cycle

(CCC) and Inventory Turnover in Days (ITID).

Table1: Correlation coefficients, using the observations 1:1 - 6:9 (missing values were skipped) 5%

critical value (two-tailed) = 0.2681 for n = 54

l_ROA 1.0000

l_ROE 0.7306 1.0000

l_ACP -0.3849 -0.5420 1.0000

l_APP 0.2799 0.3307 0.1933 1.0000

l_ITID 0.1211 0.1246 0.1979 0.4747 1.0000

l_CCC -0.2761 -0.2162 0.2199 -0.0686 0.7219 1.0000

l_ROA l_ROE l_ACP l_APP l_ITID l_CCC

Source: Researcher’s Computation 2019

4.2 Heteroskedasticity Test The distribution free Wald test for heteroskedasticity was run to test for the presence of

heteroscedasticity. The test revealed the following results;

Distribution free Wald test for heteroskedasticity:

Chi-square (5) = 4.24143e+029, with p-value = 0

The above test reports a significant value of 0% below the 5% level of the set hypothesis. This means

that the chi2

of 4.24143e+029 and 1.16284e+030 were significant and for that matter could not afford to

reject the alternate hypothesis of saying that heteroscedasticity is present.


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4.3 Fixed Panel Regression

Table 2: Model 4: Fixed-effects, using 31 observations Included 6 cross-sectional units

Time-series length: minimum 1, maximum 9

Dependent variables: l_ROE & l_ROA

Coefficient Std. Error t-ratio p-value

l_ROE l_ROA l_ROE l_ROA l_ROE l_ROA l_ROE l_ROA

Const 4.419 2.202 1.119 1.289 3.9506 1.7079 0.00073 0.10239

l_ACP -0.644 -0.396 0.196 0.226 -3.2814 -1.7489 0.00356 0.09490

l_APP 0.211 0.0169 0.234 0.269 0.9041 0.0628 0.37620 0.95051

l_ITID 0.161 0.994 0.681 0.785 0.2368 1.2658 0.81513 0.21943

l_CCC -0.179 -0.826 0.541 0.623 -0.3308 -1.3305 0.74407 0.19762

l_ROE l_ROA l_ROE l_ROA

Mean dependent

var 2.974440 2.068348

S.D. dependent

var 1.017423 0.983479

Sum squared

resid 11.74632 15.59897

S.E. of

regression 0.747896 0.861863

R-squared 0.621751 0.462419 Adjusted R-

squared 0.459644 0.232027

F(9, 21) 3.835444 2.007097 P-value(F) 0.005322 0.090579

Log-likelihood -28.94516 -33.34197 Akaike

criterion 77.89032 86.68393

Schwarz criterion 92.23019 101.0238 Hannan-Quinn 82.56476 91.35837

Rho -0.190440 -0.153547 Durbin-Watson 2.152285 2.290319


Test for differing group intercepts -

Null hypothesis: The groups have a common intercept

Test statistic: F (5, 21) = 1.14755

With p-value = P (F(5, 21) > 1.14755) = 0.366989

Mathematical expression of the relationship between explained variables and explanatory variables: -

Equation 1: ^l_ROE = 4.42 - 0.644*l_ACP + 0.211*l_APP + 0.161*l_ITID - 0.179*l_CCC

(1.12) (0.196) (0.234) (0.681) (0.541) n = 31, R-squared = 0.622 (standard errors in

parentheses)

Equation 2: ^l_ROA = 2.20 - 0.395*l_ACP + 0.0169*l_APP + 0.994*l_ITID - 0.829*l_CCC

(1.29) (0.226) (0.269) (0.785) (0.623) n = 31, R-squared = 0.462 (standard errors in

parentheses)

Equation1 above shows that the constant parameter has a positive relationship impact on

profitability of the selected manufacturing firms proxied with return on equity (l_ROE) at a value of

4.42 units, which implies that if all explanatory variables are held constant, that is, a situation of no

working capital management in the selected companies, the profitability of the manufacturing

companies will be averagely affect by 4.42 units. The average collection period which measures the

level of efficiency of the companies in the collection of their receivables had an inverse impact of

64.4% on the return of equity of the companies. The average period within a year of the selected

companies used for paying back the amount owed its creditors (APP) and inventory turnover in days

(ITID) indicated a positive impact of 21.1% and 16.1% respectively on the level of profitability (ROE)

of the selected quoted companies. The adverse impact of the selected companies average collection

period on ROE reflected in their poor cash conversion periods which depicted negative impact of

17.9% on ROE. This finding contradicts the finding of Akinyomi (2016) that revealed a positive and

significant relationship between cash conversion circle and return on equity while examining the

relationship between cash management and profitability in the Nigerian manufacturing firms. In respect

of equation 2, which used return on asset (ROA) as the proxy for profitability of the selected quoted


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companies, it was indicated that a situation of no working capital management in the companies will

always result to 2.20 unit growth in return on asset. Both average collection period (ACP) and cash

conversion cycle (CCC) showed an inverse impact of 39.5% and 82.9% respectively on ROA, which

correlate with Akinyomi (2016) that showed a non significant negative relationship between cash

conversion circle and return on assets and Ngwenya (2012) that indicated a significant negative

relationship between profitability and cash conversion cycle, while on the contrary APP and ITID

indicated a positive impact of 0.0169 and 0.994 on the return of asset of the quoted companies

4.4 Model Diagnostics In relation to equation1, The R

2 showed that 62.2 % variations of the selected quoted companies’

profitability (ROE) were explained by their working capital management variables (ACP, APP. ITID,

CCC), while the remaining 32.8% should be explained by the variables exogenous to the model

specified. This is further proved by Wald test F-Test (F- Test of 3.835444 at p-value of 0.005322 lesser

than 5% level of significance) which signified that the variables (ACP, APP. ITID, CCC) had a strong

chance of explaining the outcome of the selected companies profitability proxied with Return on Equity

(ROE). Based on equation 2, The R2 showed that 46.2 % variations of the selected quoted companies’

profitability (ROA) were explained by their working capital management variables (ACP, APP. ITID,

CCC), while the remaining 54% could be explained by the variables exogenous to the model specified,

this is further proved by Wald test F-Test (F- Test of 2.007 at p-value of 0.0906 above 5% level of

significance), which signified that the variables (ACP, APP. ITID, CCC) had a poor chance of

explaining the outcome of the selected companies profitability proxied with Return on Asset (ROA)

4.5 Tests of Significance (T-Test)

The T-test is used to test the statistical significance of the explanatory variables in the model. It is

done by comparing the T-statistics in the Panel result and the table value (T-tab). An explanatory

variable is significant when the T-calculated is greater than T-tabulated and on the reverse it is

insignificant.

Table 3: T-Statistics

Variables T-cal

T-tab (9, 0.05) Decisions

l_ROE l_ROA l_ROE l_ROA

Const 3.9506 1.7079 1.83311 Significant Insignificant

l_ACP -3.2814 -1.7489 1.83311 Significant Insignificant

l_APP 0.9041 0.0628 1.83311 Insignificant Insignificant

l_ITID 0.2368 1.2658 1.83311 Insignificant Insignificant

l_CCC -0.3308 -1.3305 1.83311 Insignificant Insignificant


5. Conclusion

There is an existence of tradeoff between working capital management policies adopted by the

companies and level of profitability in the period under study. Specifically, the average period used by

the companies in the collection of their receivables is inversely related with profitability level, the

policy management adopts as regards its account payables positively impacted the profitability level,

the level of efficiency of companies’ sales and marketing department is influential its corporate

profitability and the higher the period of cash conversion of a manufacturing company the lower its

financial performance. This study contributes to the body of knowledge on how best working capital

variables can enhance firms’ performance.


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6. Recommendation

Manufacturing firms should be prompt in the collection of its receivables because the result

showed an inverse relationship between the duo, which implied that the higher the period allowed by

companies for its debtors to repay the lower the profitability. Companies should opt for suppliers that

will allow a longer period of time for the repayment of credit purchases. Management should motivate

its sales and marketing force in terms of performance based incentives so as to encourage efficiency

geared towards profitability. The cash conversion cycle of manufacturing companies should be shorter

due to the inverse effect it portrays on the level of profitability.

Future studies can widen the scope of this study in terms of period and sampled firms. Also, a

related study should be carried out in the following industries: telecommunication, Oil and gas and

banking.

7. References Mbawuni, Mbawuni and Mimako, (2016). The Impact of Working Capital Management on Profitability

of Petroleum Retail Firms: Empirical Evidence from Ghana. International Journal of Economics

and Finance. 8 (6). 49-62.

Agyei, S. K., and Yeboah, B. (2011). Working capital management and profitability of banks in Ghana.

British Journal of Economics, Finance and Management Sciences. 2(2), 1-12.

Tauringana, V., and Afrifa, A. (2013). The relative importance of working capital management and its

components to SMEs‟ profitability. Journal of Small Business and Enterprise Developmen., 20(3),

453-469.

Keown, A.J., Martin, J.D., Pretty, J.W. and Scott, D. (2003), Foundations of Finance. Pearson

Education, New Jersey.

Adolphus, J. T (2014). Working Capital Management Policy and Corporate Profitability of Nigerian

Quoted Companies: A Sectoral Analysis. International Journal of Financial Management. 3 (1).

8-19.

Akinyomi, O. J (2016). Effect of Cash Management on Profitability of Nigerian Manufacturing Firms.

International Journal of Marketing and Technology. 4 (1). 128-140.

Eljelly, A. (2004). Liquidity-Profitability Trade-off: An empirical Investigation in An Emerging

Market. International Journal of Commerce & Management, 14(2). 48 – 61.

Mwanahamisi, A., W (2013). Effects of Working Capital Management on the Performance of Firms in

Kenya: A Case Study of Kenya Ports Authority. Journal of Science and Research. 4(4). 1124-

1136.

Lamberson M., (1995), Changes in Working Capital of Small Firms in Relation to Changes in

Economic Activity. Mid-American Journal of Business. 10(2). 45-50.

Jeng-Ren, C., Li, C. and Han-Wen, W. (2006). The determinants of working capital management.

Journal of American Academy of Business, Cambridge. 10(1), 149-155.

Ngwenya, S. (2012). The relationship between working capital management and profitability of

companies listed on the Johannesburg Stock Exchange. Journal of Modern Accounting and

Auditing. 8(66).

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