CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
The ongoing squeeze on cash and credit threatens the survival of enterprises world-wide bearing in mind that they are the sources of the companies’ working assets and liabilities which are collectively captioned as “working capital” (Takon, 2013). The cardinal objective of managing working capital efficiently is understandingly to ensure that the firm is capable of continuing to function with sufficient cash flow. The latter enables it to pay maturing short-term debts and defray operational expenses. This involves taking important decisions on aspects like managing accounts receivable and payables, preserving a required level of inventories, as well as the investment of surplus cash. A very important component of corporate finance is working capital management (WCM). The cash conversion cycle (CCC) is a metric that expresses the time (measured in days) it takes for a company to convert its investments in inventory and other resources into cash flows from sales. Also called the Net Operating Cycle or simply Cash Cycle, CCC attempts to measure how long each net input dollar is tied up in the production and sales process before it gets converted into cash received.
This metric takes into account how much time the company needs to sell its inventory, how much time it takes to collect receivables, and how much time it has to pay its bills.
The CCC is one of several quantitative measures that help evaluate the efficiency of a company’s operations and management. A trend of decreasing or steady CCC values over multiple periods is a good sign while rising ones should lead to more investigation and analysis based on other factors. One should bear in mind that CCC applies only to select sectors dependent on inventory management and related operations.
WCM is essential because it affects the liquidity and profitability of a company directly (Murugesu, 2013; Appuhami and Ranji, 2008). Liquidity management is viewed as one of the most crucial financial management concerns because it involves some intense trade-offs between risks and return which are associated with the management of short term assets and liabilities (Anser and Malik, 2013; Jose et al., 1996; Farris and Hutchson, 2002), Every organization, whether profitoriented or not, and, irrespective of size and nature of its business, needs some measure of working capital. This is so because working capital constitutes the life-giving force for every economic unit. WCM is one of the most important functions of corporate managers (Achchuthan and Kajamanthan, 2013).
MTN is a useful and standard measure of a firm’s efficiency in its management of its working capital (Attari and Raza, 2012). The MTN period is seen as one of the fundamental ingredients of WCM (Appuhami and Ranji, 2008; Keown et al., 2003; Bodie and Merton, 2000). It is useful as a comprehensive measure because it effectively takes into consideration the time-lag between the disbursement for the acquisition or procurement of raw materials and the collection from the trade debtors on account of the sale of finished goods (Padachi, 2006). An effective and efficient handling of short-term assets and the corresponding payables is a question of life and death for the business enterprise and has much to do with it’s continued existence. Every corporate organization is concerned seriously about the best way to sustain and improve its profitability. Consequently, firms have to keep an eye on those factors which affect their profitability. Liquidity management is one of those factors one cannot afford to over look because it has implications on corporate risks and returns. As a measure of WCM, MTN needs to be explored as to how it may affect the profitability of corporate bodies. Today, owing to the changing world’s economic advancement of technology and increased competition among firms, each of the firms is making frantic efforts to enhance its profits. To achieve their profitability enhancement, firms now strive hard to bring their MTN at optimal level (Anser and Malik, 2013).
The management of working capital is among the most essential and vital aspect of the entire financial management of a business entity. This is because, efficiency in this area of financial management is necessary in order to ensure the firms long term success and to achieve its overall goals which is the maximization of owner’s wealth. A certain amount of working capital is needed for operation of companies. This level of working capital constitutes the cash holding or near cash assets required of a bank by a statute of a government or it is necessary to note that the amount of working capital does not directly earn the firm any income since they are almost in all cases held in cash form. A well maintained working capital will ensure that there is smooth running of the business through the circulation of the vital ingredients in the firm (cash, inventory, receivables). Therefore, the number of days accounts receivable is outstanding, which determines the credit policy of the firm; the number of days inventory are held, which signifies the inventory management policy; and the cash conversion cycle, which is the comprehensive assessment of the quality and efficiency of the already established working capital management practices, are the tools that ensure that the daily operations of the firm are not hampered if well managed. How the working capital is managed will invariably determine the level of profitability in the firm. In other words the return on assets is a product of how the assets are managed. Good management of working capital will entails the reduction to minimum level the working capital requirement and realizing maximum possible revenues (Ganeson, 2007).