THE EFFECT OF LIQUIDITY MANAGEMENT ON FINANCIAL PERFORMANCE OF LISTED INSURANCE COMPANIES IN NIGERIA
Abstract
This study was carried out to investigate the effect of liquidity management on financial performance of listed insurance companies in Nigeria. In addressing the objectives of the study, the first objective of the study was examine the effect of Premium to asset ratio on the financial performance of listed insurance companies in Nigeria. The second objective was to examine the effect of capital adequacy ratio on the financial performance on listed insurance companies in Nigeria. The study uses secondary data from some listed insurance companies in Nigeria. Secondary data was adopted in analyzing the data. Data for this study was source from the Annual report and statement of account (various issues) of the insurance companies under consideration for the period of seven years (2012-2018), the variables employed include: liquidity ratio as the dependent variable; premium income, underwriting revenue, claims expense paid and lending interest rates are the independent variables. This study recommends that insurance companies should embrace every business strategy for prompt premium collection from policyholders as at when due. The insurance companies should recognize that profit is a necessity for the survival, so therefore excess claims reserves that may unduly depress profitability should be avoided.
TABLE OF CONTENTS
Content Pages
Title page i
Certification ii
Dedication iii
Acknowledgment iv
Abstract v
Table of Content vi
CHAPTER ONE
INTRODUCTION
1.1 Background of the study
1.2 Statement of the problem
1.3Research Questions
1.4 Objective of the Study
1.5 Research Hypotheses
1.6 Significance of the Study
1.7 Scope of the Study
CHAPTER TWO
LITERATURE REVIEW
2.1 Introduction
2.2 Conceptual Literature
2.2.1 The Concept of Financial Performance
2.2.2 The Concept of Different Measurement of Financial Performance
2.2.3 Firm Performance and its Measurement
2.2.4 The Concept of Liquidity
2.2.5 The Concept of Liquidity management
2.2.6 The Concept of Different Measurement of Liquidity
2.2.7Determinants of Financial Performance of Firms
2.2.7.1 Asset Quality
2.2.7.2 Firm Size
2.2.7.3 Capital Adequacy
2.2.8 The Relationship between Liquidity and Financial Performance (Profitability)
2.3 Empirical Review
2.4 Theoretical Framework
2.4.1Risk Return Theory
2.4.2 Extreme Value Theory
CHAPTER THREE
RESEARCH METHODOLOGY
3.1 Introduction.
3.2 Research Method/Design
3.3 Population and sample of the Study
3.2.2 Sample Size
3.4 Techniques of Data Analysis
3.4.1 Variables and their Measurement
3.5 Limitation of the Methodology
CHAPTER FOUR
DATA PRESENTATION AND ANALYSIS
4.1 Introduction
4.2 Data Analysis and Interpretation
CHAPTER FIVE
CONCLUSION AND RECOMMENDATIONS
5.1 Introduction
5.2 Summary
5.3 Conclusion
5.4 Recommendation
References
Appendix
CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
Efficient liquidity management is essential for the growth and profitability of a firm. Good liquidity management is therefore an important focus for all companies in order to avoid insolvency and eventual bankruptcy as a result of poor financial performance (Goodhart, 2008). Jenkinson (2008) noted that liquidity is an important financial indicator that measures whether the company has the ability to meet its short-term liabilities or not without incurring undesirable losses. According to Bhunia (2010) liquidity plays a significant role in the successful functioning of a business firm. A firm should ensure that it does not suffer from lack of liquidity to meet its shortterm demands. Also, keeping excess liquidity is not beneficial to the company because idle fund does not generate any income or returns to the company. It can be inferred that a well-managed firm will neither suffer inadequate liquidity, nor experience excess liquidity.
According to Panigrahi (2013) it is often observed that whenever a financial analysis of companies is done, more emphasis is given on the profitability of the business rather than on its liquidity. This is quite obvious, as the most important financial objective of any business is to earn profit. So, the managers lay more emphasis towards profitability. But another significant variable is liquidity which means the ability of a company to honor short term financial obligations. If the company which is not able to honor its short-term financial obligations, it moves a step ahead towards its bankruptcy. Liquidity management, therefore, involves the amount of investments in liquid assets to meet the short-term maturing obligation of creditors and others.
Liquidity is having enough money in the form of cash, or near-cash assets, to meet the financial obligations. In business, cash is king, particularly during tough economic times or when the markets are turbulent. Without cash, company cannot pay its bills nor carry out growth plans, and it may find it difficult to get credit or take advantage of business opportunities. A company that cannot pay its creditors on time and continue not to honor its obligations to the suppliers of credit, services, and goods can be declared a sick company or bankrupt company.
The insurance market plays an important role in the financial services industry in almost all developed and developing countries, contributing to economic growth, allocating efficient resources, reducing transaction costs, creating liquidity, promoting investments and distribution of financial losses (Das, Davies, & Podpiera, 2003). Insurance companies shares the function of insurance companies and other financial institutions beside to the role of risk minimizing by pooling similar risk exposures (Dare, 2016). The function of insurance companies and other financial institution is to establish effective and efficient pecuniary structure by risk transfer, intermediation and savings mobilization in economy. Consequently, financial bodies canal resources and transport risks from one monetary element to another to assist resources pact and trade (Saeed & Khurram, 2015). One of the most severe liquidity stress scenarios faced by an insurer is a mass surrender of policies owing to a loss of confidence in its financial strength. This happened to Equitable Life following the House of Lords ruling on its guaranteed annuity liabilities in 2000. Risk is a natural element of business and community life (kamau, F & Njeru, 2016). It is a condition that raises the chance of losses/gains and the uncertain potential events which could manipulate the success of financial institutions (Crowe, 2009).
Current assets are liquid so holding more current assets refer to high liquidity but on the other hand current assets include such items which diminish firm’s profitability. It must be remembered that different items of current assets have different degree of liquidity. Cash is the most liquid asset. For other types of current assets, liquidity concept has two dimensions of time and risk. The speed with which current assets other than cash can be converted into cash is known as time dimension of liquidity consideration. More quickly and rapidly current assets are converted into cash, more liquid those current assets shall be. The greater the relative proportion of liquid assets, the lesser the risk of running out of cash, all other things being equal. All individual components of working capital including cash, marketable securities, account receivables and inventory management play a vital role in the performance of any firm.
For the business owners, one of the most important tasks is to estimate and evaluate cash flows of the business, to well identify the long run and short run cash inflows and outflows to timely sort out the cash shortages and excess to formulate financing and investing strategies respectively. It also helps in planning the payments to creditors on time to avoid losing reputation and trust of the customers and to avoid potential bankruptcy.
If all the current obligations are met without any delay as and when these become due, creditors and all others will have a feeling of confidence in the financial strength of the organization and this will sustain the credit standing of the organization. But failure to meet such obligations on continuous basis would cause an adversely effect on the credit standing and market reputation resulting in more difficult to finance the level of current assets from the short-term sources. Keeping liquidity is usually costly, but helps avoiding negative effects of unexpected cash-flow shocks.
According to Bhunia (2010) liquidity plays a significant role in the successful functioning of a business firm. A firm should ensure that it does not suffer from lack-of or excess liquidity to meet its short-term compulsions. A study of liquidity is of major importance to both the internal and the external analysts because of its close relationship with day-to-day operations of a business. Liquidity requirement of a firm depends on the peculiar nature of the firm and there is no specific rule on determining the optimal level of liquidity that a firm can maintain in order to ensure positive impact on its profitability.
One should try neither to maximize nor minimize the liquidity ratios; one should try to optimize them in relation to the objective, which in case of a commercial company is probably the maximization of profit on capital employed. The lower the liquidity ratios are, the more vulnerable the company is to pressure from creditors which it unable to meet and vice versa. Therefore, one should seek to have as little working capital as is consistent with not being unduly vulnerable to pressure from creditors.
Liquidity Risk is also a risk of insufficient liquid assets to meet payouts from policies (surrender, expenses, maturities, etc.), forcing the sale of assets at lower prices, leading to losses, despite company being solvent (kamau, F & Njeru, 2016). Loss from meeting liquidity comes either from fire sale or by paying interest on borrowing to meet payouts. Liquidity risk arises due to two reasons, one on the liability side and other on the asset side (Sonjai, 2008). Financial performance on the other hand refers to the act of performing financial activity; it is used to measure firm’s overall financial health over a given period of time. Financial performance is a desirable objective for all profit-oriented firms. The absence of it can indeed spells failure. Typical measures of financial performance are profitability, (Yahaya & Lamidi, 2015).
Profitability refers to the process of measuring the results of a firm’s policies and operations in monetary terms. It is used as a measure of a firm’s overall financial health over given period of time. Institutions have various measures of financial performance. However, the common measures of financial performance are the Return on Assets and Return on Equity. Financial performance is a measure of the amount in which oil and gas companies return on investment exceed its cost of investment. For firm it is the gross profit margin and net profit margin that depicts their profitability position.
According to Trivedi (2010) financial performance refers to the act of performing financial activity. In broader sense, financial performance refers to the degree to which financial objectives being or has been accomplished. It is the process of measuring the results of a firm’s policies and operations in monetary terms. It is used to measure firm’s overall financial health over a given period of time and can also be used to compare similar firms across the same industry or to compare industries or sectors in aggregation. Profitability relates to the measurement of operating efficiency of companies. The profitability ratio measures efficiency of companies in using their assets to generate net income as well as return on equity which focuses on return to the shareholders of a company (Ishola, 2013).
Profitability’s information is crucial for decision making and it is used by many people in the company such as managers, investors, and financial analysts as guide for dividends payment, management efficiency tool measurement and instrument for decision making evaluation (Nassirzadeh & Rostami, 2010).
In Nigeria, previous studies such as (Ahmed et al (2011), Daniel and Tilahun (2012), Sumaira and Amjad (2013) among others concentrated on the effect of liquidity on profitability of commercial insurance companies and non-10financial institution. From the review, very few study focus on insurance sectors. This study therefore differs by concentrating on the effect liquidity management on the performance of insurance firms in Nigeria.
1.2 Statement of the Problem
The issue of liquidity for organizations is very vital to the existence of any organization especially the insurance companies. However, illiquidity of firms especially the insurance companies can lead to loss of businesses thereby reducing the potentials of earnings and profitability. This is the because high liquidity position of firm helps it to meet up with obligations of which some lead to funding of loans and advances that could aid the insurance companies to earn income inform of interests and loans.
In the light of this, scholars have argued for and against liquidity as being critical in firms’ life and profitability. Some scholars such as Duru and Ekwe (2013), argue found out that firms that maintain high liquidity earn high profitability. However, other authors argue that liquidity does not positively affect profitability. In other words, for sustainable intermediation function, insurance companies need to be profitable. Beyond the intermediation function, the financial performance of insurance companies has critical implications for economic growth of countries. Good financial performance rewards the shareholders for their investment. This, in turn, encourages additional investment and brings about economic growth. On the other hand, poor insurance company’s performance can lead to insurance company’s failure and crisis which have negative repercussions on the economic growth, Ongore and Kusa (2013).
Liquidity problems may adversely affect the financial performance of insurance companies as well as its solvency. Some studies have shown a significant positive relationship between insurance company’s profits and liquidity while others have shown a weak positive relationship. Although, studies have it that lack of adequate liquidity in insurance companies is often characterized by the inability to meet daily financial obligations. At times it may have the risk of losing deposits which erodes its supply of cash and thus forces the institution into disposal of its more liquid assets. As opined by Pandy (2015), managing monies of a firm in order to maximized cash availability and interest income on any idle cash is a function of liquidity management.
However, the problems of weak corporate governance, poor capital base, illiquidity and insolvency, poor asset quality and low earnings are some of the constraints faced by the insurance sector in Nigeria. Some worked by Johnson (2008) examined the differences in financial ratio averages between industries. The results showed that liquidity management has no effect on the firm’s profitability. Moreover, Kweri (2011) examined the same problem among manufacturing firms. There is only but a few study done so far on the effect of liquidity management on the performance of insurance companies in Nigeria. It is the light of this, that this study has evaluated the effect of liquidity management on the financial performance of insurance companies in Nigeria.
1.3 Research Questions
For the purpose of this research study, the following research questions have been formulated to guide the researcher:
- What is the relationship between Premium to asset ratio and financial performance of listed insurance companies in Nigeria?
- What is the effect of Capital adequacy on the financial performance of listed insurance companies in Nigeria?
1.4 Objective of the Study
This study evaluated the effect of Liquidity management on the financial performance of insurance companies in Nigeria. The specific objectives include:
- To examine the effect of Premium to asset ratio on the financial performance of listed insurance companies in Nigeria.
- To examine the effect of capital adequacy ratio on the financial performance on listed insurance companies in Nigeria
1.5 Research Hypotheses
- Premium to asset ratio has no significant effect on the financial performance of listed insurance companies in Nigeria
- Capital adequacy ratio has no significant effect on the financial performance of listed insurance companies in Nigeria
1.6 Significance of the Study
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.
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.
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 Management on the Financial Performance of insurance companies 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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