SECTION ONE

INTRODUCTION

 

1.1       Background to the Study

One of the main decisions that need to be considered by firms is how to finance its day to day operations. The financial policies of firm often differ from one firm to the other (Githaiga & Kabiru, 2015). This is because the decision taken by a firm’s management has a direct or indirect impact on the value of the companies. A well-developed financial policy is able to assist firms obtain funds and to finance its investment and operative needs at the same time. It is therefore very important for every firm to have access to finance for survival and maintain their financial performances that will increase the company’s shareholders wealth.

The business world will always require management of firms to formulate financial policy in an attempt to improve performance of the firms they run. This financial policy should have the ability and can take advantage of any opportunities to improve company performance. One of the key questions has been what the relationship between financial policy and financial performance is. In broad terms, the two main factors in the equation are the benefits of liquidity for a firm and the agency costs of managerial discretion. Both arguments have their supports. For example, Myers and Majluf (1984) argue that costly external financing means that firms should maintain a sufficient cash reserve that provides liquidity to take advantage of emerging positive NPV projects. However, according to Jensen (1986) the agency costs of managerial entrenchment means that large cash holdings should be paid to shareholders to keep managers from over investing in negative NPV projects. Surprisingly, there are no uniform standard that can be applied to all firms at once as both the needs of a firm and its managers are diverse. The market value of cash can be divided into two depending on whether the studies concentrate on the benefits of liquidity or the agency costs. The former approaches the question typically by examining the financial policy and corporate finance decisions of a firm, whereas the latter estimates the degree of agency conflicts through corporate governance factors. Despite the common division between the two issues, both are always present in the findings most studies.

The ultimate goal of these financial policies is for firms to have funds that they required at all times in order to finance their inventories, machineries, equipment, utilities, labour costs, suppliers and other creditors. The financing policy chosen and adopted by managers usually affects the liquidity and profitability of the firms. Liquidity means firms are able to meet the short term obligations (Romano, Tanewski & Smyrnios, 2001).  It is very crucial for managers to maintain a balance between liquidity and profitability in the day to day operations of their organizations.

Generally, firms will invest more on current assets and uses more current liabilities in its day to day operation (Padachi, 2006) compared to non-current assets and long term financing. Too much investment in current assets may lead to lower profitability of firms, whilst low level of current assets may lead to lower liquidity (Van Horne & Wachowicz, 2001). On the other hand, heavy reliance on current liabilities may affect the liquidity of the firm, since firms needs to frequently pay the creditors. In addition, too much dependence on long term source of finance will affect the profitability of the firm, since long term finance is costly. Therefore the need to come out with a well-balanced financial policy that will ensure that the firms’ survival is guaranteed is the ultimate task of firms’ managers. However, firms limitations in financing their operations may seriously limit their expansion potential (Akhtar, 2005).

Understanding the impact of financial policy on profitability of firm is not only of interest to researchers and the academics but even more so to practitioners, financial analysts, corporate finance managers. This is because firm need to know what extent the ease of accessing long term loan, short term debit, Capital expenditure portfolio and dividend payout play in determining the firm profitability.

Short term debt financing have a maturity period of one year or less, they must be repaid quickly within 90 – 120 days. Term loans with short maturities help to meet immediate need for financing without long term commitment (Peavler, 2014). The cost of servicing short term debt is less taxing on the company.  Short term loans usually offer lower interest charges, and most lenders do not charge interest until all credit allowance period is breached.

Long term debt is money that is owed to lenders for a period of more than one year from the date of current balance sheet. The study by EBaid (2009) found that there was no significant relationship between long term debt and return on assets. Long term debts are most preferable sources of debt financing among well-established corporate institution mostly by virtue of their asset base and collateral is a requirement many deposit taking financial institutions.

Capital expenditure related to investment policy, where the policy is part of the financial policies that have significance to make the value of the company increases. This policy is usually done when the company expanded the business by adding production capacity, modernization or building factories and capital budgeting changes. Woolridge and Snow (1990), has treated  capital expenditure expansion of production capacity, plant modernization and changes in capital expenditure as capital expenditure.

Dividend payout policy of a firm has implication for investors, mangers and lenders and other stakeholders (more specifically the claimholders). Investors are particularly interested in the dividend payout ratio because they want to know if companies are paying out a reasonable portion of net income to investors. For instance, most startup companies and tech companies rarely give dividends at all (Benartzi, 1997).  Lenders have interest in the amount of dividend a firm declares, as the more the dividend paid the less would be the amount available for servicing and redemption of their claims. The payment of dividends reduces the discretionary funds available to managers for extra consumption and investment growth and requires managers to seek financing in capital markets (Sujata 2006). The net profit after taxes belong to shareholders but the income that they really receive is the amount of earnings distributed and paid as cash dividend. The dividend payout generally influences the financial policy of firm in a negative direction.

Profitability is a measure of the amount by which a company's revenues exceed its relevant expenses. Profitability ratios are used to evaluate the management's ability to create earnings from revenue-generating bases within the organization. A profit ratio indicates how effectively management can make profits from sales. It also indicates how much room a company has to withstand a downturn, fend off competition and make mistakes. Potential investors are interested in dividends and appreciation in market price of stock, so they focus on profitability ratios. Managers, on the other hand, are interested in measuring the operating performance in terms of profitability. Hence, a low profit margin would suggest ineffective management and investors would be hesitant to invest in the company.

This study is motivated by the global financial crisis which affects the liquidity position and the overall business activities across the world.  In Nigeria, the recent economic recession since early 2015 has made credit either too expensive to obtain or unavailable, there exist some other corporate issues that affect financial policy and consequently the operating performance of almost all firms. Foreign exchange currency shortage is also having seriously adverse impact, pushing up costs and prices of goods and services in the country. Therefore, financial managers are forced therefore to investigate the current assets and current liabilities in order to make informed decision with regards to profitability of the entity. The significance of the insurance industry to the economy cannot be overemphasized. For one, it is an industry that employs thousands of Nigerians at present, for another, it has billions of naira as shareholders' funds but far more important is the fact that the industry provides the security and buffer that are needed against risk by businesses in the economy. An insurance firm also ensures the soundness of other firms in Nigeria (Kwanbo & Gugong, 2013).

Insurance companies are not only providing the mechanism of risk transfer but also helps to channel the funds in an appropriate way to support the business activities in the  economy. Insurance companies have importance both for businesses and individuals as they indemnify the losses and put them in the same positions as they were before the occurrence of the loss. In addition, insurers provide economic and social benefits in the society for example prevention of losses, reduction in anxiousness, fear and increasing employment. However, the current business world without insurance companies is unsustainable because risky businesses do not have the capacity to retain all types of risk in current extremely uncertain environment. Therefore, study on the impact of financial policy on profitability of listed insurance companies in Nigeria is desirable because of the rareness of this study. Insurance companies was selected as a domain because of their significant contribution to the Nigerian economy in the area of risk management that help to rescue some companies from collapsing.

1.2       Statement of Problem

The performance of publicly listed companies in Nigeria has been unsatisfactory despite several policy reforms introduced over the years (Salawu, Asaolu & Yinusa, 2012). There is an argument that corporate firms carrying heavy short-term debt burdens (risk), long term loan portfolio and huge dividend payout ratio can pose a threat to firms’ performance and the economy. This has implication on the capital choice and performance of listed companies in Nigeria (Abdulrashid, et al, 2017).

One of the major reasons that may cause liquidation is implementation of wrong financial policy that can cause illiquidity and inability to make adequate profit. For these reasons companies are developing various strategies to improve their liquidity position through sound financial policies. Strategies which can be adapted within the firm to improve liquidity and cash flows concern the management of working capital, these are areas usually neglected in times of favorable business conditions (Pass & Pike, 1984). 

Although several empirical studies have been conducted on different mechanism of financial policy and  profitability in developed and developing countries such as Pinkowitz and Williamson (2004), Faulkender and Wang (2006), Denis and Sibilkov (2007), Dittmar and Mahrt-Smith (2007), Wambu (2013) and Lartey, Antwi & Boadi (2013), and Panigrahi (2013), it is instructive to note that there are still ambiguity regarding the appropriate variables that might serve as proxies for financial policy, as the previous studies do not combine the impact of short term debt ratio, long term debt ratio, Capital expenditure ratio and dividend payout ratio on profitability of firms in one study to the best of my knowledge, this creates a gap for further study.

In Nigeria similar studies were also conducted on financial policy and corporate profitability such as Salawu (2009), Akhigbe and Madura (2008). However, most of the studies conducted in Nigeria focused more attention on banking or manufacturing companies, for now few or none have examined the impact of financial policy on profitability of listed insurance companies despite its strategic importance to the Nigerian economy.

Furthermore, the works of Salawu et al, (2012),  Salawu (2009), Gill et al, (2011), Habib et al, (2016), Denis and Sibilkov (2007), Dittmar and Mahrt-Smith (2007), Wambu (2013) and Sudiyatno, Puspitasari and Kartika (2012); all these works covered the period from 2004 to 2013. As such, some of the findings of the studies may not be in tune with these days reality in view of the fact that there have been some changes that have affected the both the business and political environment. This creates a period gap which this study intends to fill by investigating the period of work to 2016.

For some of the literatures reviewed such as Hurdle (1973) using two stage least squares (2SLS) as a regression model to analyzed his data;  Sudiyatno, Puspitasari and Kartika (2012) and Rehman, Khan and Khokhar(2015) used statistical package for social sciences (SPSS), as techniques of data analysis which is less robust in comparison to STATA that will be used in this study while Nwaolisa and Chijindu (2016), Soumadi and Hayajneh (2012), Nimer, Warrad and Omari (2015),Ehiedu (2014) and Mathuva (2009) used ordinary least square (OLS) without running other robustness test such as heteroscedasicity test, fixed effect model, random effect model and hausman specification test which will further confirm the reliability and validity of the statistical inferences derived. This creates a methodological gap which this study intends to fill by means of employing generalised least square (GLS) and using STATA as tool of analysis that will test the robustness of the data this study will use.

Finally,   little or no research has been conducted to provide empirical evidence particularly on the impact of financial policy on profitability of insurance companies in Nigeria to the best of the researcher's knowledge. In view of the above mentioned gaps, this study intends to fill the gaps highlighted above in order to provide empirical evidence on the impact of financial policy on profitability of listed insurance companies in Nigeria. Hence, this study seeks to address the question as to whether financial policies impacts on the profitability of listed insurance companies in Nigeria?

1.3       Objectives of the Study

The main objective of this study is to examine the impact of financial policy on profitability of listed insurance companies in Nigeria. Thus, the specific objectives are to: 

        i.            examine the impact of short term debt ratio on  profitability of listed insurance companies in Nigeria;

      ii.            examine the impact of long term debt ratio on profitability of listed insurance companies in Nigeria;

    iii.            determine the impact of capital expenditure ratio on profitability of listed insurance companies in Nigeria; and

    iv.            identify the impact of dividend payout ratio on profitability of listed insurance companies in Nigeria.

1.4       Hypotheses of the Study

Consistent with the research objectives, the following research hypotheses are formulated in null form;

H01:      Short term debt ratio has no significant impact on the profitability of the listed insurance companies in Nigeria.

H02:      Long term debt ratio has no significant impact on the profitability of listed insurance companies in Nigeria.

H03:      Capital expenditure ratio has no significant impact on the profitability of listed insurance companies in Nigeria.

H04:      Dividend payout ratio has no significant impact on the profitability of listed insurance companies in Nigeria.

1.5       Significance of the Study

Business financing policy, especially at the wake of the Nigerian financial crisis curled technical recession by the federal government of Nigeria, has become a major source of concern for managers of insurance companies as payment of insurance claims and sourcing new insurance premium from clients are becoming too expensive to maintain as a result of tightening of both the local and international financial market and the reluctance of the public to invest in the share of companies sequel to the crash of the capital market.

This study is therefore significant in revealing the effect of financial policy on the profitability of insurance firms listed on the floor of Nigeria Stock Exchange. The study’s findings will help the insurance firms in Nigeria and other firms in general improve on their financial decision making so as to optimize the value of the shareholders and maintain a satisfactory trade-off between profitability and financial policies. The following specific benefits are extractable from the findings of the study:

i.                    The findings of the study will help managers of these insurance companies and to generate profits for their companies by handling correctly its financial policies and ensuring that each different component of financial policies is at their optimum level. It can therefore be expected that the way in which financial policies are managed will have a significant impact on the profitability of firms.

ii.                  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 financial policies.

iii.                The proposed study would guide managers of the listed insurance firms in Nigeria. 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 suitability of their firms’ financial policies and decisions particularly under unfavorable economic conditions.

iv.                The study will also assist policy makers to implement new set of policies regarding financial policy in Nigeria to ensure continuous economic growth and also enable them meet the need of finance managers, management accountants, academia, and students who will be interested in this study. It will also add to the existing literature on the topic.

1.6       Scope of the Study

The study will examine the impact of financial policy on profitability of listed insurance companies in Nigeria for the period of ten (10) years from 2007 to 2016. The explanatory variables are financial policy proxy by short term debt ratio, long term debt ratio, Capital expenditure ratio and dividend payout ratio while the dependent variable is profitability proxy by return on assets. These variables were selected because to the best of the researcher’s knowledge they have not been combined and used in a single study in Nigeria.

This period was selected due to: the recent economic recession that has affected Nigerian business climate from 2015 to 2017 fiscal year, the financial meltdown that engulfed the Nigerian economy between the year 2008 and 2012 and to also access the effect of the changes from the compulsory adoption of international financial reporting standard by all listed companies in Nigeria that was roll out for adoption in 2012. Insurance companies were selected as a domain because of their significant contribution to the Nigerian economy in the area of risk management that helps to rescue some companies from collapsing.

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