Introduction
Background to the study
Every business aims to survive and thrive in the long term. However, the extent to which an organization attains long-term success is dependent on the management practices adopted. Management of the working capital enhances the efficiency with which an organization enhances its level of liquidity, the shareholders’ value, and the level of profitability. Afza and Nazir (2007a) define working capital management to include the effectiveness and efficiency with which an organization controls its current liabilities and current assets in its pursuit to maximize the returns on assets. Managing working capital also deals with minimizing the payment of liabilities. Afza and Nazir (2008a, p.25) define short-term capital as ‘the capital that organizations utilize in their day-to-day functions and it covers current assets and current liabilities. Effective operating capital management plays a fundamental role in enhancing the well-being of an organization about its liquidity. Furthermore, optimal working capital management enhances organizational growth by stimulating the growth of the shareholders’ value.
The proper management of working capital forms a critical aspect amongst organizations in all economic sectors. Afza and Nazir (2007b, p.2) argue that the ‘profitability liquidity trade-off is critical for if working capital management is not accorded the necessary attention, then most probably firms will run bankrupt’. On the other hand, working capital is an essential element in the success of an organization and is hence considered a critical aspect in an organization’s corporate governance efforts. Baltagi (2001) contends that working capital is essential in maintaining an organization’s stability about profitability, solvency, and liquidity. Subsequently, the significance of working capital in an organization’s long-term survival is irrefutable.
Firms in the retail industry greatly depend on working capital in their daily functions (Chiou & Cheng 2006). Consequently, working capital management is essential in promoting retail firms’ efforts to achieve the desired level of profitability coupled with avoiding solvency. One of the main challenges encountered in the management of capital relates to the maintenance of the optimum amount of working capital. Additionally, another major issue relates to determining the amount of money to invest in fixed assets or fixed liabilities (Blinder & Macinni 2001). The United Kingdom’s businesses have experienced a remarkable increment in the level of their working capital over the past few years. Currently, the UK businesses have a working capital, which is more than £64 billion.
Problem statement
Previous studies indicated that a positive correlation exists between an organization’s working capital and the level of its profitability. Furthermore, poor management of working capital increases the risk faced by a particular business and hence its value. Subsequently, managing working capital is critical in maintaining an organization’s level of profitability (Brigham & Ehrhardt 2004). The current business environment is characterized by numerous changes originating from the external business environment. The occurrence of the Euro Zone crisis had adverse effects on the operations of firms in the European region. Subsequently, business managers have prioritized three main aspects, which include capital management, liquidity management, and risk avoidance. Enhancing an organization’s profitability through effective capital management has gained prominence amongst retail firms. However, managing capital management is a challenging undertaking for most retail businesses. The changing economic environment underscores the significance of optimal handling of operating capital. A study conducted in the Department for Business Innovation & Skills in the UK shows that it has become difficult for SMEs to access credit from financial institutions since 2008 due to the financial crisis (Nazir & Afza 2009). In a bid to enhance their profitability, firms in the UK’s retail sector must adopt optimal strategies to manage their operating capital.
Research objectives
- To assess the operating capital management practices undertaken by retail companies and determine their effect on the functioning of the organizations
- To evaluate the operating capital cycle amongst firms in the UK retail sector
- To evaluate how to profit-making and operating capital management of retail organizations in the UK relate.
Research questions
- Which are the various types of working capital management practices undertaken by retail companies? What is their effect on the performance of UK retail firms?
- Which are the various working capital cycles amongst firms in the UK’s retail sector?
- What is the relationship between operating capital management and the profitability of retail organizations in the UK?
Literature review
Introduction
Operating capital is defined as the capital that an organization requires to take care of its short-term financial obligations. Gill, Biger, and Mathur (2010) argue that working capital is engaged in the operation of a business for one year. All organizations irrespective of their profit orientation should have enough working capital in a bid to attain operational efficiency.
Organizational managers are not only concerned with long-term investment decisions, but also short-term decisions. Previously, organizational managers paid greater emphasis on long-term financing and investment decisions as compared to short-term investment decisions, which are reflected in the working capital.
Subsequently, the significance of working capital in promoting an organization’s longer performance has not been evaluated by many organizations. According to Gitman (2001), management of working capital takes into account two main components, which include management of current liabilities and current assets. In the quest to improve its operational efficiency, an organization can increase the volume of inventory held such as raw materials. However, such a decision might increase the risk faced by the organization. Subsequently, the significance of adopting optimal working capital management practices cannot be underestimated. Managing working capital is considered a trade-off between an organization’s level of liquidity and profitability. An organization’s management team must take into account several aspects, which include marketable securities, inventory management, and account receivables and cash in managing working capital.
Diverse research has been conducted to understand the relationship between the level of profitability and working capital. Ghosh and Maji (2003) argue that extensive studies have been conducted on the significance of working capital in both private and public organizations. A study conducted to measure the effectuality of operating capital in enhancing the performance of British American Tobacco in Bangladesh shows that working capital management has led to significant improvement in the organization’s level of inflows (Garcia-Teruel & Martinez-Solano 2007). Furthermore, the study revealed that the management of working capital enables organizations to sustain an all-around operational efficiency. A study conducted to evaluate the relationship between the level of profitability and operating capital management practices adopted by organizations listed in the Athens Stock Exchange market points to a positive and strong correlation between the level of profitability and an organization’s cash conversion cycle (Lazaridis & Tryfonidis 2006). Another study conducted on several Belgian firms shows that organizational managers have the capability of improving their firm’s profitability by reducing the cash conversion cycle.
Significance of managing working capital
Falope and Ajilore (2009) assert that managing capital is fundamental in organizations’ efforts to promote their financial strength irrespective of their size. Afza and Nazir (2008b) further argue that the amount of finances invested by organizations in their working capital is higher as compared to the total employed assets. Therefore, it is critical for an organization’s management team to ensure that it adopts effective working capital management practices. Furthermore, operating capital has a direct impact on the level of liquidity and profitability in an organization. Consequently, organizational managers should ensure a balance in their level of liquidity and profitability (Gill, Biger & Mathur 2010).
Managing working capital enables an organization to have a high level of flexibility. This aspect arises from the view that the organization is in a position to adjust to market changes, for example, fluctuation in market demand due to economic changes. Failure to integrate optimal strategies in managing working capital can lead to bankruptcy (Filbeck & Krueger 2005).
Furthermore, effective management of working capital improves a firms’ operational efficiency by ensuring that a firm has the adequate capital required to sustain the firm’s daily operations.
Components of operating capital
Eljelly (2004) asserts that operating capital is comprised of two main components, which include net and gross working capital. Deloof (2003, p.307) defines gross working capital to include ‘all the current assets in the business’. On the other hand, net operating capital is obtained by calculating the difference between the current liabilities and the current assets. The current assets include marketable securities, cash receivables, and inventory, which are considered the largest components of an organization’s working capital. Czyzewski and Hicks (2002) further assert that the components of working capital vary about their liquidity, which refers to the ease with which an asset can be used to meet the current obligations. Some of the assets are more liquid as compared to other assets. Cash is ranked as part of the highly liquid components of operating capital.
An organization’s current liabilities are considered short-term liabilities. Some of the components of current liabilities include accruing bank overdrafts and bills payables (Mukhopadhyay 2004). The ideal situation refers to a situation whereby the current assets exceed the current liabilities, which results in positive working capital. Howorth and Westhead (2003) assert that the nature of working capital [positive or negative] has an impact on an organization’s level of profitability. A high positive working capital hinders an organization’s ability to achieve its profitability objective. However, positive working capital increases an organization’s level of liquidity. Conversely, negative working capital has adverse effects on a firm’s level of liquidity (Harris 2005).
The extent to which a firm invests in various current assets is subject to several factors, which include the nature of its products and the type of business that the firm undertakes. Firms in the retail sector invest a substantial amount of their finances in current assets, for example, inventory as opposed to long-term assets (Lazaridis & Tryfonidis 2006). On the other hand, manufacturing companies invest a substantial amount of their capital on long-term assets, for example, equipment and land. Additionally, the amount of working capital is determined by an organization’s operating cycle. Rahman and Nasr (2007, p.32) assert that the ‘long the operating cycle the more is invested in the current assets’.
Working capital cycle
This term refers to the duration taken for the capital invested to be transformed into cash. Working capital is also known as the operating cycle, which is determined by summing the inventory days with the receivable days and subtracting the payable days. The working capital cycle varies from one organization to another. For example, the working capital cycle for manufacturing firms commences when the organization receives the raw materials to when the final product is sold to the target consumer. The operating capital cycle enables an organization’s management team to determine the amount of working capital that it requires to operate efficiently. Padachi (2006) argues that it is important for a firm’s management team to maintain a short operating capital cycle to improve the effectiveness of their operating capital.
Cash conversion cycle
In the course of their operation, retail companies require various types of raw materials. Subsequently, they have to source the raw materials from suppliers. Most organizations purchase the raw materials on credit, which they are required to pay within a given duration. The duration between the purchase and the payment date is referred to as the creditors’ payment period. Additionally, some customers purchase on credit and are required to pay on a certain predetermined date. This duration is referred to as the debtors’ payment period. Wilner (2000) defines the cash conversion cycle to include the period between the debtors and the creditors’ payment periods. The cash conversion cycle entails the duration taken to convert the invested cash into actual cash.
Wang (2002) asserts that the cash conversion cycle is influenced by three main factors, which include the debtors’ collection period, the stock conversion period, and the creditors’ payment period. The stock conversion period refers to the duration needed to convert the raw materials into the final products. The cash conversion cycle is determined by adding the debtors’ collection period to the stock conversion period and subtracting the creditors’ payment period (Tapping, Luyster, & Shuker 2002).
Determining the cash conversion cycle is critical in improving the profitability of an organization. Optimal management of the cash conversion cycle is paramount in increasing an organization’s working capital.
Working capital policy
Mathuva (2009) defines working capital policy as the policy formulated by organizations about the amount of money to be put in the various components of current assets coupled with how the selected current assets will be financed. Therefore, an organization’s management team must formulate a policy on the level of inventory to be held, the number of account receivables to be allowed, and the amount of cash that they should hold (Vishnani & Bhupesh 2007). Furthermore, the policy should also stipulate how the aforementioned components should be financed; that is, using long-term funds or short-term funds. Slack, Chambers, and Johnston (2010) contend that working capital policy is critical in sustaining the profitability of an organization. Failure to implement an effective working capital policy may affect the creditworthiness of an organization adversely.
Approaches to working capital policies
Diverse approaches are integrated into the process of formulating working capital policies and they include the aggressive, conservative, and moderate approaches. In a moderate approach, a firm uses its short-term and long-term funds in financing its assets (Uyar 2009). A moderate approach is used in establishing a firm’s effort to establish stability about its risks and returns. On the other hand, the aggressive approach mainly relies on short-term funds as opposed to long-term funds in financing an organization’s current assets. Afza and Nazir (2008a), argue that “a firm may adopt an aggressive working capital management policy with a low level of current assets as a percentage of total assets” (p.25). The risks related to using short-term funds are relatively higher as compared to long-term funds. However, adopting an aggressive approach in managing working capital increases the profitability potential of an organization due to the risk involved (Van Horne & Wachowicz 2000). Afza and Nazir (2008a) further assert that aggressive working capital requires a firm’s management teams to integrate an effective bookkeeping strategy to ensure that the diverse working capital components are effectively recorded.
Factors that determine the level of working capital required
Organizations should not have excessive working capital. Subsequently, firms’ management teams should adopt effective working capital management strategies (Shin & Soenen 2007). The size of working capital in a given firm is dependent on several factors, which include
- Business cycle
- Nature of business
- Production policy
- The growth and expansion of the business
- Credit policy
- Operating efficiency
Samiloglu and Demirgunes (2008) assert that the amount of money invested in working capital varies depending on the nature of the business operation. For example, firms in the manufacturing sector invest a substantial amount of money in both working and fixed capital. On the other hand, firms in the financial sector such as banks invest more in working capital as compared to fixed capital. Other firms such as retail firms should invest a substantial amount of money in current assets such as inventory.
In addition to the above, some businesses are affected by seasonality. During high seasons, the firms invest highly in working capital to enhance their production capacity. However, the production capacity is reduced during low seasons, hence the need to maintain a low working capital (Shah & Sana 2006).
Adequacy of working capital
Organizational managers must keep a reasonable level of operating capital. Some of the benefits that an organization can derive from the maintenance of the adequate level of working capital include attainment of an optimal credit standing and safeguarding the firm against a decline in the level of current assets. Furthermore, maintaining an adequate level of working capital improves the effectiveness and efficiency with which an organization meets its customers’ needs.
On the other hand, inadequate capital limits an organization’s ability to pay dividends to its shareholders. Additionally, inadequate working capital reduces an organization’s level of liquidity and hence the level of liquidity. Excessive working capital also leads to an imbalance between an organization’s level of profitability and liquidity.
Methodology
Research design
Adopting an effective methodology in conducting a particular study is critical in improving the findings of the study. The researcher appreciates the importance of adopting an effective research design. Cohen, Manion, and Morrison (2003) assert that the research design illustrates the structure of the entire research process. Furthermore, it depicts how the various components of the research study are interrelated in a bid to answer the predetermined study questions. The research design is comprised of several components, which include the data collection method and instrumentation, sampling method, the research technique, and the data analysis method. Adopting an effective research design improves the relevance of a research study. Furthermore, research design makes the findings of a particular research study more appropriate and logical. Cohen, Manion, and Morrison (2003) further argue that the research design contributes to the improvement in the degree of a research study.
In conducting this study, the researcher will adopt both qualitative and quantitative research designs. The qualitative research design will enable the researcher to collect a substantial amount of data from the field. Furthermore, the decision to adopt a qualitative research design is informed by the explanatory nature of the study. Demming (2002) asserts that qualitative research design allows one to gather a wide range of data. The study will also incorporate a quantitative research design. The decision to adopt a quantitative research design arises from the need to ensure that the target parties [retail businesses] understand the research findings.
Data collection and instrumentation
The study will take into account several aspects in the process of gathering data, which include the source, amount, and form of data coupled with its reliability and accuracy. Maxwell (2005) asserts that it is important for the researcher to consider the most effective and credible source of data. This study will entail conducting a survey in collecting the necessary data. Subsequently, a number of questionnaires will be developed. The questionnaires will be both open and close-ended. The open-ended questionnaires will be designed by formulating a number of questions, which the target respondents will answer according to their experience and knowledge. The decision to adopt open-ended questionnaires arose from the need to provide the respondents an opportunity to answer the questions freely by not limiting their answers. On the other hand, the study will also utilize close-ended questionnaires in order to get specific answers.
Before carrying out the study, the researcher will conduct a comprehensive review of the questionnaires in order to eliminate possible ambiguities in the questionnaires. Furthermore, the researcher will distribute the questionnaires one day prior to the scheduled date of the interview. This aspect will give the respondents an opportunity to be acquainted with the contents of the research questions.
The study will also adopt structured interviews in collecting the data. The interviews will be conducted over the telephone in order to minimize the cost of conducting the research (Sabri & Shaikh 2010). Before conducting the research, the researcher will conduct a reconnaissance in order to develop a strong resonance between the respondent and the interviewer. Additionally, an interview guide will be used in an effort to ensure that the interviews are conducted in an organized and consistent manner.
Sampling and sample size
In the process of conducting the study, the researcher will incorporate the concept of sampling. Longnecker (2008) defines a sample as a finite part of a statistical population, which is considered in conducting a study. Subsequently, the sample is considered representative of the target population. In conducting the study, the target population will be comprised of retail businesses operating in different sectors of the UK economy. Identifying the target population is important since it helps the research to collect the right data related to the study from the field. The target population will mainly be comprised of small and medium-sized enterprises. A number of retail outlets, which deal with diverse consumer products, will be targeted as the study population. The researcher will conduct a survey on the retail sector in the UK in order to understand the operations of the firms in the sector.
The researcher will adopt the sampling technique in selecting the study sample. Longnecker (2008) asserts that there is a direct relationship between the degree of errors in a research study and the sample size used. A small sample size diminishes the power of a particular study. On the other hand, a large sample size increases the degree to which the results of the study are statistically significant. Despite this aspect, selecting a large sample size would lead to an increment in the cost of conducting the study about time and finances. Therefore, it is vital to select an adequate sample size in a bid to improve the reliability of the study results. In conducting the study, a sample of 100 respondents will be used.
Data analysis
Longnecker (2008) defines data analysis as the process of evaluating data through various analytical tools to understand the various components. Alternatively, data analysis can be defined as the process of transforming data collected from the field into useful information, which can be utilized by the target audience (Longnecker 2008). Data analysis simplifies the findings of a particular research study by incorporating numerals such as averages, and percentages. Furthermore, data analysis enables the target audience to undertake further analysis on the issue under investigation by asking additional questions. The data analysis process is also undertaken by integrating graphs hence making it easy for the target audience to understand the research findings.
In conducting this study, the researcher will integrate both qualitative and quantitative data analysis techniques. Subsequently, the researcher will employ Microsoft Excel software. Furthermore, the researcher will ensure that the data is coded effectively. Subsequently, the data collected will be grouped into different classes, which will be assigned various codes. Using Microsoft Excel will enable the researcher to present the research data using tables and graphs. Subsequently, the researcher will be able to condense the data collected from the field. Therefore, it will be possible for the target audience to interpret the study findings.
Ethics, validity, and reliability
In an effort to ensure effectiveness in the process of conducting the study, a number of ethical considerations will be incorporated. The researcher will ensure that all the participants involved in the study are respected. This aspect will improve the relationship between the researcher and the respondents. Furthermore, the researcher will ensure that the study respondents are not exploited in any way, which means that the researcher will adhere to human dignity during the entire study.
In a bid to ensure that the data is collected effectively, the researcher will ensure obtain consent from the target respondents prior to the actual study. This goal will be achieved by making sure that all the study participants understand the purpose of the study and their role in it. Seeking informed consent will ensure that the respondents are not coerced into participating in the study. However, their decision to participate in the study will emanate from a conscious decision, which means that participation in the research will be voluntary. The researcher will give the respondents the freedom to withdraw from the study without any consequences. Furthermore, the researcher will assure the respondents of the confidentiality of their responses. The researcher will obtain permission from the necessary authorities prior to conducting the study.
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