Effect of Working Capital on Profitability of Quoted Pharmaceutical Companies in Nigeria

Effect of Working Capital on Profitability of Quoted Pharmaceutical Companies in Nigeria

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Abstract on Effect of Working Capital on Profitability of Quoted Pharmaceutical Companies in Nigeria

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 of  Effect of Working Capital on Profitability of Quoted Pharmaceutical Companies in Nigeria

INTRODUCTION

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.

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.

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.

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?

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.

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.

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.

 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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