The Effect of Management of Working Capital Policies on Firm's profitability:Evidence from Manufacturing Private Limited Companies in Tigray Region, Ethiopia

Abstract

Research studies on the effects of management of working capital policies on firms’ profitability in developing countries, especially in Ethiopia remained an ignored area of empirical research. Thus, this study examined the effect of working capital investment and financing policies on firms’ profitability by using audited financial statements of a sample of 11 manufacturing private limited companies in Tigray region, Ethiopia for the period of 2005 to 2009. The study used return on assets, return on equity and operating profit margin as dependent profitability variables. Accounts receivable period, inventory holding period and accounts payable period are used as independent working capital investment policy variables. Moreover, cash conversion cycle and current assets to total assets ratio are used as comprehensive measures of working capital investment policy. On the other hand, current liabilities to total assets ratio is used as measure of working capital financing policy. The two traditional measures, current ratio and quick ratio, are used as liquidity indicators. In addition, the study used firm size as measured by logarithm of sales, firm growth rate as measured by change in annual sales, financial leverage and annual GDP growth rate as control variables. Both correlation analysis and pooled panel data regression models of cross-sectional and time series data were used for analysis. The results show that longer accounts receivable and inventory holding periods are associated with lower profitability. There is also negative relationship between accounts payable period and profitability measures; however, except for operating profit margin this relationship is not statistically significant. The results also show that there exists significant negative relationship between cash conversion cycle and profitability measures of the sampled firms. No significant relationship between current assets to total assets ratio and profitability measures has been observed. On the other hand, findings show that a highly significant positive relationship between current liabilities to total assets ratio and profitability. Finally, negative relationships between liquidity and profitability measures have also been observed. Managers, therefore, can increase firms’ profitability by improving the efficiency of management of working capital investment and financing policies while, also keeping in view the trade-off between liquidity and profitability.