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JOURNAL OF RESEARCH IN NATIONAL DEVELOPMENT VOLUME 8 NO 1, JUNE, 2010


AN APPRAISAL OF THE RELATIONSHIP BETWEEN WORKING CAPITAL
AND LIQUID ASSETS OF NIGERIAN COMPANIES:
A COMPARATIVE STUDY OF TEN SELECTED COMPANIES

Jinadu Olugbenga
Department of Accountancy, Rufus Giwa Polytechnic, Owo
E-mail: olugbengajinadu@yahoo.com

 

Abstract
This study was carried out to establish the relationship that subsists between working capital and liquidity levels of Nigerian companies. Specifically, the study seeks to find out whether most Nigerian companies suffered from inadequacy of liquid assets to meet their short term financial obligations. To determine this relationship, descriptive approach was adopted coupled with the use of correlation coefficient to establish the nature of the relationship. It was recommended that companies should strive to maintain optimal stock level; short term bank facilities should be a last resort; and companies are encouraged to exploit more cost-effective funding like rights issue to raise the needed working capital.
Keywords: Working capital, liquid assets, financial obligations, relationship


Introduction
There is a pronounced problem of working capital management if critically looked at Nigerian situation (Oluboyede, 2007). Some promising investments with high rate of return had turned out to be failures and were frustrated out of business because of inadequacy of working capital. Many factories had been either temporarily or completely shot down because they could not meet their financial obligations as at when due because they were not liquid. Many Nigerian workers had been forcefully thrown into unemployment market and frustratingly became dependent on relations as a result of the aborted mission of their organization caused by twin variables of working capital and liquidity. Unfortunately, Nigeria capital and money markets are not really helping to ameliorate the problem, instead, more often than not they compound the problem by creating bottlenecks with harsh conditions that could not be easily met by the companies that are at the verge of collapse.

It is in the light of this operational crisis faced by many companies in Nigeria that the need to carry out a study on the topical issue arises. The focus is to exploit the possibility of coming out with feasible suggestions that will remove or cushion the attendant adverse effects of working capital and liquidity on the overall performance of the Nigerian economy.
Working capital is concerned with short-term financial planning. Weston and Brigham (1997) described working capital as a firm’s investment in short-term assets, namely cash, short-term investments, trade debtors and stock. On the other hand, Copeland (1998) defined working capital as current assets minus current liabilities. Thus, working capital is the aggregate of funds, which are continuously in use and turned over many times in a year. Every business firm requires an amount of working capital, though they differ in their degree of requirements. Hence, it can be said that working capital is vital for business survival and Brealey and Myers (1996) described it as the effective blood of any business.
The importance of working capital cannot be over-emphasized. For instance, surveys indicate that the largest portion of a financial manager’s time is devoted to the day-to-day internal operations of the firm, which can appropriately be included under the heading of working capital management. Fox and Limmack (1998) opined that current assets represent more than half the total assets of a business firm and this investment tends to be relatively volatile and thus current assets  of firms need careful attention.

Brigham (1980) explained liquidity as the ease with which a company can turn its current assets into cash. Liquidity is an offshoot of working capital because cash is a component of current assets. Horne (1998) opined that linear relationship subsists between liquidity and profitability of a firm, more especially the manufacturing outfits in which they have to make frequent and timely disbursements to the various stakeholders before they can enjoy smooth operation needed to reach the desired goals.

Ten companies were selected from both first and second-tier stock market. Five each of the companies were chosen from manufacturing and trading outfits.

Objective of the study

The general objective is to find out whether industry average of working capital requirement has any relevance to a company in meeting her financial obligations as at when due.
The specific objectives are as follows:
i.          to appraise the relationship between working capital and liquidity.
ii.         to establish the effect of the relationship of the said two variables on the operation of the selected companies.

 Review of related literature and theoretical framework

The study of relationship between working capital and liquidity level is becoming more relevant because many organizations in the recent past had fallen a victim of premature liquidation as a result of inadequate attention to management of working capital from the management of the affected firms. Pandey (2005) classified working capital into gross and net concepts. He defined gross working capital as the firm’s investment in current assets. Current assets are the assets which can be converted into cash within an accounting year and these include cash, short-term securities, debtors, bills receivables and stocks. He described net working capital as the difference between current assets and current liabilities. Current liabilities are those claims of outsiders, which are expected to mature for payment within an accounting year. These include trade creditors, bills payable, bank overdraft and short-term loan. Horne Van (2000) described working capital management as involving the administration of these assets namely cash, marketable securities, receivables and inventories and the administration of current liabilities.

Brigham (1997) explained liquidity as the ease with which a firm can turn its current assets into cash.  Horne Van (2000) defined liquidity as the ability to realize value in money. . Most of the studies were centered on how to achieve efficiency and reach optimal level in all the components of both the current assets and current liabilities, including cash management. It is regrettable to note that in spite of huge literature in this area, many firms had crashed, more especially manufacturing sector in which application of working capital is more pronounced. The study thus seeks to fill the vacuum by having a closer look at the relationship between working capital and liquidity level, and its implication on the operation and performance of companies.

 An understanding of the concept of working capital cycle will give appreciation for the study of relationship between working capital and liquidity level. Weston (1998) described working capital or cash operating cycle as the total length of time required to complete the following sequence of events:
-           Conversion of cash into raw materials;
-           Conversion of raw materials into work in progress;
-           Conversion of work in progress into finished goods;
-           Conversion of finished goods into debtors through sales; and
-           Conversion of debtors into cash.

Grass (1972) defined working capital cycle as the total length of time between investing cash in paying for raw materials at the start of production and its recovery at the end with the collection of cash from debtors. The relevance of working capital cycle is that it provides information on length of time required to recover the initial investment in current assets. Beyond this also, it enables firms too know the required funds needed to sustain its smooth operation and to source for them while the cycle lasts. Frame and Curry (1974) opined that there is a linear relationship between working capital cycle and liquidity because the latter is concerned with the relative amount of each and other assets that can be quickly converted to cash available to meet short-term liabilities.

Time is the common feature of all items making up working capital. Clearly, Frame and Curry optimized this by saying that the longer the stocks and work-in-progress are held and debtors remained outstanding the more capital needs to be found to finance them. Consequently, an effective working capital should concentrate on minimizing the time stocks are held, work-in-progress is processed and debtors paid up but on the other hand, extending the time creditors are paid.

It has been highlighted that every business must have an objective or objectives as a basis upon which short-time targets can be established. The concept is based on the assumption of efforts to achieve wealth maximization for the owners. The financial managers are tasked to find an optimal level where liquidity objective of an organization equates the profitability objective. These two objectives are termed by the classical theorists of financial management as ‘twin’ evils. Prasanna (2003) explained that there must be trade-off between how a firm maintains its liquidity position and its profitability position as well. He opined that to make more profit, an organization is likely to be short of liquid assets; conversely, in order to retain more liquid funds in the company’s capital structure, the profitability objective might be impaired. The financial statement coming out as output from the accounting process needs to be analysed by the management of the firm or by  outsiders in order to make certain deduction about the strengths, weaknesses and potential of the firm.

The key to management of working capital, as explained by Bridge & Dodds (1975), is striking a balance between risk and profitability. They opined that when cash comes into a business and it actually leaves the business is not a matter of interpretation but a matter of fact notwithstanding the records or accounting system in operation. All items of expenditure, including those that are ultimately profitable, reduce the company’s liquidity in the short term, for example, the cash outflow associated with payment of wages will not result in a cash inflow until the goods have been produced, placed in inventory, sold and finally, the revenue collected.

 The implication is that there is a need of a powerful tool for analysis of the financial position and operational performance of the firm. The developed tool for this purpose is described as ratio analysis. Pickle and Lafferty (1982) defined ratio analysis as the indicated quotients of two mathematical expressions and as the relationship between two or more variables. For the purpose of this study, ratio analysis is referred to as mathematical expressions, which in the context of profit and loss account and balance sheet will mean the relationship between two or more items appearing on the financial statements. The two most relevant ratios in this study are liquidity ratios and profitability ratios. Liquidity ratios measure the firm’s ability to meet current obligations as they become due. Oye (2002) explained that analysis of liquidity needs the preparation of cash budgets and cash flow statements to facilitate establishment of relationship between cash and other current assets to current obligations thus providing a quick measure of liquidity. As explained by Jinadu (2005), the most common ratios, which indicate the extent of liquidity or lack of it, are current ratio and quick assets ratio: Current ratio measures the relationship between current assets and current liabilities and is designated as current assets/current liabilities. On the other hand, quick assets ratio indicates the relative amount of cash and other assets that can be quickly converted to cash available to meet short-term liabilities. For these purposes only liquid assets are considered. Therefore, stocks are deducted from the current assets. It is formulated as: Current Assets – Stock/Current Liabilities.

A firm should ensure that it does not suffer from lack of liquidity and also that it is not too much highly liquid. Oye (2002) opined that the failure of a company to meet its obligations due to lack of sufficient liquidity will result in bad credit image, loss of creditor’s confidence or even in lawsuits resulting in the closure of the company. A very high degree of liquidity is also bad because the assets earn nothing, it is, therefore, necessary to strike a proper balance between liquidity and lack of it.

Methodology

The study was conducted using secondary data originating from the past financial statements of ten selected trading companies. The selection was purposive towards the companies with the earlier quotations at stock market and with decades of trading activities. Six of the companies were picked from the first-tier market and the remaining four from the second-tier market. Compiled data was used which Miller (1999) described as data which has received some form of selection. The choice of documentary secondary data which Imonitie (2004) termed as archival research was informed by the nature and objective of the study to establish the relationship that subsists between working capital and liquidity level by analyzing trend between the two variables of aggregate of five-year financial statements of the ten companies. The selected years are 2004 to 2008. The choice of these companies was due to the fact that their operations are spread throughout the country and they are the largest employers of labour in the manufacturing and trading sectors. Descriptive approach was adopted to explain the trend of relevant key accounting ratios from the selected companies, which gave corroboration and better explanations to the type of relationship established from the study. Correlation Coefficient was the statistical inference used to establish the nature of the relationship between working capital and liquidity.

 

Data analysis


Table 1: Analysis of Working Capital of the Selected Companies


COMPANY

      A

         B

       C

       D

       E

       F

         G

         H

         I

         J

CURRET ASSET (N’000)

1,322.000

2,368,000

2,293,000

3,482,000

5,466,000

8,142,000

12,779,000

20,111,000

18,966,000

20,570,000

CURRENT LIABILITY (N’000)

1,128,000

2,093,000

1,839,000

2,650,000

4,361,000

6,679,000

10,274,000

16,853,000

16,823,000

18,200,000

 

WORKING CAPITAL
(N’000)

194,000

275,000

454,000

832,000

1,105,000

1,463,000

2,505,000

3,258,000

2,143,000

2,370,000

CURRENT RATIO

1.17:1

1.13:1

1.25:1

1.31:1

1.25:1

1.22:1

1.24:1

1.19:1

1.13:1

1.13:1

 

 

 

 

 

Sources: Aggregate of 5years Financial Statements of10 Selected Companies (2004-2008).


Table 1 reveals that all the ten companies’ current assets covered their current liabilities more than one. Thus, using the current ratio as an analysis of the liquidity positions of the companies, it becomes obvious that all the companies were liquid over the period. However, it is noteworthy to explain that stocks, which are quickly convertible to cash, were included. It becomes necessary to remove stocks from current assets of such Company in order to arrive at a more accurate analysis of the liquidity position of each company.

The quick ratio is considered as the basic measure of core liquidity. By removing inventory, quick ratio enables us to test whether the organization can meet its short-term obligations even if it can not sell its inventory. This is important because there is always a danger that market conditions can change to make inventory unsaleable.


Table 2: Analysis of Quick Ratio of the Selected Companies


COMPANY

       A

       B

         C

         D

         E

        F

         G

         H

         I

         J

CURRENTASSET (N’000)

1,322.000

2,368,000

2,293,000

3,482,000

5,466,000

8,142,000

12,779,000

20,111,000

18,966,000

20,570,000

STOCK (N’000)

481,000

1,289,000

1,365,000

1,578,000

2,918,000

5,280,000

8,069,000

13,943,000

11,499,000

9,520,000

NET CURRENT ASSET (N’000)

841,000

1,079,000

927,000

1,904,000

2,547,000

2,862.000

4,710,000

6,168,000

7,466,000

11,050,000

CURRENT LIABILITY (N’000)

1,128,000

2,093,000

1,839,000

2,650,000

4,361,000

6,679,000

10,274,000

16,853,000

16,823,000

18,200,000

Quick RATIO

0.75:1

0.52:1

0.50:1

0.72:1

0.58:1

0.43:1

0.46:1

0.37:1

0.44:1

0.61:1

 

 

 

 

Sources: Aggregate of five years Financial Statements of 10 Selected Companies (2004-2008).

 


It becomes evident therefore from table 2 that none of the companies was liquid enough to cover its current liabilities when considered under quick ratio. Experts believed healthy company should have a quick ratio that exceeds 1. Many analysts consider a quick ratio of 1.2:1 and 1.5:1 as ideal.

Only three of the companies were nearer to quick ratio that is at par with their current liabilities, and these are companies A, D and J with 0.75:1, 0.72:1 and 0.61:1 respectively.
The implication is that most trading companies in Nigeria are not meeting their short-term financial obligations.


 

Table 3: Ratio of Stock to Current Assets of  the selected companies

 

COMPANY

         A

        B

        C

        D

        E

        F

        G

       H

       I

       J

CURRENT ASSETS (N’000)

1,322,000

2,368,000

2,293,000

3,482,000

5,466,000

8,142,000

12,779,000

20,111,000

18,966,000

20,570,000

STOCK (N’000)

481,000

1,289,000

1,365,000

1,578,000

2,918,000

5,280,000

8,069,000

13,943,000

11,499,000

9,520,000

% STOCK TO CURRENT ASSETS

0.36

0.54

0.60

0.45

0.53

0.65

0.63

0.69

0.61

0.46

Sources: Aggregate of five years Financial Statements of the10 Selected Companies (2004-2008).


Table 3 shows the relationship between stocks and total current assets. Seven out of the ten companies reveal that more than 50 per cent of their investment in current assets was spent on inventories. Five of the companies spent between 60 to 69 per cent on inventories. The table vividly revealed that most of the selected companies carried heavy stocks, thus unnecessarily under pressure to source for additional funds to meet their pressing short-term financial obligations.


 

Table 4: Percentage of Short-Term Bank Facilities to Current Liabilities of the Selected Companies

COMPANY

          A

        B

        C

        D

         E

        F

       G

       H

       I

       J

 CURRENT LIABILITY (N’000)

1,128,000

2,093,000

1,839,000

2,650,000

4,361,000

6,679,000

10,274,000

16,853,000

16,823,000

18,200,000

 SHORT   TERM FACILITY (N’000)

216,000

482,000

558,000

1,084,000

2,096,000

3,222,000

5,860,000

13,357,000

10,759,000

8,865,000

PERCENT-AGE

19%

23%

30%

41%

48%

48%

57%

76%

64%

49%

Sources: Aggregate of five years Financial Statements of the10 Selected Companies (2004-2008).

 


As a result of tying down capital on inventories as revealed in Table 4, there was evidence of heavy dependent on short-term bank facilities by majority of the companies. Seven of the companies (that is, companies D to J) were worst off. Their operations were sustained by the use of bank facilities to meet their financial obligations before the completion of their working capital cycle.
This picture is a clear description of the uncertain level of liquidity position of these companies every year with the attendance of high cost of servicing the facilities.

 

Correlation coefficient between working capital and liquid assets

The data from the financial statements of the ten selected companies for aggregate of five years was used to establish the relationship between their working capital and their liquidity levels.

The study, with the use of product moment correlation coefficient, reveals a positive correlation coefficient of 0.19 between table 1 and 2, which depicted the relationship between working capital and liquid assets of ten selected companies in Nigeria. There was a further high degree of positive correlation coefficient of 0.67 between table 3 and 4. Table 3 and 4 further corroborated the relationship by comparing companies carrying heavy stocks to their heavy dependence on short term bank facilities. It is therefore evident that there was a positive relationship between working capital and liquidity. Surprisingly, notwithstanding the position of the correlation of the two variables, almost all the companies under the study suffered from inadequacy of liquid assets to meet their short-term financial obligations.
The model and computations for the analysis are given below:

r = N∑XY- ∑X∑Y
     √ {(N∑X2 – (∑X) 2 (N∑Y2 –(∑Y)2}

 

Correlation Coefficient between tables 1 & 2:

X

Y

XY

X2

Y2

1.17

0.75

0.8775

1.3689

0.5625

1.13

0.52

0.5876

1.2769

0.2704

1.25

0.5

0.625

1.5625

0.25

1.31

0.72

0.9432

1.7161

0.5184

1.25

0.58

0.725

1.5625

0.3364

1.22

0.43

0.5246

1.4884

0.1849

1.24

0.46

0.5704

1.5376

0.2116

1.19

0.37

0.4403

1.4161

0.1369

1.13

0.44

0.4972

1.2769

0.1936

1.13

0.61

0.6893

1.2769

0.3721

12.02

5.38

6.4801

14.4828

3.0368

r = +0.19

 

 

 

 


Correlation Coefficient between tables 3 & 4

X

Y

XY

X2

Y2

0.36

0.19

0.0684

0.1296

0.0361

0.54

0.23

0.1242

0.2916

0.0529

0.6

0.3

0.18

0.36

0.09

0.45

0.41

0.1845

0.2025

0.1681

0.53

0.48

0.2544

0.2809

0.2304

0.65

0.48

0.312

0.4225

0.2304

0.63

0.57

0.3591

0.3969

0.3249

0.69

0.79

0.5451

0.4761

0.6241

0.61

0.64

0.3904

0.3721

0.4096

0.46

0.49

0.2254

0.2116

0.2401

5.52

4.58

2.6435

3.1438

2.4066

                                   
r = +0.67


 


Conclusion
The inference that could be drawn from the findings of this study is that positive correlation subsists between working capital and liquid assets. By implication, in a high positive correlation between the two variables as in the case of this study, one expects logically that the scenario would result in having sufficient liquid assets to meet operational commitments. Surprisingly, the study reveals a reversal of the logical expectation.

It could therefore be deduced from the study that liquid funds that could have been made available was tied down in the finance of inventories without corresponding rapid turnover to justify huge expenditures on inventories. The study reveals that the sensitivity of inventories to the liquidity position of these companies is not in doubt.

 

Recommendations

  1. It is therefore recommended that companies, especially those in the trading sector, should strive to maintain optimal stock level by avoiding both excessive and under-stocking of the required inventories.
  2.  Short-term bank facilities should be a last resort because of the adverse implication on the overall performance of an organization.
  3.  Companies are encouraged to exploit more cost-effective funding like making rights issue to raise the needed working capital.
  4. It is equally beneficial to companies to regularly review their credit policy in the light of development in the operating environment, so as to achieve overriding objective of shortening their working capital cycles.

References
Brealey, R.A. and Myers, S.C. (1996): Principles of Corporate Finance, London: McGraw Hill   Company

Bridge and Dodds (1975): Managerial Decision Making, Groom Helm Publishers

Copeland, T.E. and Westow, J.F. (1998):Managerial Finance, London: Cassel Wellington Publishing House

Fox, A.F. and Limmack (1998): Managerial Finance, Witshire: Redwood Books

Frame, R. J. and Curry, D.W. (1974): Financial Management, Charleds E. Merrill Publishing Company

Grass, M. (1972): Control of Working Capital, Groom Helm Publishers .

Horne J.C.V. (2000): Fundamentals of Financial Management, India: Prentice-Hall

Imonitie C. I. (2004): Social Research Methods for Nigerian Students, Lagos: Malthouse

Jinadu O. (2005):Advanced Financial Accounting Made Easy, Vol.II, Akure: Bosem Publishers

Miller D.C. (1999): Handbook of Research Design and Social Measurement, , New York: Longman

Oluboyode A.(2007): Working Capital and Liquidity Position. The Nigerian
Accountant Vol.40 No.3 July/September

Oye A (2002): Financial Management, Lagos: El-Toda Ventures

Pandey, I.M. (2005): Financial Management, New Delhi, India, :Vikas Publishing House.

Pickle and Lafferty. J. (1982): Accountancy, London: Pitman

Prasanna C.(2003):  Financial Management Theory and Practice, New Delhi, Tata McGraw-Hill Publishing Company Ltd.

 

Weston and Brigham (1997): Managerial Finance, Dryden Press, Division of Rinehart         and      Wiston Publishers, 6th edition.