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EFFECT OF WORKING CAPITAL ON
PROFITABILITY OF QUOTED PHARMACEUTICAL COMPANIES IN NIGERIA
ABSTRACT
The
importance of working capital in profitability and liquidity of firms cannot be
undermined. The study examined the impact of working capital on profitability
of quoted firms in pharmaceutical industry in Nigeria. Working capital was
represented by accounts receivable period, accounts payable period, inventory
turnover period, cash conversion cycle, current ratio and debt ratio and
profitability was proxied by return on assets. The sample of the study
comprised five quoted firms in the pharmaceutical industry. Data was obtained
from the financial reports of selected firms between 2011 and 2016, and the
panel least square technique, precisely the fixed-effect model was adopted for
the analysis of data. The results indicated that working capital variables explained
61.1% variation in firm profitability. Furthermore, accounts payable period,
inventory turnover period and current ratio had positive impact on
profitability of selected firms, while accounts receivable period, cash
conversion cycle and debt ratio had negative impact on profitability of
selected firms.. Furthermore, accounts payable period, inventory turnover
period, cash conversion cycle and current ratio exerted significant influence
on profitability of selected pharmaceutical firms in Nigeria within the periods
estimated. The study suggested amongst others that firms should strive to
reduce their cash conversion cycle in order to improve profitability and
maximize the wealth of shareholders.
CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
Working
capital indicates the level of a firm’s investment in short-term assets.
Working capital is simply the excess of current assets over current
liabilities. Management of working capital refers to adjustment and regulation
of a firm’s current assets and liabilities in order to ensure that short-term
capital structure are met and fixed assets are appropriately maintained
(Akinyomi & Tasie, 2013). Working capital management is a strategic aspect
of financial management because it centers on decisions pertaining to how
current assets are composed and financed. The management of working capital is
pertinent to the financial position of a firm irrespective of their size,
capital and line of operations. The reason as espouse by Padachi (2006) is
attributable to the fact that management of working capital enhances the
profitability, liquidity and efficiency of a firm. Furthermore, management of
working capital ensures the optimal utilization of investment that is channeled
to short-term assets. Thus, the management of working capital attempts to
balance the divergence between profitability and liquidity position of a firm
simultaneously with its daily operations. However, excessive level of current
assets hampers the profitability of an entity while little level of current
assets makes an entity susceptible to illiquidity and insolvency, thereby
making it difficult to run such organization.
The
decisions pertaining to working capital concentrates on maintaining the
relationship between the short-term assets and liabilities of a firm so as to
ensure such entity continues operations and have adequate cash flows to meet
short-term debts and prospective operational expenditure as well as enhancing
profitability (Paul & Agbo, 2014). Working capital constitutes current
assets and liabilities that are needed to be combined with fixed assets in
order to carry out daily activities of an entity. The current assets relevant
for managing fixed assets are cash in hand, cash at bank, stock and accounts
receivable while the current liabilities needed for the working of fixed assets
include accounts payable, short-term bank loan and bank overdraft. Current
assets and liabilities are the main components of working capital (Ojeani,
2014). The management of working capital is imperative in the financial
management of an entity simply because working capital influences profitability
and liquidity position of an entity. Efficient working capital management is
sine qua non for the financial performance of firms as it serves as a yardstick
for measuring their financial health.
The finance
manager is expected to accommodate working capital management as part of his
financing decisions along with capital budgeting and capital structure. Brealy
J., Finns A., & Floyd M.(2006) states that working capital is the
conjunction of current assets and liabilities while current assets are the kind
of capital tied up in cash such as short-term investment, stocks, accounts
receivable and the other current assets, while current liabilities encompasses
short-term loans, debts to suppliers, outstanding taxes from income, dividends
payable, interest payable on loan and other current liabilities (Bello &
Yinusa, 2010). Working capital enlightens an entity on how to manage its short-term
capital and the objective of working capital management attempts to enhance
liquidity, net-worth, profitability and wealth of shareholders. Yahaya (2016)
maintains efficiency in the management of working capital enables an entity
meet its short-term obligations and maintain adequate liquidity in order
engender continuity of operations.
Optimal
working capital management involves co-coordinating an entity’s account
receivables, account payables, inventory management and cash conversion cycle
in order to strike a balance between risk and return and consequently enhancing
the profitability position of an entity. Account receivable refers to the time
period taken by credit customers to settle their short-term obligations.
Finance managers must ensure that the amounts recovered is greater than the
cost of debt collection. Account receivable refers to the time taken by an
entity to fulfill its short-term obligations.
It indicates the credit time extended to an entity by its suppliers and
creditors. Stephen (2012) posits that cash conversion cycle reflects the
synergy between the components of working capital and cash flows of an entity.
It is an indicator of cash management and is equally used to ascertain the
amount of cash needed for sales. Inventory management consists of raw
materials, work in progress and finished goods. Holding too much stock results
in tied up capital in stock reduces profit and at the same time holding little
stock results in stock-out situations, which increases the likelihood of an
entity to be unable to settle its short-term obligations whenever they arises.
The economic quantity theory is usually employed by manufacturing outfits to
know the optimal stock holdings. Thus, efficient working capital management
ensures that current assets and current liabilities are managed in such a way
that an entity is able to meet its short-term obligations as well as avert
occurrences of excessive investment on those assets.
1.2 Statement of Problem
The
objective of working capital is to enable firms develop and maintain regular
cash flows to run their daily business activities. Efficient management of
working capital improves the profitability and liquidity positions of an entity
and engenders the continuance of business operations. Excessive capital
holdings reduce profits and insufficient holdings of capital threaten the
continuity of business operations. Ridah (2015) posits that most firms are
unable to meet their short-term obligations because of their incapability to
hold optimal amount of stocks, debts and cash. Excessive or inadequacy of
working capital indicates that the firms lacks the capacity to finance its
projects, improves its sales, thereby inhibiting profitability and
organizational growth. Ojeani (2014) supports that most Nigerian firm
especially those operating in the non-financial sector record poor performance
in recent years because of their ineptitude to effectively manage their working
capital.
Apart from
the holding too much or less of stock, firms in Nigeria are beset with low capacity utilization, poor
financial base, high cost of raw-materials importation thereby resulting in
high cost of production, volatility in demand,
high cost of doing business and toughness of business environment in
Nigeria. Maintaining an optimal level of working capital pertains to weighing
the risk and returns of investment in short-term capital. In reality, it is a
herculean task to precisely ascertain the amount of working capital needed by
an entity. An entity that is not interested in undertaking more risk can settle
for short-term liquidity. It is therefore germane for an entity to gear efforts
towards the efficient use of funds in order to maximize profit. Little
investment in working capital is injurious to the profitability, liquidity as
well as solvency of an entity.
Studies such
as Akinyomi & Tasie (2013); Ojeani (2014), Paul and Agbo (2014); Ridah
(2015) and Ahmad N., Malik M., Nadeem N., & Hamad N.(2014) focuses on the
impact of working capital/ working capital management on profitability or
financial performance majorly on the manufacturing (chemical and industrial)
and construction industries. An intensive investigation of literature revealed
that there is paucity of studies on working capital and profitability firms in
industries like agro-allied, pharmaceutical, textile, plastic and paint
industry in Nigeria. There is need to extend the subject area to these
industries in order to have broadened findings on the actual effect of working
capital on firm profitability. To this end, the study covered gap in literature
by assessing the effect of working capital on profitability of quoted firms in
the Nigerian pharmaceutical industry.
1.3 Objectives of the Study
The main
objective of the study is to assess the effect of working capital on
profitability of selected quoted firms in Nigeria. The specific objectives of
the study are to;
Evaluate the effect of accounts receivable
period on the profitability of selected quoted pharmaceutical firms in Nigeria.
Examine the
effect of accounts payable period on the profitability of selected quoted
pharmaceutical firms in Nigeria.
Assess the
effect of inventory turnover period on the profitability of selected quoted
pharmaceutical firms in Nigeria.
Explore the
effect of cash conversion cycle on the profitability of selected quoted
pharmaceutical firms in Nigeria.
Evaluate the
effect of current ratio on the profitability of selected quoted pharmaceutical
firms in Nigeria.
Evaluate the
effect of debt ratio on the profitability of selected quoted pharmaceutical
firms in Nigeria.
1.4 Research Questions
The study
attempts to provide relevant answers to the following questions:
To what
extent does accounts receivable period affect the profitability of quoted
pharmaceutical firms in Nigeria?
Does
accounts payable period affect the profitability of quoted pharmaceutical firms
in Nigeria?
How does the
inventory turnover period affect the profitability of quoted pharmaceutical
firms in Nigeria?
To what
extent does cash conversion cycle affect the profitability of quoted
pharmaceutical firms in Nigeria?
Does current
ratio affect the profitability of selected quoted pharmaceutical firms in
Nigeria?
How does
debt ratio affect the profitability of selected quoted pharmaceutical firms in
Nigeria?
1.5 Research Hypotheses
The
hypotheses guiding the study are stated as follows:
H01: Accounts receivable period has no significant
effect on the profitability of quoted pharmaceutical firms in Nigeria.
H02: Accounts payable period has no significant
effect on the profitability of quoted pharmaceutical firms in Nigeria.
H03: Inventory turnover period has no significant
effect on the profitability of quoted pharmaceutical firms in Nigeria.
H04: Cash conversion cycle has no significant
effect on the profitability of quoted pharmaceutical firms in Nigeria.
H05: Current ratio has no significant effect on
the profitability of quoted pharmaceutical firms in Nigeria.
H06: Debt ratio has no significant effect on the
profitability of quoted pharmaceutical firms in Nigeria.
1.6 Significance of the Study
This study
through its findings is of immense benefits of management of organizations,
industries, shareholders, creditors, business environment and academia. The
study is beneficial to the management of pharmaceutical firms and other firms
as it enlightens them on how to make better decisions in order to maximize the
wealth of shareholders and strike a balance between their profitability and
liquidity. Shareholders will find this study worthwhile as it informs them on
how their investment can be enhanced for better profit performance. It unravels
how each components of working capital affects the profitability of their
firms.
This study
is of paramount importance to finance managers as it enables them ascertain the
level of their profitability and liquidity positions during periods of economic
and financial crises. The study will equally help managers of organizations to
assess their ability to meet to obligations for better profit performance and
also makes them prepared for unanticipated situations.
Creditors
will find this study useful as it unveils the credit worthiness of an entity.
It inform their decisions on whether to supply credit facilities to an entity
as well as the capacity of such entity to repay credit as at when due.
Government through its agencies will be informed to make sound policies to
foster the business climate of Nigeria.
This study
serves as a body of reserved knowledge that can be consulted by future
researchers on the subject matter.
1.7 Scope of the Study
This study
evaluates the effect of working capital on the profitability of quoted
pharmaceutical firms in Nigeria. The study covers health and drug industries in
Nigeria. The time frame of the study is a six (6) year period spanning between
2011 and 2016.
1.8 Definitions of Key Terms
Working
Capital – refers to the excess of current assets over current liabilities. It
is the amount of investment in assets expected to be realized within a year’s
trading.
Working
Capital Management –refers to the regulation and control of a firm’s current
assets and current liabilities in order to meet short-term obligations and
service fixed assets of such firm.
Profitability
– refers to the ability of an entity to make profit. It indicates the
efficiency of an entity to make profits given the available resources at its
disposal.
Quoted Firms
– This is used to describe firms whose shares and stocks are tradable on the
floor of stock exchange markets. Quoted firms in Nigeria therefore refer to
those firms whose shares are traded on the Nigerian Stock Exchange.
Liquidity –
This refers to the ability of an entity to pay its liabilities in a timely
manner, as they come due for payment under their original payment term.
Efficiency–
This describes the measurement of the productivity of a company’s assets by
comparing level of assets and total assets to revenues this assets produce.
Nigerian
stock exchange – This is used to describe the financial market that provides
the platform for stockbrokers and traders to meet and transact in financial
securities.
Pharmaceutical
industry – This is described as a drug company which is a commercial business
licensed to research, develop, market and/or distribute drugs, most commonly in
the context of healthcare.
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