THE EFFECT OF WORKING CAPITAL MANAGEMENT ON THE COMPANYS PERFORMANCES A SELECTION OF VARIOUS MANUFACTURING COMPANIES IN NAIROBI

BY

CATHERINE CHEBET BIRIR

BBM/2757/10

THE RESEACH PROJECT IS APARTIAL FULLFILLMENT OF A REQUIREMENT FOR THE AWARD OF BACHEROR IN BUSINESS MANAGEMENT DEGREE, SCHOOL OF BUSINESS AND ECONOMICS, MOI UNIVERSITY.

OCTOBER 2010

DECLARATION DECLARATION BY THE CANDIDATE This research project is my original and has not been presented for degree in any other university or institution. No part of this project may be reproduced without prior permission of the author and or Moi University.

Signature; Name; Catherine Chebet Birir Reg No.BBM/2757/10

Date;

DECLARATION BY SUPERVISIOR This research project has been submitted for examination with our approval as university SUPERVISIOR Signature; Name; George NChembere Date;

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MOI UNIVERSITY, NAIROBI KENYA ACKNOWLEDGEMENT I wish to express my heartfelt appreciation to all those who contributed either directly or indirectly to the success of my research I wish to thank my mother Monica Birir, brothers Kevin, Ruben and my sweet sister Irene for giving me encouragement to go on. Special thanks go to my beloved husband Augustine for moral and financial support

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DEDICATION This research is dedicated to my husband Augustine and my sons Ethan and Jayden for their patient, understanding and support.

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ABSTRACT The overall objective of the study was to examine the effect of working capital management on the company performances but with specific references on Nairobi. Manufacturing have been faced with many problems. The study population was to assess effect of investment in cash on companys performances, the effect of holding stock on the companys performances, the effect of giving credit on the companys performances, the effect of having creditors and the effect of delaying payment of creditors on the performances of the firm. The study population was 20 manufacturing companies in Nairobi. A sample of 200 manufacturing companies was picked The respondents were managers finance and treasures. Closed and open ended questionnaires were administered to 20 targeted respondent using a drop and pick method. Finance data was targeted was analyses at Nairobi central A and B district office. The data was analyses using descriptive statistics with the help of SPSS and excess worksheet and presented in the table and figures. The findings of the study are that working capital management is an important part in firm financial management decision. An optimal working capital management is

expected to contribute positively to the creation of firm value. To reach optimal working capital management firm manager should control the trade off between profitability and liquidity accurately. The purpose of this study is to investigate the relationship between working capital management and firm profitability. Cash conversion cycle is used as measure of working capital management.

It is recommended that that reducing cash conversion period results to profitability increase. Thus, in purpose to create shareholder value, firm manager should concern on shorten of cash conversion cycle till accomplish optimal level.

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TABLE OF CONTENT
DECLARATION...................................................................................................ii ACKNOWLEDGEMENT......................................................................................iii DEDICATION.................................................................................................... iv ABSTRACT........................................................................................................v TABLE OF CONTENT........................................................................................vii CHAPTER ONE..................................................................................................1 INTRODUCTION.............................................................................................1 Background................................................................................................1 Overview of the context scope...................................................................3 Statement of the problem..........................................................................3 Objectives of the study..............................................................................4 Hypotheses Testing....................................................................................5 Scope of the study.....................................................................................6 Significance of the Study...........................................................................6 CHAPTER TWO..................................................................................................7 LITERATURE REVIEW.....................................................................................7 Introduction ...............................................................................................7 The concept of working capital management..........................................10 Conceptual framework.............................................................................10 CHAPTER THREE.............................................................................................12 METHODOLOGY...........................................................................................12 Introduction..............................................................................................12 Research design.......................................................................................12 Sampling design......................................................................................13 vii

Descriptive Analysis................................................................................13 Quantitative Analysis...............................................................................13 Data collection process............................................................................14 Data analysis and presentation................................................................14 Limitation of study...................................................................................15 REFERENCES ...........................................................................................16 APENDICES...............................................................................................18 Appendix 1; Time plan.............................................................................18 Appendix 2; Proposal research budget....................................................19

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CHAPTER ONE INTRODUCTION Background Working capital 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. 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. Excessive levels of current assets can easily result in a companys realizing a substandard return on investment. However companys 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 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.

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. Therefore, there must be a trade off between these two objectives of the companys. 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. Companys 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 working capital is accounts payable. 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. 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. This discussion of the importance of working capital management, its different components and its effects on profitability leads us to the problem statement which we will be analyzing. Overview of the context scope The city of Nairobi is located in the southern region of Kenya on the banks of Nairobi River. Besides having the largest population in Africa, Nairobi claims to be the fourth largest city in the continent. Some of the major cities of Kenya that are located nearby Nairobi include Kileleshwa, Chiromo, and Kilimani Estate in the west and Pangani in the north. Statement of the problem Does Working Capital Management Affect Profitability of manufacturing Companys? To analyze this problem statement, we have developed objectives of our research, which will hopefully contribute towards a very important aspect of financial management known as working capital management. This research is focusing on working capital management and its effects on profitability for a sample of manufacturing companys.

Objectives of the study The main objectives are:

To establish a relationship between Working Capital Management and Profitability.

To find out the effects of different components of working capital management on profitability of manufacturing companies.

To establish a relationship between the two objectives of liquidity and profitability of the manufacturing companies.

To find out the relationship between profitability and size of the manufacturing companies.

To find out the relationship between debt used by the Manufacturing companies and its profitability

To analyze the Operating profit margin of manufacturing industry. To analyze the Working Capital of manufacturing industry.

To investigate the impact of Working Capital Management on profitability of manufacturing Companies.

To draw conclusion about relationship of working capital management and profitability of the Manufacturing companies.

To achieve these objectives, this study is organized as follows: Section two reviews the literature for the relevant theoretical and empirical work on working capital management and its effect on profitability. Section three presents the methodology and framework used in the empirical analysis.

Hypotheses Testing Since the objective of this study is to examine the relationship between profitability and working capital management, the study makes a set of testable hypothesis {the Null Hypotheses H0 versus the Alternative ones HA}. Hypothesis 1 The first hypothesis of this study is as follows: H01: There is no relationship between efficient working capital management and profitability of manufacturing companies. HA1: There is a possible positive relationship between efficient working capital management and profitability of manufacturing companies. Companies more efficient in managing their working capital is expected to pose high level of profitability and vice versa. Hypothesis 2 The second hypothesis of the study is as follow: H02: There is no relationship between liquidity and profitability of manufacturing companies. HA2: There may exist a negative relationship between liquidity of Manufacturing companies and profitability. Companys with high level of liquidity are expected to post low level of profitability and vice versa. Hypothesis 3 The Third hypothesis of the study is as follow: H03: There is no relationship between size of manufacturing companies and profitability.

HA3: There may exists a positive relationship between the company size and its profitability. This may be due to the ability of large companies to reduce liquidity levels and cash gaps. Hypothesis 4 The Fourth hypothesis of the study is as follow: H04: There is no relationship between debt used by manufacturing companies and profitability. HA4: There is a possible negative relationship between debt used by manufacturing company and profitability. Companies with high level of debt usage are expected to post low level of profitability and vice versa. Scope of the study The study assessed the working capital management within the selected manufacturing companies in Nairobi focusing on small, Middle level and giant manufacturing companies whose turnover do not exceed Kshs 2 billion. Significance of the Study The results of this study shall be useful to managers in manufacturing companies in Kenya. Information from this study shall inform companies on the importance of working capital management. The results shall inform shareholders on the current practice of working capital management, on the underlying risks that currently exist and ways these risks would be mitigated. The results of the study will also be useful to members who are interested to know how safe there investment are in term of working capital management, what practices would be they proposed to e adopted by the managers to ensure financial viability of these institution.

CHAPTER TWO LITERATURE REVIEW Introduction This chapter covers the review of related literature in regards to working capital management concept, perception and practices in financial institution. It also portray the conception framework that attempts to show the assets liquidity management liability measure of liquidity information system. In intention to discover the relationship between efficient working capital management and companys profitability(Shin & Soenen, 1998) used net-trade cycle (NTC) as a measure of working capital management. NTC is basically equal to the CCC whereby all three components are expressed as a percentage of sales. The reason by using NTC because it can be an easy device to estimate for additional financing needs with regard to working capital expressed as a function of the projected sales growth. This relationship is examined using correlation and regression analysis, by industry and working capital intensity, in all cases; they found, a strong negative relation between the length of the companys net-trade cycle and its profitability. In addition, shorter NTC are associated with higher risk-adjusted stock returns. In other word, (Shin & Soenen, 1998) suggest that one possible way the firm to create shareholder value is by reducing companys NTC. The study of (Shin & Soenen, 1998) consistent with later study on the same objective that done by (Deloof, 2003) by using sample of 1009 large Belgian non-financial companys for the period of 1992-1996. However, (Deloof, 2003) used trade credit policy and inventory policy are measured by number of days accounts receivable, accounts payable

and inventories, and the cash conversion cycle as a comprehensive measure of working capital management. He founds a significant negative relation between gross operating income and the number of days accounts receivable, inventories and accounts payable. Thus, he suggests that managers can create value for their shareholders by reducing the number of days accounts receivable and inventories to a reasonable minimum. He also suggests that less profitable companys wait longer to pay their bills. In other study, (Lyroudi & Lazaridis, 2000) use food industry Greek to examined the cash conversion cycle (CCC) as a liquidity indicator of the companys and tries to determine its relationship with the current and the quick ratios, with its component variables, and investigates the implications of the CCC in terms of profitability, indebtness and firm size. The results of their study indicate that there is a significant positive relationship between the cash conversion cycle and the traditional liquidity measures of current and quick ratios. The cash conversion cycle also positively related to the return on assets and the net profit margin but had no linear relationship with the leverage ratios. Conversely, the current and quick ratios had negative relationship with the debt to equity ratio, and a positive one with the times interest earned ratio. Finally, there is no difference between the liquidity ratios of large and small companys The management of working capital is important to the financial health of businesses of all sizes. The amounts invested in working capital are often high in proportion to the total assets employed and so it is vital that these amounts are used in an efficient and effective way. (Padachi, 2006) Working capital starvation is generally credited as a major cause if not the major cause of small business failure in many developed and developing countries (Rafuse,

1996). The success of a firm depends ultimately, on its ability to generate cash receipts in excess of disbursements. The cash flow problems of many small businesses are exacerbated by poor financial management and in particular the lack of planning cash requirements (Jarvis, 1996). The management of working capital is important to the financial health of businesses of all sizes. The amounts invested in working capital are often high in proportion to the total assets employed and so it is vital that these amounts are used in an efficient and effective way. (Padachi, 2006). Working capital starvation is generally credited as a major cause if not the major cause of small business failure in many developed and developing countries (Rafuse, 1996). The success of a firm depends ultimately, on its ability to generate cash receipts in excess of disbursements. The cash flow problems of many small businesses are exacerbated by poor financial management and in particular the lack of planning cash requirements (Jarvis, 1996). Despite the fact that business performance is relying on efficient working capital practices, this area has been neglected for research for a long time period. Even in the developed countries like Although abundant research and theoretical development has been done in the area of investment and long-term finance but this gray area of short-term finance, in particular working capital management has been neglected for a very long time. Such neglect might have been acceptable, if working capital had a relatively little importance to the firm, but effective working capital management has a crucial role to play in enhancing the profitability and growth of the firm. Indeed, experience shows that inadequate planning and control of working capital is one of the more common causes of

business failure. (Pass and Pike 1984). This knowledge gap has led the researcher to find out that how management of working capital management in general and cash management in particular is being addressed in Nairobi kenya. The concept of working capital management The principal activities of manufacturing companies are production and sales and distribution of products. Basically manufacturing companies will be interested in maintaining a good working capital management to ensure that manufacturing flow smoothly therefore financial performance of manufacturing companies will be concerned with the rate of current assets/ current liabilities. Conceptual framework All the variables stated below have been used to test the hypotheses of our study. They include dependent and independent variables: Net Operating Profitability (NOP) which is a measure of Profitability of the firm is used as dependant variable. It is defined as Operating Income plus depreciation, and divided by total assets minus financial assets. Average Collection Period (ACP) used as proxy for the Collection Policy is an independent variable. It is calculated by dividing account receivable by sales and multiplying the result by 365 (number of days in a year). Inventory turnover in days (ITID) used as proxy for the Inventory Policy is also an independent variable. It is calculated by dividing inventory by cost of goods sold and multiplying with 365 days.

Average Payment Period (APP) used as proxy for the Payment Policy is also an independent variable. It is calculated by dividing accounts payable by purchases and multiplying the result by 365. The Cash Conversion Cycle (CCC) used as a comprehensive measure of working capital management is another independent variable, and is measured by adding Average Collection Period with Inventory Turnover in Days and deducting Average Payment Period. Current Ratio (CR) which is a traditional measure of liquidity is calculated by dividing current assets by current liabilities.

IND P ND NTVAR L EE E IAB E Net profitability Avarage collection period Inventory Turnover in days Avarage payment period Cash Conversion Cycle Current Ratio Influence

D PE E VAR L E ND NT IAB E

Financial Performances

CHAPTER THREE METHODOLOGY Introduction This chapter covers the research design, target population, sample size, data collection method, data analysis and presentation. This was achieved by developing a similar empirical framework first used by Shin and Soenen (1998) and the subsequent work of Deloof (2003). Research design The most difficult issue faced by the authors was to decide about the sample and the methodology. Although manufacturing companies are dispersed in the main cities of Kenya, it was decided to take the data from industrial area cities. Hence, results can be generalized. Personal interviews and telephone surveys were deemed infeasible due to high cost and geographical dispersion of the firms. It was decided to use the tool previously used by Ricci and Vito in 2000 in their paper to identify working capital management practices in Nairobi. While this method allows for easier analysis of the data due to standardized questions, its limitation is that it allows the researcher to determine only what the respondents are doing, not how or why they are doing it. Again the researchers have tried to overcome this limitation by adding few open ended questions in order to get the picture closer to the reality.

Sampling design In this research we have provided two types of data analysis; descriptive and quantitative. Descriptive Analysis Descriptive analysis is the first step in our analysis; it will help us describe relevant aspects of phenomena of cash conversion cycle and provide detailed information about each relevant variable. Research has already been conducted in our area of study anda lot of information is already on hand, and SPSS software has been used for analysis of the different variables in this study. Quantitative Analysis In quantitative analysis we applied two methods: First: we used correlation models, specifically Pearson correlation to measure the degree of association between different variables under consideration. Second: we used Regression analysis to estimate the causal relationships between profitability variable, liquidity and other chosen variables. We have used Pooled Ordinary Least Squares and Generalized Least Squares (cross section weights) methods for analysis. We used panel data in a pooled regression, where timeseries and cross-sectional observations were combined and estimated. In other words, several cross-sectional units were observed over a period of time in a panel data setting. For this purpose of analysis the E - views software was used to analyze financial data and especially in case of pooled data.

Data collection process The data used in this study was acquired from internet and web sites of different companies. The period covered by the study extends to six years starting from 2003 to 2009. The reason for restricting to this period was that the latest data for investigation was available for this period. The sample is based on financial statements of the 20 manufacturing companies, including firms from different sectors of our economy. Because of the specific nature of their activities, companies in financial sector, banking and finance, insurance, leasing, business services, renting and other services are excluded from the sample. Finally, the firm with data of the number of days accounts receivable, number of days inventories, number of days accounts payable and operating income are included in sample. Data analysis and presentation The first part of data analysis, profile of the respondents and results of open ended questions is being discussed. A total of 10 responses were received comprising 83% response rate. These responses represent four broad industries mainly service sector (covering banks and financial institutes, petroleum gas, telecommunication and service providers). When analyzed the total respondent pool about the working capital decision making, it was revealed that 65.8 % of the respondents confirmed it at the corporate level. This result is closer to the Ricci and Vito study who had reported it as 57.3%. The regional level value was 32.1% and only 1.6% of the respondents were taking decisions at local level. Overall, it may be concluded that most of the companies tend to make it at corporate level which shows the centralized approach for making working capital decisions. Response rate was 76.3% when inquired about the firms percentage of

overseas sales, it was discovered that 71% of the respondents replied it between 1-50%. However 29% of the respondents answered that it was between 51-100%. About relationship with foreign banks, the results of the survey indicate that almost 68.7% of the firms have relationship with 1-20 foreign banks. This result is quite parallel with Ricci and Vito study which show that 74.1% of the firms have relationship with 125 foreign banks. Response rate for this question was 77.3%. 71% of the respondents claimed that overseas demand deposit account were between 1-20. More surprisingly it was revealed that 3.2% firms confirmed between the numbers 10,000-50,000. Limitation of study Like any other study, this survey is not without limitations. First, the scale used was just taken as teacher made instrument and was not without loop wholes. For example, some of the questions were answered by the respondents based on their own understanding. Second, some concepts specially related to foreign exchange activities are relatively novel and the respondents had not enough knowledge about it. Third, response rate was somewhat low for open ended questions which might reflect in generalizing the results. Last, but not least there is a lack of fundamental research in the area of working capital so enough literature was not available which could provide a strong foundation for proper research design

REFERENCES Deloof, M and Jegers, M. 1996. Trade credit, product Quality, and Intra Group Trade: Some European Evidence, Financial Management, Vol 25 No 3 pp. 33-43 Eljelly, A. 2004. Liquidity-Profitability Tradeoff: An empirical Investigation in an Emerging Market, International Journal of Commerce & Management, Vol 14 No 2 pp.48 - 61 Joshi, P. V. 1995. Working Capital Management under Inflation, 1st Ed. Anmol Publishers, pp. 20 - 93Long, Michael. S, Malitz. Lleen. B, and Ravid, S. Abraham, (1993) Trade Credit,Quality Guarantees, and Product Marketability Financial Management, pp. 117 127 Rao, R. K. S. 1989. Fundamentals of Financial Management, 3rd Ed. Macmillan publishers, pp 550-644 Ricci, C. and Vito, N. D. 2000. International Working Capital Practices in the UK, European Financial Management, Vol 6 No 1 pp. 69-84 Richard, V. D. and Laughlin, E. J. 1980. A Cash Conversion Cycle Approach toLiquidity Analysis, Financial Management, Vol 9 No 1 pp. 32-38 Shin, H.H and Soenen, L. 1998. Efficiency of Working Capital Management and Corporate Profitability, Financial Practice and Education, Vol 8 No 2, pp 37-4 45 Smith, M. Beaumont, Begemann, E. 1997 Measuring Association Soenen, L. A. 1993. Cash conversion cycle and corporate profitability, Journal of Cash Management, Vol 13 No 4 pp. 53-58 Eljelly, A. 2004. Liquidity-Profitability Tradeoff: An empirical Investigation in an Emerging Market, International Journal of Commerce & Management, Vol 14 No 2 pp.48 61 Long, Michael. S, Malitz. Lleen. B, and Ravid, S. Abraham, (1993) Trade Credit, Quality Guarantees, and Product Marketability Financial Management, pp. 117 127 Rao, R. K. S. 1989. Fundamentals of Financial Management, 3rd Ed. Macmillan publishers, pp 550-644 Ricci, C. and Vito, N. D. 2000. International Working Capital Practices in the UK, European Financial Management, Vol 6 No 1 pp. 69-84

Shin, H.H and Soenen, L. 1998. Efficiency of Working Capital Management and Corporate Profitability, Financial Practice and Education, Vol 8 No 2, pp 37-45 Smith, M. Beaumont, Begemann, E. 1997 Measuring Association between Working Capital and Return on Investment, South African Journal of Business Management, Vol 28 No 1 Soenen, L. A. 1993. Cash conversion cycle and corporate profitability, Journal of Cash Management, Vol 13 No 4 pp. 53-58 Van Horne, J. C. & Wachowicz, J. M. 2000. Fundamentals of Financial Management, 11th Ed. Prentice Hall Inc

APENDICES Appendix 1; Time plan

Groundwork Literature review DefiningMethods Data collection Progress Seminar Data Analysis Write first draft Write second draft Write Final draft T hesisD ue

Ja n xx

F eb xx xx

Ma r xx xx

Aprl xx xx

Ma y xx xx

Jun xx xx 15th xx

Jul

Aug

S ept Oct Nov D ec

xx xx xx xx xx xx xx xx xx xx

xx

xx

xx

xx

xx

xx 15th

Appendix 2; Proposal research budget

N 1

De scription Per diem allow ances Miscellaneous travel expenses Insurance Accommodation Security Communication Printing, stationery, drafting, reproduction of reports 2 Computers and office equipment4 Local transport and vehicle running costs Office running costs4

Unit Month

Unit Cos t 750

Quantity 82

USD 61,500

2 3 4 5 6

Trip Month Month Month Month

150 265 3500 2250 1250

40 85 36 36 36

6,000 22,525 126,000 81,000 45,000

7 8

Month Lump

500

36

18,000 10,000

9 10

Month Month

750 1250

144 36

108,000 45,000

11 12 Total Cos ts

Workshops & seminars Study Tours

Unit Unit

1000 20000

12 3

12,000 60,000 595,025