The Effect of Working Capital Management on Manufacturing Firms’ Profitability

Abstract

Working capital investments are essential for daily business operations of an entity. For that matter firms make huge amounts of investments in working capital that enables them to pay recurring obligations. Current asset investments are, however, the least profitable assets of an entity. Thus, in order to maintain healthy business managers involve in trade-off decisions between profitability and liquidity. In response for this, researchers from developed economies have been striving to investigate the impact of firms’ working capital management on their profitability, since recent years. But, those researches have not considered the issue in underdeveloped economies and there exist a knowledge gap on the literature, with only scanty of studies available in such economies. Therefore in an attempt to fill this research gap, this study investigated the effect of working capital management on profitability of 39 large taxpayer manufacturing firms from four industries of Addis Ababa; namely, chemical, plastic and rubber, leather and nonmetallic industries by employing explanatory research design with quantitative approach. Firms’ financial statements were collected for five years period from 2011 to 2015. Accounts receivable period, inventory holding period, accounts payable period and cash conversion cycle as measures of working capital management, and return on assets as a measure of firms profitability were the variables used in this study. Current ratio, firm size, debt ratio, and current assets to total assets and current liabilities to total assets ratios were also used as control variables. Data was analyzed with the help of STATA (version 13) and, correlation analysis and pooled panel data regression models of cross-sectional and time series data were employed. Results from the analysis revealed that there is statistically significant negative relationship between profitability and all working capital management measures of accounts receivable period, inventory holding period, accounts payable period and cash conversion cycle. Overall, accelerated cash collections, quick inventory turnovers, early payments to suppliers, and reduced time interval between those activities will increase corporate profitability of the chemical, plastics and rubber, leather and nonmetallic mineral manufacturing companies. Thus, by efficiently managing their working capital components managers of those firms could enhance their corporate profitability.