ABSTRACT
Working capital management involves the management of the most liquid
resources of the firm which includes cash and cash equivalents, inventories,
trade debtors and other receivables. Most firms do not ensure optimal level of
working capital and this has been a major obstacle to their overall
profitabilty. The study examined the impact of working capital management on
the profitability of Pharmaceutical firms listed on the Nigerian Stock Exchange
market. Correlation and ex-post facto research design were used in a sample of
5 Pharmaceutical firms. Secondary data for a period of 10 years (2002-2011) was
used, and Ordinary Least Squares (OLS) multiple regression was employed in data
analysis. The study found that working capital management (account receivables
collection management, accounts payables management, inventory management, cash
conversion cycle management, operating cash flow management) has a significant
impact on the profitability of listed pharmaceutical firms in Nigeria. It is
therefore recommended among others that managers should focus on reducing
inventory days, collect receivable as soon as possible because it is better to receive
inflows sooner than later, and delay payment of creditors in order to invest
the money in short-term securities which are profitable. Also, the cash
conversion cycle should be elongated to the extent that it maximizes
profit.
CHAPTER ONE
INTRODUCTION
1.1 Background to the
Study
The economic theory of firm requires that
firm resources should be utilized efficiently in order to achieve economic
successes. Moreover, the competitive modern business environment makes
financial managers irrespective of the nature of their business to ensure
efficient utilization of firm resources. Firm resources are broadly classified
into two, longterm assets (non-current assets) and short-term assets (current
assets). Therefore, there are two major decisions in the theory of corporate
financial management, that is, the long-term or capital budgeting decision and
the short-term or working capital management decision (Pandey, 2009). Although
long-term capital decisions are of critical importance to the going concern of
a firm, workings capital management has direct consequences on the liquidity
position and the ultimate profitability of a firm (Burt & Abbate, 2009).
Working capital connotes the funds lock up
in materials, work in progress, finished goods, receivables and cash. In this
regard, Khan and Jain, (2005) state that current assets are those assets, which
can be converted into cash within a short period of time, and the cash received
is again invested into these assets; hence, it is constantly receiving or
circulating. Therefore, working capital is one of the most important
measurements of the financial position, which according to Guthmann (2008) is
the life-blood and nerve centre of any business entity. This necessitated the
need for the careful management of working capital in every business
organization with the value maximization objective.
Therefore, working capital management
involves the application of strategies and policies in the use of firm’s
current assets and liabilities in such a way that an optimum level of working
capital is maintained. In essence, the goal of working capital management is to
promote a satisfying profitability and maximizes shareholders’ value (Li &
Han-Wen, 2006). They further lament that profitability is affected by the
choices that companies make regarding their working capital policies. Thus, if
a firm cannot maintain an optimum level of working capital, it is likely to
become insolvent and may even be forced into bankruptcy. However, the need for
working capital to run day-to-day business activities effectively cannot be
overemphasized.
In essence, managing working capital is
necessary because of its’ directs effects on the profitability and liquidity of
a corporate entity. Rehn (2012) asserts that working capital usually refer to
net working capital, the difference between current assets and current
liabilities. Thus, it involves minimizing the timing of collecting receivables,
deferring the period of payables, and keeping the minimal inventory. Moreover,
working capital management includes cash management, that is, how to invest
idle cash without compromising liquidity.
Consequently, extant literature on firm
profitability and efficiency documents different resulting effect of
sub-optimal working capital management on performance and value of firm
(Deloof, 2003). According to him, efficient working capital have many effects,
which include speeds payment of short-term commitments on firms; facilitating
owner financing and it reduces working capital as a cause of firms’ failure. In
addition, Osisioma, (1997) and
Wignaraja and O’Neil (1999) revealed that
working capital ensures a sound liquidity for assurance of long-term economic
growth and attainment of profit generating process, and also ensures acceptable
relationship between the components of firms’ working capital for efficient mix
which guarantee capital adequacy. On the contrary, Peel and Wilson (1996), Shin
and Soenen (1998), Eljielly (2004) and Appuhami (2008) are of the view that
inefficient working capital induces firms’ failures, overtrading signs,
inability to propel firm liquidity and profitability, and loss of business due
to scarcity of products.
However, optimal efficient working capital
management is usually achieved through the management of receivables, payables,
inventory, cash conversion cycle and the operating cycle as a whole. In this
regards, Van Horne (1995) laments that accounts receivables management involves
achieving an optimal average time taken by credit customers to settle their
accounts. Moreover, since the purpose of offering credit is to maximise
profitability, the costs of debt collection should not be allowed to exceed the
amounts recovered. Accounts or trade payables management focuses on the average
time taken by a company to pay its trade payables (suppliers); it the current
liabilities and all obligations, which mature within a year such as creditors,
bills payable, accrued expenses, short-term bank loan, income tax liability and
long-term debt excluding bank overdraft, all of which quickly mature in the
current year (Uyar, 2009).
Moreover, accounts payables management is
used to know how much credit time received by the firm from its trade
creditors; it therefore shows the breathing time received by the firm in terms
of payment of credit purchase. Hence, the effectiveness lies in whether the
firm is enjoying the actual credit period promised by suppliers. Cash conversion
cycle according to Wang (2002) is used in measuring cash management, and it
represents the interaction between the components of working capital and the
flow of cash within a company. Similarly, it can also be used to determine the
amount of cash needed for any sales level; it is therefore a period of timebetween the outlay of cash on raw
materials and the inflow of cash from the sale of finished goods.
Inventory management according to Stephen
(2012) especially in a manufacturing firm consist of three components: raw
material, work in progress and finished goods. He further explain that the
holding of excessive stocks will lead to tied up capital in stocks while the
holding of inadequate stock may lead to stock out costs such as lost
profitability and goodwill from customers. A firm therefore needs to set an
optimal level of stock to hold. To set the optimal amount of stock to hold and
order, the Economic Order Quantity (E.O.Q) is usually used (Erlenkotter,
1990).
In view of the foregoing discussions,
working capital management is considered as a very sensitive area in the field
of financial management (Joshi, 1994); because it involves the decision of the
amount and composition of current assets and the financing of these assets.
Moreover, the decisions with regards the level of different working capital
components become frequent, repetitive, and time consuming. However, most firms
do not hold the correct amount of working capital and this has been a major
obstacle to their overall profitability (Stephen, 2012). This together with the
current liquidity crisis has highlighted the significance of working capital
management. Because management of working capital has profitability and
liquidity implications, which requires the firm manager to reach optimal
working capital by controlling the trade-off between profitability maximization
and liquidity accurately (Raheman & Mohamed, 2007).
This study is motivated by the recent
global financial crises which significantly affect the liquidity position and
the overall business activities across the world. In Nigeria, where credit is
either not available or expensive to obtain, there are corporate issues across
almost all the firms that, has to do with liquidity problem and consequently
their operating performance. Financial managers are always expected when there
is a liquidity problem, to examine the current assets and current liabilities
in order to make an informed decision with regard the profitability of their
entity. In the same vein, researchers do conduct studies to examine the
relationships among the firms’ working capital components and profitability
using different methodologies.
Therefore, this study focuses on
pharmaceutical companies in Nigeria; the pharmaceutical industry manufactures
and distributes drugs and medical equipment to the Nigerian populace.
Nigeria as an African nation with over 140
million citizens is known with high demand of drugs and adequate health care
services to address medical problems. Despite the high demand of pharmaceutical
business in Nigeria, the market is described as one of the smallest among
Middle and East African (MEA) region (Lead Capital Limited, 2008). With the
exception of a few globally recognized brands, many of the pharmaceutical
companies and health care providers in Nigeria cannot adequately compete
internationally (Lead Capital Limited, 2008). However, several effects
particularly from foreign agencies and governments are in place to improve the
pharmaceutical industry in Nigeria.
However, it is necessary and logical to
carry out a study on the performance in relation to the management of working
capital of the Nigerian pharmaceutical companies. The rationale is to provide
empirical evidences as to the effectiveness of the financial management of the
pharmaceutical firms, in line with the effort of improving the sector. It is
against this background that this study attempt to assess the impact of working
capital management and the profitability of listed pharmaceutical firms in
Nigeria.
1.2 Statement of the
Problem
One of the major objectives of working
capital management is to ensure that corporate entities have sufficient,
regular and consistent cash flow to fund their activities. Therefore, efficient
working capital management could enable firms in sustaining growth which, in
turn leads to strong liquidity and profitability for ensuring effective and
efficient customer services. As such efficient management of working capital is
very vital for a business survival.
For instance, too much capital signifies
inefficiency where as too little cash in hand signifies that the survival of
the business is shaky. Stephen (2012) documents evidence that most business
organizations do not hold the right amount of stocks, debtors and cash; as a
result of which the firms are unable to meet there maturing short term
obligations and its upcoming operational needs. Similarly, insufficient working
capital means that a firm is unable to undertake expansion projects and
increase its sales, therefore limiting the growth and profitability of the
business. These are particularly the symptoms revealed by the Nigerian
pharmaceutical firms in the recent times, as majority of listed pharmaceutical
firms in Nigeria have exhibited dwindling returns as well as poor stock
performance.
Specifically, according to Lead capital
limited, (2008) drug manufactures in Nigeria are faced with several
constraints, including low capacity utilization, under capitalization, a weak
financial base, high production costs as a result of the high cost of inputs
and unstable demand among others. While efforts have been made by previous
researchers to proper solutions to these issues, little has been made to
investigate the short-term liquidity problems with respect to working capital
management. Moreover, the extent to which working capital management affects
profitability of these firms is not adequately researched, this constitute the
problem of this study. And, this also led to the research question on how does
the management of working capital components impacted the profitability of
listed pharmaceutical firms in Nigeria?
However, working capital management has
been empirically examine in many different ways, while some authors studied the
impact of an optimal inventory management; others have studied the optimal way
of managing accounts receivables that leads to profit maximization (Lazaridis
& Tryfonidis, 2006; Besley & Meyer, 1987). Other studies have focused
on how reduction of working capital improves a firm’s profitability (Shin &
Soenen, 1998; Deloof, 2008; Raheman & Nasr, 2007; Samiloglu, 2008;
Zariyawati, 2009; Falope & Ajilore, 2009; Dong & Su, 2010; Sharma &
Kumar, 2011. In summary, most of these studies concentrated on a single working
capital component and the study are mostly from the developed economy, where
the market mechanisms and the business environment
significantly differ from
Nigeria. This provided a gap for this study to fill.
Similarly, this study used all the working
capital components and examines their effect on the profitability using a
multiple linear regression model. This also differentiates this study from the
previous studies in the field of working capital management and firm
performance.
1.3 Objectives of the
study
The main objective of the study is to
examine the impact of working capital management on the profitability of listed
pharmaceutical firms in Nigeria. Other specific objectives are:
i. To investigate the impact of receivables collection management on the
profitability of listed
pharmaceutical firms in Nigeria ii.To
examine the impact of inventory management on the profitability of listed
pharmaceutical firms in Nigeria.
iii.
To determine the effect of
accounts payable management on the profitability of the listed pharmaceutical
firms in Nigeria.
iv.
To identify the impact of cash
conversion circle on the profitability of listed pharmaceutical firms in
Nigeria.
v.
To determine the impact of
operating cash flow on the profitability of listed pharmaceutical firms in
Nigeria.
vi.
To determine the impact cash
ratio on the profitability of listed pharmaceutical firms in Nigeria.
1.4 Research Hypotheses
In line with the
objectives of the study, the following hypotheses have been formulated:
H01: Receivables
collection management has no significant impact on the
profitability of the
listed pharmaceutical firms in Nigeria.
pharmaceutical firms in
Nigeria.
1.5 Scope of the Study
This study aims to evaluate the impact of
working capital management and its main components on the profitability of the
listed pharmaceutical firms in Nigeria. The study is restricted to all
pharmaceutical firms listed on the Nigerian Stock Exchange (NSE) market during
the period 2002 to 2011. The study limits itself to the information in the
annual report and accounts of listed pharmaceutical firms for the period under
review.
The dependent variable of the study is
profitability, defined as the gross operating profit; and the independent
variable is working capital management measured by account payables management,
cash conversion cycle, account receivables management, inventory management,
and cash management (cash to sales ratio and cash to current liability ratio).
The study covers the
period of ten (10) years (2002-2011).
1.6 Significance of the Study
The critical role working capital
management is playing in the short-term liquidity position and the recent
crises of credit and liquidity make this study a necessity. Therefore, this
study is significant in revealing the effect of working capital management on
the profitability of pharmaceutical firms listed on the floor of Nigeria Stock
Exchange. The study’s findings may help the pharmaceutical firms in Nigeria and
other companies in general improve on their financial decision making so as to
optimize the value of the shareholders and maintain a favorable trade-off
between liquidity and profitability. The findings are also expected to be
useful to Shareholders (as owners), Creditors, Managers, and Researchers.
Shareholders as the business owners could
be the primary beneficiaries of the findings from this research, as anything
affecting the value of their investments is of great importance to them.
Working capital management has the potentials of improving profitability and
the overall firm value in general; this study is design to find out the impact
of the individual working capital components on the profitability of
pharmaceutical firms in Nigeria. Thus, the shareholders of the pharmaceutical
firms will benefit from the findings of the study.
Managers of the listed pharmaceutical
firms in Nigeria are also among the main beneficiaries of the finding of this
research. This is because managers are usually interested in understanding the
effects of their performance on the profitability and firm value. Hence, this
study is an attempt towards such direction. Moreover, managers will like to
know the stability of their firms’ liquidity position, particularly under
unfavourable economic conditions. On the other hand, the findings will enable
businesses to measure the level of safety in being able to discharge
obligations in order to attain profitability and to be prepared for unforseen
events by providing cushion for such occurences.
This study could also be of significant
importance to creditors, because they are interested in the credit worthiness
of the firms in meeting their obligations, which could only be possible with
efficient management of firm’s working capital. The study could be of interest
to the business community in particular and to the government of Nigeria whose
concern is to promote economic growth of the country through creation of an
environment that is conducive for business.
Lastly, students and researchers could
find this study useful in that they are interested in how theoretically related
variables empirically affect each other. This study is in the same direction,
and it will also serve as sources of knowledge for the student and a point of
references for researchers.