RICHARD 6TH NOV - University of Nairobi

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THE RELATIONSHIP BETWEEN WORKING CAPITAL
MANAGEMENT POLICY AND FINANCIAL PERFORMANCE OF
COMPANIES QUOTED AT NAIROBI SECURITIES EXCHANGE
BY
RICHARD ODHIAMBO MINGORI
A RESEARCH PROJECT IN PARTIAL FULFILLMENT OF THE
REQUIREMENTS FOR THE AWARD OF THE DEGREE OF
MASTER OF BUSINESS ADMINISTRATION OF
UNIVERSITY OF NAIROBI
NOVEMBER, 2013
DECLARATION
This is my original work and has not been previously either published or presented for
the award of a degree in any other university.
Richard Odhiambo Mingori
Signed……………………Date………………………
REG NO D61/74183/2012
This research project has been submitted for examination with my approval as the
university supervisor.
Nixon Omoro Signed……………………………..Date………………………………..
Lecturer Department of Accounting & Finance
University of Nairobi
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ACKNOWLEDGEMENTS
I wish to express my sincerest gratitude to Almighty God for good health, stable mind
and strength throughout the study. I appreciate and value the special role of my
supervisor, Mr. Nixon Omoro whose wise counsel and availability for consultation was
key to the completion of this research project. The words of encouragement, support and
understanding of my dear wife and friends cannot go unrecognized. My parents who
instilled in me the virtue of diligence deserve a mention.
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DEDICATION
This research project is dedicated to my family for their tolerance, encouragement,
inspiration, understanding and prayers.
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ABSTRACT
Corporate financial managers identify working capital as being important to firm’s value.
Working capital management is defined as the ability of an organization to fund short
term assets and short term liabilities .The objectives of the study was to establish working
capital policies adopted by quoted companies at NSE and to establish the influence of
working capital management policy on financial performance. This study was premised
on three theories to explain the management of working capital. They include; the
quantity theory of money, the Keynesian theory of money, Baumol inventory model, the
modern quantity theory, the Miller and Orr’s cash management model, the treasury
approach to cash management and operating cycle theory. The research adopted
correlation research design to establish the relationship between working capital
management policies and firm’s performance for firms listed the NSE. To establish the
causal relationship multiple regressions was used as a tool of data analysis for the study
covering a period of five years from 2008 to 2012.Data was represented using tables.
The population of the study included all the firms listed at the NSE from which a sample
of sixteen Companies was selected. The study sought to establish the relationship
between the degree of working capital management policy and financial performance for
firms listed at the NSE. From the results it was concluded that working capital policy
affects performance of a company. The value of R-square was 0.194. This means that
19.4% of the changes in dependent variables could be explained by explanatory variables
while 80.6 % cannot be explained by explanatory variables hence error term. Conclusions
from this study could assist financial managers to make prudent decisions on working
capital management.
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TABLE OF CONTENTS
DECLARATION................................................................................................................. ii
ACKNOWLEDGEMENTS ............................................................................................... iii
DEDICATION ................................................................................................................... iv
ABSTRACT .........................................................................................................................v
TABLE OF CONTENTS ................................................................................................... vi
ACRONYMS AND ABBREVIATIONS ......................................................................... viii
CHAPTER ONE: INTRODUCTION ..............................................................................1
1.1 Background to the Study................................................................................................1
1.1.1 Concept of Working Capital Management ......................................................................... 3
1.1.2 Financial performance ........................................................................................................ 5
1.1.3 Companies Quoted at Nairobi Securities Exchange ........................................................... 6
1.2 Research Problem ..........................................................................................................6
1.3 Research Objectives .......................................................................................................8
1.4 Value of the Study .........................................................................................................9
CHAPTER TWO: LITERATURE REVIEW ..............................................................10
2.1 Introduction ..................................................................................................................10
2.2 Theories of Working Capital Management..................................................................10
2.3 Working Capital Management Policies .......................................................................12
2.4 Empirical Review.........................................................................................................14
2.5 Summary ......................................................................................................................20
CHAPTER THREE: RESEARCH METHODOLOGY ..............................................22
3.1 Introduction ..................................................................................................................22
3.2 Research Design...........................................................................................................22
3.3 Population of the study ................................................................................................22
3.4 Sample Design .............................................................................................................23
3.5 Data Collection ............................................................................................................23
3.6 Data analysis ................................................................................................................23
CHAPTER FOUR: DATA ANALYSIS, RESULTS AND DISCUSSIONS ...............26
4.1 Introduction ..................................................................................................................26
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4.2 Descriptive Statistics ....................................................................................................26
4.3 Correlations: .................................................................................................................28
4.4 Regression analysis ......................................................................................................30
CHAPTER FIVE: SUMMARY, CONCLUSIONS AND RECOMMENDATIONS .32
5.1 Introduction ..................................................................................................................32
5.2 Summary of Findings ..................................................................................................32
5.3 Conclusions of the study ..............................................................................................34
5.4 Limitations of the study ...............................................................................................36
5.5 Suggestions for Further Research ................................................................................36
REFERENCES .................................................................................................................37
APPENDIX 1 NSE LISTED COMPANIES ..................................................................41
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ACRONYMS AND ABBREVIATIONS
ANOVA
Analysis of Variances
EOQ
Economic Order Quantity
NSE
Nairobi stock exchange
ROA
Return on assets
ROE
Return on equity
SPSS
Statistical Package for Social Science
TA
Total Assets
TCA
Total Current Assets
TCL
Total Current Liabilities
CLTAR
Aggressive Financing Policy
CATAR
Aggressive Investment Policy
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CHAPTER ONE: INTRODUCTION
1.1 Background to the Study
Corporate financial managers identify working capital as being important to firm’s value.
Working capital management is defined as the ability of an organization to fund short
term assets and short term liabilities Harris (2005). Management of working capital needs
careful attention since it plays an important role in determination of firms’ financial
performance, liquidity and risk as well as firms value Smith (1980).Greater investment in
current assets leads to lower risk in settling short term obligations while leading to lower
profitability. Specifically working capital investment involves a tradeoff between
profitability and risk. Decisions that tend to increase profitability tend to increase risk and
conversely decisions that focus on risk reduction was tend to reduce potential
profitability.
Every business requires working capital for its survival. Working capital is a vital part of
business investment which is essential for continuous business operations. It is required
by a firm to maintain its liquidity, solvency and profitability (Mukhopadhyay, 2004). The
importance of managing working capital of a business efficiently cannot be denied
(Filbeck & Krueger, 2005). Working capital management explicitly impacts both the
profitability and level of desired liquidity of a business ( Raheman &Nasr, 2007). If a
firm was invest heavily in working capital that is more than it needs, then the profits
which can be generated by investing these resources in fixed or long term assets was
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diminished. Moreover the firm was have to endure the cost of storing inventory for
longer periods as well as the cost of handling excessive inventory ( Arnold, 2008).
On the other hand, if a firm was invest heavily on fixed assets to generate profits by
neglecting its short-term capital needs, then it is quite possible that it may have to face
bankruptcy because of insufficient funds. The profitability as well as adequate level of
liquidity is required to be maintained for the survival of a business. So if a firm was not
pay sufficient attention to its working capital management, then it is quite possible that
the firm would have to face bankruptcy (Kargar & Blumenthal, 1994). Shortage of
working capital is normally attributed as a major cause of failure of many small
businesses in various developing and developed countries (Rafuse, 1996). Effective
management of working capital decreases the need for lending funds to pay back the
short term debts of the firm.
There are different approaches for the management of working capital. Two basic
policies of working capital management are namely aggressive working capital
management policy and conservative working capital management policy. An aggressive
investment policy with high levels of fixed assets and low investment in current assets
may generate more profits for a firm. However it also accompanies a risk of insufficient
funds for daily operations and for payment of short term debts.
A conservative investment policy is opposite to it with less investment in fixed assets and
more in current assets. For financing of working capital aggressive policy implies that
current liabilities are maintained at a greater portion as compared to long term debts.
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High level of current liabilities requires more resources to be in liquid form to pay back
debts earlier. But current pay outs bear less rate of interest and hence can cause more
savings. In conservative working capital financing policy a greater portion of long term
debts is used in contrast to current liabilities.
Working capital management and profitability certainly have some relation with each
other. Much research work is available on this relationship though the same has not been
explored in Kenya. Working capital is very important part of business activities of any
firm. The rest of the study is based on an analysis of previous literature which provides
the theoretical background for the study, research methodology and sample size.
1.1.1 Concept of Working Capital Management
Firms face a number of important decisions in their operations and one of these important
decisions concerns the efficient management of liquidity. According to Gupta (2002)
working capital management provides the firm with information on the liquidity needed
to operate efficiently. Gitman (2000) describes working capital management as the
regulation, adjustment, and control of the balance of current assets and current liabilities
of a firm such that maturing obligations are met, and the fixed assets are properly
serviced. Pandey (2007) defines current assets as those assets which in the ordinary
activities of the firm was converted into cash within one year and current liabilities as
those liabilities which are intended, at their inception to be paid in the ordinary course of
business in a year.
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Deloof (2003) asserts that the management of working capital necessitates short term
decisions in working capital and financing of all aspects of both firm’s short term assets
and liabilities. He further contends that the main objective is to ascertain that the firm has
the ability to continue operating with sufficient cash flow for payment of both maturing
short term debt and impending operational expenses. Its thus involves multiple crucial
decisions which involves managing account payables and account receivables, preserving
a certain level of inventories and the investment of accessible cash.
A firm can either adopt an aggressive working capital management policy or a
conservative working capital management policy. According to Nazir and Afza (2008) an
aggressive Investment Policy is an approach that results in minimal level of investment in
current assets versus fixed assets. This has the expectation of higher profitability but
greater liquidity risk. As an alternative, a more conservative policy places a greater
proportion of capital in liquid assets, but at the sacrifice of some profitability. To measure
the degree of aggressiveness the current asset to total asset ratio is used, with a lower
ratio meaning a relatively more aggressive policy.
According to Pandey (2007) an aggressive financing policies utilize higher levels of
normally lower cost short-term debt and less long-term capital. Although lowering capital
costs, this increases the risk of a short-term liquidity problem. A more conservative
policy uses higher cost capital but postpones the principal repayment of debt, or avoids it
entirely by using equity. The total current liability to total asset ratio is used to measure
the degree of aggressive financing policy, with a high ratio being relatively more
aggressive.
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1.1.2 Financial performance
Financial performance is a subjective measure of how well a firm can use assets from its
primary mode of business and generate revenues. The term is also used as a general
measure of a firm’s overall financial health over a given period of time and can be used
to compare similar firms across the same industry or to compare industries or sectors in
aggression. Financial performance can be measured by the rate of return on investment.
The management of a firm working capital affects its performance. Ricci and Vito (2000)
argues that 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. Holding high levels of current
assets especially in form of marketable securities, account receivables and inventory may
render the firm incapable of paying its short term obligation when they fall due. Also
high levels of short liabilities increase chances of bankruptcy.
The performance of a firm can be measured in several ways. Brigham and Gapenski
(1999) argue that the measures of profitability can either be book value based or market
value based. They contend that accounting ratios such as Tobin’s Q, ROE and ROA can
be used to measure firm’s performance. Falope and Ajilore (2009), Biwott (2011), Kithii
(2008), Dan (2010) and Afza and Nasir (2007) used (ROA). Aquino (2010) used the
ratio of net income after taxes to stockholders' equity (ROE).
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1.1.3 Companies Quoted at Nairobi Securities Exchange
Nairobi securities Exchange is one of the most robust Capital markets in Africa NSE
started in the 1920's when the country was still a British colony. NSE has undergone
numerous transformations over the years to enhance its effectiveness and adapt to
changes in the Economic Environment, Investors interest and leverage on technology.
NSE has stringent rules and regulations on how accompany is to be enlisted on the stock
market. Quoted companies are divided into different sectors, namely Agricultural,
Commercial and services, Telecommunication and Technology, Automobile and
Accessories, Banking, Insurance, Investment, Manufacturing and Allied, construction
and Energy. Different companies Quoted at the NSE have adopted different working
capital management policies; this study aims to determine how these policies have
affected their financial performance.
1.2 Research Problem
Working capital management is one of the most important issues in organizations where
many financial managers are struggling to identify the basic working capital drivers and
the appropriate working capital levels. According to Nazir and Afza (2008) a large
number of business failures have been attributed to the inability of financial managers to
plan and control properly the current assets and current liabilities of their respective
firms. Deloof (2003) contends that the way working capital is managed has a significant
impact on profitability and risk of firm. Although profitability may be considered the
governing factor of a business, nevertheless the management of working capital can
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effectively bring to a halt, or to its ultimate downfall, what might otherwise be a
successful and profitable company.
The current squeeze on cash and credit is threatening the survival of most businesses all
over the world and Kenya in particular; as it is considered the sources of company
working assets and liabilities. The aftermath of this credit crunch is drastic reduction in
production and sales, leading to massive retrenchment of workers and liquidation of
many organizations. Unfortunately, not every company is able to find external financing
easily. Where it is available, the cost of borrowing may be expensive, resulting in poorer
bottom line. In view of the above liquidity management (working capital management)
has become one of the most important issues in the organizations where many executives
strive to identify the basic working capital drivers and the appropriate level of working
capital.
Working capital management and profitability relationship has been explored by many
researchers. However most of the studies have focused on the relationship between the
cash conversion cycle and its components with profitability. Studies on the association
between the impact of aggressive or conservative working capital management policies
on profitability have not been carried out in Kenya. Nazir and Afza (2008), Weinraub and
Visscher (1998 and Sathyamoorthi (2002) analyzed the degree of aggressiveness and
profitability. These earlier studies were built on western data and economies and thus
more research is necessary to establish if these findings are applicable to a developing
economy like Kenyan.
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Further data was not found about empirical analysis that directly addresses the question
of aggressive or conservative working capital policy in Kenya. Though several studies
have been carried out in the area of working capital management policies in Kenya such
Ochieng (2006), Kithii (2008), Deloof (2003) and Nyakundi (2003) none has focused on
the association between the degree of aggressiveness and profitability for firm listed at
the NSE.
Since the earlier studies were built on western data and specific research studies
exclusively on the impact on the degrees of aggressiveness in working capital on
profitability are scanty, this study was conducted with an attempt to bridge the gap in
literature by providing empirical evidence. This study therefore seeks to establish the
relationship between the degree of aggressiveness in working capital management
policies and profitability for firms listed at the NSE for the period between 2008 and
2012.
The aim of this study was to find out ‘Does efficient working capital management have
any effect on the financial performance of firms quoted at NSE?’
1.3 Research Objectives
i) To establish working capital policy adopted by quoted companies at NSE.
ii) To establish the influence of working capital management policy on financial
performance.
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1.4 Value of the Study
This study investigates the potential relationship between aggressive/conservative
policies and profitability for firms listed at the Nairobi Securities Exchange. The study is
expected to contribute to better understanding of the policies of formulating strategies on
the management of working capital and their impact on profitability especially in a
developing economy like Kenya. Equally important, the outcome of the study was of
benefit to managers in organization on what strategy to employ regarding working capital
management in order to improve the performance of the organization. The study was help
corporate finance managers and firms directors to set appropriate working capital
management policies.
An in-depth understanding of the association between working capital and profitability
was enable investors to make optimal investment decisions. With these information they
can be able to increase returns by making informed decisions on where to and how much
to invest.
The study was provide an opportunity for scholars and academicians to critique the
findings and methodology. The study adds up to the existing literature that can be
reviewed in subsequent studies. By studying the research, students can identify potential
research areas.
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CHAPTER TWO: LITERATURE REVIEW
2.1 Introduction
This chapter is about literature review on working capital management and firm
performance. It also reviews the theories of working capital management, and prior
empirical studies in the area under study.
2.2 Theories of Working Capital Management
This study is premised on three theories to explain the management of working capital.
They include; the quantity theory of money, the Keynesian theory of money, Baumol
inventory model, the modern quantity theory, the Miller and Orr’s cash management
model, the treasury approach to cash management and operating cycle theory.
According to the ‘quantity theory’, which was proposed by Fisher (1911), money is held
only for purpose of making payments for current transactions. Irving Fisher’s version of
the quantity theory can be explained in terms of the equation of exchange model The
Nominal Stock of Money in Circulation multiplied by The Transaction Velocity of
Circulation of Money equals The Average Price of all Transactions and the number of
transactions.
Quantity theory measure the total value of transactions during the time period and so
must be identical. Thus ‘the equation’ is really an identity which must always be true; it
tells us only that the total amount of money handed over in transactions equal to the value
of what is sold.
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Keynes (1936) in his work, the General Theory of Employment, Interest and Money
identified three reasons why liquidity is important, the speculative motive, the
precautionary and the transaction motive. The speculative motive is the need to hold cash
to be able to take advantage of, for example bargain purchase opportunities that might
arise, attractive interest rates and in the case of international firms, favorable exchange
rate fluctuations. For most firms, reserve borrowing ability and marketable securities can
be used to satisfy speculative motives. The precautionary motive is the need for a safety
supply to act as financial reserve. Once again, there is probably a precautionary motive
for liquidity. However, given that the value of money market instruments is relatively
certain and that instruments such as Treasury bills are extremely liquid, there is no real
need to hold substantial amount of cash for precautionary purpose. Cash is needed to
satisfy the transaction motive, the need to have cash on hand to pay bills. Transaction
related needs come from collection activities of the firm. The disbursement of cash
includes the payment of wages and salaries, trade debts, taxes and dividends.
Baumol (1952) developed the inventory development model. The Baumol model is based
on the economic order quantity (EOQ). The objective of the model is to determine the
optimal target cash balance. The model is based on the following assumptions; The firm
is able to forecast its cash requirements with certainty and receive a specific amount at
regular intervals; The firm’s cash payments occur uniformly over a period of time that is;
a steady rate of cash outflows; the opportunity cost of holding cash is known and does not
change over time; cash holdings incur an opportunity cost in the form of opportunity
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foregone; the firm was incur the same transaction cost whenever it converts securities to
cash; cash transaction incurs at a fixed and variable cost.
The limitations of the Baumol model as explained by Van Horne (1977) are as follows;
assumes a constant disbursement rate; in reality cash outflows occur at different times,
different due dates; assumes no cash receipts during the projected period, obviously cash
is coming in and out on a frequent basis; no safety stock is allowed for, reason being it
only takes a short amount of time to sell marketable securities.
In conclusion the three theories guiding this study namely quantity theory, liquidity
theory and baumol model have direct relation to working capital policies of a firm.
Quantity theory specifically measures how the value of money is affected by the quantity
of money in supply; Money is one current asset hence directly affects working capital of
firm. Liquidity theory explains motives for holding money among them, speculative
motive is the need to hold cash to be able to take advantage of, for example bargain
purchase opportunities that might arise, this directly was impact on the working capital of
firm. The Baumol model is based on the economic order quantity (EOQ). The objective
of the model is to determine the optimal target cash balance which one of the working
capital challenges.
2.3 Working Capital Management Policies
There are different approaches for the management of working capital. Two basic
policies of working capital are namely aggressive working capital management policy
and conservative working capital management policy.
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Nazir and Afza (2008) posit that aggressive investment policy (CATAR) results in
minimal level of investment in current assets versus fixed assets. In order to measure the
degree of aggressiveness of working capital investment policy the following ratio is used;
According to Nazir and Afza (2008) an aggressive financing policy (CLTAR) utilizes
higher levels of current liabilities and less long-term debt. The firms are more aggressive
in terms of current liabilities management if they are concentrating on the use of more
current liabilities which put their liquidity on risk. This approach is considered more risky
because of the frequent need to refinance to support permanent current assets as well as
fluctuating current assets. Moyer et al. (2005) observes that if a firm relied on overdraft
for this, it was vulnerable to a rapid withdrawal of that facility and if stocks and cash are
reduced to pay back the overdraft, the firm may experience severe disruptions, loss of
sales and output, and additional costs because of a failure to maintain the minimum
required working capital to obtain optimum profitability. Thus, Bringam and Ehrardt
(2004) posit that this working capital policy was associated with higher return and risk.
In contrast, a conservative investment policy places a greater proportion of capital in
liquid assets with the opportunity cost of less profitability. If the level of current assets
increases in proportion to the total assets of the firm, the management is said to be more
conservative in managing the current assets of the firm. The firm finances its permanent
assets and also a part of temporary current assets with long term financing. When there
are times in the cause of the year when surplus cash is available, this was invested in
short term instruments. Many managers feel happy under the conservative approach
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because of the lower risk of being unable to pay bills as they arise. The low-risk is to
ensure that long term financing covers the total investment of the assets. However such a
policy may not be in the best interest of owners of the firm. The short term funds invested
in the short term securities is unlikely to earn satisfactory return relative to the cost of the
long term funds. Shareholders would be better off if the firm reduced its long term
financing, by returning cash to shareholders or paying off some long term loans.
Van Horne and Wachowicz (2004) observe that excessive levels of current assets as
advocated by the conservative working capital may have a negative effect on the firm’s
profitability, whereas a low level of current assets may lead to a lower level of liquidity
and stock outs, resulting in difficulties in maintaining smooth operations. More
aggressive working capital policies are associated with higher return and risk, while
conservative working capital policies are associated with lower return and risk (Weinraub
and Visscher, 1998).
2.4 Empirical Review
The subject of working capital management has been explored in the discipline of
finance. However, very few studies have been conducted in Kenya to address whether the
degree of aggressiveness or conservativeness of working capital management policies
affects profitability.
Salawu (2006) investigated fifteen diverse industrial groups over an extended period to
establish the relationship between aggressive and conservative working capital practices.
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His results strongly show that the industries had significantly different current asset
management policies. Additionally the relative industry ranking of the aggressive or
conservative asset policies exhibited remarkable stability over time. It is evident that
there is a significant negative correlation between industry asset and liability policies.
Relatively aggressive asset management seems balanced by relatively conservative
working capital finance management. Furthermore he explains that a firm in deciding it’s
working capital policies adopted in a particular industry in which it operates and a firm
pursuing an aggressive working capital investment policy should match it with a
conservative working capital financing policy. This is important to mitigate the risk being
faced under aggressive working capital investment policies by safety involved under
conservative working capital financing policy.
However, Weinraub and Visscher (1998) have discussed the issues of aggressive and
conservative working capital management policies by using quarterly data for a period of
1984 to 1993 of US firms. The researchers have examined ten diverse industry groups to
study the relative relationship between their aggressive, conservative working capital
policies and they have concluded that the industries have distinctive and significantly
different working capital management policies overtime.
Nazir and Afza (2007) studied the impact of different types of working capital
management policies on financial performance of firms in different sectors in Pakistan.
For this they used a sample of 263 non-financial firms belonging to 17 different sectors
listed at KSE from1998 to 2003. The secondary data was collected from the financial
reports of selected companies and also from the publications of State Bank of Pakistan.
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For the measurement of the degree of aggressiveness they used current liabilities to total
assets ratio and current assets to total assets ratios. To locate the impact of these policies
on the performance of firms they used Return on Equity (ROE) and Return on Assets
(ROA). Results were found by using regression analysis. They found an inverse
relationship between degree of aggressiveness of these policies and profitability.
Another important study confirms the results of Afza and Nazir (2007) conducted by
Mian S. and Talat (2009) have shown that the negative relationship between the
profitability measures of the firm and the degree of aggressiveness of working capital
management policies by analyzing the 204 Pakistani firms listed under sixteen industrial
groups in the Karachi Stock Exchange (KSE). The data was analyzed for the period
(1998-2005). The finding says that firms with more aggressive working capital policy
may not be able to generate more profit proving the negative relationship of working
capital management and profitability.
Pandey and Parera (1997) provided an empirical evidence of working capital
management policies and practices in the private sector manufacturing companies in Sri
Lanka. The information and data for the study were gathered through questionnaires and
interviews with chief financial officers of a sample of manufacturing companies listed on
the Colombo Stock Exchange. They found that most companies in Sri Lanka have
informal working capital policy and company size has an influence on the overall
working capital policy (formal or informal) and approach (conservative, moderate or
aggressive). Moreover, company profitability has an effect on the methods of working
capital planning and control.
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The study of Mohamad and Saad (2010) was based on secondary data of 172 firms of
Malaysia. They evaluated the impact of various components of working capital on
profitability and market value of the firms. The study covered a time span of five years
from 2003 to 2007. For this purpose they used different working capital components
namely cash conversion cycles (CCC), debt ratio (DR), current assets to total assets ratio
(CATAR), current liabilities to total assets ratio (CLTAR) and current ratio (CR). To see
the effect of these working capital components on financial performance they used
Tobin’s Q (TQ), return on invested capital (ROIC) and return on assets (ROA) as a
measurement of financial performance of the selected firms. To deduce the results they
used correlations and multiple regression analysis. The results showed that there exists an
inverse relationship between different working capital components and performance of
firms.
Sathyamoorthi (2002) focused on good corporate governance and in turn effective
management of business assets. He analyzed selected Co-operatives in Botswana for the
period of 1993-1997 and observed that more emphasis is given to investment in fixed
assets both in management area and research. He also noted that that effective
management working capital has been receiving little attention and yielding more
significant results and concluded that these firms followed an aggressive approach during
the whole four-year study period.
Ochieng (2006) on his studies on the effects of the relationship between working capital
of firms listed at the Nairobi Stock Exchange and the economic activity in Kenya, finds
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that the liquidity of the firms, measured by the current and quick ratios, increases with
economic expansion and decreases during economic showdowns. He however says that
the liquidity positions reacted differently to various economic indicators such as inflation
and lending rates. The study showed that inflation was not significant in a massive 83%
of the firms. It is however found that lending rates indeed affect the amount of working
capital policy of a firm.
Apuoyo (2010) on his study on the relationship between working capital management
policies and profitability for companies quoted at the NSE finds that the financial and
investment sector has been able to achieve high scores on the various components of
working capital and this has positive impact on profitability.
Biwott (2011) and Deloof (2003), found a strong negative relationship between the
measures of working capital management including the average collection period,
inventory turnover in days, the average payment period and cash conversion cycle with
corporate profitability.
According to Gitman (2000) working capital management is concerned with the
problems that arise in attempting to manage current assets, the current liabilities and the
relationship that exists between them. Pandey (2007) defines current assets as those
assets which in the ordinary course of business can be, or was converted into cash within
one year without undergoing a diminution in value and without disrupting the operation
of the firms. Examples are cash, marketable securities, account receivables and inventory.
On the other hand, current liabilities are those liabilities which are intended, at their
inception to be paid in the ordinary course of business in a year out of current assets or
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earnings of the concern. The basic current liabilities are account payables, bills payable,
bank overdraft and outstanding expenses.
Van –Horne and Wachowicz (2004) posits that when a business entity takes the decisions
regarding its current assets and liabilities then it can be termed as working capital
management. He defines working capital management as an accounting approach that
emphasize on maintaining proper levels of both current assets and current liabilities. It
provides enough cash that meets short-term obligations.
Lamberson (1995) observes that working capital management has become one of the
most important issues in organizations where many financial executives strive to identify
the basic working capital drivers and the appropriate level of working capital. Efficient
management of working capital is a fundamental part of the overall corporate strategy to
create the shareholders’ value. He suggests that managers should strive to achieve an
optimal or efficient level of working capital.
Raheman & Nasr (2007) emphasizes the importance of working capital that every
business requires working capital for its survival. Working capital is a vital part of
business investment which is essential for continuous business operations. It is required
by a firm to maintain its liquidity, solvency and profitability. Filbeck and Krueger (2005)
assert that the importance of managing working capital of a business efficiently cannot be
denied and thus needs to be accorded the importance it deserves.
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Arnold (2008) observes that working capital management explicitly impacts both the
profitability and level of desired liquidity of a business. If a firm was invest heavily in
working capital, that is, more than its needs, then the profits which can be generated by
investing these resources in fixed or long term assets was diminished. Moreover the firm
was have to endure the cost of storing inventory for longer periods as well as the cost of
handling excessive inventory.
Arnold (2008) further argues that if a firm was invest heavily in fixed assets to generate
profits by neglecting its short-term capital needs then it is quite possible that it may have
to face bankruptcy because of insufficient funds. The profitability as well as adequate
level of liquidity is required to be maintained for the survival of a business, so if a firm
was not pay sufficient attention to its working capital management, then it is quite
possible that the firm would have to face bankruptcy.
2.5 Summary
The importance of working capital in realising the desired levels of financial performance
cannot be underestimated. From the prior studies highlighted above working capital
management and financial performance certainly have some relations with each other.
The policies adopted by a firm, whether aggressive or conservative have an impact on
financial performance. The subject of working capital management has received great
attention locally and intentionally. Most local studies have used the cash conversion cycle
and its components as a proxy for working capital management. Some studies have
focussed on the factors that influence working capital management policies. However, no
20
study was found to have addressed how the degree of aggressiveness affects financial
performance. The same subject has received attention internationally. The studies have
confirmed a relation between working capital and financial performance. But we have to
appreciate the fact these economies are different from the Kenyan economy .The question
to be answered is whether the same relationship holds in the Kenyan economy as in the
foreign economies. This study therefore is carried to address the identified gap
21
CHAPTER THREE: RESEARCH METHODOLOGY
3.1 Introduction
This section sought to identify the research design, the population and sample of the
study. It also outlines the methods of data collection and analysis.
3.2 Research Design
The research adopted correlation research design to establish the relationship between
working capital management policies and firm’s profitability for firms listed the NSE. To
establish the causal relationship multiple regressions was used as a tool of data analysis
for the study covering a period of five years from 2008 to 2012.Data was represented
using tables.
Correlation research design was deemed appropriate since it determines the strength and
direction of the association between two or more variables. Correlation coefficient
explains the relationship between variables. It shows change in one variable because of
any change in other variable (Kohler, 1994). The method was also used by Nazir and
Afza (2007) who conducted a similar study in Pakistan.
3.3 Population of the study
The population of the study included all the firms listed at the NSE for five years from
2008 to 2012. From the Nairobi securities Exchange hand book (2012) sixty two firms
are listed, drawn from the agriculture sector, Commercial and services, Financial and
22
Investments, Industrial and allied Sector, Alternative Investment Market Segment. Firms
quoted at NSE were preferred due to the availability and reliability of the financial
statements in that they are subject to mandatory audits by recognised audit firms. Over
and above, firms listed at the NSE have an incentive to present profits if those exist in
order to make their shares more attractive ( Lazaridis & Tryfonidis, 2006).
3.4 Sample Design
A sample of twenty companies from which NSE 20 Share index is calculated from was
used. This was to ensure that all the five main investment segments at the Nairobi
Securities Exchange were represented.
3.5 Data Collection
The study utilised secondary data obtained from the published financial statements which
were readily available at the NSE and the CMA libraries. The data collected included
information on assets, liabilities and revenue levels for the period 2008 to 2012, using the
annual reports published by the above mentioned companies which had been listed by
NSE. Further the data was obtained from the annual handbook published by NSE.
3.6 Data analysis
The study sought to establish the relationship between working capital management
policy and financial performance for firms listed at the NSE. Current Assets to Total
Assets Ratio (CATAR) was used as an independent variable. This ratio was used to find
out the investment policy of working capital adopted by the firms under consideration.
23
This investment policy can be of two types, first is the aggressive policy and second is
the conservative policy. In aggressive investment policy of working capital, less
investment is made in current assets as compared to fixed assets to get more returns. On
the other hand in conservative investment policy of working capital, more investment is
made in current assets as compared to fixed assets. It can be measured using the
following formula;
CATAR = Total Current Assets (TCA)/ Total Assets (TA)
A lesser value of current assets to total assets ratio demonstrates more aggressive policy
Current Liabilities to Total Assets Ratio (CLTAR) was used to discover working capital
financing policy. It can also be of two types, aggressive financing policy and
conservative financing policy. In aggressive financing policy, a greater portion of current
liabilities is used than long term debts. In conservative financing policy, more long term
debts are used than current liabilities. The ratio can be measured as follows;
CLTAR = Total Current Liabilities (TCL)/ Total Assets (TA)
The study employed Return on Asset (ROA) as the dependent variable and measures of
profitability. The debt ratio and firm size were used as control variables and was
measured by the debt ratio and natural log of asset respectively. Therefore, the model of
the study was as follows:
ROAit = ROA it= β0i+ β1(CATARit) + β2(CLTAR it) + β3(QRit) + β4(DERit) +u
24
Where;
β 0i ……. is the constant
β1... β4
are coefficients to explanatory variables
Where: ROA= Return on Assets,
CATAR= Current Assets to Total Assets Ratio,
CLTAR= Current Liabilities to Total Assets Ratio,
DER= Debt to equity Ratio,
QR= Current Assets to/ Current Liabilities
u it= error term
To determine the association between working capital policy and financial performance
both descriptive and quantitative analysis was conducted. Descriptive statistics such as
the mean, median and standard deviation were used to describe the different variables. To
establish the strength of the association among the variables under study the Pearson
correlation coefficient and multiple regressions was utilized.The integrity and
effectiveness of the model was assessed by considering the coefficient of determination
and analysis of variance. The descriptive and quantitative measures was calculated using
the Statistical Package for Social Sciences (SPSS). Data was presented using tables and
graphs.
25
CHAPTER FOUR: DATA ANALYSIS, RESULTS AND
DISCUSSIONS
4.1 Introduction
This chapter describes the data analysis and specifically looked into the findings
discussion and presentation of the findings.
4.2 Descriptive Statistics: Descriptive Variables=ROA CATAR CLTAR DER QR /
Statistics=MEAN STDDEV MIN MAX
The descriptive statistics for the three variables were obtained for empirical investigation
and are presented in the Table 4.2. The variables are ROA, CLTAR and DER, QR.
Table 4. 2
Descriptive Statistics. Descriptive Variables=ROA CATAR CLTAR
DER QR / Statistics=MEAN STDDEV MIN MAX
Descriptive Statistics
N
Minimum
Maximum
Mean
Std. Deviation
ROA
74
-3.56738
9.56058
.3679227
1.54624936
CATAR
75
.03000
.68000
.3127562
.16543397
CLTAR
75
.01000
1.53000
.2497725
.19088603
DER
73
.00000
26.91000
4.8174393
6.35975408
QR
75
.30650
8.47451
1.6175266
1.15784906
Valid N (listwise)
72
Source research data
Table 4.2 provides the descriptive statistics for all the variables. It shows the number of
observations of all variables, their average values and their standard deviation. It shows
the minimum and maximum values as well which can be attained by these variables. The
26
descriptive statistics show that all the variables have 75 observations. The dependent
variable return on assets has the average value of .367 It has a minimum value of -3.55
and a maximum value of 9.56.
The standard deviation for return on assets is 1.54. To check the working capital
investment policy of these companies, current assets to total assets ratio (CATAR) is
included, it has an average value of .312 with a standard deviation of .165. Minimum
value of CATAR is 0.03 and its maximum value is 0.68. To check the financing policy
adopted by the selected firms for the management of working capital and its relationship
with profitability, current liabilities to total assets ratio (CLTAR) is used. It has an
average while the standard deviation of 1.98. The minimum value for CLTAR is 0.01 and
the maximum value for it is 0.53. The independent variable quick ratio (QR) has a
maximum value of 8.4745 and a minimum value of 0.30. It has an average value of 1.617
while standard deviation of 1.15784. To check the leverage of these firms, debt to equity
ratio (DER) is used. It has the average value of 0 while standard deviation of 6.35. The
minimum value is 0 for debt to equity ratio and its maximum value is 26.91
27
4.3 Correlations: ROA, CATAR, CLTAR, DER,QR
Table 4.3 Correlation: ROA, CATAR, CLTAR, DER,QR
ROA
ROA
Pearson Correlation
CATAR
1
Sig. (2-tailed)
N
CATAR
Pearson Correlation
.267*
Sig. (2-tailed)
.021
N
CLTAR
QR
.267*
.044
.309**
.050
.021
.711
.008
.673
74
74
72
74
1
.437**
-.099
.188
.000
.404
.107
75
75
73
75
Pearson Correlation
.044
.437**
1
-.137
-.422**
Sig. (2-tailed)
.711
.000
.247
.000
74
75
75
73
75
.309**
-.099
-.137
1
.006
.008
.404
.247
72
73
73
73
73
.006
1
Pearson Correlation
Sig. (2-tailed)
N
QR
DER
74
N
DER
74
CLTAR
.958
Pearson Correlation
.050
.188
-.422**
Sig. (2-tailed)
.673
.107
.000
.958
74
75
75
73
N
75
Source research data
*. Correlation is significant at the 0.05 level (2-tailed).
**. Correlation is significant at the 0.01 level (2-tailed).
Correlation coefficient explains the relationship between two variables. It shows change
in one variable because of any change in other variable. Table 4.3 shows the matrix of
Pearson’s correlation coefficient analysis. This analysis helps to locate the relationship
that exists among the independent or explanatory variables. Correlation between
dependent variable which is return on assets (ROA) and independent variable current
assets to total assets ratio (CATAR) is analyzed. The results of correlation analysis show
a positive correlation between them having a value of 0.267 .This correlation indicates
28
that these two variables have a positive relationship with each other i.e. if there was an
increase in current assets to total assets ratio then the dependent variable return on assets
was also increase and vice versa. Return on assets (ROA) has a negative correlation with
independent variable current liabilities to total assets ratio (CLTAR) 0.044 which is not
significant at 5% level of significance. The correlation outcomes for current assets to total
assets ratio (CATAR) and current liabilities to total assets ratio (CLTAR) show that they
have a positive correlation of .437**with each other. This means that an increase in the
value of independent variable current assets to total assets ratio was cause an increase in
current liabilities to total assets ratio and vice versa. The correlation of current assets to
total assets ratio is 0.050 with quick ratio .This correlation has a positive value so this
relationship is also positive as the previous one which is insignificant at 5% level of
significance. Pearson’s correlation coefficient analysis Current assets to total assets ratio
has a positive relationship with debt to equity ratio. The value of correlation coefficient
between them is 0.309**.This correlation signifies that a raise in current assets to total
assets ratio is accompanied by an increase in debt to equity ratio and vice versa Pearson’s
correlation. Correlation coefficient of current liabilities to total assets ratio with debt to
equity ratio is -.099. Quick ratio has an insignificant but positive relationship with both
debt to equity ratio 0.006.
29
4.4 Regression analysis
Table 4.4 Model Summary
Model
Std. Error of the
R
R Square
.440a
1
Adjusted R Square
.194
Estimate
.146
1.44815121
Source Research data
a. Predictors: (Constant), QR, DER, CATAR, CLTAR
Table 4.5 ANOVA
Model
1
Sum of Squares
Regression
Df
Mean Square
33.813
4
8.453
Residual
140.509
67
2.097
Total
174.321
71
F
Sig.
4.031
.005a
Source research data
a. Predictors: (Constant), QR, DER, CATAR, CLTAR
b. Dependent Variable: ROA
Table 4.6 Standardized and Unstandardized Coefficients
Model
Standardized
Unstandardized Coefficients
B
1
Coefficients
Std. Error
Beta
(Constant)
-.770
.505
CATAR
3.446
1.316
CLTAR
-.740
DER
QR
T
Sig.
-1.524
.132
.358
2.620
.011
1.206
-.091
-.614
.541
.081
.027
.330
2.975
.004
-.079
.181
-.059
-.435
.665
Source research data
a. Dependent Variable: ROA
30
The working capital management and profitability relationship is analyzed by using data
regression model. The results are illustrated in table 4.4, table 4.5 and 4.6The value of Rsquare for fixed effect model between variables is 0.194 R-square. This means that 19.4%
of the changes in ROA can be explained by explanatory by changes in CATAR and
CLTAR while 80.6 % of changes in ROA cannot be explained by explanatory variables
hence error term. R Square of 0.194 means the regression model does not have a good fit
.The Beta-coefficient of current assets to total assets ratio is 0.358, which shows that if
there is an increase of 1 unit in CATAR then it causes an increase of 0.358 units in ROA.
So, there is positive relationship between them. Similarly the Beta-coefficient of current
liabilities to total assets ratio is -0.091. This coefficient with negative sign shows an
inverse relationship of CLTAR with the independent variable.
This can be interpreted as an increase of 1 unit in CLTAR was lead to a decrease of 0.091units in ROA. Quick ratio has Beta-coefficient of -0.059 which demonstrates a
positive relation between QR and ROA. But this relationship is not significant.
31
CHAPTER FIVE: SUMMARY, CONCLUSIONS AND
RECOMMENDATIONS
5.1 Introduction
The chapter summarizes the findings of the study of the relationship between working
capital management policies and firm performance. It also draws conclusions and gives
recommendations based on the findings. The chapter highlights limitations of the study
and makes suggestions for further future research
5.2 Summary of Findings
Correlation coefficient explains the relationship between two variables. It shows change
in one variable because of any change in other variable. Table 4.3 shows the matrix of
Pearson’s correlation coefficient analysis. This analysis helps to locate the relationship
that exists among the independent or explanatory variables. Correlation between
dependent variable which is return on assets (ROA) and independent variable current
assets to total assets ratio (CATAR) is analyzed. The results of correlation analysis show
a positive correlation between them having a value of 0.267 .This correlation indicates
that these two variables have a positive relationship with each other i.e. if there is an
increase in current assets to total assets ratio then the dependent variable return on assets
also increases and vice versa. Return on assets (ROA) has a negative correlation with
independent variable current liabilities to total assets ratio (CLTAR) 0.044 which is not
significant at 5% level of significance. The correlation outcomes for current assets to total
assets ratio (CATAR) and current liabilities to total assets ratio (CLTAR) show that they
have a positive correlation of .437**with each other. This means that an increase in the
32
value of independent variable current assets to total assets ratio would cause an increase
in current liabilities to total assets ratio and vice versa. The correlation of current assets to
total assets ratio is 0.050 with quick ratio .This correlation has a positive value so this
relationship is also positive as the previous one which is insignificant at 5% level of
significance. Pearson’s correlation coefficient analysis Current assets to total assets ratio
has a positive relationship with debt to equity ratio. The value of correlation coefficient
between them is 0.309**.This correlation signifies that a raise in current assets to total
assets ratio is accompanied by an increase in debt to equity ratio and vice versa.
Correlation coefficient of current liabilities to total assets ratio with debt to equity ratio is
-.099. Quick ratio has an insignificant but positive relationship with debt to equity ratio of
0.006.
The value of R-square for fixed effect model between variables is 0.194 R-square. This
means that 19.4% of the changes in depended variables can be explained by explanatory
variables while 80.6 % cannot be explained by explanatory variables hence error term.
This model does not have a good fit.
The Beta-coefficient of current assets to total assets ratio is 0.358, which shows that if
there is an increase of 1 unit in CATAR then it causes an increase of 0.358 units in ROA.
So there is positive relationship between them. Similarly the Beta-coefficient of current
liabilities to total assets ratio is -0.091. This coefficient with a negative sign shows an
inverse relationship of CLTAR with the independent variable. This means that an
increase of 1 unit in CLTAR would lead to a decrease of -0.091units in ROA. Quick ratio
33
has Beta-coefficient of -0.059 which demonstrates a positive relation between QR and
ROA. But this relationship is not significant.
5.3 Conclusions of the study
The management of working capital is one of the most important financial decisions of a
firm. Efficient level of working capital should be present for smooth running of business
regardless of the nature of business. From this study it can be concluded that maintaining
efficient level of working capital is very important for any business. The present study
included 16 firms of Nairobi Securities Exchange for a time span five years from 2008 to
2012. It explored the role of efficient working capital management in generating profitability
through two main policies of managing working capital namely working capital investing
policy and working capital financing policy. In aggressive working capital investing policy
more resources are invested fixed assets than current assets to gain more profits. A
conservative working capital investment policy is opposite to it. In aggressive working
capital financing policy more current liabilities are used than long-term debts and vice versa
for conservative financing policy.
The results of this study shows that conservative investing policy of working capital leads
to more profitability similarly conservative financing policy also results in more
profitability. Moreover, the results show a positive correlation between investing policy
and financing policy of working capital. This positive relation demonstrates that the firms
which follow aggressive working capital investing policy also go for aggressive financing
policy. Similarly the firms pursuing conservative investing policy also prefer
conservative financing policy for the management of working capital. The study
34
illustrates that there is a significant relationship between aggressive and conservative
working capital investment policy and profitability.
The objectives of the study were to establish working capital policy adopted by
companies quoted at NSE and to establish the influence of working capital management
policy on financial performance. The result of the study confirms that both aggressive
and conservative working capital management policies are employed by companies
quoted at NSE. Similarly it establishes that working capital management policies indeed
influences financial performance of companies quoted at NSE.
The results of the study reinforces the findings of Nazir and Afza (2007) who studied the
impact of different types of working capital management policies on financial
performance of firms in different sectors in Pakistan. They found that there is an inverse
relationship between the degree of aggressiveness of these policies and profitability.
Studies by Mian S. and Talat (2009), Salawu (2006) and Mohamad and Saad (2010) also
yielded similar results.
The findings of this study will be useful to the financial managers of the company as
these provide the information regarding the management of short-term capital and also
inform them about the management policies used by their peers. This information will be
useful for maintaining a healthy competition and improving own organization. Eventually
it is recommended that the managers should try to create good synchronization between
the assets and liabilities of the firm.
35
5.4 Limitations of the study
The study only used information available in financial statements; other variables that
influence profitability may not have been captured in the model. Time limitation did not
allow the companies to be analyzed by segment and then comparison be made. The
findings therefore are general to all companies listed at the NSE. The time constraint also
confined the study to a limited period of time between 2008 and 2012.
Due to the need for reliable data, qualitative analysis was not possible to establish the
views of the finance managers in relation to the relationship between working capital
management policies and firm performance.
The format of financial statements for banks; where assets are not categorized as either
current or fixed, affected our sample size since four of the twenty share index companies
are banks. The sample size was subsequently reduced to sixteen.
5.5 Suggestions for Further Research
The study was based on the NSE 20 share index and no attempt was made to conduct
analysis by sector. Future studies should consider sectored analysis so as to indicate the
existence of any differences in working capital management policies and firm
performance. A longer period of analysis should be considered so as to ascertain whether
a firm can change its working capital management policy in the long run.
Performance of qualitative research will be of essence to establish whether the same
results are obtained as with quantitative research.
36
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40
APPENDIX 1 NSE LISTED COMPANIES
AGRICULTURAL
Eaagads Ltd
Kapchorua Tea Co. Ltd
Kakuzi
Limuru Tea Co. Ltd
Rea Vipingo Plantations Ltd
Sasini Ltd
Wasiamson Tea Kenya Ltd
COMMERCIAL AND SERVICES
Express Ltd
Kenya Airways Ltd
Nation Media Group
Standard Group Ltd
TPS Eastern Africa (Serena) Ltd
Scangroup Ltd
Uchumi Supermarket Ltd
Hutchings Biemer Ltd
Longhorn Kenya Ltd
TELECOMMUNICATION
AccessKenya Group Ltd
Safaricom Ltd
AUTOMOBILES
Car and General (K) Ltd
CMC Holdings Ltd
Sameer Africa Ltd
Marshalls (E.A.) Ltd
41
BANKING
Barclays Bank Ltd
CFC Stanbic Holdings Ltd
I&M Holdings Ltd
Diamond Trust Bank Kenya Ltd
Housing Finance Co Ltd
Kenya Commercial Bank Ltd
National Bank of Kenya Ltd
NIC Bank Ltd 0rd 5.00
Standard Chartered Bank Ltd
Equity Bank Ltd
The Co-operative Bank of Kenya Ltd
INSURANCE
Jubilee Holdings Ltd
Pan Africa Insurance Holdings Ltd
Kenya Re-Insurance Corporation Ltd
CFC Insurance Holdings
British-American Investments Company ( Kenya) Ltd.
CIC Insurance Group Ltd
INVESTMENT
Olympia Capital Holdings ltd
Centum Investment Co Ltd
Trans-Century Ltd
MANUFACTURING AND ALLIED
B.O.C Kenya Ltd
British American Tobacco Kenya Ltd
Carbacid Investments Ltd
East African Breweries Ltd
Mumias Sugar Co. Ltd
Unga Group Ltd
42
Eveready East Africa Ltd
Kenya Orchards Ltd
MANUFACTURING
A.Baumann CO Ltd
CONSTRUCTION
Athi River Mining
Bamburi Cement Ltd
Crown Berger Ltd
E.A.Cables Ltd
E.A.Portland Cement Ltd
ENERGY
KenolKobil Ltd
Total Kenya Ltd
KenGen Ltd
Kenya Power & Lighting Co Ltd
43
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