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THE EFFECT OF WORKING CAPITAL MANAGEMENT ON THE
COMPANYS PERFORMANCES A SELECTION OF VARIOUS
MANUFACTURING COMPANIES IN NAIROBI
BY
CATHERINE CHEBET BIRIR
BBM/2757/10
THE RESEACH PROJECT IS APARTIAL FULLFILLMENT OF A
REQUIREMENT FOR THE AWARD OF BACHEROR IN BUSINESS
MANAGEMENT DEGREE, SCHOOL OF BUSINESS AND
ECONOMICS, MOI UNIVERSITY.
OCTOBER 2010
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DECLARATION
DECLARATION BY THE CANDIDATE
This research project is my original and has not been presented for degree in any other
university or institution. No part of this project may be reproduced without prior
permission of the author and or Moi University.
Signature; Date;
Name; Catherine Chebet Birir
Reg No.BBM/2757/10
DECLARATION BY SUPERVISIOR
This research project has been submitted for examination with our approval as university
SUPERVISIOR
Signature; Date;
Name; George NChembere
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MOI UNIVERSITY, NAIROBI KENYA
ACKNOWLEDGEMENT
I wish to express my heartfelt appreciation to all those who contributed either directly or
indirectly to the success of my research
I wish to thank my mother Monica Birir, brothers Kevin, Ruben and my sweet sister
Irene for giving me encouragement to go on.
Special thanks go to my beloved husband Augustine for moral and financial support
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DEDICATION
This research is dedicated to my husband Augustine and my sons Ethan and Jayden for
their patient, understanding and support.
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ABSTRACT
The overall objective of the study was to examine the effect of working capital
management on the company performances but with specific references on Nairobi.
Manufacturing have been faced with many problems.
The study population was to assess effect of investment in cash on companys
performances, the effect of holding stock on the companys performances, the effect of
giving credit on the companys performances, the effect of having creditors and the
effect of delaying payment of creditors on the performances of the firm.
The study population was 20 manufacturing companies in Nairobi. A sample of 200
manufacturing companies was picked The respondents were managers finance and
treasures. Closed and open ended questionnaires were administered to 20 targeted
respondent using a drop and pick method. Finance data was targeted was analyses at
Nairobi central A and B district office. The data was analyses using descriptive statistics
with the help of SPSS and excess worksheet and presented in the table and figures.
The findings of the study are that working capital management is an important part in
firm financial management decision. An optimal working capital management is
expected to contribute positively to the creation of firm value. To reach optimal working
capital management firm manager should control the trade off between profitability and
liquidity accurately. The purpose of this study is to investigate the relationship between
working capital management and firm profitability. Cash conversion cycle is used as
measure of working capital management.
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It is recommended that that reducing cash conversion period results to profitability
increase. Thus, in purpose to create shareholder value, firm manager should concern on
shorten of cash conversion cycle till accomplish optimal level.
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TABLE OF CONTENT
DECLARATION ................................................................................................... ii
ACKNOWLEDGEMENT ...................................................................................... iii
DEDICATION .................................................................................................... iv
ABSTRACT ........................................................................................................ v
TABLE OF CONTENT ........................................................................................ vii
CHAPTER ONE .................................................................................................. 1
INTRODUCTION ............................................................................................. 1
Background ................................................................................................ 1
Overview of the context scope ................................................................... 3
Statement of the problem .......................................................................... 3
Objectives of the study .............................................................................. 4
Hypotheses Testing .................................................................................... 5
Scope of the study ..................................................................................... 6
Significance of the Study ........................................................................... 6
CHAPTER TWO .................................................................................................. 7
LITERATURE REVIEW ..................................................................................... 7
Introduction ............................................................................................... 7
The concept of working capital management .......................................... 10
Conceptual framework ............................................................................. 10
CHAPTER THREE ............................................................................................. 12
METHODOLOGY ........................................................................................... 12
Introduction .............................................................................................. 12
Research design ....................................................................................... 12
Sampling design ...................................................................................... 13
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Descriptive Analysis ................................................................................ 13
Quantitative Analysis ............................................................................... 13
Data collection process ............................................................................ 14
Data analysis and presentation ................................................................ 14
Limitation of study ................................................................................... 15
REFERENCES ........................................................................................... 16
APENDICES ............................................................................................... 18
Appendix 1; Time plan ............................................................................. 18
Appendix 2; Proposal research budget .................................................... 19
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CHAPTER ONE
INTRODUCTION
BackgroundWorking capital management is a very important component of corporate finance
because it directly affects the liquidity and profitability of the company. It deals with
current assets and current liabilities. Working capital management is important due to
many reasons. For one thing, the current assets of a typical manufacturing firm accounts
for over half of its total assets. Excessive levels of current assets can easily result in a
companys realizing a substandard return on investment. However companys with too
few current assets may incur 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). Many surveys have indicated that managers spend
considerable time on day-to-day problems that involve working capital decisions. One
reason for this is that current assets are short-lived investments that are continually being
converted into other asset types (Rao 1989). With regard to current liabilities, the firm is
responsible for paying these obligations on a timely basis. Liquidity for the ongoing firm
is not reliant on the liquidation value of its assets, but rather on the operating cash flows
generated by those assets (Soenen, 1993). Taken together, decisions on the level of
different working capital components become frequent, repetitive, and time consuming.
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Working Capital Management is a very sensitive area in the field of financial
management (Joshi, 1994). It involves the decision of the amount and composition of
current assets and the financing of these assets. Current assets include all those assets that
in the normal course of business return to the form of cash within a short period of time,
ordinarily within a year and such temporary investment as may be readily converted into
cash upon need. The Working Capital Management of a firm in part affects its
profitability. The ultimate objective of any firm is to maximize the profit. But, preserving
liquidity of the firm is an important objective too. The problem is that increasing profits
at the cost of liquidity can bring serious problems to the firm. Therefore, there must be a
trade off between these two objectives of the companys. One objective should not be at
cost of the other because both have their importance. If we do not care about profit, we
cannot survive for a longer period. On the other hand, if we do not care about liquidity,
we may face the problem of insolvency or bankruptcy. For these reasons working capital
management should be given proper consideration and will ultimately affect the
profitability of the firm.
Companys may have an optimal level of working capital that maximizes their value.
Large inventory and a generous trade credit policy may lead to high sales. Larger
inventory reduces the risk of a stock-out. Trade credit may stimulate sales because it
allows customers to assess product quality before paying (Long, Maltiz and Ravid, 1993,
and Deloof and Jegers, 1996). Another component of working capital is accounts
payable. Delaying payments to suppliers allows a firm to assess the quality of bought
products, and can be an inexpensive and flexible source of financing for the firm. On the
other hand, late payment of invoices can be very costly if the firm is offered a discount
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for early payment. A popular measure of Working Capital Management (WCM) is the
cash conversion cycle, i.e. the time lag between the expenditure for the purchases of raw
materials and the collection of sales of finished goods. The longer this time lag, the larger
the investment in working capital (Deloof 2003). A longer cash conversion cycle might
increase profitability because it leads to higher sales. However, corporate profitability
might also decrease with the cash conversion cycle, if the costs of higher investment in
working capital rise faster than the benefits of holding more inventories and/or granting
more trade credit to customers. This discussion of the importance of working capital
management, its different components and its effects on profitability leads us to the
problem statement which we will be analyzing.
Overview of the context scope
The city of Nairobi is located in the southern region of Kenya on the banks of Nairobi
River. Besides having the largest population in Africa, Nairobi claims to be the fourth
largest city in the continent. Some of the major cities of Kenya that are located nearby
Nairobi include Kileleshwa, Chiromo, and Kilimani Estate in the west and Pangani in the
north.
Statement of the problem
Does Working Capital Management Affect Profitability of manufacturing Companys? To
analyze this problem statement, we have developed objectives of our research, which will
hopefully contribute towards a very important aspect of financial management known as
working capital management. This research is focusing on working capital management
and its effects on profitability for a sample of manufacturing companys.
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Objectives of the study
The main objectives are:
To establish a relationship between Working Capital Management and
Profitability.
To find out the effects of different components of working capital management on
profitability of manufacturing companies.
To establish a relationship between the two objectives of liquidity and
profitability of the manufacturing companies.
To find out the relationship between profitability and size of the manufacturing
companies.
To find out the relationship between debt used by the Manufacturing companies
and its profitability
To analyze the Operating profit margin of manufacturing industry.
To analyze the Working Capital of manufacturing industry.
To investigate the impact of Working Capital Management on profitability of
manufacturing Companies.
To draw conclusion about relationship of working capital management and
profitability of the Manufacturing companies.
To achieve these objectives, this study is organized as follows:
Section two reviews the literature for the relevant theoretical and empirical work on
working capital management and its effect on profitability. Section three presents the
methodology and framework used in the empirical analysis.
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Hypotheses Testing
Since the objective of this study is to examine the relationship between profitability and
working capital management, the study makes a set of testable hypothesis {the Null
Hypotheses H0 versus the Alternative ones HA}.
Hypothesis 1
The first hypothesis of this study is as follows:
H01: There is no relationship between efficient working capital management and
profitability of manufacturing companies.
HA1: There is a possible positive relationship between efficient working capital
management and profitability of manufacturing companies. Companies more efficient in
managing their working capital is expected to pose high level of profitability and vice
versa.
Hypothesis 2
The second hypothesis of the study is as follow:
H02: There is no relationship between liquidity and profitability of manufacturing
companies.
HA2: There may exist a negative relationship between liquidity of Manufacturing
companies and profitability. Companys with high level of liquidity are expected to post
low level of profitability and vice versa.
Hypothesis 3
The Third hypothesis of the study is as follow:
H03: There is no relationship between size of manufacturing companies and profitability.
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HA3: There may exists a positive relationship between the company size and its
profitability. This may be due to the ability of large companies to reduce liquidity levels
and cash gaps.
Hypothesis 4
The Fourth hypothesis of the study is as follow:
H04: There is no relationship between debt used by manufacturing companies and
profitability.
HA4: There is a possible negative relationship between debt used by manufacturing
company and profitability. Companies with high level of debt usage are expected to post
low level of profitability and vice versa.
Scope of the study
The study assessed the working capital management within the selected manufacturing
companies in Nairobi focusing on small, Middle level and giant manufacturing
companies whose turnover do not exceed Kshs 2 billion.
Significance of the Study
The results of this study shall be useful to managers in manufacturing companies in
Kenya. Information from this study shall inform companies on the importance of working
capital management. The results shall inform shareholders on the current practice of
working capital management, on the underlying risks that currently exist and ways these
risks would be mitigated. The results of the study will also be useful to members who are
interested to know how safe there investment are in term of working capital management,
what practices would be they proposed to e adopted by the managers to ensure financial
viability of these institution.
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CHAPTER TWO
LITERATURE REVIEW
Introduction
This chapter covers the review of related literature in regards to working capital
management concept, perception and practices in financial institution. It also portray the
conception framework that attempts to show the assets liquidity management liability
measure of liquidity information system.
In intention to discover the relationship between efficient working capital management
and companys profitability(Shin & Soenen, 1998) used net-trade cycle (NTC) as a
measure of working capital management. NTC is basically equal to the CCC whereby all
three components are expressed as a percentage of sales. The reason by using NTC
because it can be an easy device to estimate for additional financing needs with regard to
working capital expressed as a function of the projected sales growth. This relationship is
examined using correlation and regression analysis, by industry and working capital
intensity, in all cases; they found, a strong negative relation between the length of the
companys net-trade cycle and its profitability. In addition, shorter NTC are associated
with higher risk-adjusted stock returns. In other word, (Shin & Soenen, 1998) suggest
that one possible way the firm to create shareholder value is by reducing companys
NTC.
The study of (Shin & Soenen, 1998) consistent with later study on the same objective that
done by (Deloof, 2003) by using sample of 1009 large Belgian non-financial companys
for the period of 1992-1996. However, (Deloof, 2003) used trade credit policy and
inventory policy are measured by number of days accounts receivable, accounts payable
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and inventories, and the cash conversion cycle as a comprehensive measure of working
capital management. He founds a significant negative relation between gross operating
income and the number of days accounts receivable, inventories and accounts payable.
Thus, he suggests that managers can create value for their shareholders by reducing the
number of days accounts receivable and inventories to a reasonable minimum. He also
suggests that less profitable companys wait longer to pay their bills.
In other study, (Lyroudi & Lazaridis, 2000) use food industry Greek to examined the cash
conversion cycle (CCC) as a liquidity indicator of the companys and tries to determine its
relationship with the current and the quick ratios, with its component variables, and
investigates the implications of the CCC in terms of profitability, indebtness and firm
size. The results of their study indicate that there is a significant positive relationship
between the cash conversion cycle and the traditional liquidity measures of current and
quick ratios. The cash conversion cycle also positively related to the return on assets and
the net profit margin but had no linear relationship with the leverage ratios. Conversely,
the current and quick ratios had negative relationship with the debt to equity ratio, and a
positive one with the times interest earned ratio. Finally, there is no difference between
the liquidity ratios of large and small companys
The management of working capital is important to the financial health of
businesses of all sizes. The amounts invested in working capital are often high in
proportion to the total assets employed and so it is vital that these amounts are used in an
efficient and effective way. (Padachi, 2006)
Working capital starvation is generally credited as a major cause if not the major
cause of small business failure in many developed and developing countries (Rafuse,
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1996). The success of a firm depends ultimately, on its ability to generate cash receipts in
excess of disbursements. The cash flow problems of many small businesses are
exacerbated by poor financial management and in particular the lack of planning cash
requirements (Jarvis, 1996).
The management of working capital is important to the financial health of
businesses of all sizes. The amounts invested in working capital are often high in
proportion to the total assets employed and so it is vital that these amounts are used in an
efficient and effective way. (Padachi, 2006). Working capital starvation is generally
credited as a major cause if not the major cause of small business failure in many
developed and developing countries (Rafuse, 1996). The success of a firm depends
ultimately, on its ability to generate cash receipts in excess of disbursements. The cash
flow problems of many small businesses are exacerbated by poor financial management
and in particular the lack of planning cash requirements (Jarvis, 1996).
Despite the fact that business performance is relying on efficient working capital
practices, this area has been neglected for research for a long time period. Even in the
developed countries like
Although abundant research and theoretical development has been done in the
area of investment and long-term finance but this gray area of short-term finance, in
particular working capital management has been neglected for a very long time. Such
neglect might have been acceptable, if working capital had a relatively little importance
to the firm, but effective working capital management has a crucial role to play in
enhancing the profitability and growth of the firm. Indeed, experience shows that
inadequate planning and control of working capital is one of the more common causes of
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business failure. (Pass and Pike 1984).
This knowledge gap has led the researcher to find out that how management of working
capital management in general and cash management in particular is being addressed in
Nairobi kenya.
The concept of working capital management
The principal activities of manufacturing companies are production and sales and
distribution of products. Basically manufacturing companies will be interested in
maintaining a good working capital management to ensure that manufacturing flow
smoothly therefore financial performance of manufacturing companies will be concerned
with the rate of current assets/ current liabilities.
Conceptual framework
All the variables stated below have been used to test the hypotheses of our study. They
include dependent and independent variables:
Net Operating Profitability (NOP) which is a measure of Profitability of the firm is used
as dependant variable. It is defined as Operating Income plus depreciation, and divided
by total assets minus financial assets.
Average Collection Period (ACP) used as proxy for the Collection Policy is an
independent variable. It is calculated by dividing account receivable by sales and
multiplying the result by 365 (number of days in a year).
Inventory turnover in days (ITID) used as proxy for the Inventory Policy is also an
independent variable. It is calculated by dividing inventory by cost of goods sold and
multiplying with 365 days.
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Average Payment Period (APP) used as proxy for the Payment Policy is also an
independent variable. It is calculated by dividing accounts payable by purchases and
multiplying the result by 365.
The Cash Conversion Cycle (CCC) used as a comprehensive measure of working capital
management is another independent variable, and is measured by adding Average
Collection Period with Inventory Turnover in Days and deducting Average Payment
Period.
Current Ratio (CR) which is a traditional measure of liquidity is calculated by dividing
current assets by current liabilities.
INDEPENDENT VARIABLE DEPENDENT V
Net profitability
Avarage collection period
Inventory Turnover in days Influence
Avarage payment period
Cash Conversion Cycle
Financial Perf
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CHAPTER THREE
METHODOLOGY
Introduction
This chapter covers the research design, target population, sample size, data collection
method, data analysis and presentation. This was achieved by developing a similar
empirical framework first used by Shin and Soenen (1998) and the subsequent work of
Deloof (2003).
Research design
The most difficult issue faced by the authors was to decide about the sample and the
methodology. Although manufacturing companies are dispersed in the main cities of
Kenya, it was decided to take the data from industrial area cities. Hence, results can be
generalized. Personal interviews and telephone surveys were deemed infeasible due to
high cost and geographical dispersion of the firms. It was decided to use the tool
previously used by Ricci and Vito in 2000 in their paper to identify working capital
management practices in Nairobi. While this method allows for easier analysis of the data
due to standardized questions, its limitation is that it allows the researcher to determine
only what the respondents are doing, not how or why they are doing it. Again the
researchers have tried to overcome this limitation by adding few open ended questions in
order to get the picture closer to the reality.
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Sampling design
In this research we have provided two types of data analysis; descriptive and
quantitative.
Descriptive Analysis
Descriptive analysis is the first step in our analysis; it will help us describe relevant
aspects of phenomena of cash conversion cycle and provide detailed information about
each relevant variable. Research has already been conducted in our area of study anda lot
of information is already on hand, and SPSS software has been used for analysis of the
different variables in this study.
Quantitative Analysis
In quantitative analysis we applied two methods: First: we used correlation models,
specifically Pearson correlation to measure the degree of association between different
variables under consideration. Second: we used Regression analysis to estimate the causal
relationships between profitability variable, liquidity and other chosen variables. We have
used Pooled Ordinary Least Squares and Generalized Least Squares (cross section
weights) methods for analysis. We used panel data in a pooled regression, where time-
series and cross-sectional observations were combined and estimated. In other words,
several cross-sectional units were observed over a period of time in a panel data setting.
For this purpose of analysis the E - views software was used to analyze financial data and
especially in case of pooled data.
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Data collection process
The data used in this study was acquired from internet and web sites of different
companies. The period covered by the study extends to six years starting from 2003 to
2009. The reason for restricting to this period was that the latest data for investigation
was available for this period. The sample is based on financial statements of the 20
manufacturing companies, including firms from different sectors of our economy.
Because of the specific nature of their activities, companies in financial sector, banking
and finance, insurance, leasing, business services, renting and other services are excluded
from the sample. Finally, the firm with data of the number of days accounts receivable,
number of days inventories, number of days accounts payable and operating income are
included in sample.
Data analysis and presentation
The first part of data analysis, profile of the respondents and results of open ended
questions is being discussed. A total of 10 responses were received comprising 83%
response rate. These responses represent four broad industries mainly service sector
(covering banks and financial institutes, petroleum gas, telecommunication and service
providers). When analyzed the total respondent pool about the working capital decision
making, it was revealed that 65.8 % of the respondents confirmed it at the corporate level.
This result is closer to the Ricci and Vito study who had reported it as 57.3%. The
regional level value was 32.1% and only 1.6% of the respondents were taking decisions
at local level. Overall, it may be concluded that most of the companies tend to make it at
corporate level which shows the centralized approach for making working capital
decisions. Response rate was 76.3% when inquired about the firms percentage of
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overseas sales, it was discovered that 71% of the respondents replied it between 1-50%.
However 29% of the respondents answered that it was between 51-100%.
About relationship with foreign banks, the results of the survey indicate that almost
68.7% of the firms have relationship with 1-20 foreign banks. This result is quite parallel
with Ricci and Vito study which show that 74.1% of the firms have relationship with 1-
25 foreign banks. Response rate for this question was 77.3%. 71% of the respondents
claimed that overseas demand deposit account were between 1-20. More surprisingly it
was revealed that 3.2% firms confirmed between the numbers 10,000-50,000.
Limitation of study
Like any other study, this survey is not without limitations. First, the scale used was just
taken as teacher made instrument and was not without loop wholes. For example, some
of the questions were answered by the respondents based on their own understanding.
Second, some concepts specially related to foreign exchange activities are relatively
novel and the respondents had not enough knowledge about it.
Third, response rate was somewhat low for open ended questions which might reflect in
generalizing the results. Last, but not least there is a lack of fundamental research in the
area of working capital so enough literature was not available which could provide a
strong foundation for proper research design
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REFERENCES
Deloof, M and Jegers, M. 1996. Trade credit, product Quality, and Intra Group Trade:
Some European Evidence,Financial Management, Vol 25 No 3 pp. 33-43
Eljelly, A. 2004. Liquidity-Profitability Tradeoff: An empirical Investigation in an
Emerging Market,International Journal of Commerce & Management, Vol 14
No 2 pp.48 - 61
Joshi, P. V. 1995. Working Capital Management under Inflation, 1st Ed. Anmol
Publishers, pp. 20 - 93Long, Michael. S, Malitz. Lleen. B, and Ravid, S.Abraham, (1993) Trade Credit,Quality Guarantees, and Product Marketability
Financial Management,pp. 117 127
Rao, R. K. S. 1989. Fundamentals of Financial Management, 3rd Ed. Macmillan
publishers, pp 550-644
Ricci, C. and Vito, N. D. 2000. International Working Capital Practices in the UK,European Financial Management, Vol 6 No 1 pp. 69-84
Richard, V. D. and Laughlin, E. J. 1980. A Cash Conversion Cycle ApproachtoLiquidity Analysis,Financial Management, Vol 9 No 1 pp. 32-38
Shin, H.H and Soenen, L. 1998. Efficiency of Working Capital Management andCorporate Profitability,Financial Practice and Education, Vol 8 No 2, pp 37-4
45 Smith, M. Beaumont, Begemann, E. 1997 Measuring Association
Soenen, L. A. 1993. Cash conversion cycle and corporate profitability,Journal of
Cash Management, Vol 13 No 4 pp. 53-58
Eljelly, A. 2004. Liquidity-Profitability Tradeoff: An empirical Investigation in anEmerging Market, International Journal of Commerce & Management, Vol 14
No 2 pp.48 61
Long, Michael. S, Malitz. Lleen. B, and Ravid, S. Abraham, (1993) Trade Credit,
Quality Guarantees, and Product Marketability Financial Management, pp. 117 -
127
Rao, R. K. S. 1989. Fundamentals of Financial Management, 3rd Ed. Macmillan
publishers, pp 550-644
Ricci, C. and Vito, N. D. 2000. International Working Capital Practices in the UK,
European Financial Management, Vol 6 No 1 pp. 69-84
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Shin, H.H and Soenen, L. 1998. Efficiency of Working Capital Management and
Corporate Profitability, Financial Practice and Education, Vol 8 No 2, pp 37-45
Smith, M. Beaumont, Begemann, E. 1997 Measuring Association between Working
Capital and Return on Investment, South African Journal of Business
Management, Vol 28 No 1
Soenen, L. A. 1993. Cash conversion cycle and corporate profitability, Journal of
Cash Management, Vol 13 No 4 pp. 53-58
Van Horne, J. C. & Wachowicz, J. M. 2000. Fundamentals of Financial Management,
11th Ed. Prentice Hall Inc
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APENDICES
Appendix 1; Time plan
Jan Feb Mar Aprl May Jun Jul Aug Sept Oct
Groundwork xx xx
Literature review xx xx xx xx xx
Defining Methods xx xx
Data collection xx xx xx
Progress Seminar 15th
Data Analysis xx xx xx
Write first draft xx xx xx xx xx xx xx
Write second draft xx xx xx
Write Final draft xx x
Thesis Due
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Appendix 2; Proposal research budget
N Description Unit Unit Cost Quantity
1 Per diem allow ances Month 750 82
2
Miscellaneous travel
expenses Trip 150 40
3 Insurance Month 265 85
4 Accommodation Month 3500 36 1
5 Security Month 2250 36
6 Communication Month 1250 36
7
Printing, stationery,
drafting, reproduction of
reports 2 Month 500 36
8
omputers an o ce
equipment4 Lump
9Local transport andvehicle running costs Month 750 144 1
10 Off ice running costs4 Month 1250 36
11 Workshops & seminars Unit 1000 12
12 Study Tours Unit 20000 3
Total Costs