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THE EFFECT OF WORKING CAPITAL MANAGEMENT POLICIES ON FIRMS’ PROFITABILITY
(Evidence, from Manufacturing P.L.Cs in Addis Ababa)
Chapter OneIntroductionBackground of the StudyFinancial manager must be concerned with three basic types of questions. The first question concerns the firm’s long-term investments; the process of planning and managing a firm’s long-term investments is called capital budgeting. The second question is about ways in which the firm obtains and manages the long-term financing it needs to support its long term investments (or financial structure). The third question concerns working capital management. The term working capital refers to a firm’s short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers (Ross et al; 2002). Managing the firm’s working capital is a day-to-day activity that ensures the firm has sufficient resources to continue its operations and avoid costly interruptions. This involves a number of activities related to the firm’s receipt and disbursement of cash.
The two main objectives of working capital management are to increase the profitability of a company and to ensure that it has sufficient liquidity to meet short-term obligations as they fall due and so continue in business Profitability is related to the goal of shareholder wealth maximization, so investment in current assets should be made only if an acceptable return is obtained. While liquidity is needed for a company to continue in business, a company may choose to hold more cash than is needed for operational or transaction needs, for example for precautionary or speculative reasons. The twin goals of profitability and liquidity will often conflict since liquid assets give the lowest returns. Cash kept in a safe will not generate a return, for example, while a six-month bank deposit will earn interest in exchange for loss of access for the period. (Watson and Head; 2007)
Though there is no standard fixed requirement, all businesses, one way or another, require working capital. The actual amount required will depend on many factors such as the age of the company, the type of business activity, credit policy, market and demand conditions, technology and manufacturing policy, operating efficiency, availability of credit from suppliers and price level changes (Pandey, 2007). It is indispensable that an appropriate amount of working capital is budgeted to meet anticipated future needs. Failure to budget correctly could result in the business being unable to meet its liabilities as they fall due. If a business finds itself in such a situation, it is said to be technically insolvent. In conditions of uncertainty, firms must hold some minimal level of cash and inventories based on expected sales plus additional safety stocks.

The management of working capital is very important to businesses of all sizes (Padachi, 2006). First, it consists of a large portion of firms’ investment. It represents around 40 percent of total assets in a typical manufacturing firm and 50 percent to 60 percent of total assets in retailing and wholesales (Moyer, et al., 1995; Sebhatleab, 2002). Second, according to Smith (1980), the efficient management of working capital is important from the point of view of liquidity (risk) and profitability as well as firm value. Poor management of working capital results in unnecessary investment in unproductive assets or inadequate investment in current assets. Unnecessary investment in current assets will tie up funds idle and hence reduces firms’ ability to invest in productive assets such as plant and machinery, thereby reducing profitability. On the other hand, inadequate investment in current assets reduces the liquidity position causing insolvency, which intern leads to bankruptcy.
According to Sebhatleab (2002), working capital management has evolved through control, optimization and value creation stage. Initially, it was started as an organized way of controlling current assets like balances of cash, receivables and inventories. At this stage the main objective was to make sure that working capital is not embezzled. At that time, both Academicians and practitioners were developed various control procedures. In the optimization phase, the main focus was not only on the physical safety of working capital items but also on the optimization of accounting profits by minimizing related costs and maximizing related income. At this stage particular models like cash optimization models and inventory optimization models were developed to ensure that firms do not get problems due to lack of liquidity or incur too many costs by holding excessive working capital levels. At last stage (value creation), the concern is on how to help managers in the creation of value without disregarding the above two objectives. Particularly, the cash flows approach is used as a main tool to measure the value created by firms. In this study, the researcher uses the cash conversion cycle as a measure of continuous cash or liquidity flow to analyze the effect of working capital policies on firms’ profitability.

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Statement of the ProblemThe effect of working capital management on corporate profitability has been studied considerably by different researchers (Deloof, 2003; Filbeck and Krueger, 2005; Lazaridis and Tryfonidis, 2006; Padachi, 2006; Samiloglu and Demirgunes, 2008; Shin and Soenen, 1998; Tewodros 2010).

Most of these and other researchers identify significant association between efficiency in working capital management and firms’ performance. However, almost all, these studies concentrated on large firms operating within well-developed money and capital markets of developed economies. From such findings it is difficult to generalize for relatively small size Ethiopian firms that operate within an undeveloped financial sector (with limited financial markets), where firms mostly obtain funds for investment in working capital from owner financing, trade credit and short term bank loans. Research studies on the effects of working capital management policies on firms’ profitability in developing countries, especially in Ethiopia remained an ignored area of empirical research. To the best of researcher’s knowledge, only one research has been done in Ethiopia by Tewodros Abera (2010) on Tigray region.

Generally, to address the issue under consideration, the researcher tried to answer the following research questions.

How working capital investment policies affect profitability of manufacturing Private Limited Companies in Addis Ababa?
How working capital financing policy affects profitability of manufacturing Private Limited Companies in Addis Ababa?
How are profitability and liquidity related, in manufacturing Private Limited Companies of Addis Ababa?
Objectives of the Study1.3.1 General ObjectiveThe general objective of this study was to investigate the effect of working capital management policies on profitability of manufacturing private limited companies in Addis Ababa, Ethiopia. At the same time, the study also examined the relationship between the two goals of working capital management policies: liquidity and profitability.

1.3.2. Specific ObjectivesSpecifically, the aim of this study was:-To study the effect of working capital investment policies on firms’ profitability.

To look into the effect of working capital financing policy on firms’ profitability.

To observe the relationship between the two objectives of working capital policies: liquidity and profitability.

Significance of the StudyThe study can be beneficial at least for the following two reasons. First, as it has been discussed in the statement of problem part, no empirical research has been done, yet to examine the effect of working capital management on firms’ profitability in Addis Ababa. Therefore, the findings of this study can have a great contribution to the body of knowledge by identifying how working capital management efficiency affect the profitability of manufacturing private limited companies in Addis Ababa. Second, it can serve as a base for other researchers who want to do a further research on this topic.

Scope of the StudyTo address the problem under consideration this research is delimited to:
Topic: the topic of this study is limited to the effects of working capital management policies on firm’s profitability whilst, also look into the relationship between profitability and liquidity.

Study area: The geographical scope of this study is limited to the boundary of Addis Ababa, Ethiopia
Variables: the variables used are enclosed to the four types of variables- profitability, working capital policies, liquidity and control variables, which are specific to firms and/or general to the economy as a whole and clearly pinpointed in the methodology part.

Sampling Units and size of sample: the sampling units of this study is delimited to 224 manufacturing private limited companies located and operating in Addis Ababa and the sample size is delimited to 22 companies (i.e. around 10% of the sampling unit).
Methodology used: the methodology is only limited to quantitative method of research adopted with descriptive statistics, correlation and econometrics analysis tools.
Limitations of the StudyThe sample size for this study may not be large enough to study the issue and to represent the study population, for the very reason that, the problem of getting complete financial information for the study period. Moreover, the financial managers of the sample manufacturing private limited company were not interested to give primary information about the issue under investigation.

1.7 Organization of The paperThis research paper consists of five chapters. The first chapter presented Background of the Study, Statement of the Problem, Objectives of the Study, Significance of the Study, Scope of the Study and Limitations of the Study. Discussion in chapter two focuses on literature review of important concepts that are relevant to the study. The third chapter of the study deals with the methodology of the study (i.e. Research Design, Data Source and Collection Methods, Sampling Design, Method of Data Analysis and Description of Variables and Research Hypotheses). The forth chapter consists data presentation, analysis and interpretation elements of the study. Finally, the last chapter attempt to generalize and recommend possible solutions to the problems.

Chapter ThreeResearch Methodology3.1. Research Design
The explanatory type of study with quantitative approach is employed to analyse the collected data. The research design, used in this study is a pooled panel data analysis of cross-sectional and time series data. Pooled panel data analysis, also called the constant coefficients model is one where both intercepts and slopes are constant, where the cross section firm data and time series data are pooled together in a single column assuming that there is no significant cross section or temporal effects (Gujarati, 2003).
3.2. Data Source and Collection MethodsThe data required for the purpose of analysis was only obtained from secondary sources, through document analyses (Financial statements of five years of sampled firms i.e. for the period2006-2010). The researcher considers five years as a study period, because of limited number of firms having an operating life of more than five years. Most of the required data are obtained from the financial statements submitted to the Ethiopian Revenues and Customs Authority (ERCA), for income tax purpose. However, due to incompleteness of data that are obtained from ERCA some of the data are collected directly from the respective companies. Moreover this data are adjusted so that it is useful for comparison with other companies.

3.3. Sampling DesignThe total population of the study is all manufacturing private limited companies located and operating within Addis Ababa. To select sample firms, the researcher employed convenience and purposive sampling. It is because of the following requirements.

The first criterion that was used to select sample units to be included in the study is holding a complete 6 years financial statement data. The data pertaining to year 2005 were only used to compute the variable growth whose indicator is change in total sales and it is used to compute the sales growth only for the year 2006 of all observations.

The researcher further conducted two stage restriction criterions to arrive at defining the study population. The study first considers the manufacturing industry sector from the business classification, i.e. agriculture, industry and service e.t.c. In doing so, the sample considers companies that are engaged in the manufacturing sector of the economy only.
Then the researcher makes the second level sample restriction that the manufacturing companies need to hold the legal status of ‘Private Limited Company.
The above restrictions has made in an attempt to avoid bias that may result from, first, industrial classification i.e. since firms operating in different class of economy have different decision criteria in selecting sources of funds needed for executing investment opportunities and different working capital requirements. In order to alleviate this problem the researcher limits the study population only to those companies engaged in manufacturing industry.
Secondly, the approach followed by tax authority in collecting tax from business organizations in Ethiopia is progressive in nature. Therefore; it basically uses size of sales turnover as its criteria for categorizing business firms. Since different tax category firms have different capacity in appropriating tax shield advantage from their capital structure choice (Equity versus debt financing), in an effort to minimize this size bias, researcher will includes those firms having a legal status of private limited company only in constructing sample elements.

The researcher tried to make the sample representative of the population-manufacturing private limited companies operating in Addis Ababa. The researcher, therefore, selected and collected 22 companies’ financial statements.

3.4. Data Analysis MethodDescriptive statistics is used as the first step in the analysis and it was used to describe relevant aspects of observable facts about the variables and provide detailed information about each relevant variable. At this stage, mean, standard deviation, maximum and minimum values of the required variables are computed. The obtained data was analyzed by using two quantitative analysis methods. First, Pair wise Correlation analysis is used to measure the degree of association between the dependent variables and explanatory variables. Second, linear panel data regression models are employed to analyze the causal relationships of profitability variables with working capital investment and financing policies, liquidity and control variables. “By combining time series of cross-section observations, panel data gives more informative data, more variability, less co-linearity among variables, more degrees of freedom and more efficiency” ( Baltagi cited by Gujarati 2003:637). Eviews 6 software is employed for the purpose of analysis and tables are used to present the results from the analysis.3.5. Description of Variables To investigate the effects of working capital management policies on firms’ profitability the researcher identifies key variables that indicate profitability, working capital policies, liquidity and other factors that influence profitability. The chosen variables include dependent, independent and some control variables.

3.5.1. Dependent VariablesDependent Variables are variables that are used to measure the profitability of firms. Due to the absence of secondary market in Ethiopia it is impossible to use market indicators such as share price, only accounting measures of profitability will be used in the study. According to Ross et al (2002), Return on Assets (ROA), Return on Equity (ROE) and Operating Profit Margin (OPM) are best known and most frequently used profitability measures. To set up a factual association between the operating “success” or “failure” of firms and working capital policies and to avoid the effect of tax incentives (if available), Earning Before Interest and Tax (EBIT) is used as a base to calculate ROA and OPM as follows:
Return on Assets (ROA) = Earnings Before Interest and Tax (EBIT)
Total Assets (TA)
Operating Profit Margin (OPM) =Earnings Before Interest and Tax (EBIT)
Net Sales (NS)
To measure the return to the owners’ equity, earning before tax is used.

Return on Equity (ROE) = Earnings Before Tax (EBT)
Total Equity (TE)
3.5.2. Independent Variables Accounts Receivable Period (ARP), Inventory Holding Period (IHP) and Accounts Payable Period (APP) as an independent variable, will be used to measure specific working capital investment policy. Furthermore, Cash Conversion Cycle (CCC) and Current Assets to Total Assets Ratio (CATAR) are used as compressive measures of working capital policy. Current Liabilities to Total Assets Ratio (CLTAR) is used as a measure of working capital financing policy whilst the two conventional measures, Current Ratio (CR) and Quick Ratio (QR), are used as indicators of liquidity (Eljelly, 2004; Lazaridis and Tryfonidis, 2006; Padachi, 2006; Raheman and Nasr, 2007; Tewodros 2010;).Accounts Receivable Period (ARP), also used as proxy for Collection Policy, and represents the average time it takes to gather payments from customers from sales of goods and services. The longer the accounts receivable period, the higher will be the investment in accounts receivable. Theoretically, the higher the investment in account receivable, the lower will be the profitability. To calculate ARP the researcher uses the following formula:
Accounts Receivable Period (ARP) = Accounts Receivable / Sales X 365 days
Inventory Holding Period (IHP), is used as alternative for the Inventory Policy, and stands for the average time it takes to acquire and sell inventory. The longer the inventory storage period, the higher will be the investment in inventory. In the same manner, the higher the amount invested in inventory, the lower will be the profitability of firms.
IHP can be calculated as:
Inventor Holding Period (IHP) = Inventories /Purchase X 365 days
Accounts Payable Period (APP), is used as substitute for the Payment Policy, and represents the average time between purchases of inventory and payment for it. The higher the value, the longer it takes to settle payment commitments to suppliers and hence, the lower will be the investment in working capital.
The following formula is used to calculate Accounts Payable Period:
Account Payable Period (APP) = Accounts Payable/ Purchases X 365 days
In addition, the Cash Conversion Cycle (CCC) and Current Assets to Total Assets Ratio (CATAR) were used as comprehensive measures of working capital investment policy. The Cash Conversion Cycle (CCC) represents the average time between cash disbursement for inventory and cash collection from receivables. The theory says, the shorter the Cash Conversion Cycle (CCC), the lower will be the investment in inventories and receivables. The longer the Cash Conversion Cycle the greater the investment in current assets hence the greater the need for financing of current assets. The formula used to calculate the Cash Conversion Cycle (CCC) is:
Cash Conversion Cycle (CCC) = Accounts Receivable Period (ARP) + Inventory Period (IP) – Account Payable Period (APP)
Current Assets to Total Assets Ratio (CATAR) represent the proportion of current assets in the total assets of the firm. The higher the value, the higher will be the investment in current assets.
It is calculated as:
Current Assets to Total Assets Ratio (TCATAR) =Total Current Assets (TCA)
Total Assets (TA)
To measure working capital financing policy efficiency Current Liabilities to Total Assets Ratio, which measures the Degree of Aggressiveness in Working Capital Financing, was used (Weinraub and Visscher, 1998; Afza and Nazir, 2007; Tewodros 2010;). Degree of Aggressiveness in working capital financing (DOAWCF) represents the extent to which the firm uses current liabilities to finance its working capital. The higher the value, the more the firm is aggressive in using current liabilities. Theoretically, aggressive working capital financing police relate with higher profitability.
The following formula was used to calculate current liabilities to total assets ratio
Current Liabilities to Total Assets Ratio (CLTAR) = Total Current Liabilities (TCL)
Total Assets
Liquidity, one of the two objectives of working capital management is liquidity. In this study, the researcher examines the relationship between the two objectives of working capital management policies: liquidity and profitability. Liquidity refers to the ability to meet current liabilities from available current assets. In this study the traditional measures of liquidity: Current Ratio (CR) and Quick Ratio (QR) are employed.
The formulas used to calculate Current Ratio and Quick Ratio were;
Current Ratio (CR) = Current Assets
Current Liabilities
Quick Ratio (QR) = Current Assets- Ending Inventory
Current Liabilities 3.5.3. Control VariablesIn order to have a reliable analysis of the effect of working capital management policies on profitability, it is common in working capital literature to use some control variables to account for various factors that may influence profitability of firms (Deelof, 2003; Eljelly, 2004; Lazaridis and Tryfonidis, 2006; Padachi, 2006; Afza and Nazir, 2007; Tewodros 2010;). Accordingly, together with the above working capital variables, some control variables that are specific to firms and general to the economy as a whole were taken into account in this study. Firm Size (FS), Firm Growth Rate (FGR) and Financial Leverage (FL) are control variables that are specific to the firm. In order to account for Firm Size (FS), as used by different prior researchers, the natural logarithm of sales is used (Deloof, 2003; Eljelly, 2004; Padachi, 2006; Raheman and Nasr, 2007; Tewodros 2010;). As a proxy for Firm Growth Rate (FGR) change in annual sales (Salest?Salest-1)/Salest-1 is used. Total debt to total assets ratio was used as a proxy for Financial Leverage (FL). Finally, since change in economic conditions affect operating efficiency of firms and tend to be reflected in firms’ profitability (Lamberson 1995), GDP Growth Rate (GDP) of the country was also used as a control variable. 3.6. Model SpecificationsAs mentioned above, the effect of working capital management policies on firms’ profitability was estimated by using similar quantitative models of Tewodros (2010) studies. The general model was:
Yi = ?0 +? ?iXi + ?iWhere
Yi = the ith observation of dependent variables (ROA, ROE and OPM)
?0= the intercept of the equation
?i = coefficients of Xi variables
Xi = the different independent variables
?i = the error term
When the above general model is converted into the specified Variables of this study the following regression equations were run to estimate the impact of working capital policies on the profitability of selected companies:
Inventory holding period and profitability measures:
ROA i = ?0 + ?1(IHPi) + ?2(FSi) + ?3(FGRi) + ?4(FLi) + ?5(GDPt) + ?……………(1)
ROE i = ?0 + ?1(IHPi) + ?2(FSi) + ?3(FGRi) + ?4(FLi) + ?5(GDPt) + ?…………….(2)
OPM i = ?0 + ?1(IHPi) + ?2(FSi) + ?3(FGRi) + ?4(FLi) + ?5(GDPt) + ?……………(3)
Accounts Receivable Period and Profitability Measures:
ROA i = ?0 + ?1(ARPi) + ?2(FSi) + ?3(FGRi) + ?4(FLi) + ?5(GDPt) + ?………….(4)
ROE i = ?0 + ?1(ARPi) + ?2(FSi) + ?3(FGRi) + ?4(FLi) + ?5(GDPt) + ?…………..(5)
OPM i = ?0 + ?1(ARPi) + ?2(FSi) + ?3(FGRi) +?4(FLi) + ?5(GDPt) + ?…………..(6)
Accounts payable period and profitability measures:
ROA i = ?0 + ?1(APPi) + ?2(FSi) + ?3(FGRi) + ?4(FLi) + ?5(GDPt) + ?…………..(7)
ROE i = ?0 + ?1(APPi) + ?2(FSi) + ? 3(FGRi) + ?4(FLi) + ?5(GDPt) + ?…………..(8)
OPM i = ?0 + ?1(APPi) + ?2(FSi) + ?3(FGRi) + ?4(FLi) + ?5(GDPt) + ?…………..(9)
Cash Conversion Cycle and Profitability Measures:
ROA i = ?0 + ?1(CCCi) + ?2(FSi) + ?3(FGRi) + ?4(FLi) + ?5(GDPt) + ?…………(10)
ROE i = ?0 + ?1(CCCi) + ?2(FSi) + ?3(FGRi) + ?4(FLi) + ?5(GDPt) + ?………….(11)
OPM i = ?0 + ?1(CCCi) + ?2(FSi) + ?3(FGRi)+ ?4(FLi) + ?5(GDPt) + ?………….(12)
Current Assets to Total Assets Ratio and Profitability Measures:
ROA i = ?0 + ?1(CATARi) + ?2(FSi) + ?3(FGRi) + ?4(FLi) + ?5(GDPt) + ?……..(13)
ROE i = ?0 + ?1(CATARi) + ?2(FSi) + ?3(FGRi) + ? 4 (FLi) + ?5(GDPt) + ?……..(14)
OPM i = ?0 + ?1(CATARi) + ?2(FSi) + ?3(FGRi)+ ?4(FLi) + ?5(GDPt) + ?………(15)
Current Liabilities to Total Assets Ratio and Profitability Measures:
ROA i = ?0 + ?1(CLTARi) + ?2(FSi) + ?3(FGRi)+ ? 4 (FLi) + ?5(GDPt) + ?………(16)
ROE i = ?0 + ?1(CLTARi) + ?2(FSi) + ?3(FGRi) + ?4(FLi) + ?5(GDPt) + ?………..(17)
OPM i = ?0 + ?1(CLTARi) + ?2(FSi) + ?3(FGRi) + ? 4 (FLi) + ?5(GDPt) + ?……..(18)
Current Ratio and Profitability Measures:
ROA i = ?0 + ?1(CRi) + ?2(FSi) + ?3(FGRi) + ? 4 (FLi) + ?5(GDPt) + ?……………..(19)
ROE i = ?0 + ?1(CRi) + ?2(FSi) + ?3(FGRi) + ?4(FLi) + ?5(GDPt) + ?………………..(20)
OPM t = ?0 + ?1(CRi) + ?2(FSi) + ?3(FGRi) + ?4(FLi) + ?5(GDPt) + ?……………….(21)
Quick Ratio and Profitability Measures:
ROA i = ?0 + ?1(QRi) + ?2(FSi) + ?3(FGRi) + ?4(FLi) + ?5(GDPt) + ?……………….(22)
ROE i = ?0 + ?1(QRi) + ?2(FSi) + ?3(FGRi) + ?4(FLi) + ?5(GDPt) + ?………………..(23)
OPM i = ?0 + ?1(QRi) + ?2(FSi) + ?3(FGRi)+ ?4(FLi) + ?5(GDPt) + ?………………..(24)
Where:
ROA i = Return on Assets of observation i
ROE i = Return on Equity of observation iOPM i = Operating Profit Margin of observation iARPi = Accounts Receivable Period of observation iIHP i = Inventory Holding Period of observation iAPPi= Accounts Payable Period of observation iCCCi= Cash Conversion Cycle of observation iCATARi = Current Assets to Total Assets Ratio of observation iCLTARi = Current Liabilities to Total Assets Ratio of observation iCRi = Current Ratio of observation iQRi= Quick Ratio of observation iFSi = Firm Size of observation iFGRi = Firm Growth Rate of observation iFli = Financial Leverage of observation iGDPt = Gross Domestic Product Growth Rate of Ethiopia for time period t
? =error term of the model
?0 = intercept

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