LIQUIDITY, FOREIGN EXCHANGE FLUNCTUATION AND FINANCIAL PERFORMANCE IN NIGERIA’S MANUFACTURING INDUSTRY

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CHAPTER ONE

INTRODUCTION

1.1      BACKGROUND OF THE STUDY

Over the years, it has been observed that the financial performance of any business can be assessed using the concept of liquidity. Liquidity is a major concept that has been a source of worry to the management of firms about the uncertainty of the future. Talking about the liquidity of an asset, it means how quickly it can be transformed into cash. It is the ability of the company to convert its assets into cash.

When referring to a company’s liquidity one usually means its ability to meet its current liabilities and is usually measured by different financial ratios (www.investorwords.com). According to Reider and Heyler (2003), liquidity refers to having an adequate cash flow that allows the business to make necessary payments and ensure the continuity of operations. Liquidity relates to solvency of a firm’s overall financial position.

Also, when discussing on liquidity, one needs to have in mind the concept of Liquidity management ; which requires maintaining liquidity in day to day operations to ensure its smooth running and meet its obligations when they fall due (Eljelly, 2004). With this, it can be said that the objective of business owners and managers is to conceive a strategy of managing all its day to day operations in order to meet their obligations as they fall due and increases profitability and shareholders value. The importance of liquidity management as it affects corporate profitability in today’s business cannot be over emphasis. Liquidity ratios are used for liquidity management in every organization. That greatly have effect on profitability of organization.

Efficient liquidity management involves planning and controlling current assets and current liabilities in such a manner that eliminates the risk of the inability to meet due short-term obligations, on one hand, and avoids excessive investment in these assets, on the other. This is due in part to the reduction of the probability of running out of cash in the presence of liquid assets. Liquidity is having enough money in form of cash, to meet ones financial obligations.

In terms of accounting, liquidity can be defined as the ability to satisfy short-term obligation as they fall due. In terms of investment, it is the ability to quickly convert an investment portfolio to cash with little or no loss in value. A liquid company is one that stores enough liquid assets and cash together with the ability to raise funds quickly from other source to enable it meet its payment obligation and financial commitment in a timely manner. Cash is the most liquid asset of all.

There are various ratios used to measure liquidity. These include: the current ratio, which is the simplest measure and is calculated by dividing total current assets by total current liabilities; and the quick ratio, calculated by deducting inventories from current assets and then dividing the remainder by current liabilities (Mudida & Ngene, 2010). Even though the two ratios seems to be similar, the quick ratio provides a more accurate assessment of a business’s ability to pay its current liabilities. The quick ratio takes into account the most liquid of all current assets. Inventory is the least liquid because it is not speedily convertible to cash. The quick ratio is a reasonable marker of a business’s short term liquidity. The higher the quick ratio the better the position of the business. 

Other liquidity ratios include: stock/ inventory turnover or rate of stock turnover; stock/ inventory holding period; working capital turnover; cash and cash equivalent ratio; cash flow to debt ratio; debtors turnover ratio; debtors or average collection period; creditors payment period e.t.c

The inability of a company to pay its creditors on time and continue not to honor its obligations to the suppliers of credit, services, and goods can be said to be a sick company or bankrupt company. A company’s inability to meet the short term liabilities may affect the company’s operations and in many cases it may affect its reputation too. Lack of cash or liquid assets on hand may force a company to miss the incentives given by the suppliers of credit, services, and goods. Loss of such incentives may result in higher cost of goods which in turn affect the profitability of the business. So there is always a need for the company to maintain certain degree of liquidity.

Exchange rate is the price of one country’s currency expressed in terms of some other currency. It determines the relative prices of domestic and foreign goods, as well as the strength of external sector participation in the international trade. Exchange rate regime and interest rate remain important issues of discourse in the International finance as well as in developing nations, with more economies embracing trade liberalization as a requisite for economic growth (Obansa, Okoroafor, Aluko and Millicent, 2013).

The performance of the manufacturing sector since 1986 has been poorly attributed to macroeconomic instability and inconsistence in the exchange rate. The manufacturing sector is weak and heavily import dependent. It is in the light of the foregoing that this study seeks to evaluate the effects of exchange rate fluctuations on the Nigeria manufacturing sector output from the year 2000 to 2015.

While embarking on a research, Ewa, (2011) agreed that the exchange rate of the naira was relatively stable between 1973 and 1979 during the oil boom era and when  agricultural products accounted for more than 70% of the nation’s gross domestic products (GDP). In 1986 when Federal government adopted Structural Adjustment Policy (SAP) the country moved from a peg regime to a flexible exchange rate regime where exchange rate is left completely to be determined by market forces but rather the prevailing system is the managed float whereby monetary authorities intervene periodically in the foreign exchange market in order to attain some strategic objectives (Mordi, 2006)

Following the fluctuation of the Naira in 1986, a policy induced by the Structural Adjustment Programme (SAP), the subject of exchange rate fluctuations has become a topical issue in Nigeria. This is because it is the goal of every economy to have a stable rate of exchange with its trading partners. In Nigeria, this goal was not realized in spite of the fact that the country embarked on devaluation to promote export and stabilize the rate of exchange. The failure to realize this goal subjected the Nigerian manufacturing sector to the challenge of a constantly fluctuating exchange rate. This was not only necessitated by the devaluation of the naira but the weak and narrow productive base of the sector and the rising import bills also strengthened it. In order to stem this development and ensure a stable exchange rate, the monetary authority put in place a number of exchange rate policies. However, very little achievement was made in stabilizing the rate of exchange. As a consequence, the problem of exchange rate fluctuations persisted throughout the study period.

In an advanced country, the manufacturing sector is a leading sector in many aspects. It is an avenue for increasing productivity in relation to import substitution and export expansion, creating foreign exchange earning capacity, raising employment, promoting the growth of investment at a faster rate than any other sector of the economy, as well as wider and more efficient linkage among different sectors (Fakiyesi, 2005). But the Nigerian economy is under-industrialized and its capacity utilization is also low. This is in spite of the fact that manufacturing is the fastest growing sector since 1973/74 (Obadan, 1994). The sector has become increasingly dependent on the external sector for import of non-labour input (Okigbo, 1993). Inability to import therefore, can impact negatively on manufacturing production.

In Nigeria, exchange rate has changed within the time frame from regulated to deregulated regimes. The impact of fluctuations in exchange rate on manufacturing output had not received adequate attention. This paper attempts to give attention to the issue. Exchange rate fluctuations affect operating cash flows and firm value through translation, transaction, and economic effects of exchange rate risk exposure. (Choi and Prasad, 1995).Exchange rate movements have been a big concern for investors, analyst, managers and shareholders since the abolishment of the fixed exchange rate system of Bretton Woods in 1971. This system was replaced by a floating rates system in which the price of currencies is determined by supply and demand of money. Exchange rates may affect a firm through a variety of business operation models: a firm may produce at home for export sales as well as domestic sales, a firm may produce with imported as well as domestic components, a firm may produce the same product or a different product at plants abroad. The model of the firm must be broad enough to capture all of these channels. The firm described below is a multinational firm (producing and selling at home and abroad) that uses both foreign and domestic components.