FMC 04
FMC 04
FMC 04
BY
BEEMNET KUMELACHEW
FEBRUARY, 2018
ADDIS ABABA, ETHIOPIA
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“THE IMPACT OF WORKING CAPITAL MANAGEMENT ON PROFITABILITY OF
CONSTRUCTION COMPANIES “
BY Beemnet Kumelachew
Addis Ababa, Ethiopia
February, 2018
ii
Addis Ababa University
Department of Accounting and Finance
College of Business and Economics
Statement of Declaration
I, undersigned declare that this work or any part thereof has not previously been
presented in any form to the university or to other whether for the purpose of
assessment , publication or for any other purpose. I confirm that the intellectual
content of the work are the result of my own efforts and no other person.
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Addis Ababa University
Department of Accounting and Finance
College of Business and Economics
Statement of Certification
This is to certify that Beemnet Kumlachew has carried out her research work on
the topic entitled ― The Impact of working capital management on profitability of
construction firms in Ethiopia – the case of category A construction companies ―.
The work is original in nature and is suitable for submission for the award of the
Degree of Master of Business Administration in Finance at the Addis Ababa
University.
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Addis Ababa University
Department of Accounting and Finance
College of Business and Economics
Examiner:
__________________ ______________ _____________
Name Signature Date
Examiner:
__________________ ______________ _____________
Name Signature Date
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Acknowledgement
My deepest and warmest thank goes to the Almighty and lord of lords Jesus Christ , who help
me in all respect of my life and sincere and deepest gratitude goes to my advisor Ato G/Medihn
G/Hiwot for his unreserved assistance in giving me relevant comments and guidance through the
study.
My acknowledgement also go to my family for all the supports they provided especially to Mom
and Dad, the encouragement they inspired on me and for their spiritual supports throughout my
carrier. My grateful thanks also goes to ERCA-high tax payer‘s authority for their positive
corporation in giving eight year audited financial statement.
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Abstract
The purpose of this study is to examine the impact of working capital management on
profitability of construction firms in the case of category A Construction companies. In light of
this object the study adopted quantitative approaches to test a series of research hypothesis.
Financial statement of a sample of seventeen (17) construction companies is used for a period of
eight years (2008-2015) with the total of 136 observations. Data was analyzed on quantitative
basis using descriptive and regression analysis (ordinary least square) method. Proportionate
random stratified sample was used. It examined the components in working capital such as
accounts receivable period, inventory holding period, account payable period, and cash
conversion cycle in relation to return on assets (ROA). In addition the study used current ratio
and quick ratio, used as liquidity indicator; firm size , as measured by logarithms of sales ; sales
growth rate as measured by change in annual sales, as control variables. The key findings from
the study are: firstly, there exists a significant negative relationship between average collection
period and profitability indicating that an increase in the number of days a firm receives
payment from sales affects the profitability of the firm negatively; secondly, there exists a
negative relationship between inventory holding period with profitability and positive
relationship between accounts payable period and profitability. But, both inventory holding
period and accounts payable
period was found to be insignificant in affecting profitability of the firms. Thirdly, there exists
a negative relationship between cash conversion cycle and profitability of the firm. Which
indicates that as the cash conversion cycle decreases it leads to an increase in profitability of
the firm, and managers can increase profitability of their firms by shortening the time lag
between a firm’s expenditure for purchases of raw materials and the collection of sales of
finished goods. In general the study recommended that firms should minimize
working capital management components in order to maximize profitability.
Key terms: liquidity, working capital management, profitability and construction firms.
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List of Acronyms
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Table Content
Acknowledgement ........................................................................................................................... i
Abstract ............................................................................................................................................ii
1. Introduction .......................................................................................................................... 1
Chapter Two.................................................................................................................................... 8
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2.3.2 Working Capital Policy ................................................................................................ 14
Chapter Three................................................................................................................................ 28
3. Introduction ........................................................................................................................ 28
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4.2 Model selection criteria (Random vs. Fixed effect model) ................................................. 41
4.3.1. Test for average value of the error term is zero (E (ut) = 0) assumption .................... 43
REFERENCE ................................................................................................................................ 63
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Chapter One
1. Introduction
1.1. Background of the study
Construction companies are currently experiencing liquidity crunch due to tightening funding
norms being employed by institutional financers. The profit margins of the companies are
squeezing due to increasing commodity prices. The sector is faced with high operation,
maintenance, and financial costs. Recent trends show that this is primarily due to increase in
international prices and are thus unlikely to go down in the near future. When a company is
going through liquidity crisis, the best things it can do is to revisit its working capital
management practices and examine where further improvements are possible.
Working capital refers to firm's investment in short-term assets, cash, short-term securities,
accounts receivable (debtors) and inventories. This is called gross working capital. But the most
popular concept of working capital is net working capital which is the difference between current
assets and current liabilities. Current liabilities are those claims of outsiders, which are expected
to mature for payment within an accounting year and include creditor‘s dues, bills payable, bank
overdraft and outstanding expenses. It also deals with current assets and current liabilities.
Current asset is cash and other assets are expected to be converted in to cash in the ordinary
course of business within one year or within such longer period as constitutes the normal
operating cycle of a business. Working capital is a critical component in the functioning of any
business and understanding of working capital is, therefore, crucial to analyze the financial
position of construction companies (Fitzgerald, 2006).
Net working capital can be positive or negative. Excessive levels of current assets can easily
result in a firm‘s realizing a substandard return on investment. However firms with too few
current assets may face shortages and difficulties in maintaining smooth operations (Horne and
Wachowicz, 2000). Efficient working capital management involves planning and controlling
current assets and current liabilities in a manner that eliminates the risk of inability to meet due
short term obligations on the one hand and avoid excessive investment in these assets on the
other hand ( Eljelly, 2004).
1
Working capital is a very important part of corporate finance because it directly affects
company‘s liquidity and profitability (Deloof, 2003). Therefore, there must be a tradeoff between
these objective (- of liquidity and profitability-). One objective should not be at the cost of the
other since both have their own contribution. If firms do not care about profit, they could not
survive for a long time. If firms do not care about liquidity they may face the problem of
insolvency or bankruptcy (Nguyen, 2013).
Some researchers (Wajahat and Syed (2010), and Vishnanis and Shah B (2007) pointed out that
working capital is just an idle resource with a high cost and low benefit associated with it. So
they advised companies to follow zero working capital policy. Another scholar Stephen (2000)
explained that net working capital is usually positive in a healthy firm. Excessive levels of
current assets may have a negative effect on the firm‘s profitability whereas a low level of
current assets may lead to lower level of liquidity and stock outs- resulting in difficulties in
maintaining smooth operations (Van and Wachowicz, 2004). Traditional concept of working
capital is the different between assets and current liabilities. Thus - working capital management
is an attempt to manage and control the current assets and the current liabilities in order to
maximize profitability and proper level of liquidity in business (Wobshet, 2013).
This includes ensuring the optimum balance of working capital components receivables,
inventory and payables and using the cash efficiently for day-to-day operations. Optimization of
working capital balance can be achieved by minimizing the working capital requirements and
realizing maximum possible revenues. If working capital is efficiently managed, it will increase
firms' free cash flow, which in turn increases the firms' growth opportunities and return to
shareholders.
The WCM of a business enterprise in part affects its profitability. The ultimate objective of any
business enterprise is to maximize the profit. But, preserving liquidity of the business enterprise
is an important objective too (Niman, 2015). The problem is that increasing profits at the cost of
liquidity can bring serious problems to the firm. For these reasons- WCM should be given proper
consideration and will ultimately affect the profitability of the business enterprise. Therefore: - it
is a critical issue to know and understand the impacts of working capital management and its
influence on firm‘s profitability.
2
A contractor needs enough cash to pay wages and salaries as they fall due and to pay creditors if
it is to keep its workforce and ensure its supplies. Maintaining adequate working capital; is not
only important in the short term. Sufficient liquidity must be preserved in order to insure the
survival of business in the long term as well. Even a profitable business may fail if it does not
have adequate cash flows to meet its liabilities (Vinay k., 2015).
Therefore, when a business makes an investment decision they must not only consider the
financial outlay involved with acquiring the new machine or the new building but must also take
account of the additional current assets that are usually involved with any expansion of activity.
In working capital analysis, the direction of change over a period of time is of crucial
importance. Not only that, analysis of working capital trends provides a base to judge whether
the practice and prevailing policy of the management with regard to working capital is good
enough or an improvement is to be made in managing the working capital funds.
However, in the context of Ethiopia, to the knowledge of the researcher, there is a lot of study
taken in working capital management and firm‘s profitability in the case of Manufacturing,
Textile and small and medium enterprise but there is no study undertaken about working capital
management and profitability in the case of construction companies. Therefore- the aim of the
study was to study the impact of working capital management on profitability of construction
industry by selecting category ―A‖ contractor in Ethiopia.
The ultimate question that calls to mind at this juncture is "How does working capital
management impact the profitability of category ―A‖ construction companies in Ethiopia?‖ This
study is therefore designed to analyze the impact of working capital management on profitability
of construction companies in Ethiopia between 2008 and 2015.
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1.2. Statement of the problem
Every firm is required to maintain a balance between profitability and liquidity during
conducting its day to day operations. As inadequate amount of working capital impairs a firm
liquidity, holding of excess working capital results in the reduction of the profitability. (Henok,
2015). Working capital management plays an important role in any companies because without
working capital management, firms operation will not run smoothly (Diep, 2013).
Working capital management have a significant impact upon both the liquidity and profitability
(Shin and Soenen, 1998; Dong and Su, 2010). Therefore, the crucial part of managing working
capital is maintaining the required liquidity in day – to day operation to ensure firms running and
to meet its obligation (Eljelly, 2004).
As a result, in order to explain the relationship between working capital management and
profitability of construction firms, many researchers in different countries have carried out a
study. Several research studies have been done in relation to working capital management in
Ethiopia. Ephrem (2011) studied the impact of working capital management on the profitability
of small and medium enterprise; Henok, 2015; Wobshet, 2014; Moftah, 2016; and Niman, 2015:
did a survey of the impact of working capital management on the profitability of manufacturing
firms in Ethiopia.
However, this issue on construction sector has not attracted to researchers in Ethiopia. Therefore,
the researcher believed that the problem is almost untouched and there is a knowledge gap on the
area. Hence, lack of proper research on the area gives a chance for the Ethiopia construction
company‘s managers to have limited awareness in relation working capital management with
increasing firm‘s profitability.
Therefore, the study try to find out the impact of working capital management on firm‘s
profitability on construction firms in Ethiopia.
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1.3. Objectives
The general and specific objectives of the study are set below.
HP1: There is a significant and negative relationship between account receivable period and
construction firm‘s profitability.
HP2: There is a significant and negative relationship between inventory holding period and
construction firm‘s profitability
HP3: There is a significant and positive relationship between account payable period and
construction firm‘s profitability.
HP4: There is a significant and negative relationship between cash conversion cycle and
construction firms profitability.
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1.5. Scope of the study
The general aim of the study is to assess the impact of working capital management on
profitability of Construction Company in Addis Ababa, Ethiopia. Therefore, the study is
restricted to the construction company annual financial statements and focus on selected 17
Ethiopian construction companies financial statements for the period of 2008-2015.
The rationale behind taking eight years data (i.e started from 2008) was that because of the
availability of data found from ERCA and the sample selection was done by randomly and all the
sample data company are in Addis Ababa.
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used to gather data for the study were presented in chapter three, the results of analyses and
findings to emerge from the study would be contained in chapter four. Chapter five contained a
summary of the study findings, conclusions and recommendation.
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Chapter Two
2. Literature review
2.1 Introduction
The purpose of this chapter is to review the conceptual / theoretical and empirical evidence
issues relating on working capital management and profitability of a firm. It is arranged into
three sub-themes. The first part presents the theoretical review of working capital management
and then the empirical evidence pertaining to working capital management will be addressed.
Finally, on the summary of the existing literatures on working capital management and
profitability of a firm with the knowledge‘s gap that this study attempts to address is explained.
The term liquidity refers to the ability of an organization to pay its current liabilities as they
come due. Not only does financial management aim at the effective utilization- but also at the
proper management of a money. If sufficient funds are available at the time when needed, a
company can clear its short term debts: its operations can be maintained effectively and so the
working capital financing lends a hand for a business to do well (Fareed, 2014).
Working capital is defined as ―the administration of the firm‘s current assets and financing
needed to support current assets‖. The term working capital is used for everyday requirement of
funds for any business. A business needs certain amount of cash for meeting routine payments,
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providing unforeseen events or purchasing raw materials for productions. Thus, working capital
refers to the excess of the current assets over the current liabilities (Fareed, 2014).
Therefore, the difference of current assets and current liabilities is called working capital and it
can be mathematically calculated as
The quantity of working capital in a firm account is a measure of the short term financing
strength of a construction firms. Current assets are used to pay current liabilities, and therefore it
is important to know how much current assets exceed current liabilities, which is evaluated by
the amount of working capital. Working capital increases when a company makes a profit on a
project, sells equipment‘s or other assets, or has a long term loan from a bank. A long term bank
loan can increase - (short term) - assets, but at the same time increases long term liabilities.
However, construction companies usually do not easily resort to selling equipment or borrowing
long term loans. -Working capital decreases when a company had higher expense of money on a
project, or when it purchases equipment, or makes repayments on long term loans. Construction
companies are, mainly eager to purchase equipment or to pays off loans (Tang, 2015).
According to Khan and Jain (2007), - there are two basic concepts in working capital:
Gross Working Capital: means that the total sum of all current assets of a business as a
gross working capital. It is estimated as
Net Working Capital: is the difference between current assets and current liabilities of a
business as a net working capital. Hence, it also estimated as
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2.2.2 Nature of Working Capital
The nature of working capital have the following characteristics,
Gross working capital refers to the amount of funds invested in various components of current
assets. It consists of raw materials, work in progress and finished goods.
Net working capital is the excess of current assets over current liabilities known as net working
capital.
Positive working capital refers to the surplus of current assets over current liabilities.
Negative working capital refers to the excess of current liabilities over current assets. Negative
working capital (NWC) is also defined as the excess of current liabilities over current assets.
While calculating the net working capital, if the figure is found negative, it is called NWC. This
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situation indicates that current liabilities havefinanced100%of current assets and a portion of
fixed assets (Mohan, 2015).
e) Permanent Working Capital
It is also known as Fixed Working Capital and refers to a minimum amount of investment in
all working capital which is required at all times to carry out minimum level of a business
activities (Brigham and Houston, 2003). The minimum amount of working capital is essential
during the dullest season of the year is known as Permanent Working Capital. The minimum
level of investment in current assets that is required to continue the business without interruption
is referred to as Permanent Working Capital (Fabozzi and Peterson, 2003 p. 679).
Kumar (1999) suggests that permanent working capital should be obtained with the help of long-
term sources of finance while variable/ fluctuating working capital should be collected through
short-term sources of finance. Efficient utilization of working capital enhances operating
efficiency as well as profit of the firms.
The additional current assets required at different times during the operating year to meet
additional inventory, such as - extra cash-, is called temporary or variable working capital.
According to Fabozzi and Peterson (2003 p. 678), - temporary working capital was defined as a
rises of working capital from seasonal fluctuations in a firm‘s business.
Permanent working capital represents minimum amount of the current assets required through
the year for normal production whereas temporary working capital is the additional capital
required at different time of the year to finance the fluctuations in production due to seasonal
change. A firm having constant annual production will also have constant permanent working
capital and only variable working capital changes due to change in production caused by
seasonal changes. (Figure 1)
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Figure 1 working capital of firms having constant annual sales (Board, 2009)
Similarly, a growth firm is the firm having utilized Capacity. However, production and operation
continues to grow naturally. As its volume of production rises with the passage of time also does
the quantum of the permanent working capital. (See figure 2)
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indications of a possible nonlinear relationship were found, which were not statistically
significant.
Working capital management involves finding the optimal levels for cash, marketable securities,
account receivable and inventory and then financing that working capital at the least cost
effective. Working capital management can generate considerable amounts of cash and efficient
inventory usage (Brigham and Houston, p520, 2015)
The working capital management is influenced by the nature of business. A trading business
needs to invest a great deal of money in the working capital as compared to the money required
in the fixed assets. The similar case in point is related to a manufacturing business as well.
Relaxed investment policy = relatively large amount of cash, marketable securities and
inventories are carried. This policy minimizes firm‘s risks but because of turns over it
reduce Return on equity (ROE).
Restricted investment policy (lean and Mean) = holdings of cash, marketable securities,
inventories and receivables are constrained. It also indicates a low level of assets (a high
total asset turnover ratio), which results in high ROE, other things held constant.
However, this policy also exposes the firm risks because shortages can lead to work
stoppages, unhappy customers and serious long- run problems.
Moderate investment policy = an investment policy that is between the restricted and
relaxed policy.
The optimal strategy is the one that maximizes the firm‘s long-run earnings. (Brigham and
Houston, p.523, 2015)
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2.3.2 Working Capital Policy
Working capital policy is a set of decisions on the level of investment and sources of financing
current assets and liabilities (Kasumi and Ramada, 2012). To reduce the cash conversion cycle
(CCC) and maximize firm profitability, owners and managers must formulate and implement
appropriate WCP (Nyabuti and Alala, 2014).The policy calls for matching assets and liabilities
maturities. Actually some factors prevent an exact maturity matching and when there is
uncertainty about the lives of assets. The short term interest rates are, in most cases, cheaper
compared to their long term counterparts. This is due to the amount of premium which is higher
for short term loans. As a result, financing the working capital from long term sources means
more cost. However, the risk factor is higher in case of short term finances. Whereas, during a
short term sources, fluctuations in refinancing rates are a major cause and pose a major threats to
business.
There are mainly three strategies that can be employed in order to manage the working capital.
Each of these strategies considered the risk and profitability factors which contributed for pros
and cons of a firms. The three strategies are:
Aggressive Policy
In this policy, the entire variable working capital, either- some parts or the entire permanent
working capital and sometimes the fixed assets are funded from short term sources. This results
in significantly higher risks for any firms. The cost capital is significantly decreased in this
policy that maximizes the profit. A firm may select an aggressive working capital policy, which
adopts a lower ratio of total current assets to total assets or select an aggressive Working capital
policy that focus in maintaining a higher ratio of total current liabilities to total assets (Afza and
Nazir, 2007).
Firms with an aggressive WCP run the risk of heavy reliance on short-term debt to finance
current assets, - whereas firms with a conservative WCP take the risk of high inventory costs and
bad debts (Awopetu, 2012). If companies with an aggressive WCP are operating in stable
markets and generating steady cash flows, they have a higher likelihood of having a short CCC
and high potential for profitability (Al-Shubiri, 2011).An aggressive WCP is a high-risk, high-
return strategy. An aggressive WCP is appropriate for firms operating in a stable market with
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established products that generate a steady cash flow (Awopetu, 2012). Companies with
aggressive WCP use only small investment in current assets and rely on current liabilities as a
primary source of financing (Weinraub and Visscher, 1998).
Conservative Policy
As the name suggests, the conservative strategy involves low risk and low profitability. In this
strategy, apart from the permanent working capital, the variable working is also financed from
the long term sources. This means an increased cost capital. However, it also means that the risks
of interest rate fluctuations are significantly lower. The firm used a small amount of short term
credit to meet its peak requirements. But it also meets part of its seasonal needs by storing
liquidity in the form of marketable securities. Companies in volatile or seasonal industries such
as construction might adopt conservative working capital policies to buffer against risk.
Bansal (1999) observes that due to the conservative policy of the corporation:-
I) Short-term creditor‘s position regarding their claim is threatened due to lack of funds,
ii) The company was not following uniform policy regarding the collection of debtors, and
iii) Inefficiency on the part of the management causes over investment in inventories.
As a result, a serious situation arose due to shortage of working capital. The author warns the
corporation that if it did not plan its cash needs properly, it would be lead to bankruptcy. If
companies with a conservative WCP are slow in converting inventory and receivables into cash,
they have a higher likelihood of having a long CCC and little potential for profitability (Nyabuti
and Alala, 2014).
A conservative policy is a low-risk low return strategy, which is appropriate for firms operating
in a volatile market with uncertain demand for goods (Awopetu, 2012). Firms with a
conservative WCP make a substantial investment in current assets to avoid the risk of stock out
and loss of revenue (Bei and Wijewardana, 2012).
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Moderate or Hedging Policy
This approach involves moderate risks along with moderate profitability. In this policy, the fixed
assets and the permanent working capital are financed from long term sources whereas the
variable working capital is sourced from the short term sources. (Awopetu, 2012).
According to Mike (2016) the formula used to calculate cash conversion cycle is represented as
follows:
CCC = Average Collection Period + Inventory Turnover Day – Average Payment Period
The cash conversion cycle, also called the net operating cycle, is the number of days it takes a
company to generate revenues with assets. Cash conversion cycle analyze the cash coming into
and going out of the business and help make smarter decision and monitor projects effectively. A
construction contract begins with cash. What happens next depends on the terms of the contract,
but tends to follow this pattern:
(Mike, 2016)
CCC is used as an overall measure of working capital (WC), as it shows the gap between
expenditure for purchases and collection of sales (Deloof, M. (2003)). Cash cycle also defined as
―the time between cash disbursement and cash collection V. Ganesan. (2007).
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2.3.4 Receivable Management
Receivable management aims to maximize the value of the firm by achieving a tradeoff between
risk and profitability, (Diep, 2013). For this purpose, the financial management have to control
the cost of receivables, cost of collection, administrative expense, and bad debt and so on.
Companies can control how well accounts receivable are managed using schedules and financial
ratio. Whereas, financial ratio can be used to get an overall picture of how fast credit manager
collect receivables. It‘s the length of time it takes to clear all accounts receivables, or how long it
takes to receive the money for goods it sells. This is useful for determining how efficient the
company is at receiving whatever short term payments it is owed (Steven J. Peterson, P134,
2015).
So, the average collection period is a measurement of the average time it takes a company to
collect its accounts receivable or the average number of days that capital is tied up in accounts
receivable. The collection period is also a measure of how long the company‘s capital is being
used to finance client‘s construction projects. It may also be referred to as the Average age of
Accounts Receivable. The collection period is calculated as follows:
Average collection period ratio explains how many days of credit a company is allowing to its
customers to settle their bills (- Ramana and Rao, 2015- ). - For the construction industry the
collection period is affected by retention. Retention held is recorded as an accounts receivable
when the work is completed but will not be available for release until the project is completed.
This has the effect of lengthening the collection period. The greater the percentage of retention
being held and the longer the project the greater this effect is. For an accurate measure of how
long capital is being used to finance client‘s construction projects it is necessary to include the
accounts receivable that are in the form of retention because retention is a source of capital to the
project‘s owner.
However, including the accounts receivable that are in the form of retention in the calculation of
the collection period distorts the collection period as a measure of how well a company is
collecting the accounts receivable that are due to it. This is because no matter how aggressive a
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company collects its accounts receivable it cannot collect the retention until the project is
complete. A better measure of how well a company is collecting its accounts receivable is to
exclude the accounts receivable that are in the form of retention from the calculations. When a
company has met the requirement for receipt of the retention, the retention should be moved to
the accounts receivable trade account, thus reflecting that the retention is now collectable.
A company‘s collection period should be less than 45 days. A collection period of more than 45
days indicates that the company has poor collection policies or has extended generous payment
terms to its clients. For a company whose clients do not hold retention, this time should be
reduced to 30 days. Reducing the collection period reduces a company‘s need for cash and may
reduce the company‘s need for debt and the interest charges that accompany debt. Generous
payment terms and slow collections often increase a company‘s reliance on debt, which increases
its interest expenses and thereby reduces its profitability. (Steven J. Peterson, P134, 2015)
Inventory turnover ratio in days indicates the number of time the stock has been turned over sales
during the period and evaluates the efficiency with which a firm is able to manage its inventory.
It‘s calculated:
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Inventory Turnover = Inventory / (Cost of Sales / 365)
The ratio shows how many times inventory has turned over to achieve the sales. Inventory
should be maintained at a level, which balances production facilities and sale's needs. Higher the
ITR, lower would be inventory holding period and vice versa (Ramana and Rao, 2015).
Therefore, payable management is very important. There is one way of controlling accounts
payable is the average age of accounts payable. The average age of accounts payable represents
the average time it takes a company to pay its bills and is a measure of how extensively a
company is using trade financing. The average accounts age of accounts payable is the average
amount of accounts payable divided by the total of the invoices that pass through the accounts
payable for the period. The average age of accounts payable is often calculated as follows:
The underlying assumption is that the bulk of the invoices that pass through the accounts payable
for the period are material and subcontract construction costs. When a significant amount of
invoices for equipment, other construction costs, or general overhead pass through the accounts
payable, they will lengthen out the average age of accounts payable because they will increase
the
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Numerator in without changing the denominator. To get a realistic measure of the average age of
accounts payable a company may need to increase the materials and subcontract amount by the
estimated amount of invoices from equipment, other construction costs, and general overhead
that pass through the accounts payable account.
When the average age of accounts payable is greater than 45 days this is an indication that the
construction company is slow to pay its bills and may receive less favorable credit terms and
pricing from its suppliers and subcontractors. When the average age of accounts payable is
shorter than 20 days—unless a construction company is taking advantage of trade discounts—it
may be an indication that a company is underutilizing trade financing. If the average age of
accounts payable is equal to or slightly greater than the collection period—calculated with
retention—it is an indication that the construction company is using its suppliers and
subcontractors to fund the construction work. If the average age of accounts payable is much
greater than the collection period it may be an indication that the construction company is
withholding payments from its suppliers
And subcontractors even after it has received payment for the work. If the average age of
accounts payable is less than the collection period, the construction company is in the habit of
using its working capital to pay bills before it has received payment from the owner. It is
desirable for the average age of accounts payable to be equal to or slightly greater than the
collection period.
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Current Ratio =Current Assets / Current Liabilities.
A current ratio of 2 to 1 is considered a strong indication that a company is able to pay current
liabilities. If a company‘s current ratio is below 1 to 1 it is an indication that the company does
not expect to receive enough revenue over the next year to pay its current liabilities. To pay these
liabilities the company needs to sell long-term assets or raise cash through debt or equity
financing. If a company‘s current ratio is below 1.5 to 1 the company is undercapitalized and
may run into financial problems during the next year. If a company‘s current ratio is over 2.5 to
1, the company may have too much of its assets tied up in current assets and should possibly be
investing its assets in other long-term ventures or distributing them to its shareholders.
Different authors addressed this issue of maintaining a tradeoff between these two conflicting
goals of profitability and liquidity but only gave a general approach to solve the problem. Waller,
D. L.-(2002)-. Stated that increased investment in working capital is associated with decreased risk
of inadequate liquidity, risk of lesser inventory for sales and risk of not granting credit for sales
and production. Similarly -if the firm decreased investment in working capital, it will increase
the above mentioned risks. Increased risk also increases profitability of the firm as the decreased
investment in working capital can be used for some productive use. Weston and Brigham (1975)
also discussed this trade off issue and suggested that investment in working capital should be
made till that time marginal return are more than cost of invested capital. And working capital
financing should be used instead of long term financing as long as their use does not increase
firm‘s cost of capital. The study conducted by Waller, D. L. (2002) also encouraged the use of
21
more working capital assets but emphasized on the risk involved as the major determinant of
degree of working capital investment.
A research by Smith (1980), Raheman & Nasr, (2007), also states the main purpose of any firm
is to maximize profit. But, maintaining liquidity of the firm also is an important objective. The
problem is that increasing profits at the cost of liquidity can bring serious problems to the firm.
Thus, strategy of firm must maintain a balance between these two objectives of the firms.
First as found by Lazaridis and Tryfonidis (2006) companies may enjoy better pricing when they
hold enough cash to purchase from own suppliers and thus they may enhance their profit. So
having enough liquidity also affects the profitability of the firm. Secondly, Deloof (2003) has
also proved that by minimizing the amount of funds tied up in current assets; firms can reduce
financing costs and/or increase the funds available for expansion.
Referring to theory of risk and return, investment with more risk will result to more return.
Accordingly, firms with high liquidity of working capital may have low risk then low
profitability. On the contrary, firm that has low liquidity of working capital, facing high risk
results to high profitability. The issue here is in managing working capital, firm must take into
consideration all the items in both accounts and try to balance the risk and return.
Therefore, the profitability liquidity tradeoff is important because if working capital management
is not given due considerations then the firms are likely to fail and face bankruptcy (Kargar &
Bluementhal 1994). Efficient working capital management involves planning and controlling
current assets and current liabilities in a manner that eliminates the risk of inability to meet due
short term obligations on the one hand and avoid excessive investment in these assets (Eljelly
(2004).
Smith, (1980) emphasized that profitability and liquidity comprised the silent goals of working
capital management. Therefore, in the next portion of this chapter, we present the studies
specifically on the relationship between working capital management and the profitability of a
firm.
22
2.5 Working Capital Management and Profitability
Profitability can be termed as the rate of return on investment, if there is an unjustifiable over
investment in working capital then, this would negatively affect the rate of return on investment -
Vishnani & Shah, (2007)-. Therefore, the basic purpose of managing working capital is
controlling of current financial resources of a firm in such a way that a balance is created
between profitability of the firm and risk associated with that profitability.
As stated by Siddiquee and Khan (2008) it has been observed that, firms which are better at
managing working capital are more profitable. They are also better at generating fund internally
and also face lesser trouble while seeking external sources of financing.
Short-term assets and liabilities are important components of total assets and need to be carefully
analyzed. Management of these short-term assets and liabilities warrants a careful investigation
since the working capital management plays an important role in a firm profitability and risk as
well as its value (Smith, 1980). Recent works of Deloof, (2003); Howorth and Westhead, (2003)
and Afza and Nazir, (2008), state that firms try to keep an optimal level of working capital that
maximizes their value.
According to Steven J. Peterson (2009) the return on assets is a measurement of how efficiently
a construction company is using its assets and is often expressed as a percentage. The return on
assets is calculated as follows:
Return on Assets = Net Profit after Taxes / Total Assets
Efficiently run companies will have a high return on assets, whereas companies that are poorly
run will have a low return on assets.
23
Vinay (2015) conducted a study to analyze the effect of working capital management policy on
profitability .The result shows that the liquidity of the company has an negative impact on
profitability of 10 Indian infrastructure companies . When there is an increase in liquidity the
profitability of the company decreases and vice versa. And there is inverse relationship between
current ratio and profitability and positive relation of profitability to debt turnover.
Jagongo and Makori (2013) investigated the working capital management and firm profitability:
empirical evidence from manufacturing and construction firms listed on Nairobi securities
exchange, Kenya. There is a positive correlation between return on inventory holding period,
average payable period and negative correlation between return on asset and the firms average
collection period and cash conversion cycle. The study finds a negative relationship between
profitability and number of day‘s accounts receivable and cash conversion cycle, but a positive
relationship between profitability and number of days of inventory and number of day‘s payable.
Moreover, the financial leverage, sales growth, current ratio and firm size also have significant
effects on the firm‘s profitability.
24
Gill et al(2010) investigated the relationship between working capital management and
profitability in United States firms by selected 88 American manufacturing and construction
firms listed on New York Stock Exchange for a period of 3 years from 2005 - 2007. They found
negative and statistically significant relationship between the cash conversion cycle and
profitability, measured through gross operating profit.
Kulkanya (2012) studied the effects of working capital management on the profitability of the
Thailand firms. The regression analysis was based on a panel sample of 255 companies listed on
the Stock Exchange of Thailand from 2007 through 2009. The results revealed a negative
relationship between the gross operating profits and inventory conversion period and the
receivables collection period. Therefore, managers can increase the profitability of their firms by
shortening the cash conversion cycle, inventory conversion period, and receivables collection
period. However, they cannot increase profitability by lengthening the payables deferral period.
The findings also demonstrated that industry characteristics have an impact on gross operating
profits.
Chikore el at al (2014) examined the impact working capital management on profitability of
non-financial firms of Zimbabwe and it found that there is a positive relationship between
debtor‘s days and firm‘s profitability, a positive relationship between firm‘s cash conversion
cycle and its profitability. Negative relationship between current ratio and profitability and also
inventory turnover days and profitability are positive related.
Ramana and Rao, (2015) and Rao (1996) conducted a study on working capital management in
Hindustan Construction Limited Company (HCL) India. The study conducted to analyze the
working capital management practice of two significant players in the industry, namely,
Hindustan Construction Company (HCC) and simplex infrastructure limited company (SIL).the
study used seven ratios and statement of changes in working capital and observed that the
company‘s working capital management is not up to the expected level. And the study makes of
efficiency indices like current ratio, quick ratio, and inventory turnover ratio etc. of working
capital management and the analysis shows that HCC needs to focus more on inventory and
credit management whereas SIL should focus on receivable management. It should be improved
by effective utilization and control of current asset.
25
Meszek et al (2006) examined the profiles of selected construction companies from the
viewpoint of working capital formation and their management strategies applied to working
capital. The analysis is based on the financial ratios. The authors conclude with the observation
that complex working capital management requires controlling methodology to be developed. A
specific character of the construction industry, including operational factors and market
requirements make working capital management a task exceeding the financial sphere, as it
embraces the issues of organization of investment processes, the organization of production
processes and logistics.
Diep (2012) examined the impact of Working Capital Management on Construction firms
profitability in Vietnam by selected a sample of selected 11 audited construction companies
listed in Vietnam stock exchange for the period 0f 2010-2012 and analysis found a significant
negative relationship between receivables collection period, inventory conversion period ,
average payment period, cash conversion cycle and profitability. The study also suggested that
the impact of working capital management on firm‘s performance and highlight how managers
affects firms profitability by managing working capital efficiently.
Deloof (2003) used a sample of 1009 Belgian companies during the period 1992-1996, he found
a significant negative relationship between gross operating income and account receivable
period, inventories and account payable of Belgian companies. The result suggest that managers
can create value for their shareholders by reducing the account receivable period and inventories
to reasonable minimum. The negative relationship between account payable and profitability is
consistent with the view that less profitable firms wait longer to pay their bills.
26
Generally, the existing studies indicates that working capital management has impacts on
profitability of a firm. Therefore, there is still a vagueness regarding the appropriate variables,
hypotheses and effect size measures that might serve as proxies for working capital management
as a whole.
And also , in case of Ethiopia there are a few literatures such as Niman Ibrahim (2015),Henok
Yohannes (2015), Wobshet Mengesha (2014) , Miftah Ahmed (2016) and Mulualem Mekonen
(2011) focused on the impact of working capital management on profitability of Manufacturing
share companies and small and medium enterprise (SMEs) in Ethiopia by considering different
variables . But in Ethiopia to the knowledge of the researcher, empirical studies on the area of
working capital management and its impact on the profitability of Construction Company in
Ethiopia has not been carried out so far . This study therefore, aimed to contribute to this
research gap and identify which variables of working capital have a significant role on the
profitability of construction companies that is located in Addis Ababa, Ethiopia .
27
Chapter Three
Research Methodology
3. Introduction
The previous chapter indicated the literature on the impacts of working capital management on
construction firm‘s profitability, and pointed out that there is limited research in Ethiopia. The
intent of this chapter is giving brief outline of the broad objective of the study and hypothesis,
the underlying principle of the research methodology and the choice of the appropriate research
method for study.
In general Creswell (2009) stated three basic types of research approaches, i.e. qualitative,
quantitative and mixed research approach. In the quantitative approach, results are based on
numbers and statistics that are presented in figures, whereas in qualitative research approach
where focuses on describing an event with the use of words. Mixed research approach, on the
other hand, lies in between.
Thus, to gain a deeper understanding of the issue of impact of working capital management and
profitability of construction company and ultimately to achieve the above mentioned objectives
of this research study the researcher has used quantitative research approach. As noted by
Yesgat (2009) the quantitative research approach translated the research problem in to specific
variables and hypothesis to be tested (Yesgat, 2009, p.70). Thus, it enables the researcher to get a
deep understanding about the area being investigated. In investigating the impact of working
capital management on profitability of construction firms in Ethiopia, the researcher tried to test
28
the relationship between return on asset, which is a dependent variable, four explanatory
variables and four control variables.
This study was conducted on Ethiopian Construction Industry, in which a total of forty-five
construction companies1 are operating at the moment and classified as a large construction
companies by Ethiopian Revenue and Custom Authority. Therefore, as noted by Cohen et al.
(2005), covering the entire construction firms in the study makes the study difficult. Therefore
the researcher decided to draw only 17 companies as a sample from the total population. To give
equal chance for each construction company being included in the sample, random sampling
technique have been used. Thus only 17 construction companies, which is almost 40 percent of
the total population, have, therefore, been drawn randomly from the whole population.
Sample companies are:-
1. Adam Construction
2. Afro Tsion Construction PLC
3. Akir Construction PLC
4. Aser Construction PLC
5. Blue Nile Construction
6. Defense Construction and Engineering Enterprise
7. DMC construction PLC
8. Dugda Construction PLC
9. Enyi Construction
10. Genet Construction PLC
29
11. Gift Construction PLC
12. Orchid Business Group PLC
13. OSAC Business PLC
14. Rama Construction PLC
15. Sunshine Construction PLC
16. SUR Construction PLC
17. Universal Construction
30
3.4 Model Specification, Variable Description and related Hypothesis
3.4.1 Model specifications
To analyses the impact of working capital management on profitability, the study used the
following methods:
(i) Descriptive statistical analysis wherein a description of features of the data in the
study such as mean and standard deviation of each variable is presented.
(ii) regression analysis is used to gauge the extent to which a unit change in each
respective
Explanatory variable has on profitability. Pooled ordinary least squares method was used in
regression analysis, wherein time series and cross-sectional observations is combined in
determining the causal relationship between profitability variable and the independent variables
used in the study.
31
Specific regression model
Pooled OLS regressions are simply a linear regression applied to the whole data set. One of the
biggest advantages of OLS method is that it relaxes the restriction of an enough large data set
and simplicity. (Deloof, 2003; Garcia-Teruel &Martinez-Solano, 2006; Padachi, 2006) used OLS
to investigate the impact of WCM on corporate profitability.
Four regression models were run in which one for all the variables based on selected sample
companies. When the above general model is converted to the specified variables of this study
the following regression equations was run to obtain the impact of working capital management
on the performance of manufacturing firms.
β1, β2, β3, β4, and β5 = coefficients on each respective explanatory variables,
32
SGit = Sales growth for firm i at corresponding time t.
In the first regression model, the ARP has been regressed against the ROA. In the second
regression model, the IHP has been regressed against the ROA. The third regression model
involves a regression of the APP against the ROA. In the fourth regression model, the CCC is
regressed against the ROA.
Dependent Variable
The dependent variable are variables that are used to measure the profitability of firms. In order
to analyses the impact of working capital components on the profitability of construction firms in
Ethiopia, profitability is measured by return on assets (ROA). The dependent variable in this
study is return on asset, calculated by dividing a company‘s annual earning by its total assets, it
is displayed as a percentage. Several recent studies have used ROA as a proxy for firm‘s
profitability such as (Miftah and Zelalem, 2016).
Independent variable
As an independent variables the researcher has tested a total of four firm specific explanatory
variables i.e. cash conversion cycle, account receivable period, inventory holding period and
account payable period. The description of those explanatory variables and related hypothesis is
described as follows;
33
3.4.2.1. Average Collection Period (ARD)
It is used as a proxy for the collection policy of firms. ACP is equal to (Debtors/Credit Sales) x
365. This ratio explains how many days of credit a company is allowing to its customers to settle
their bills (Ramana and Rao, 2015) and also (Fried et al, 2003) state that average collection
period measures the effectiveness of the firms credit policy. It indicates the level of investment in
receivables needed to maintain the firm‘s sales level.
35
The size of the firm is measured as logarithm of Sales
Size of Firm = Natural Log of Sales
Other researchers which have also included sales growth as part of the control variables in their
studies are Falope and Ajilore (2009) and Nazir and Afza (2009). Thus, in this study, sales
growth is measured by the following formula:
Sales Growth = Sales1 – Sales0 / Sales0
According to Akinlo (2012), sales growth is anticipated to have a positive relation with
profitability in view that higher achievement in sales growth is derived as a result of better
quality of product or services, lesser time required to evaluate the quality of the products, which
leads to lower accounts receivables days and positive impact on profitability. The positive
36
association between sales growth and profitability is also supported by other researchers (Deloof,
2003; Zariyawati, Annuar, Taufiq and Abdul Rahim, 2009; Raheman, Afza, Qayyum and Bodla,
2010).
37
and current liabilities
Firm size Determine the size of the Natural --
firm logarithm of
total asset
Quick ratio Explain the birr of liquid CA- INV --
current assets available CL
per birr of current
liabilities
Sales growth Shows the amount by Percentage --
which the average sales
volume of a company‘s
product or service has
grown, typically from
year to year.
38
Chapter Four
Data analysis
First, this study collects the needed data from selected construction firms who agree to provide
their financial statement to the study. After that, collected data are rearranged, edited and
calculated in order to become complete data that is needed for this study. Next, these collected
data are analyzed by using STATA and EVIEW. The last step is interpreting the result of
STATA and output.
In this section the results from descriptive statistics was discussed. Table 4.1 below presents
descriptive statistics of the dependent and independent variables of the study. It shows the mean
and standard deviation of the variables used in the study. In addition, it shows the minimum and
maximum values of each respective variable which essentially gives an indication of how wide
ranging each respective variable can be.
39
Table 4.1 presents descriptive statistics for 17 construction firms companies in Ethiopia for a
period of eight years from 2008 to 2015.The study has used nine variables for the analysis
purpose which was classified in to four dependent , four control and one dependent variable. The
dependent variable which measures the profitability of the firm is return on asset. Out of eight
independent variables, four are (accounts receivable period, inventory holding period, accounts
payable period and cash conversion cycle) proxies for profitability of the sample firms. The
remaining four independent control variables used are firm size as measured by natural logarithm
of sales, quick ratio, sales growth rate measured by the relative change in sales as compared to
previous year and current ratio which measures liquidity.
As it is shown in table 4.1, the mean value of return on assets is around 14.85 percent and
standard deviation is 6. 06 percent. It means that value of profitability can deviate from mean to
both sides by 6.06 percent. The minimum value of return on asset is -3 percent while the
maximum is 31 percent.
Firms under the study receive payment on sales on average of 88 days and it can vary by 35 days
to both sides of the mean value. The minimum and maximum account receivable period for the
sampled firms is 10 and 171 days respectively.
The descriptive statistics show that it takes on average of 231 days to sell inventory. The
standard deviation of inventory holding period is 47 days with 123 and 331 days as minimum
and maximum values respectively.
On average, firms wait 177 days to pay for their purchases. Its standard deviation for the firms
under study is 31 days which deviates from both sides of the mean value. The accounts payable
period ranges from 109 to 241 days to pay their credit purchases.
The cash conversion cycle, used as a comprehensive measure of working capital management
has an average 142 days and the standard deviation of 53 days. The minimum value of the cash
conversion cycle shows 24 days and on the other way, the maximum time for the cash
conversion period is 248 days.
Table 4.1 also includes the descriptive statistics of control variables used in the study. A
traditional measure of liquidity (current ratio) shows that on average construction firms
companies keep current assets at 2.6 times current liabilities with a standard deviation of 0.53.
The highest current ratio for a firm in the study period is 3.9, with the lowest at 1.5.
40
The results of descriptive statistics show that the quick ratio for the construction firms are
companies is 1.02 with a standard deviation of 0.41. The maximum ratio used by the firm is 2.1
and its minimum level is 0.1.
The other control variable, firm size, as measured by the natural logarithm of annual sales, is
8.01 on average and standard deviation is 0.58. The minimum and maximum values of firm size
for the firm measured by natural logarithm of annual sales are 6.54 and 9.34 respectively.
Lastly, the firm sales growth measured by changes in annual sales has an average of 19.7% and
there is a deviation of 10.64 percent from mean value of sales growth to both directions. The
sales growth among the study firms is ranged from -10 percent to 53 percent.
The pooled regression assumes that the intercepts are the same for each firm. This may be an
inappropriate assumption; (Brooks, 2008) recommended that we could instead estimate a model
with firm fixed effects, which will allow for latent firm specific heterogeneity. The simplest
types of fixed effects models allow the intercept in the regression model to differ cross-section
ally. To determine whether the fixed effects are necessary or not, this study run a redundant fixed
effects test as recommended by (Brooks, 2008) and others using GLS regression
H0: Random Effects model is appropriate
H1: Fixed Effects model is appropriate
Decision Rule: Reject H0 if the value less than significance level 5%. Otherwise, do not reject
H0. According to the results presented below the study adopt fixed effects model
41
Table 4.2 Redundant fixed effect test
Equation: Untitled
Test cross-section random effects
Chi-Sq.
Test Summary Statistic Chi-Sq. d.f. Prob.
Chi-Sq.
Test Summary Statistic Chi-Sq. d.f. Prob.
Chi-Sq.
Test Summary Statistic Chi-Sq. d.f. Prob.
Chi-Sq.
Test Summary Statistic Chi-Sq. d.f. Prob.
42
4.3 Diagnostic tests
Diagnostic tests are robust statistical tests carried out to verify if the data used have met the
assumptions underlying the ordinary least squares regression and where possible to remove
problems associated with panel data. The diagnostic tests carried out in the study are detailed
below.
4.3.1. Test for average value of the error term is zero (E (ut) = 0) assumption
the first assumption required is that the average value of the errors is zero. In fact, if a constant
term is included in the regression equation, this assumption will never be violated. Therefore,
since the constant term (i.e. α) was included in the regression equation, the average value of the
error term in this study is expected to be zero.
4.3.2 Heteroscedasticity
According to (Brooks, 2008), Heteroscedasticity means that error terms do not have a
constant variance. If Heteroscedasticity occur, the estimators of the ordinary least square
method are inefficient and hypothesis testing is no longer reliable or valid as it will
underestimate the variances and standard errors. There are several tests to detect the
Heteroscedasticity problem, which are Park Test, Glesjer Test, Breusch-Pagan-Goldfrey Test,
White‘s Test and Autoregressive Conditional Heteroscedasticity (ARCH) test. This study used
Breusch-Pagan-Goldfrey test to detect the presence of Heteroscedasticity.
H0: The model is Hetroscedasticity
H1: The model is Homoskedastic
43
Model 2: ROA C IHP CR QR SG FS
Heteroskedaticity Test: Breusch –Pagan Godgrey
F-statistic 0.958263 Prob. F(5,145) 0.4463
Obs*R-squared 4.837351 Prob. Chi-Square(5) 0.4361
Scaled explained SS 6.064617 Prob. Chi-Square(5) 0.3000
44
Due to the invalid hypothesis testing, it may lead to misleading results on the significance of
parameters in the model. Breusch-Godfrey Serial Correlation LM Test was used to detect
autocorrelation problem.
Ho: ρ=0, i.e. no serial correlation
H1: ρ=1 i.e. presence of serial correlation
Decision Rule: Reject H0 if p-value less than significance level. Otherwise, do not reject Ho.
Hence all the models used in this study have no serial correlation.
45
4.3.4 Testing for normality
Normality is a condition in which the variables to be used in the model follow the standard
normal distribution. The Jarque-Bera statistics was used to test the normality of the variable
under different conditions and under the hypotheses;
Ho: The series is normally distributed
H1: The series is not normally distributed
If the series are normally distributed, the histogram should be bell shaped and the Jarque- Bera
statistic insignificant.
Model 1: ROA C ARP CR QR SG FS
Figure 4.1: Normality test for the model effect of ARP on ROA
Observation 136
Mean 4.88e-10
Median 0.001067
Maximum 0.0954400
Minimum 0.001067
Std. Dev. 0.034791
Skewedness -0.146039
Kurtos is 3.123
Jarque bera: 0.46045
Probability: 0.790949
46
Model 2: ROA C IHP CR QR SG FS
Figure 4.2: Normality test for the model effect of IHP on ROA
14
Series: Standardized Residuals
12 Sample 2008 2015
Observations 136
10
Mean 4.90e-18
Median -0.005991
8
Maximum 0.146079
Minimum -0.153295
6
Std. Dev. 0.057819
Skewness 0.015347
4
Kurtosis 3.005023
2 Jarque-Bera 0.005482
Probability 0.997263
0
-0.15 -0.10 -0.05 0.00 0.05 0.10 0.15
14
Series: Standardized Residuals
12 Sample 2008 2015
Observations 136
10
Mean -8.15e-17
Median -0.006537
8
Maximum 0.149517
Minimum -0.154526
6
Std. Dev. 0.058035
Skewness 0.030083
4
Kurtosis 3.023744
2 Jarque-Bera 0.023708
Probability 0.988216
0
-0.15 -0.10 -0.05 0.00 0.05 0.10 0.15
47
Model 4: ROA C CCC CR QR SG FS
Figure 4.4: Normality test for the model effect of CCC on ROA
14
Series: Standardized Residuals
12 Sample 2008 2015
Observations 136
10
Mean 1.00e-16
Median -0.005215
8
Maximum 0.147402
Minimum -0.155494
6
Std. Dev. 0.057910
Skewness -0.002868
4
Kurtosis 3.023612
2 Jarque-Bera 0.003346
Probability 0.998329
0
-0.15 -0.10 -0.05 0.00 0.05 0.10 0.15
48
Table 4.5: Correlation matrix between explanatory variables
ROA 1.000
ARP -0.1203 1.000
IHP -0.1291 0.3475 1.000
APP 0.2178 -0.1144 -0.2134 1.000
CCC -0.0907 0.4162 -0.5266 0.4622 1.000
CR -0.2109 -0.2611 -0.0890 -0.1280 -0.0196 1.000
QR -0.2146 0.2591 -0.0704 0.1305 0.0331 0.1935 1.000
FS -0.0829 0.2740 0.0895 0.0160 0.0919 0.1311 0.1411 1.000
SG 0.1753 -0.1172 0.0929 -0.2383 -0.1322 0.0379 0.0471 -0.0522 1.000
Source: source SPSS output from financial statements of sample companies, 2008 - 2015
Following descriptive statistics and diagnostic tests presented in sections 4.2 and 4.3
respectively, the regression analysis in this section is used to shed more light on the impact of
working capital management components on firm profitability.
Consistent with Garcia-Teruel and Martinez-Solano (2006) and Mathuva (2010), the study
estimates determinants of firm‘s profitability using ordinary least squares in which four (4)
regression models have been run in order to investigate the impact of management of working
capital on firm‘s profitability.
49
4. 4 .1 Regression result of model specification I
Model specification I regressed effect of accounts receivable period on ROA.
Model 1: ROAit = β0 + β1 (ARPit) + β2 (CRit) + β3 (SGit) + β4 (QRit) + β5 (FSit) + εit
Table 4.6 Regression results of profitability measures and ARP
Effects Specification
50
The regression results in table 4.5 indicate that holding other things constant a day increase in
day‘s sales receivable is associated with a decrease in 0.0852 percent in profitability and
statically significant.
chapter one as shown in 1.4 section. The first research hypothesis was that accounts receivable
period have significant negatively related to a firm‘s profitability. In conformity with hypothesis,
the indicator of profitability, return on assets is negatively and significantly related with accounts
receivable period and significant at 5% so, the null hypothesis are true.
51
4.4.2 Regression result of model specification II
Model specification II regressed effect of inventory holding period on ROA.
Model 2: ROAit = β0 + β1 (IHPit) + β2 (CRit) + β3 (SGit) + β4 (DRit) + β5 (FSit) + εit
Table 4.7 Regression results of profitability measures and IHP
Effects Specification
53
4.4.3 Regression result of model specification III
Model specification III regressed effect of account payable period on ROA.
Model 3: ROAit = β0 + β1 (APPit) + β2 (CRit) + β3 (SGit) + β4 (DRit) + β5 (FSit) + εit
Effects Specification
54
specification. From the table 4.3 the result of one can see that the model is fit with F statistics
7.68 at p-value of 0.0000.
The regression results in table 4.3 indicate that holding other things constant a day increase in
accounts payable period is associated with a decrease in 0.0611 percent in profitability but
statistically insignificant. Raheman and Nasr (2007), Miftah (2016),Lazaridis and Tryfonidis
(2006), Gill et al (2010) and Diep (2013) this finding holds that more profitable firms wait
longer to pay their bills. This implies that they withhold their payment to suppliers so as to take
advantage of the cash available for their working capital needs. Deloof (2003) who found a
strong negative relationship between profitability and number of days of account payable
justifies in his result that less profitable firms tend to delay payments and more profitable firms
pay their bills earlier.
Similarly, except the quick ratio and current ratio, all other variables have insignificant
association with firm‘s profitability. However, quick ratio and current ratio has a positive impact
on firm profitability while other control variable like size of the firm and sales growth has a
negative Impact on profitability of a firm.
The results from regression model specification III are used to determined hypothesis stated in
chapter one as shown in 1.4 section. The third research hypothesis was that the account payable
period of a firm are significant positively related to a firm‘s profitability. In conformity with
hypothesis, the indicator of profitability, return on assets are positively related with accounts
payable period and insignificant. Therefore, the null hypothesis is not confirmed and can be
conclude that hypothesis three is rejected.
55
4.4.4 Regression result of model specification IV
Model specification IV regressed effect of cash conversion cycle on ROA.
Model 4: ROAit = β0 +β1 (CCCit) + β2 (CRit) + β3 (SGit) + β4 (DRit) + β5 (FSit)+ εit
Table 4.9 Regression results of profitability measures and CCC
Effects Specification
56
more explanatory power). The F statistic is used to test the model specification. From the table
4.9 the result of one can see that the model is fit with F statistics 7.48 at p-value of 0.0000.
The regression results in table 4.9 indicate that holding other things constant a cash conversion
cycle period is associated with a decrease in 0.033 percent in profitability and statistically
significant at 5%. The combined effect of all the three variables; accounts
receivable, inventory holding period and accounts payable period used in model specification IV
was analyzed by using cash conversion cycle.
The result indicate that when the net time interval between actual cash expenditures on a firm‘s
purchase of productive resources and the ultimate recovery of cash receipts from product sales
shortens by a day, profitability of construction companies in Ethiopia increases by 0.033
percent. Therefore, decreasing the cycle by one day bring an increment of 0.033 percent profit
per year on performance of firms. In essence, this negative relationship suggests that corporate
managers can increase profitability of their firms by shortening the time lag between a firm‘s
expenditure for purchases of raw materials and the collection of sales of finished goods.
Moreover the regression results show that quick ratio and current ratio have positive correlation
coefficient values. However, except CCC variable used in this model are not significant.
Studies like Deloof (2003), Shin and Soenen (1998), Lazaridis and Tryfonidis (2006), Garcia-
Teruel and Martinez-Solano (2006), Samiloglu and Demirgunes (2008), Uyar Ali (2009) ,Tewodros
(2010) and Makori and Jagongo (2013) all found a significant negative relation between the CCC
and a firm‘s profitability. Contradicting evidence was found by Gill et al. (2010) who found a
positive relation between the two variables. This is caused by the positive, but not significant,
relation between inventories and firm‘s profitability. Also contradicting evidence is found by
Sharma and Kumar (2011) in India, who argued that firms, has a higher level of accounts
receivable due to generous trade credit policy which results in longer cash conversion cycle.
Considering the components of the cash conversion cycle (i.e., inventory period, accounts
receivable period or accounts payable period) the negative result with cash conversion cycle
points out that an increase in profitability is associated with a lower in the cash conversion cycle.
It shows that the profitable companies tend to have the longer cash conversion cycle which
indicates to inefficient working capital management. This was affected by either inventory
period, accounts receivable period or accounts payable period. The implication is that the
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increase or decrease in cash conversion cycle has significantly and negatively affect profitability
of the firms. It means that the shorter the firm‘s cash conversion cycle, the higher the
profitability and vice versa. As stated in theoretical part of this research, cash conversion cycle is
an addition of accounts receivable period and inventory holding period and a deduction of
accounts payable period. Managing cash conversion cycle efficiently, therefore, means efficient
management of these three items. By managing efficiently the accounts receivable period,
inventory holding period and accounts payable period (by making short accounts receivable
period, inventory holding period and/or long accounts payable period) managers can control the
efficiency of cash conversion cycle and its impact on profitability.
The results from regression model specification IV are used to determined hypothesis stated in
chapter one as shown in 1.4 section. The fourth research hypothesis was that the cash conversion
cycle of a firm is significant negatively related to a firm‘s profitability. In conformity with
hypothesis, the indicator of profitability, return on assets are negatively and significantly related
with cash conversion cycle at 5% level. Therefore, the null hypothesis is confirmed and can be
conclude that hypothesis four is true.
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CHAPTER FIVE
5.1 Conclusions
The management of working capital is one of the most important financial decisions of a firm.
The ability of the firm to operate for longer durations depends on a proper trade-off between
management of investment in long-term and short-term funds (working capital).
Firms can achieve optimal management of working capital by making the trade-off between
profitability and liquidity. It is necessary for a firm to monitor its working capital properly and
maintain its balance at the appropriate level. Shortage of working capital may lead to lack of
liquidity as well as loss of production and sales; on the contrary, excess balance of working
capital could be seen as loss of investment opportunities.
This research studied the impact of working capital management on profitability of construction
companies in Ethiopia. The study used quantitative research approach. Data was analyzed using
descriptive statistics and regression analysis on a sample of 17 construction companies in
Ethiopia for the period of 2008-2015.
The impact of working capital management has been analyzed by using OLS regression model
between WCM and profitability. The study used return on asset as dependent variable. Accounts
receivable period, inventory turnover in days and average payment period were used as
independent working capital management variables. Moreover, cash conversion cycle was used
as comprehensive measures of working capital management. In addition, the study used current
ratio, which was used as liquidity indicator; firm size, as measured by logarithm of sales; sales
growth rate, as measured by the change in annual sales; and quick ratio as control variables.
Descriptive statistics were used to examine the trend of the chosen variables among the Samples
firms. The mean value of the 17 firms included in the study as measured by return on asset was
14.9 percent and it deviates from the mean to both sides by 6.1 percent. Its minimum value is -3
percent while the maximum is 31 percent. While the liquidity position as measured by current
ratio is on average 3.6. The firms receive cash collection from their customer on average at 142
days and have accounts payable period on average at 177 days. The average inventory period
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that means the period from inventory purchased to inventory sold averaged is 231 days. On the
other side, cash conversion cycle as a comprehensive measure of working capital management of
construction companies of the study on average takes 142 days. Before the regression were run,
the data have tested the assumptions underlying OLS and are fulfilled all tested assumptions
made.
The regression analyses of the number of day‘s accounts receivables indicate that there is a
significant negative relation at 5 percent level between these days and firm‘s profitability. This
means that the shorter the firm‘s accounts receivable period, the higher the profitability and vice
versa. Therefore, firms can increase their profitability by reducing the accounts receivable period
as much as possible.
The regression analyses of inventory holding period indicate that there is a negative relation
between these days and firm‘s profitability. This means that the shorter the firm‘s inventory
holding period, the higher the profitability and vice versa. Therefore, firms can increase their
profitability by reducing the inventory holding period as much as possible. In another way, firms
should faster the speed of inventory turnover to maximize profitability.
The regression analyses of account payable period indicate that there is a positive relation
between these days and firm‘s profitability. This means that the longer the firm‘s accounts
payable period, the higher the profitability and vice versa. This can be described as the longer a
firm delays its payments to its creditors, can increases profitability.
The regression analyses of cash conversion cycle indicate that there is a significant negative
relation at 5percent level between this cycle and firm‘s profitability. This means that the shorter
the firm‘s cash conversion cycle, the higher the profitability and vice versa. The negative
relationship between accounts receivable period and profitability suggests that high profitable
firms pursued an increase of their accounts receivables in an attempt to increase their cash gap in
the cash conversion cycle.
Similarly, the positive relationship between accounts payable period and profitability shows that
when firms delay their payments they earn more profits. The negative relationship between
inventory holding period and profitability suggests that firms should make speed the turnover of
inventory to be profitable. Therefore, construction firms of Ethiopia can increase their
60
profitability by making lower the length of cash conversion cycle and keeping each different
component (accounts receivables, accounts payables, and inventory) to the optimal level.
5.2 Recommendations
The recommendations of the research were premised on the summary of and conclusions from
the results and discussion. The study has shown a clear understanding of working capital
components and its impact on profitability of firms. In order to improve firms‘ performance,
management of working capital components is necessary. Therefore, the researcher recommends
the following points based on the study findings.
i) The negative relationship between construction firms ‗financial performance and
accounts receivable period increases firm‘s profitability when there is high collection
of accounts receivable. The researcher further recommended that firms should engage
in relationship with those customers who allow short payment period by considering
taking into account not to lose customers who delay payments.
ii) The study found negative relationship between inventory holding period and firms‘
profitability. It is apparent that higher IHP is associated with higher storage, carrying
cost and also prone to spoilage. However, as far as previous empirical and theoretical
studies concerned minimizing IHP will result in efficient outcome of investment. The
researcher recommended the firms should work on in bettering the inventory
management system that minimizes the holding period.
iii) The study also found positive relationship between accounts payable period and
firms‘ profitability. It indicates that whenever firms wait longer to pay their account
payables, it increases profitability. The study also found that cash conversion cycle
has a negative relationship with firms‘ profitability. This means that Investment in
working capital could be optimized and cash flows could be improved by reducing
the time frame of the physical flow from receipt of raw material to shipment of
finished goods, i.e. inventory management, and by improving the terms on which firm
sells goods as well as receipt of cash.
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Finally, management of construction firms made under study can create value for the
shareholders as well to make the firms performance well by reducing: the net time interval
between actual cash expenditures on a firm‘s purchase of productive resources and the ultimate
recovery of cash receipts from product sales.
This study also recommends that another study should be done to augment the findings in this
study; it therefore recommends a study be done on the impact of working capital management on
construction firm‘s profitability in Ethiopia by incorporating other factors.
62
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