EFFECT OF LIQUIDITY RISK ON THE FINANCIAL PERFORMANCE OF LISTED MANUFACTURING INDUSTRY IN NIGERIA
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Abstract
This research work tends to investigate the effect of liquidity risk on the financial performance of listed manufacturing industry in Nigeria. To achieve profitability, manufacturing firms must maintain adequate liquidity as failure to meet their obligation as and when due results in bad credit rating by short term creditors. The study employed an explanatory research design to assess the relationship using data obtained from audited financial statements of 16 manufacturing firms in the consumer goods sector from 2009-2018. All manufacturing companies listed on the Nigerian Stock Exchange (NSE) are included in the study’s sample size calculations. The financial statements of the listed companies, which cover the five-year period from 2008 to 2017, were used to acquire secondary data. Correlation matrices and ordinary least squares regression were used to analyze the data collected. The study’s findings showed that while the quick ratio is negative and the current ratio is positive, there is little correlation between the two and profitability in a manufacturing organization. On the other hand, return on asset and debt ratio are positively and significantly correlated. Since the debt ratio has a big impact on profitability, management was advised to properly manage their debt in order to increase profitability.
CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
Liquidity and profitability of financial institutions are two vital concepts that have attracted the attention of researchers, as many empirical studies contradict the assumed inverse relationship between the two concepts (Charmler, Musah, Akomeah, & Gakpetor, 2018). Extant studies ascribe the global financial crisis of 2009/10 to liquidity crunch. Still, most of them used theoretical approached, only a few supported their claim by empirical, and those few also employed controversial metrics for profitability (Marozva, 2015). Profitability is a significant factor in the going concern of a business, and managers strive to achieve a reasonable level of profitability to maximise their shareholders’ wealth. The Management of Liquidity is a direct tie-in to the management of working capital and its components viz; inventories, cash and cash equivalents and short term/current liabilities. Definitively, the management of management entails the quick transformation of stock or inventory and receivables to cash, prompt payment of creditors, and the astute re-investment of free lying cash into cash equivalents such as treasury bills and commercial papers which are short term in nature, and easily marketable. All these contribute to the ultimate goal of profit maximisation.
Firms across all sectors and nations have failed due to improper liquidity management. Many of the failed companies always experience difficulties in meeting their short-term obligations, those that managed their liquidity problems in prudent manners survived while those who did not manage it well eventually liquidated. Liquidation occurs as a result of persistent illiquidity and inability to make adequate profit. Often times, during favourable economic conditions, many firms neglect working capital management, which is very fundamental to continuous cash flow, liquidity and profitability. Insufficient working capital makes it difficult for firms to expand and trade profitably. Liquidity problem has forced some Nigerian firms to reduce their workforce leading to increase in unemployment market; Ajaokuta steel complex reduced their staff from 5000 to 1000 in 2007 (Duru, Ekwe, & Eje, 2014). Similarly, liquidity problem has made it difficult for some manufacturing firms in Nigeria to pay dividends; Champion Breweries has not paid a dividend since 1988, and likewise, Golden Breweries since 1997 (Duru et al., 2014). This study, therefore, seeks to find out the relationship between liquidity and profitability manufacturing companies in the Nigerian Stock Exchange.
Liquidity is the ability of a firm to meet its short-term obligations like payment to creditors, bills payable and outstanding expenses. It ascertains the firm’s capacity to honour all its matured obligations. Meaning firm’s survival hinge on liquidity management (Yameen & Pervez, 2016). Risk management as part of business management function is argued to be an essential element to be considered in the contemporary business world. According to Ugwuanyi and Ibe (2012) the method of planning, leading, organising and directing the operation of a firm to be able to reduce the outcome of risk on a firm’s performance is very essential. Mugenda, Momanyi, and Naibei (2012) also is of the opinion that prioritizing and managing risks is becoming increasingly important to a firm has it assist in the ability to adjust to an ever-changing and global business environment. Risks are now amplifying as a result of globalisation and it management is indispensable to the success of a firm (Ironkwe & Osaat, 2019). A firm cannot function without taking measured risks. Not all risk is bad, some degree of risk must be considered in order to growth or avoid stagnation. In as much there is risk, its management will be is required.
Current ratio and quick ratio are mostly use by firms to measure their liquidity position. Current ratio is the relationship between current assets and current liabilities. Usually, the higher current ratio the better for the firm to meets its short term liabilities promptly. Quick ratio shows the relationship between quick or liquid assets and current liabilities. The liquidity of an asset is how it can be immediately converted into cash without a losing its value. Low liquidity implies companies may be unable to pay off its creditors in good time or failure to meet up the obligation to suppliers of credit, services and goods. Resulting to non- availability of supplies and possible insolvency. Also, failure to meet up with short term obligation will negatively affect the operation of the company as well as its reputation. The liquidity position of a firm is the uttermost concern of most stake holders. For instances, suppliers check the liquidity of a company before is willing to sell goods on credit. Employees should be aware of company’s liquidity position so as to ascertain whether the company is able meet their related obligations, such as salary, pension, provident fund and soon. Thus, maintenance of adequate liquidity is a necessity to companies. Debt ratio shows the relationship of total liabilities and total assets, that is, it shows the ability of a company to pay off its liabilities using its assets. In a nutshell, it measures how many assets the company must dispose in order to pay off all its liabilities. A debt ratio greater than one signifies that liabilities is more than assets, this can put the company at high financial risk. On the other hand, a ratio less than one indicates the company have more assets than liabilities, which can be a health sign for the company.
The profitability of a company is basically its capacity to incur expenses less than its income generated and as a good measure of performance, it is the profit generating ability of an asset (return on asset ROA) or alternatively, the rate of return on investment (ROI), “If there will be an unjustifiable over-investment in current assets then this would negatively affect the rate of return on investment” (Vishnani & Shah, 2007). Even though the definitive objective of any firm is profit maximisation, a firm’s liquidity management is key also. It is pertinent to note that focus on the maximisation of profit at the expense of astute liquidity management can be detrimental to a firm’s existence. Thus there must be a compromise between these two, setting a moderate divide towards the pursuit of both objectives as both are equally important.
Read Also: LIQUIDITY MANAGEMENT AND FINANCIAL PERFORMANCE OF INSURANCE INDUSTRY
However, existing studies have cantered on financial institutions and financial aspect of liquidity, whereas, much more work is needed in other sectors and the operational dimension of liquidity such as cash conversion cycle (Demirgünes, 2016). Liquidity plays a crucial role in firms sustainability as it smoothens firms’ operation, and it is an indicator of firms’ ability to pay back their short-term liabilities (Yameen, Farhan, & Tabash, 2019). Liquidity management as it were, determine to a large extent the quantity of profit that result as well as the value of shareholders wealth (Ben-Caleb, 2008). This is because, a firm in order to survive must remain liquid as failure to meet its obligation in due time results in bad credit rating by the shortterm creditors, reduction in the value of goodwill in the market and may ultimately leads to liquidation (Bhavet,2011). Hence, a good and firm financial management policy seeks to maintain adequate liquidity in order tomeet its short-term maturing obligations without impairing profitability.
1.2 Statement of the Problem
Unfortunately, the principal focus of most organizations is profitability maximization while the need for efficient management of liquid assets is ignored. This approach is justified by the belief that profitability and liquidity are conflicting goals. Hence, a firm can only pursue one at the expense of the other, in consonance with the theory of liquidity and profitability trade-off. On the contrary, Padachi (2006) advised that a firm is required to maintain a balance between liquidity and profitability while conducting its daily operations. This is because both inadequate liquidity and surplus liquidity directly affect profitability (Ogundipe, Idowu and Ogundipe, 2012). For instance, when the “necessary” level of liquid assets is exceeded, their surpluses when the market risk remains stable, become a source of ineffective utilisation of resources which has an adversed effect on profitability. An insufficient working capital on the other hand, result in a liquidity crisis which is life threatening and can force a company into bankruptcy, often with little notice; this also affect the returns of the firm (Spinella, 2007). To the best of the researcher’s knowledge there are limited studies done on liquidity management and profitability of manufacturing firms in Nigeria which constitute a gap that this study seek to fill. This study investigates the effect of liquidity risk on the financial performance of listed manufacturing industry in Nigeria.
1.3 Objective of the Study
The main aim of this study is to examine the effect of liquidity risk on the financial performance of listed manufacturing industry in Nigeria. The specific objectives are:
- To examine the effect of current ratio on the profitability of listed manufacturing firms in Nigeria.
- To examine the effect of quick ratio on the profitability of listed manufacturing firms in Nigeria.
- To examine the influence of debt ratio on the profitability of listed manufacturing firms in Nigeria.
1.4 Research Questions
The study will be guide by the following research questions:
- Does current ratio has any significant relationship with profitability of listed manufacturing firms in Nigeria?
- Does quick ratio has no significant relationship with profitability of listed manufacturing firms in Nigeria?
- Does debt ratio has no significant relationship with profitability of listed manufacturing firms in Nigeria?
1.5 Research Hypotheses
The following hypotheses were developed in null form:
H01: Current ratio has no significant relationship with profitability of listed manufacturing firms in Nigeria.
H02: Quick ratio has no significant relationship with profitability of listed manufacturing firms in Nigeria.
H03: Debt ratio has no significant relationship with profitability of listed manufacturing firms in Nigeria.
1.6 Significance of the Study
The study has a significant role to play in filling the gap and understanding the effect of Liquidity Management on the Financial Performance of insurance companies in Nigeria. It will also help financial managers to decide and understand the effect that firm’s Liquidity has on Financial Performance of companies in general and Insurance companies in particular in order to maintain an optimal and ideal Liquidity that will help firms achieve organizational objectives.
Acquiring knowledge on the effect of Liquidity Management on the profitability of quoted insurance companies in Nigeria will help finance manager to predict potential problems associated with financing decisions and also help to achieve the goals of shareholders.
It will also help investor to invest in insurance companies to understand and analyze the effect of Liquidity Management on their Financial Management and maximizing their objectives. It will also serve as a reference to other researchers in the area of financial management.
1.7 Scope of the Study
The study is concerned with the effect of liquidity risk on the financial performance of listed manufacturing industry in Nigeria; the evaluation of the profitability of insurance firms is for the period of seven years (2012-2018).
1.8 Definition of Terms
Liquidity Management: This is a concept broadly describing a company’s ability to meet financial obligations through cash flow, funding activities and capital management.
Financial Performance: this is subjective measure of how well a firm can use assets from its primary mode of business and generate revenue
Listed insurance company: Thus is a business that provides coverage, in the form of compensation resulting from loss damage, injury treatment or hardship in exchange for premium and also listed on the Nigeria stock Exchange.
Revenue per policyholder: This is a simple key performance indicator (KPI) that measures the amount of revenue generated by the insurance company, per policyholder serviced.
Average cost per claim: This measures how much the insurance company pays out for each claim filed by their customers.
Return on surplus: This shows how much profit an insurance company can bring in relative to the amount of revenue it generates from underwriting insurance proceeds and investing proceeds, with policyholder surplus representing how much an insurer’s assets exceed its liabilities.
Policy sales growth: This measures how many new policies your organization has sold over a set period of time and compares that to a target value.
Current Ratio: This is a liquidity ratio that measures a company’s ability to pay short-term obligations or those due within one year.
Liquidity buffer: This refers to the proportion of highly liquid assets held by financial institutions, to ensure their ongoing ability to meet short-term obligations.
Risk monitoring and reporting: This is a process of actively monitoring and reporting any risk exposures or funding needs.
Acid test ratio: This is a liquidity ratio that measures the ability of a company to pay its current liabilities when they come due with only quick assets; quick assets being assets that can be converted into cash within 90 days or in the short term.
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