1.1       Background of the Study

The Nigerian Economy is faced with several factors which could impede the speed of having a huge return on the resources employed by the firms and companies. As a result, however, proper initiative and capital (resource) management is required. It is worthy to note that out of every resource that an organization has, working capital is the most important or the basic. Working capital is a vital element in any organizational setting that requires cogent attention, proper planning and management. Again it is an essential resource required by every firm to achieve its goals and objectives. One factor that is deduced to influence firm profitability grossly is the firm’s working capital. Dougall and Guthmann (1984) define working capital as excess of current assets over current liabilities. This view was elaborated by Gladson and Park (1963) when they defined working capital as the excess of current assets of a business (cash, accounts receivables, inventories, for example) over current items owed to employees and others (such as salaries and wages payable, accounts payable, taxes owed to government). Gole (1959) also holds more or less the same view. Working capital is the stock stored that has a conversion or resale value in order to gain profit. It represents the largest cost of a firm especially the manufacturing firms. In normal circumstances, working capital consists of about 30% – 40% of a firm’s total investment. Investment in working capital to a large extent determines the returns earned by a firm.

Nevertheless, excessive levels of current assets can easily result in a firm realizing a substandard return on investment while firms with too few current assets may incur shortages and difficulties in maintaining smooth operations (Van Horne & Wachowicz, 2000). As a result, working capital management is a very important component of corporate finance as it directly affects the liquidity and profitability of a firm. It centers on current assets and current liabilities of a firm. Jagongo and Mogaka (2013) define working capital management as the ability to control effectively and efficiently, the current assets and current liabilities in a manner that provides the firm with maximum return on its assets and minimizes payments for its liabilities.

Working capital management has been considered as an important component of firm’s financial decision process, occupying a major portion of manager’s time and resources (Richard & Laughlin, 1980). Similarly, Onwumere, Ibe, and Ugbam (2012) stated that efficient management of working capital is thus a fundamental part of the overall corporate strategy of the firm in creating the shareholder’s value, keeping in mind that an optimal level of working capital will maximize the firms value.

Efficient working capital management involves planning and control of current assets and current liabilities in a manner to strike a balance between liquidity and profitability. Harris (2005) pointed out that working capital management is a simple and straightforward concept of ensuring the ability of the firm to fund the difference between the short term assets and short term liabilities. The ultimate objective of any firm is to maximize shareholders wealth and maximizing shareholders wealth can be achieved by a firm maximizing its profit. A firm that wishes to maximize profit must strike a balance between current assets and current liabilities and hence keeping abreast of the liquidity and profitability trade-off. Preserving liquidity and profitability of the firm is an important objective as increasing profit at the expense of liquidity can bring serious problems to the firm and vice-versa.

Working capital management is considered to be a very important element to analyze the firm’s performance while conducting day to day operations. There are chances of imbalance of current assets and current liability during the life cycle of a firm and profitability will be affected if this occurs. This is why the study of working capital on firm’s profitability is drawing scholar’s attention in this recent times.

The goal of working capital management is to manage the firm’s current assets and liabilities in such a way that a satisfactory level of working capital is maintained. This is so because if the firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and may even be forced into bankruptcy. The current assets should be large enough to cover its current liabilities in order to ensure a reasonable margin of safety. Each of the current assets must be managed efficiently in order to maintain the liquidity of the firm while not keeping too high a level of any one of them.

Two benefits are usually associated with working capital management. Firstly, working capital management is important with regard to its direct effect on firm liquidity (Chiou & Cheng 2006; Moss & Stine 1993). The short-term effects of working capital management on liquidity are straight forward to derive (Richards & Laughlin, 1980). Stocks lead to cash outflows to suppliers and cash inflows from customers. Therefore, if payments to suppliers are postponed, payables increase but the cash outflows materialize at a later point in time. Inversely, if a firm’s trade credit policy allows its customers late settlements, the cash inflow is delayed. This interdependency was highlighted in the financial crisis (2008–2009) when external funding became unattractive or even unavailable, leading firms to tighten their trade credit policies, reduce stocks, and delay payments to compensate for the external financing constraints (Enqvist, Graham, & Nikkinen, 2012). Longer-term effects of working capital management on liquidity are less clear. For instance, a strict trade credit policy might deter potential customers and thereby reduce future cash inflows.

Secondly, working capital management is important for managing firm value (Pass & Pike 1987; Smith, 1980). Evidence from US corporations reveals that investors value working capital investments with a discount compared to cash (Kieschnick, Laplante, & Moussawi, 2011). This can be ascribed to the fact that working capital management is linked to companies’ profitability. Working capital management can affect companies’ profitability in two ways. On the one hand, working capital management influences firm sales and hence profits. On the other hand, working capital management impacts the capital employed and thus the cost of capital. Assuming it is feasible to increase sales without increasing the capital employed would lead to a disproportionately high increase in profitability. A firm can be very profitable if it can translate cash from operations within the same operating cycle, otherwise the firm would need to borrow to support its continued working capital needs.

In Nigeria, studies on working capital have centered on aggressive conservative working capital practices, liquidity level (Jide, 2010) and policies of firms on profitability (Onwumere et al., 2012). However, no attempt has been made to use the traditional proxies to empirically investigate the working capital-performance nexus on profitability of consumer goods companies, it is against this backdrop that this study sought to empirically investigate the impact of working capital management on profitability of quoted consumer goods companies in Nigeria.