1.0 Introduction
1.1 Background of Study
The Working capital is a financial metric which represents the operating liquidity available to a business concern. As regarding fixed assets such as plants and equipment working capital is considered as a part of a company's operating capital, referring to current assets such as cash at hand, cash on bank account raw materials working progress, finished goods, account receivable etc. To measures the efficiency of company's working capitals, net working capital is often used which is defined as the difference between current assets and current liabilities if current assets are higher than current liabilities, the company has working capital efficiency explaining the company's ability to continue its operations and to have sufficient funds to satisfy both maturing short term debt and upcoming operational expenses.
Working capital management involves planning and controlling current assets and current liabilities in a manner that dominates the risk of liability to meet due short-term obligations on one hand and avoid excessive investment in these assets on the other hand. According to (Elijelly, 2004) there is a combination of policies and techniques for the management of a company's working capital. These policies involves inventory management debtor's management etc. a popular measures of working capital management is the cash conversion cycle, which tells how cash is moving through a company in terms of duration.
According to Brigham and Daves (2002) working capital management involves both setting working capital policy and carrying out that policy in day to day operation. It also involves making appropriate investments in cash, marketable securities, receivable and inventories as well as the level and mix of short-term financing (Emery Finnety and Stowe 2004). Working capital management plays a vital role in the financial health and operational success of any organization. It involves the strategic handling of a company's short-term assets and liabilities to ensure that it has sufficient liquidity to carry out its day-to-day activities effectively. As defined by Ross, Westerfield, and Jordan (2008), working capital refers to the difference between current assets and current liabilities, which represents the firm's ability to meet its short-term obligations. Efficient working capital management ensures that an organization is neither undercapitalized nor overcapitalized, both of which can adversely affect profitability.
In the dynamic and competitive business environment, the ability to maintain a sound balance between profitability and liquidity is essential. Companies often struggle to strike a balance between investing too much in working capital, which can reduce profitability, and investing too little, which can lead to liquidity crises and operational disruptions (Lazaridis & Tryfonidis, 2006). Managing working capital efficiently helps organizations avoid financial distress and enhances their capacity to generate revenue.
The significance of working capital management becomes even more pronounced in industries where firms operate with limited financial resources or are subject to seasonal fluctuations. In such cases, working capital components like inventory, receivables, and payables must be monitored and optimized to ensure seamless operations and financial viability. Deloof (2003) asserts that the management of accounts receivable, inventory, and accounts payable significantly affects the profitability of firms, especially in manufacturing and trading sectors.
Working capital management (WCM) is a fundamental aspect of financial management that deals with the administration of a company's short-term assets and liabilities to ensure operational efficiency and financial stability. According to Gitman (2009), working capital refers to the firm's investment in short-term assets such as cash, accounts receivable, and inventories, minus its current liabilities. Effective working capital management ensures that a firm maintains sufficient cash flow to meet its short-term obligations and operating expenses (Gitman, 2009). Therefore the ultimate goal of working capital management is to ensure that firm's are able to continue their operations with sufficient cash-flow that will service their long-term debts and satisfy both maturing short-term obligation (debts) and upcoming operational expenses. Hence, organization should try as much as possible to meet up with this goal so as to avoid being caught up in the trap of ineffective management of working capital components.
1.2 Statement of Problems
Investigation revealed that many financial managers still lack a practical understanding of how each component of working capital influences profitability. The disconnect between academic theory and real-world practice often results in decisions that do not align with the financial goals of the organization (Filbeck & Krueger, 2005). In today's competitive and unpredictable business environment, many organizations face significant challenges in managing their working capital effectively. Working capital mismanagement is one of the leading causes of liquidity crises and operational inefficiencies, which directly affect a firm's profitability and long-term sustainability (Lazaridis & Tryfonidis, 2006).
The problem becomes even more pronounced in environments where access to external financing is limited or expensive. In such contexts, internal cash flow management becomes the primary tool for survival and growth. Poor working capital practices, such as extending too much credit to customers or failing to pay suppliers on time, result in cash flow shortages and reduced profitability.
1.3 Aim and Objectives of Study
The aim of this study is to examine the effects of working capital management on the profitability of an organisation.
The specific objectives of the study are:
- To evaluate the relationship between components of working capital (inventory, receivables, and payables) and organisational profitability.
- To assess the impact of working capital management practices on the liquidity and operational efficiency of the organisation.
- To identify the challenges faced by organisations in managing working capital effectively.
- To determine whether efficient working capital management enhances return on investment and overall financial performance.
- To recommend strategies for improving working capital management in order to boost profitability.
1.4 Research Questions
Based on the stated objectives, the study seeks to answer the following research questions:
- What is the relationship between the components of working capital (inventory, receivables, and payables) and the profitability of an organisation?
- How do working capital management practices affect the liquidity and operational efficiency of an organisation?
- What challenges do organisations face in managing their working capital effectively?
- To what extent does efficient working capital management enhance the return on investment and overall financial performance of an organisation?
- What strategies can be recommended to improve working capital management in order to increase profitability?
1.5 Significance of Study
The outcome of this research study will be useful for organisations seeking to improve their financial performance by optimizing their working capital. The study will also help organisations avoid common pitfalls such as over-investing in inventory or extending excessive credit to customers, which can negatively impact their bottom line.
Furthermore, the study will offer recommendations for improving working capital management strategies, which will assist organisations in maintaining a balance between profitability and operational efficiency.
Lastly, this research will add to the growing body of literature on working capital management, providing a foundation for future studies in this field. It will also be beneficial for academics, policymakers, and business practitioners who are interested in understanding the broader implications of effective working capital management on business sustainability.
1.6 Scope and Limitations of the Study
This study will focus on the effects of working capital management on the profitability of organisations in Nigeria. The time frame for the study will cover data from the past five years, from 2018 to 2023, to provide a comprehensive view of how working capital management practices have evolved over time and their impact on profitability in the context of Nigeria's dynamic economic environment.
The researcher faced the following challenges/limitation during the process of data collection.
- Due to the economic situation of Nigeria and other academic issue like (buying of textbooks, paying of school fees), that requires financial attention, the researcher encountered financial challenges.
- Secondary, due to inability to reach all the members of the sample owing to some circumstance, the resulting sample was not quite of cooperation from some respondents, somehow limited this exercise.
- Finally, due to the limited time induced to complete and present the research work, the researcher curtailed her efforts to the most sensitive aspects of the topic. Notwithstanding; the above constraints, the research did her best to present worthwhile and comprehensive work.
1.7 Definition of Terms
Working Capital (WC):
Working capital refers to the difference between a company's current assets and current liabilities. It represents the short-term financial health of an organisation and its ability to cover its day-to-day operations. Proper management of working capital ensures that the business has enough liquidity to meet its short-term obligations (Emery et al., 2004). A positive working capital indicates that a company has enough assets to cover its short-term liabilities, while a negative working capital suggests potential liquidity problems.
Working Capital Management (WCM):
Working capital management involves the strategies and practices that an organisation employs to manage its short-term assets and liabilities effectively. The goal is to ensure that the company maintains adequate liquidity while minimizing the costs associated with holding excessive inventories or extended credit terms (Gitman, 2009). WCM includes decisions related to managing inventories, receivables, and payables, and optimising the cash conversion cycle to enhance operational efficiency and profitability.
Profitability:
Profitability refers to an organisation's ability to generate profit from its operations over a given period. It is often measured using financial ratios such as return on assets (ROA), return on equity (ROE), and net profit margin. Profitability indicates how efficiently an organisation is utilizing its resources to achieve financial success (Brigham & Houston, 2013). In this study, profitability will be assessed in relation to how effectively an organisation manages its working capital components.
Inventory Management:
Inventory management is the process of overseeing and controlling the storage, ordering, and use of materials and finished products. Effective inventory management ensures that an organisation has enough stock to meet customer demand without holding excessive inventory that could incur additional costs. Poor inventory management can tie up working capital and impact profitability (Wild & Shaw, 2013).
Accounts Receivable (AR):
Accounts receivable refers to the money owed to a business by its customers for goods or services that have been delivered but not yet paid for. Managing accounts receivable efficiently is critical to improving cash flow and working capital. Delays in receiving payments can increase the risk of liquidity problems and negatively affect profitability (Horne & Wachowicz, 2005).
Accounts Payable (AP):
Accounts payable represents the amount of money a company owes to its suppliers for goods or services received but not yet paid for. Effective management of accounts payable ensures that an organisation takes advantage of favorable credit terms while maintaining good relationships with suppliers. Mismanagement of accounts payable can lead to missed discounts or strained supplier relationships, which can negatively impact profitability (Ross et al., 2013).
Cash Conversion Cycle (CCC):
The cash conversion cycle measures the time it takes for a company to convert its investments in inventory and other resources into cash flows from sales. A shorter CCC indicates that a company is able to recover its cash quickly, thereby improving liquidity and profitability. It is a critical indicator of how well an organisation is managing its working capital (Deloof, 2003).
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