EFFECTS OF WORKING CAPITAL MANAGEMENT PRACTICES ON THE FINANCIAL PERFORMANCE OF TOURIST HOTELS IN MOMBASA COUNTY, KENYA

CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

Over the years, poor management of working capital has been one of the major reasons for business insolvency, bankruptcy and the ultimate failure. Working capital refers to the funds needed to pay for the daily operations of the business, which are the short-term drivers of an organisation (Harris, 2005). Gross working capital consists of cash, inventory, account receivables and account payables. Atrill (2006) defines net working capital as a net of the short-term assets and liabilities that continuously flow into and out of the business that are important for daily operations. Mukhopadhyay (2004) terms working capital as the life giving force of any business venture and states that for continued business operations then the current assets (bank, cash, marketable securities, payment of advance taxes, debtors and inventories) and current liabilities (short-term loans, creditors and advances) should be well managed. Performance revolves around an organization’s output in respect to its objectives and is expressed in terms of profitability and expected behavioral output. Financial performance is regarded the only worthy measure of organizational performance due to its value to the shareholders, management and the market (Fwaya, 2006). This is because it indicates an organization’s success and sustainability through its ability to operate above its costs.

Maintaining the working capital at an optimum is the main concern of working capital managers as a firm loses money in the form of interest on the blocked funds in case of holding excess working capital when there are inadequate opportunities. During periods of economic turbulence, the firms with reliable and efficient working capital management practices are able to survive (Reason, 2008). During periods of economic boom also, efficient management of working capital is important as it involves the management of both current assets and current liabilities (Emery, Finnerty & Stowe, 2004). According to Darun (2011), working capital management is not only important in cases of financial distress but can be managed in the most efficient way to increase a firm’s profitability and a competitive edge over the others.

The processes of managing working capital involve significant decisions on various aspects- investment of available cash, managing accounts receivable, maintaining an absolute level of inventories and the management of accounts payables (Darun, 2011). Gitman (2009) notes the main goal of working capital management as striving to reach and maintain an optimized balance between the various components of working capital, as the success of a business, according to Filbeck and Krueger (2005), depends heavily on the ability of financial executives to manage receivables, payables and inventory in the most efficient way.

A number of studies on working capital have been carried out around the world but mostly in the developed western countries, with very little on firms in the developing countries (Quayyum, 2012). These include firms operating in African countries, which face unique challenges in their operations given the high political instability, insufficient financing and little or slow technological advancement among others (World Economic Forum, 2011). Numerous theories have also been developed on working capital management including the Baumol cash management model (1952), Miller- Orr cash management model (1966) and the inventory management model. However, practitioners find these financial decision making techniques difficult to put into actual application due to their unrealistic assumptions including the ignorance of uncertainty in business operations and their complexity in explaining to decision makers (Trahan & Gitman, 1995).