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, long-
term 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
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
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
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 time between 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
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
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:
- To investigate the impact of receivables collection management on the
profitability of listed pharmaceutical firms in Nigeria
- 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.
- To identify the impact of cash conversion circle on the profitability of listed
pharmaceutical firms in Nigeria.
- To determine the impact of operating cash flow on the profitability of listed
pharmaceutical firms in Nigeria.
- 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:
H 01 : Receivables collection management has no significant impact on the
profitability of the listed pharmaceutical firms in Nigeria.
H 02 : Accounts payable management has no significant impact on the
profitability of listed pharmaceutical firms in Nigeria.
H 03 : Inventory management has no significant impact on the profitability of
listed pharmaceutical firms in Nigeria.
H 04 : Cash conversion circle has no significant impact on the profitability of
listed pharmaceutical firms in Nigeria.
H 05 : Operating cash flow has no significant impact on the profitability of listed
pharmaceutical firms in Nigeria.
H 06 : Cash ratio has no significant impact on the profitability of listed
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,
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
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.