The Impact Of Liquidity On Profitability Finance Essay
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Published: Mon, 5 Dec 2016
Padachi observed the trends in working capital management and its impact on performance of a firm. Return on assets and cash conversion cycle was used to measure the firms profitability and efficiency of working capital management respectively. He described that a firm should maintain stability between profitability and liquidity while maintaining its day to day activities. The manager of a business want to maximize firm’s value by achieving preferred tradeoff between liquidity and profitability of a firm. The results indicated that the more investment in inventories and receivables lower the profitability of a firm.
Raheman & Nasr (2007) discussed the impact of working capital management on profitability of a firm. They also highlighted that the basic objective of a firm is to maximize profit but maintaining liquidity is also an important objective. There will be a serious problem if firm increase profit at the cost of liquidity. Both objectives are important for the firm. If a firm does not concerned about profit then it cannot survive for a longer period. On the other hand, if a firm does not concern about liquidity it may face bankruptcy. They took 94 firms of Pakistan and analyzed that there is a negative relationship between liquidity and profitability of a firm.
Michalski (2008) empirically analyzed the relationship between firm’s policy regarding net working investment and firm’s profitability. Too low liquidity level may come up problems with timely reimbursement of its liabilities while surplus liquid assets would negatively affect firm’s profitability. He discussed that decisions regarding liquidity is very difficult, a firm has to choose one of the three policies: first an aggressive policy i.e. a large part of the firm’s fixed and volatile demand to finance fixed assets is supported with short term financing, second a moderate policy i.e. a fixed part of current assets is financed with long term funds and volatile part is financed with short term funds lastly a conservative policy i.e. both fixed and volatile parts of current assets are financed with long term funds.
Dash & Hanuman (2009) were concerned about working capital management and they analyzed the liquidity-profitability trade-off model named as goal programming model. They supported that proper flow of fund is needed to run any business. A firm has conflicting objectives regarding liquidity and profitability so the goal programming model determines how targeted levels of profitability and liquidity would be achieved by maintaining current and fixed assets and at the same time minimizing opportunity cost. Their model proposed that working capital and inventory must be streamlined to profitability.
Nazir & Afza (2009) tried to find out the relation between aggressive working capital management policy and firm’s profitability by using panel data regression model and Tobin’s q of 204 Pakistani companies for the period of 1998-2005. They claimed that investors give importance to stocks of those firms which adopt aggressive policies to manage current liabilities. Their findings suggested that aggressive working capital investment and financing policies and profitability are negatively associated. They claimed that investors consider that firms which have less long term loans and equity can have better performance than the others.
Burtescu (2010) documented the reflection of liquidity and profitability of a company in the accounting result. He emphasized that it is not adequate for a firm to follow only economic indicators but it is also essential for a firm to make sure its liquidity in its quality of a specific dimension of financial management. The information about solvency and liquidity are beneficial for a firm to predict the ability of a firm to fulfill its financial obligations. He argued that investors have a great concern about the cash flow of a company and it becomes obligatory for a firm to include cash flow statement in its annual financial statements.
Gill, Biger & Mathur (2010) attempted to examine the relationship between working capital management and profitability. They used sample of 88 firms listed on New York Stock Exchange for the period of 2005-2007. The results suggested that the relationship between cash conversion cycle and gross profit margin is statistically significant. They also concluded that account receivables and profitability are negatively associated. The managers can enhance profits of their company by handling the cash conversion cycle efficiently.
Mohamad & Saad (2010) attempted to scrutinize the impact of working capital management on profitability and market valuation of a firm. They analyzed the secondary data of 172 Malaysian companies for the period of 2000-2007. They took working capital variables such as cash conversion cycle, current ratio, debt to asset ratio, current asset to total asset, current liabilities to total asset and profitability variables are return on asset and return on invested capital. By using multiple regression analysis and correlation, their results revealed that working capital variables have negative association with firm’s profitability. Firms cannot exist without working capital and it can improve the profitability and market value of a firm.
Dong & Su (2010) also conducted a study to find out the relationship between working capital management and firm’s profitability. The working capital management has an important part in the success and failure of a firm because it has a great impact on the profitability and liquidity of a firm. Their sample is based on 130 firms which are listed in Vietnam stock market for the period of 2006-2008. Their findings proved that profitability and cash conversion cycle is strongly negatively associated. By optimum working capital management, the managers may create a value of stock for the shareholders. The firm should maintain a balance between its two objectives; profitability and liquidity. One objective should not be achieved at the cost of other. Their findings also suggested that profitability can be increased by decreasing the number of days accounts receivable and inventories.
Saleem & Rehman (2011) observed a significant relationship between liquidity and firm’s performance. Liquidity of a company is very important for its every stack holder. If a firm’s cash and near cash assets are insufficient to satisfy its immediate payment obligations than firm may face difficulties. This can affect firm’s day to day business operations and profitability. They evaluated that liquidity and profitability are inversely related, one increases the other will decreases.
Bhunia, Khan & Mukhuti (2011) provided the evidence with respect to the relationship between liquidity and profitability of a firm. They took steel companies of private sector in India to assess the management of liquidity as a factor of performance. They studied important liquidity indicators and analyzed that optimal working capital management can be achieved by controlling the trade-off between profitability and liquidity of a firm. Firm value is positively affected by optimal working capital management so the investment in working capital must be satisfactory. They concluded that liquidity and profitability are significantly positively associated.
Saghir, Hashmi & Hussain (2011) studied the relationship between working capital management and profitability of a firm. They used cash conversion cycle to measure working capital management efficiency and return on asset to measure profitability while analyzing the financial data of 60 textile firms listed on KSE for the period of 2001 to 2006. They suggested that smooth inflow of profit is mainly affected by the optimum point of working capital. Working capital means company’s current assets and it has a direct effect on the liquidity and profitability of a firm. According to the risk and return theory, when firm’s liquidity of working capital is high then it has low risk and low profitability and vice versa. The shorter cash conversion cycle is better for the firm profitability. Their result shows the negative relation between working capital management and profitability of a firm.
Alipour (2011) researched about working capital management and corporate profitability while taking sample of 1063 companies from Tehran stock exchange. To test the hypothesis, multiple regression and pearson’s correlation was used. He analyzed that sale and profit of a company is greatly influenced by the working capital management. Due to inefficient working capital management, a company may be incapable to pay its debts on time. The results show a significant relationship between working capital management and profitability of a company. There is a negative relationship between cash conversion cycle, average collection period, inventory turnover in days and profitability.
Qazi et al. (2011) examined the impact of working capital on the profitability of a firm. Using the financial data of Pakistani automobile and oil and gas industry for the time period of 2004-2009, he proposed that the important components of working capital are debtor, creditor and inventory. The efficient and effective working capital can create value of the shares to shareholders. He persuaded that maintaining the company’s liquid level is a major task of a company. So, by ignoring liquidity objective, company may face insolvency or bankruptcy. Their results showed the positive impact of working capital on profitability.
Ching, Novazzi & Gerab (2011) scrutinized the financial statements of two separate groups of companies: working capital intensive and fixed capital intensive having16 companies in each group listed on Brazil Stock exchange during 2005-2009. They used return on assets, returns on sales and returns on equity to measure profitability and cash conversion cycle, debt ratio, days receivables, days inventory and days of working capital are used as independent variables. Their results showed that managing working capital is very important for both type of companies. Moreover, working capital intensive type of company gets more profit by managing inventory and cash conversion efficiency at optimum level and fixed capital intensive type of company yield more profit through other two variables.
Karaduman et al. (2011) also investigated the link between management of working capital and profitability of a firm. In the recent economic conditions, the survival of a firm greatly depends upon the ability to manage its financial function. Their sample is based on 127 companies listed in the Istanbul Stock Exchange during 2005-2009. The cash conversion cycle was used as a proxy of working capital management and returns on assets was used to measure profitability. The results portrayed that ROA is positively affected by the reduction in CCC. The profitability is increased by developing efficiency of working capital.
Alam et al. (2011) studied the influence of working capital management on the profitability and its market value of firms which are listed on Karachi stock exchange. They claimed that a misconception that firm survival is based on its profits has been cleared due to the present liquidity crises. They used financial data of 65 companies listed on Karachi Stock exchange during 2005-2009. Return on assets and returns on invested capital were used as proxy for measuring financial performance of the firm, Tobin’s Q was used to determine the market value of a firm and five financial ratios such as cash conversion cycle, current ratio, debt to asset ratio, current asset to total asset ratio and current liabilities to total asset ratio were used as dependent variables. Their empirical results presented sufficient evidence that firms strongly depends upon current assets to generate profits.
Ogundipe, Idowu & Ogundipe (2012) provided evidence regarding the influence of working capital management on performance of a firm and its market value. They collected data from annual reports of 54 Nigerian companies for the period of 1995-2009. They explained working capital management as management of current assets and current liabilities and it has a direct effect on firm’s profitability and market valuation. Their findings suggested that as cash conversion cycle decreases firm’s profitability increases and efficient working capital management also increases the market value of a firm.
Barine (2012) established the relationship between efficient working capital management and firm’s profitability. Working capital management ensures a firm’s ability to satisfy both short term obligations and forthcoming operational expenses. They compared the cost and returns of working capital of 22 listed firms on Nigerian stock exchange. Their findings proposed that if cost of working capital is greater than returns on working capital investment then it negatively affects profitability and firms should have optimized working capital investments to stay away from over or under investments.
Bhunia (2012) explored the influence of liquidity on profitability while taking the sample of FMCG companies in India during 2001 to 2010. He argued that working capital management plays an important role in the financial management decisions of a firm and managers should manage the trade-off between liquidity and profitability to attain optimal working capital management as it can create value for the firm. By using applied normality test, correlation and regression, the results indicated that liquidity and profitability are positively associated.
The research of Vahid, Mohsen and Mohammadreza (2012) also highlighted the affect of working capital management policies on firm’s profitability. They explained that working capital management has a great impact on profitability and liquidity of a firm and it is responsible for the success and failure of a firm. Their sample consists of 28 Iranian companies listed on Tehran stock exchange for 2005-2009. Their results suggested that conservative investment policy i.e. high level of short term investment have a negative impact on profitability and value of a firm, while aggressive investment policy i.e. long term investment have positive impact on profitability and value of a firm. Their results also showed that aggressive financing policies i.e. high level of current liabilities to finance firms project have a negative impact on profitability and value of a firm, while conservative financing policies i.e. having more long term liabilities to finance firm’s operating activities have a positive impact on firm’s profitability and value.
Al-Mwalla (2012) tried to observe the affect of working capital management policies on the profitability and value of a firm. He persuaded that a firm has to maintain adequate level of working capital to fulfill its short term obligations. Therefore, a firm can adopt one of the two policies; a conservative policy by maintaining low level of current assets to total assets or an aggressive policy by keeping high level of current liabilities to total liabilities. He took annual data of 57 firms listed in Amman Stock Market during 2001 to 2009 for analysis. The results portrayed that conservative policy of investment and financing are positively associated with profitability and value of a firm.
Ahmad (2012) highlighted the influence of working capital management on form’s performance while taking a sample of 253 companies related to non financial sector listed on Karachi Stock Exchange, Pakistan. He use ROA and ROE as proxy of firm performance and current asset over total sales, current asset over total asset, debtor’s turnover, current ratio and inventory turnover as proxies of working capital management. Using OLS regression, Pearson correlation analysis and logistic regression techniques, he found that all explanatory variables are positively correlated to firm performance except current assets to total sales as it has a negative correlation with firm performance.
Usama (2012) extended the work of Rehman and Nasar regarding working capital management while taking the sample of 18 companies from other food sector listed on Karachi Stock Exchange for the period of 2006-2010. The researcher used different variables to measure working capital management such as average collection period, inventory turnover in days, cash conversion cycle, average payment period, debt ratio, firm size, current ratio, and financial asset to total asset. Using common effect model and pooled least square regression, the results indicated that working capital management has significant positive association with firm’s profitability and liquidity. He also concluded that firm size and minimum inventory turnover in days has positive influence on firm’s profitability.
Myers (2001) purported that there is no general theory regarding debt and equity choice. He discussed three main theories for the choice of debt and equity. He described that according to trade off theory firms adopt that debt level which balances the tax benefits of additional debt against the cost of financial distress. Debt financing gives a tax shield to a firm therefore they took high level of debt to gain maximum tax benefits and eventually increase profitability. However, the increase of debt financing increases the possibility of bankruptcy. According to pecking order theory, when firm’s internal cash flow is not enough to fulfill its capital expenditure then firms prefer debt on equity. Mostly low profitable firms entail external financing and accumulate debt. According to the free cash flow theory, when a mature firm has profitable investment opportunities and its operating cash flow is considerably exceeds its investment opportunities, so this dangerous level of debt will have a positive effect on firm’s value regardless of threat of financial distress.
Berger & Bonaccorsi di Patti (2003) supported that leverage has a direct impact on agency cost which influences firm performance. They proposed that high leverage or a low equity capital ratio causes to reduce the agency cost related to outside equity and raises firm value. They used annual information of U.S. commercial banks from 1990 to 1995. Their result showed that a 1% increase in leverage decrease equity capital ratio surrenders a predicted 6% increase in profit efficiency.
Fama & French (2005) described the financing decisions of firms. They tested predictions of pecking order theory about financing decisions and claimed that more than half of their sample firms defy the pecking order predictions. Their first result is against the pecking order prediction that firms hardly issue stock. Under their sample, 67% of the firms issue stock each year during 1973-1982 and it rises to 74% for 1983-1992, and 86% during 1993-2002. So, equity decisions of a firm frequently violate the pecking order. Second prediction is that capital structure of a firm is derived by asymmetric information problem but their findings are against this prediction. They suggested that this problem can be avoided by issuing equity through different ways.
Elsas, Flannery & Garfinkel (2006) studied firm major investment, financing decisions and long run performance. They took 1,185 U.S. firms which made huge acquisitions or capital expenditures during 1989-1999. They observed that large firms financed their new investment with debt whereas equity has a small role. With the passage of time, new debt replaced with equity funds. Small firms mostly rely on issuing equity when financing its new investments to replace debt while internal cash flow is used by medium sized firms. They analyzed that debt financing produces negative long run performance more than equity financing whereas financing with internal funds never produce important share underperformance.
Dittmar & Thakor (2007) developed a new theory of issuance of security that is when stock prices are high then firms issue equity. This issue is contradictory with the two major theories of capital structure: pecking order and trade off theory. The main idea of their theory is that manager’s decision about security issuance is based on how their decisions will influence the investment choice of the firm and how this choice will influence the post-investment stock price of the firm. After the investment in the project, managers are more concerned about the stock price and the long term equity value of the firm. The shareholders and bondholders may object to the manager’s choice of investment because they have dissimilar beliefs regarding the value of the project. Their findings suggest that firms which issue equity have higher stock prices, higher values of agreement parameter and higher increase in investments.
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