e-sRC

CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
Every business organization is primarily focused on extracting the highest amount of profit from
their business activities. When investments are made in a business venture, whether by owners or
shareholders, it is because they expect profit out of their investments. The measure of a
successful enterprise is frequently based on how much and how consistently it can turn a profit.
However, profit and profitability are two different concepts, albeit related. Raval (2006) reduced
profitability to its simplest terms by defining it as the ability of a given instrument to earn a
profit. Whether the firm is generating enough profit from its resources, whether it is utilizing
resources properly, whether it is performing better or worse than its competitors in terms of
making profit etc. cannot be adequately judged simply by looking at the firm’s net profit. Instead,
profitability has to be taken into account considering both the internal and external factors that
can affect it either positively or negatively. In technical terms, profitability is the ratio of profit to
revenue, which gives a clearer picture of the performance of a company rather than just the
profit.
In the same vein, profit is the main motive of every business organization which pharmaceutical
companies are not exempted. Shareholder desire for wealth maximization cannot be achieved
without profit. Profit ensures that the business continues as a going concern. The existence and
survival of any business is dependent on the level of profit.Thus, it is the driving force for the
business enterprises. The perpetual existence of the firms depends on the profit earning capacity of
the firm, which is considered to be the foremost factor in influencing the reputation of the firm.
Profit is an absolute term, whereas, the profitability is a relative concept. Profit refers to the total
income earned by the enterprise during the specified period of time, while profitability refers to the
operating efficiency of the enterprise and delivers the evidence about the company‘s ability to
spawn earnings. An enhancement in profitability sparks to an increase in stock price, thereby
registering capital gains.
Profitability of firms is of vital importance to investors, stakeholders and economy at large. For
investors, the return on their investments is highly valuable, and a well performing business can
bring high and long-term returns for their investors. Furthermore, profitability of firm will boost
the income of an organization, bring better quality products for its customers, and have better
environment friendly production units. Also, more profits will mean more future investments,
which will generate employment opportunities and enhance the income of people. Many studies
have been conducted to determine various financial and non-financial factors that can boost or
have an adverse effect on the performance of firm.
The performance of any enterprise is influenced by the environment in which it is located. The
last two decades has witnessed the pre and post democratic governance in Nigeria as well as a
number of government initiatives aimed at addressing some challenges facing the health delivery
system of the country. The pharmaceutical sector is a complex one, involving many different
stakeholders such as the manufacturers themselves, national regulators, government ministries,
wholesalers and others. Developing the industry requires concerted action across these
stakeholders to create the environment in which that industry can flourish and realize its full
potential as an asset to economic and social development. Since 2006, United Nation
Development Organisation(UNIDO), with funding from the Government of Germany, has been
conducting a project on strengthening the local production of essential generic drugs in
developing and Least Developed Countries. The objective is to help the pharmaceutical sectors
in developing countries such as Nigeria realize their potential role of acting as a pillar of public
health and contributing to economic and social development. The key challenges confronting
Nigeria‘s pharmaceutical market include counterfeit medicines, poor healthcare infrastructure
and the limited spending power of citizens. These challenges is as a result of high cost of
production by pharmaceutical companies.According to the survey conducted by UNIDO in 2011,
there are about 120 local drug manufacturers in Nigeria. Capacity utilization within the sector is
about 40 per cent, meaning that there is a large volume of under-utilized manufacturing capacity
which could be applied to produce new products upon demand. According to the Pharmaceutical
Manufacturers Group of the Manufacturers Association of Nigeria (PMG-MAN), about 60 per
cent of pharmaceutical production in ECOWAS countries is located in Nigeria.
The survey further indicated that poor infrastructure (power, water, and transportation) increases
the cost of medicine manufacture and distribution whilst also hampering growth. Currently, no
Nigerian pharmaceutical manufacturer has attained WHO cGMP (current Good Manufacturing
Practice) requirements and WHO pre-qualification although some companies are inter alia
upgrading their facilities and hope to attain this status in the near future. However, for the time
being, they cannot participate in international tenders for pharmaceutical supplies and their scope
for exporting is also limited. Attainment of WHO GMP and prequalification status will enable
local pharmaceutical producers to participate in international tenders for supplies of antiretrovirals, anti-malarials and anti-TB medicines. A further obstacle faced by local
manufacturers is access to finance for working capital and upgrading facilities, which is
constrained by high bank interest rates.
However, the profitability of Nigeria pharmaceutical was never above 20% for the past 7 years
using their Return on Asset as a proxy for profitability. The graph below shows the trend of
profitability between 2010 to 2016.
Fig. 1.0. Profitability Trend
Source: Researcher‘s compilation
The above graph showing the industry profitability proxied by average Return on Asset (ROA) of
the quoted pharmaceutical firms in Nigeria shows a fluctuating pattern for a period of 7 years
(2010-2016). The graph shows a rise in the profitability of the firms between 2010, 2011 and 2012
which is 8.8%, 9.9% and 16.5% respectively. However, between 2013, 2014 and 2015 the
profitability level fell drastically to 3.5%, 6.4% and 5.4 respectively indicating a problem which
can either be internal or external to the firm.
Hence, the need to study how they perform becomes inevitable because their contributions are very
vital to the welfare of the citizens and the economy at large. This can be achieved if the firms are
having a great profit margin.Due to the fact that firm‘sprofitability straightforwardly influence the
stability of the countries‘ economic systems in today‘s capitalist world economy, the factors
affecting firm profitability justify special attention (Akbas&Karaduman, 2012). Profitability is the
most important objective of the majority business entities; hence it‘s comparative significance in
the investigation of business enlargement and endurance. There are lots of factors that can have
impact on the profitability of firms. Among these factors are; leverage, liquidity, firm size and firm
age (Akbas&Karaduman). These determinants with the inclusion of asset tangibility have been
measured in this study as determinants of corporate profitability. In line with the above the study
examines the effect of these determinants on the profitability of Pharmaceutical firms in Nigeria.
1.2 Statement of the Problem
Nigeria is a relatively large country with an estimated population of 169 million and it is
endowed with natural resources, high levels of human and social capital (Ogaji et al, 2014).
However, it is plagued with a very high incidence of disease, poverty and malnutrition and has
lower life expectancy than some other African countries of comparable economy (WHO, 2013).
In the last five decades, the Nigerian health sector has remained grossly underdeveloped, despite
seeming better off than other African peers(AFRINVEST, 2014). Healthcare delivery in Nigeria
is characterized by inefficient budget execution, inadequate funding, poor service quality and a
shortage of qualified personnel essential to the delivery of public health services. Despite modest
increases in healthcare budgetary allocation, improvements to key health indicators have been
rather limited (AFRINVEST, 2014).
The pharmaceutical industry in Nigeria has a solid history which can be traced to the colonial
period where pharmaceutical business primarily involved the distribution of drugs by
representatives of different multinational drug manufacturing companies present in Nigeria such as
Beecham, May & Baker, Pfizer, Glaxo, among others. In general, the activities of this
pharmaceutical sector isimpacting on economic growth positively and presenting many individuals
with investment opportunities.
The role of the pharmaceutical industry in a country such as Nigeria in the provision of safe, pure,
quality and efficacious products to meet the healthcare need of the populace cannot be overemphasized. Provision of essential medicines by this sector will curb infiltration of the market with
spurious and sub-standard products and will also enhance the economy,(Ogaji, Alawode, and
Iranloye, 2014). In realization of key role of the availability of essential drug by Pharmaceuticals
firms and their significant impact on health system, the government of Nigeria has made more
efforts in empowering the pharmaceutical industry in the last two decades than before (Ogaji et al,
2014). The authors went further to explained that revised National Drug Policy (NDP, 2005),
anticipated that by 2008, the local pharmaceutical industry will have realized a production capacity
of 70% to satisfy at least 60% of national drug requirements of essential drugs while the balance
was to be exported (NDP,2005). Consequently, a number of essential drugs that the local
manufacturing industry has the capacity to produce have been put on import prohibition list to
encourage the local manufacture and improve on the capacity utilization of sector (NCS, 2014).
Kaplan and Liang (2005) opined that pharmaceutical sector ensures that there is no great disparity
between the demand for medicines to treat endemic diseases and the lack of purchasing power.
The authors proceeded that investments in local medicine production will be efficient when the
pharmaceuticals can be produced more cheaply locally and optimizing profits and growth. Though
the Federal government has made various policy to make sure that this sector performed to
expectation through the banning of certain drugs into the country.
The pharmaceutical market was estimated to be worth US$ 600 million in 2009 and should grow
substantially at around 12 per cent year-on-year. Despite government efforts to promote
domestic manufacturing of essential drugs, Nigeria remains heavily reliant on imported
pharmaceuticals. The revised National Drug Policy (NDP) (2004) set a target for 70 per cent (in
volume) of the country‘s demand for medicines to be met by local drug manufacturers by 2008.
Consequently, Government policies support local production of essential medicines in
accordance with the NDP.
However, these policies of government can not only improve their performance in the society but
the internal and other external specific factors of the companies should also be given a serious
consideration. In achieving this, these internal and external specific factors that can affect the
sustainability and existence (profitability and growth) of these pharmaceutical companies in both
local and international market should be recon with in order to ensure that the sector perform
their roles in the society. Firm specific characteristics are factors that are mostly under the direct
control of management. The firm specific indicators include firm size, liquidity, asset tangibility,
leverage, size and age of the firm. On the other hand, the macroeconomic indicators are those
factors that are beyond the control of management. This includes interest rate, GDP, and industry
size (Sumaira&Amjad, 2013). This means that the profitability of pharmaceutical firms could be
ascertained using firm specific attributes (internal attributes) and macroeconomics variables
(external attributes) as major determinants of profitability of the companies.
Malik (2011) clearly classified the internal attributes into two major sub-categories, namely, the
financial variables and non-financial variables. From his explanation, he regarded financial
variables as determining factors which are directly driven from items in a balance sheet and
profit and loss accounts. This includes size, leverage, liquidity, and tangibility of asset. On the
other hand, the non-financial variables are those factors which cannot be driven from the items in
the balance sheet and profit and loss accounts. The non-financial variables are classified as
management quality or competency, efficiency and productivity, age, and scope of operation
(Yuqili, 2007).
There are different forms of company characteristics depending on the nature of the research to
be conducted. For the purpose of this study, five firm specific attributes which include; liquidity,
leverage, asset tangibility, age and size of the firm were considered and discussed. Liquidity
measures the ability of managers in insurance and reinsurance companies to fulfill their
immediate commitments to policy holders and other creditors without having to increase profits
on underwriting and investment activities and/or liquidate financial assets (Adam & Buckle
2000). Liquidity refers to the degree to which debt obligations coming due in the next 12 months
can be paid from cash or assets that will be turned into cash. It is usually measured by the current
assets to current liabilities (current ratio). It shows the ability to convert an asset to cash quickly
and reflects the ability of the firm to manage working capital when kept at normal levels. A firm
can use liquid assets to finance its activities and investments when external finance is not
available or it is too costly. Higher liquidity will allow a firm to deal with unexpected
contingencies and to cope with its obligations during periods of low earnings (Liargovas&
Skandalis, 2008). It should also be noted that too much focus on liquidity will be at the expense
of profitability (Gitman, 2007).
Leverage is measured by the ratio of total liabilities to total assets. It shows the degree to which a
business is utilizing borrowed money. Companies that are highly leveraged may be at risk of
bankruptcy if they are unable to make payments on their debt; they may also be unable to find
new lenders in the future. Leverage is not always bad because it can increase the shareholders’
return on their investment and make good use of the tax advantages associated with borrowing.
The degree of financial leverage reflects a company‘s ability to manage their economic exposure
to unexpected losses.
The firm age is associated with ample of experience, expertise and reduction in perceived risks,
(Mahajan & Singh, 2013) since old firms are expected to have large market shares, high
clientele,patronage, customer loyalty, well established logistic channels, and business associates
with various factors of production. Thus, older firms tend to be more profitable due to their wellestablished operational strategies in producing various goods/services to meet various customers‘
demands. However, Graham et al, (2011) posit that young firms tend to be prone to distress
during a negative stock business period. Similarly, Carroll (2003) observesthat young firm
isprone to failure because of diversion of their resources to establish internal routines, developing
credible exchange relationship, and training of the employees.
Companies that have been in the market for a long period of time have acquired reputation, since
they have proven their ability to fulfill long-term contract obligations and their financial stability.
The company age can be calculated straightforwardly for all companies. The age factor is scaled
by considering the natural logarithm of company age. Newly established firms are not
particularly profitable in their first years of operation, as they place greater emphasis on
increasing their market share, rather than on improving profitability Athanasoglouet al (2005) as
cited in the work of Abate (2012). Similarly, Yuqi li (2007) indicate that older firms are expected
to be more profitable due to their longer tradition and they have built their reputation over the
years. In line with the above, Almajali and Yahya (2012) argued that an older well established
company is likely to be more proficient in gathering, processing and releasing information when
needed because of learning experience. In a similar vein, Liargovas and Skandal (2008) opined
that older firms are prone to inertia and the bureaucratic ossification that goes along with age;
they might have developed routines which are out of touch with market conditions. In this case,
an inverse relationship between firm‘s age and profitability could be observed.
The size of a firm plays an important role in determining the kind of relationship the firm enjoys
within and outside its operating environment. The larger a firm is, the greater the influence it has
on its stakeholders. Again, the growing influences of conglomerates and multinational
corporations in today‘s global economy are indicative of what role size plays within the
corporate environment (Ghafoorifard, Sheykh, Shakibaee and Joshaghan, 2014).The evidence
from previous studies indicate that firm size either measured by total sales or total assets is
probably the most important determinant of foreign direct investment decisions whereas other
attributes could be subordinated by firm size.(Horst, 1972; Lall, 1986; Grubaugh, 1987; Chen,
1992) Firm size is considered to represent some firm specific advantages because of the
following reasons. First, foreign investments incur sunk costs at the initial stage and large firms
are considered to have better access to credit than small firms (Horst,1972). Second, larger scale
production implies that the firm is likely to produce goods more efficiently through learning-by
doing. Third, the market for such in tangible assets (e.g.; brand name, patent) is often imperfect
and this produces an incentive to keep the use of the technology within the firm.
The type of assets owned by a firm may motivate the financing behavior of firms. The tangible
assets of a firm can be considered as the representatives of the real guarantees to its creditors.
Padron et al. (2005) underscore the significance of tangible assets in influencing a firm‘s level of
debt. Similarly, Gaud et al. (2005) affirm that tangible assets are probable to have an effect on
the borrowing decisions of a firm since they are less subject to informational asymmetries and
they have a greater value than intangible assets in case of insolvency. Moreover, the firm‘s use of
tangible assets as security reduces the risk of the moral because this is a positive indicator to the
creditors who can request the liquidation of these assets in the case of credit default. Consistent
with this line of argument, Rajan and Zingales (1995) posit that the greater the proportion of
tangible assets on the balance sheet, the more willing lenders should be to advance loans, which
in turn affect the profitability of a firm.
Over the years, the determination of profitability in pharmaceutical industries has been a problem
faced by scholars (Okwo, Mary, Enekwe, &Okelue 2012). Hence the need to study how they
perform becomes inevitable.It is therefore important to assess the determinants of performance in
an integrated way, and to identify the most important determinants of firm performance. In this
context despite the fact that external factors play an important role in transitional economies, it is
necessary to take into account major internal factors in explaining performance of listed
pharmaceutical firms in Nigeria because of the managerial influence on the internal factors
which are meant to make the sector a competitive one in Nigeria.
Although, there have been studies such as Samhan and Al-Khatib (2015), Mwangi and Murigu
(2015) among others on profitability of financial sectors (Banking and insurance) and other
sectors in Nigeria and other countries but researches are few in manufacturing sector most
especially in Nigeria while study on the pharmaceutical sector is scanty which has experienced
underutilization of capacity over the years which in turn affect it profitability. Thus, this study
attempt to assess the determinants of profitability of listed pharmaceutical firms in Nigeria in
order to provide evidence on what effect the firm-specific factors have on the profitability of
manufacturing sector which have being neglected by most researchers in Nigeria.
1.3 Research Questions
The research questions to be answered by the study are:
i. To what extent does asset tangibility affect the profitability of listed pharmaceutical
firms in Nigeria?
ii. To what extent does leverage affect the profitability of listed pharmaceutical firms in
Nigeria?
iii. To what extent does liquidity affect the profitability of listed pharmaceutical firms in
Nigeria?
iv. To what extent does firm‘s size affect the profitability of listed pharmaceutical firms in
Nigeria?
v. To what extent does firm‘s age affect the profitability of listed pharmaceutical firms in
Nigeria?