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.

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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

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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).

Studies on working capital management on Kenyan firms especially in the service sector and in particular, the tourism industry that is core to the Kenyan economy, are not explicit. It is therefore, important to study the working capital management in the tourism industry in these developing economies given their uncertain business environment.

1.1.1 The Tourism Industry

According to The World Tourism Organization (2013) tourism is one of the important sectors in the world economy and governments should support it in order to stimulate their economies. Woods, Perry and Steagall (1991) content that tourism is an export industry that offers domestic experiences and services to foreign visitors in a destination country in exchange for foreign currency and comprises of all the sub sectors that provide goods and services to enable business, leisure and pleasure activities in an environment away from home.

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In Kenya, tourism is an important sector providing employment, contributing to the GDP and stabilising the country’s balance of payments. It accounts for 12 % of the total wage employment, contributes to 13.7 % of the GDP and ranks third in contributing foreign exchange after tea and horticulture (Government of Kenya, 2013). As cited by the Government of Kenya (2013), tourism in 2011 contributed 10 % of the GDP (Kenya‘s Tourism Strategic Plan 2000-2012); 5.7 % in direct contribution and 13.7% in total contribution (World Travel and Tourism Council, 2011).

The Kenyan coastal region is the main tourist destination in Kenya. The hospitality industry in this region relies heavily on tourism and especially foreign arrivals for their existence and performance (Government of Kenya, 2013). As cited by Kingi et al., (2013), the Kenyan coastal region has the highest number of hotel bed nights by international tourists at 71 % in 2002, 56

%   in 2004 and 63 % in 2006. Nairobi region had 19 % in 2002, 28 % in 2004 and 16 % in 2008 while other regions of the country have much lower percentages (Government of Kenya, Statistical Abstract, 2008).

1.2 Statement of the Problem

The tourism industry operates on seasons (peak, shoulder and low) and is very sensitive to the environment especially on security concerns (Kuto & Groves, 2004). In Kenya, the tourism industry operates in a highly uncertain environment due to the increased political instability and terrorism incidences that have led to negative international press and travel advisories resulting in dwindling demands (Okumu, 2007). The tourism industry is highly capital

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intensive hence, the low demand has led to most tourist hotels cutting down on their services and eventually closing down due to the inability to manage their working capital optimally.

Much of the previous studies on working capital management has concentrated on the manufacturing industries in the trade sector (Filbeck, Krueger & Preece, 2007; García-Teruel & Martínez-Solano, 2007; Lazaridis & Tryfonidis, 2006; Azam & Haider, 2011; Quayyum, 2012). To date, little focus has been given to the management of working capital in the service sector and in particular, the tourism industry. Consequently, working capital management advice to the service sector has been monotonous in its prescription of trade sector solutions. To further compound the issue, many of these studies assume that trade sector praxis can be applied to the service sector though contemporary academic opinion suggests that this assumption is fundamentally flawed as it is now widely accepted that the service sector is subject to different operational dynamics to the trade sector (Kato, 2010).

Even with such uncertainty, the tourism industry players continue employing the same working capital management practices used in the other more certain and stable industries. This has led to overtrading and the subsequent poor performance of the tourist subsectors. To maintain a competitive edge or even sustain operations in such an uncertain economic environment, the working capital should be managed in the most prudent manner. This study therefore, sought to gain an empirical insight into the various working capital management practices used in the tourism industry, with special reference to

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tourist hotels in Mombasa County with the aim of determining best practices in uncertain business environments.

1.3 Objectives of the Study

1.3.1 General Objective

The overall objective of the study was to determine the effects of working capital management practices on the financial performance of tourist hotels in Mombasa County.