ABSTRACT

This study assessed the influence of Intellectual Capital on Firm’s Financial Performance with a focus on selected quoted service firms in Nigeria. This study adopted cross-sectional analysis of all the firms quoted on the Nigerian Stock Exchange as at 31st December 2014, for a period of fifteen years (2000-2014). This allows for comparison of the performance of intellectual capital indices among the firms considered in this study. Ten sectors containing thirty five firms which made up the service sector were all selected for this study. Panel Data was employed in this study. The researchers made use of Ex-post facto research design in conducting the research. The study made use of secondary data obtained from fact books and annual report and accounts of the selected quoted service firms in Nigeria as at 31st December 2014. The relevant data obtained were subjected to statistical analysis using E-view 9.0. Correlation co-efficient, regression analysis, variance inflation factors, and white heteroskedasticity test were employed to analyse the data that were collected and tested the hypotheses that were formulated. The analysis of data was done using the Value Added Intellectual Coefficient (VAICTM) model to measure the efficiency of value added of tangible and intangible assets used by a firm in its operation. The results of this study revealed that there is a positive and statistically significant relationship between intellectual capital and financial performance of service firms in Nigeria. The researcher recommends the recognition of Intellectual Capital as an important business resource.

CHAPTER ONE

INTRODUCTION

1. BACKGROUND OF THE STUDY

In recent times, a new high technology, information, and innovation based environment has gradually taken the centre stage in the global economy particularly in the service sector. The service sector has responded appropriately to the introduction of these new technologies and innovation. Under this new dispensation, knowledge, ability, skills, experience and attitude of workers, assume greater significance even as organizations use intellectual capital as a critical resource to enhance their performances (Ekwe, 2013).

In modern economics, Intellectual Capital (IC) is described as an intangible asset which can be used as a source of sustainable competitive advantage. However, intellectual capital components have to interact in themselves to create value. Intellectual Capital consists of all assets that are not shown in the company‘s statement of financial position and it includes those intangible assets such as trademarks, patents and human advantages, structure and the communication environment. Intangible assets of a company guarantee to ensure competitiveness and sustainable development (Jafari, 2013).

Intellectual Capital (IC) can be defined as the knowledge based equity of organization which has attracted during the last decade, a significant amount of practical interest (Campisi & Costa, 2008; Petty & Guthrie, 2000). Although, the importance of Intellectual Capital (IC) is constantly increasing, many organizations face problems with its management, mostly due to measurement difficulties (Andrikopoulos, 2005; Kim, Kumar & Kumar 2009; Nazari & Herremans, 2007).

Intellectual Capital represents a collection of intangible assets also known as knowledge assets. These assets distinguished from physical assets such as property, plant and equipment (PPE) or stock and financial assets such as receivable, investment and cash have become increasingly important as key resources of firms in their competitive strategies. In today‘s complex and turbulent business environment, companies are required to be flexible, highly innovative and able to develop pro-active strategic approaches. To reach these aims, many organizations have realized that knowledge (underlying capabilities) represents the most important factor in creating economic value that underpins a firm‘s value creation performance (Marr, Schiuma & Neely, 2002).

Paul (2009) argues that in the past, businesses primarily invested in the tangible means of production, for example, buildings and machines. The value of a company was at least somewhat related to the value of its physical capital. But now businesses increasingly invest in intangibles. The intangibility of a company‘s most important asset makes it extremely hard to figure out what that company really worth. That may partly explain the nauseating volatility of stock prices (New York Times, 2000).

Paul‘s observation reflects the phenomenal growth in the market values of some knowledge driven internet companies in the second half of the 1990s and the subsequent crash of 1999-2000. The ascent of stock markets around the world driven by dotcom companies was as spectacular as the crash. This experience is a potent reminder of the perils of overvaluation of knowledge rich companies. Bio-technology companies that sought to exploit new advances in bio sciences to create new drugs and cures had been similarly overvalued only to experience dramatic falls in their values.

The merger of American Online (AOL) the internet service with a more mature media company Time Warner (TW) in 2001 provides a cautionary tale in valuing knowledge- based companies. When the friendly ―merger of equals‖ was announced in January 2000, the combined market capitalization of the two entities was $288bn. When the deal was consummated in January 2001 it was $205bn. By the middle of 2003, the merged firm, AOL Time Warner, was valued at just $74bn. 74% of the value of the two firms had been wiped out. While part of the decline was due to the general decline of stock markets, given the size of the firm, the stock market decline itself is partly due to the value decline of AOLTW. An analysis of the valuation metrics used at the time of merger announcement and merger consummation shows that they were based on extraordinary and widely exuberant optimism (Sudarsanam, Sorwar & Marr, 2003).

It is starkly apparent from cases like the AOL Time Warner merger that tools for valuation of knowledge–based companies are woefully inadequate. The traditional value tools such as relative valuation multiples such as Price Earnings Ratio (PER) or enterprise value to Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) do not fully capture how intellectual capital contributes to firm value. Although the discounted cash flow (DCF) represents a more sophisticated approach to evaluation than one based on multiples, it does not adequately or correctly address the complexities that intellectual capital-based competitive strategies engender. For example, managerial flexibility in expanding, abandoning, or deferring investments while awaiting new information is an important strand of corporate strategy but hardly incorporated in the traditional DCF

model. These models make assumptions about the future, which are far too static or only hazily mapped out.

Anghel (2008) argues that in the age of competitiveness, knowledge assets provide advantages to managers, investors and other users of knowledge. Consequently, knowledge and information are the common components in most of previous researches on Intellectual Capital (IC). In addition, Drucker (2003) divided the development of knowledge economy into three main categories. These include (1) Industrial Revolution (1750-1880), knowledge was devoted to manufacture tools and products, (2) Production Revolution (1880-1956), knowledge had an improved role in the process of employment and (3) Management Revolution (after 1945) knowledge was the final destination.

Mangena, Pik and Li (2010) discussed other benefits of reporting IC information, such as increase operational efficiency, create motivation, improve moral reasoning among employees, establish honesty with stakeholders, employ value market tool and increase external reputation.

In the simplest words, IC is the difference between market value and intangible assets in a company and is composed of some details such as customers‘ loyalty, trademarks, professional skills, experience, goodwill, technology, process and other intangible value (Tayles, Pike & Sofian, 2007). Edvinsson and Sullivan (1996) are in agreement that, market value could be divided into financial capital and intellectual capital. Edvinsson and Sullivan believed that IC is knowledge that creates value for a company. Stewart (1999) categorized IC into four dimensions and noted that they are useful to create value for a company and further stressed that, knowledge, information, intellectual property and experience are IC components. Sullivan (2000) believed that human capital and intellectual assets are subdivision of IC and the composition of IC includes knowledge, innovations and tradition. Furthermore, in this structure, people, expertise and knowledge are considered as parts of human capital and they are coincident non-financial assets. Financial assets are a section of intellectual assets that can be owned by stockholders as a

―right  of  ownership‖.  Thus,  Sullvian  (2000)  shows  that  non-financial  assets  should  be transformed into financial (physical assets) such as computer software and patent.

Generally, the market value of companies is greater than their book value. This is due to lack of fully reflecting the value of intellectual capital and intangible assets in the

statement of financial position and thus causes the financial statements lose utility value and effectiveness of their information. This leads to generate interest issues related to intellectual capital (Jafari, 2013).

The increasing gap observed between market value and book value of many companies has drawn attention towards investigating the value missing from financial statements. According to various scholars, IC is considered to be the hidden value that escapes financial statement and the one that leads organizations to obtain a competitive advantage (Chen, Cheng, & Hwang, 2005; Edvinsson & Malone, 1997; Lev & Radhakrishan, 2003; Lev & Zarowin, 1999; Lev, 2001; Ruta, 2009; Yang & Lin, 2009). Additionally, it is believed that the limitations of financial statements in precisely explaining firm value reveal the fact that, nowadays, the source of economic value is the creation of IC and no longer the production of materials goods (Chen, Cheng, & Hwang, 2005).

The widespread acceptance of IC as a source of competitive advantage led to the development of appropriate methods of measurement, since traditional financial tools are not able to capture all of its aspects (Campisi & Costa, 2008; Nazari & Herremans, 2007). Pulic (2000a, 2000b) developed the most popular method that measures the efficiency of value added by corporate intellectual ability (Value Added Intellectual Coefficient – VAIC). VAIC measures the efficiency of three types of inputs: physical and financial capital, human capital, and structural capital (Firer & Williams, 2003; Montequin, Fernandez, Cabal & Gutierrez, 2006; Pulic, 2000a, 2000b).

1.2              STATEMENT OF PROBLEM

Increasing attention to firms‘ financial performance led the researcher to carry out this study on identification of unreported elements of financial statements. One of the factors affecting firms‘ financial performance but is not reported in financial statements is intellectual capital.

The gap observed between market value and book value of firms in Nigeria has drawn the researcher‘s attention towards investigating the value missing from financial statements. Intellectual capital (IC) is therefore considered to be the hidden value that escapes financial statements and the value that leads organizations to obtain a competitive advantage (Chen, Cheng & Hwang, 2005; Edvinsson & Malone, 1997; Lev & Radhakrishan, 2003; Lev & Zarowin, 1999; Lev 2001, Ruta 2009; Yang & Lin, 2009). In addition, it is believed that the limitations of financial statements in precisely explaining a

firm‘s real value reveal the fact that, nowadays, the source of economic value is the creation of intellectual capital and no longer the production of material or physical goods (Chen, Cheng & Hwang 2005). If intellectual capital does not exist in organizations, then why does stock price react to changes in management? Obviously, investors and financial markets attach value to the skills and expertise of Chief Executive Officers and other top management (Bontis, 2001). Recent contributions have suggested that knowledge and information are actually subject to increasing returns, as opposed to the decreasing returns typical of the traditional resources (Bontis, Dragonetti, Jacobsen, & Roos, 1999). If this is true, then knowledge and information become even more attractive to companies than before. Having a good base of knowledge means that a company can in future years start leveraging that base to create even more knowledge thus increasing its advantage on the competitors (Arthur, 1996).

On a theoretical level, distinguished authors argue that Intellectual Capital is the value driver of all companies (Stewart, 1997), that knowledge management is a core organizational issue (Nonaka & Takeuchi, 1995) and that organizational knowledge is at the crux of every sustainable competitive advantage (Bontis, 1999). On the other hand, empirical evidence are inconclusive and far from achieving a solid scientific consensus. The study of Riahi-Belkaoui (2003) found a positive relationship between intellectual capital and financial performance, while Bontis, Chua and Richardson (2000) concluded that, regardless of industry, the development of structural capital has a positive impact on business performance. On the other hand, Firer and Williams (2003) examined the relationship between intellectual capital and traditional measures of firm performance (Return on Asset, Return on Equity) and failed to find any relationship, while Chen, Cheng and Hwang (2005), using the same methodology, concluded that intellectual capital has significant impact on profitability. Similar to the concept of Skandia Navigator, Bontis, William and Richardson, (2000), Pulic (2000a, 2000b) depicted firm‘s market value as created by capital employed and intellectual capital which consists of human capital and structural capital.

Nowadays firms face stronger competition than it was in the past and enhanced financial performance is the main objective of every business entity. Consequently, every organization wishes to increase its financial performance by adopting different approaches and strategies that can lead to enhanced financial performance. To increase the financial

performance, organizations normally focus on their physical assets without adequate attention to their Intellectual Capital but their Intellectual Capital inefficiency result in a decrease in their financial performance. Consequently, the desired levels of financial performance are never achieved. Hall (1992) states that the benefits of managing Intellectual Capital are that it increases the market value of organization, it improves better communication, optimal utilization of potential, increase value creation ability, better image, satisfy customers, value creating human capital, motivating employees, most efficient business processes. Managing the intellectual capital also increases the financial performance of the organization. There is therefore, the need to empirically investigate whether Intellectual Capital can be used by firms to enhance their competitive edge or advantage.

Some studies on the relationship of Intellectual Capital and financial performance in some developed nations, agree that intellectual capital relates positively and significantly with organizational financial performance and as such accord organizations competitive edge over others (Bornemann 1999, Brenna and Connell 2000, Kamath 2010); others posit that there are no relationships between Intellectual Capital and organizational performance and that physical assets still maintain the key determinants of organizational financial performance (Wright, Kacmar, McMahan & DeLeeuw, 1995; Gottfredson, 1997; Jensen 1998).

Several studies have been carried out on intellectual capital and firm‘s financial performance mainly in other countries, whose findings and results may not be palatable with the Nigerian environment, hence, the need for this study, in order to build on the findings of previous researches and probably establishing new empirical findings.

1.3              OBJECTIVES OF THE STUDY

The main objective of this study is to establish the extent to which Intellectual Capital (IC) impacts financial performance.

Specifically this study will:

1. Determine the extent to which Value Added Intellectual Coefficient (VAIC) indices {that is, Capital Employed Efficiency (CEE), Human Capital Efficiency (HCE) and Structural Capital Efficiency (SCE)} affect the Market-to-Book Value (MBV) ratio of quoted service firms in Nigeria.

• Determine the extent to which Value Added Intellectual Coefficient (VAIC) indices {that is, Capital Employed Efficiency (CEE), Human Capital Efficiency (HCE) and Structural Capital Efficiency (SCE)} affect the Return on Assets (ROA) of quoted service firms in Nigeria.
• Ascertain the extent to which Value Added Intellectual Coefficient (VAIC) indices

{that is, Capital Employed Efficiency (CEE), Human Capital Efficiency (HCE) and Structural Capital Efficiency (SCE)} influence the Return on Equity (ROE) of quoted service firms in Nigeria.

• Ascertain the extent to which Value Added Intellectual Coefficient (VAIC) indices

{that is, Capital Employed Efficiency (CEE), Human Capital Efficiency (HCE) and Structural Capital Efficiency (SCE)} affect the Employee Productivity (EP) of quoted service firms in Nigeria.

• Determine the extent to which Value Added Intellectual Coefficient (VAIC) indices {that is, Capital Employed Efficiency (CEE), Human Capital Efficiency (HCE) and Structural Capital Efficiency (SCE)} affect the Growth in Revenue (GR) of quoted service firms in Nigeria.

1.4              RESEARCH QUESTIONS

In line with the objectives of the study, the following research questions shall guide discussions in this work:

1. To what extent can the Value Added Intellectual Coefficient indices {that is, Capital Employed Efficiency (CEE), Human Capital Efficiency (HCE) and Structural Capital Efficiency (SCE)} of a quoted service company affect the company‘s Market-to-Book Value (MBV) ratio?
2. To what extent can the Value Added Intellectual Coefficient indices {that is, Human Capital Efficiency (HCE), Structural Capital Efficiency (SCE) and Capital Employed Efficiency (CEE)} of a quoted service company affect the company‘s Return on Assets (ROA)?
3. How can the Value Added Intellectual Coefficient indices {that is, Human Capital Efficiency (HCE), Structural Capital Efficiency (SCE) and Capital Employed Efficiency (CEE)} of a quoted service company affect the company‘s Return on Equity (ROE)?
4. How can the Value Added intellectual Coefficient indices {that is, Human Capital Efficiency (HCE), Structural Capital Efficiency (SCE) and Capital Employed

Efficiency (CEE)} of a quoted service company affect the Employee Productivity (EP) of the company?

• To what extent can the Value Added Intellectual Coefficient indices {that is, Human Capital Efficiency (HCE), Structural Capital Efficiency (SCE) and Capital Employed Efficiency (CEE)} of a quoted service company influence the company‘s Growth in Revenue (GR)?

1.5              RESEARCH HYPOTHESES

In line with the research questions above, the researchers hypothesized the following null hypotheses:

H_o1:      Value Added Intellectual Coefficient indices of a quoted service company do not significantly affect the company‘s Market-to-Book Value (MBV) Ratio.

H_o2:     Value Added Intellectual Coefficient indices of a quoted service company do not significantly affect the company‘s Return on Assets (ROA).

H_o3:     Value Added Intellectual Coefficient indices of a quoted service company do not significantly affect the company‘s Return on Equity (ROE).

H_o4:     Value Added Intellectual Coefficient indices of a quoted service company do not significantly affect the Employee Productivity (EP) of the company.

H_o5:     Value Added Intellectual Coefficient indices of a quoted service company do not significantly affect the company‘s Growth in Revenue (GR).

1.6              SIGNIFICANCE OF THE STUDY

The wide increase in the number of service companies globally where personnel knowledge, skills, expertise and experience are the key to their success makes the reporting of intellectual capital a necessity.

Organizations do report on capital and other assets in their financial reports but reporting nothing regarding intellectual capital except as a charge in their income statements. Money spent on hiring, recruiting, training and developing human resources are expenses rather than capitalized. Nowadays, the amount invested by organizations on intellectual capital is very huge and calls for a better way of reporting. The financial information contained in the financial statements of organizations is considered inadequate because of many reasons, which inability to account and report human resources is one (Abubakar, 2011).

The concept of intellectual capital is relatively a virgin area in Accounting and yet to be applied in Nigeria (Kodwani & Tiwari, 2007). This study looks at the possible application of the concept in the financial reporting of the Nigerian quoted service companies. This study is expected to assist the Financial Reporting Council in Nigeria (formerly Nigerian Accounting Standard Board) to adopt a standard measure for valuing Intellectual Capital for inclusion in the financial statements of organizations. Adoption of a standard way of accounting for intellectual capital will increase the acceptance and application of the system by reporting organizations.

It is also expected that this study will assist the various users of financial statements in their analysis and interpretation of service companies‘ financial statements for informed decision making.

This study would be of invaluable use to academia/researchers in the course of their research works.

Moreso, this study can assist the management of the reporting organization to put more effort toward the development of their intellectual capital.

1.7  SCOPE OF THE STUDY

This study will comprise of all quoted service companies trading on the floor of the Nigerian Stock Exchange as at the end of December 2014.

The study covers a fifteen (15) year period from 2000-2014. The reason for the choice of this time frame is availability of published annual reports and accounts of the selected organizations.

1.8              LIMITATION OF THE STUDY

One of the limitations of this study was lack of sufficient relevant local materials and available accurate secondary data. Notwithstanding, scholarly articles and other relevant publications were gathered and used in this study.

1.9   OPERATIONAL DEFINITION OF TERMS AND VARIABLES Value Added Intellectual Coefficient Indices include:

• Capital Employed Efficiency (CEE) measure the efficiency of Capital Employed (CE), where (CE) – book value of firm net assets.

CE = physical capital + financial assets

CE = Total assets – intangible assets CEE = VA/CE

CE represents tangible resources while HC represents intangible resource (Chen et al., 2005)

• Human Capital Efficiency (HCE). In VAIC model, HC is defined as salary and wages in a period (Pulic, 1998). Besides showing the firm size, high HC reflects higher employee skills that would add more value compared to employees with lower salary and wages. HCE shows the efficiency of HC usage in creating VA. If the human capital cost is low while VA is high then the firm uses its HC efficiently.

HCE = VA/HC

• Structural Capital Efficiency (SCE). Structural capital (SC) includes strategy, organization network, patent, brand name. Internal structural capital is developed internally, consists of policy and process, work environment, innovation created by research and development. SC is measured using Pulic (1998)

SC = VA – HC

HC and SC are in reverse proportion, increasing HC will decrease SC. SCE is measured (Pulic, 1998):

SCE = SC/VA

• Intellectual Capital Efficiency (ICE) is calculated:

ICE = HCE + SCE

• VAIC – value added efficiency of tangible and intangible assets:

VAIC = CEE + HCE + SCE

Financial Performance indices: Market-to-Book Value Ratios

Market to Book value (MB) reflects the market valuation of the companies. It is the ratio of market capitalization of the given year to capital employed of the firm.

The Market-to-Book value ratio is simply calculated by dividing the market value (MV) with the book value (BV) of common stocks:

MV = Number of shares x stock price at the end of the year. BV = Stockholder‘s equity – paid in capital of preferred stocks

MBV = market capitalization of 365 days

Book value of total assets

Market-to-book value (market value per share (MV) divided by Book value per share (BV) is the dependent variable in this model (Pulic 1998, 2000; Syed, 2005).

Return on Assets (ROA)

ROA is an indicator of how profitable a company is in relation to its total assets. It gives an idea as to how efficient the management uses assets to generate earnings. In fact, using this ratio, we can evaluate firm performance and it reflects the degree of efficiency in employing assets to obtain profit (Firer & Williams, 2003; Chen, Cheng, Hwang, 2005; Block, Hirt & Danielsen 2010).

ROA ratio is calculated by:

ROA = Net Income/Total Assets

Return on Equity (ROE)

ROE = Net income/shareholder‘s Equity

ROE measures organization‘s profitability by revealing how much profit a company generates with the money shareholders have invested.

Employee Productivity (EP)

Employee productivity (EP) is a tool that measures the net value added per employee which represents employee productivity (Chen, Cheng, Hwang, 2005). Higher EP represents higher productivity of employee, hence contribute positively to profitability (Clarke, Seng & Whitting, 2011).

EP = Profit before tax / number of employees

Growth Revenues (GR)

GR = [(current year‘s revenues/last year‘s revenues) – 1] x 100%

GR is the most traditional measure that indicates the growth of an organization. GR measures the changes in firm‘s revenues. Increase in revenue usually signal firm‘s opportunities for growth.

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