Impacts of liquidity ratios on profitability
(Case of oil and gas companies of Pakistan)
Qasim Saleem
Lahore Business School, The University of Lahore, Pakistan
E-mail: Qami2006@yahoo.com
Ramiz Ur Rehman
Assistant Professor
Lahore Business School, The University of Lahore, Pakistan
ABSTRACT
The present study aims to reveal the relationship between liquidity and profitability so that every firm has to maintain this relationship while in conducting day to day operations. The results show that there is a significant impact of only liquid ratio on ROA while insignificant on ROE and ROI; the results also show that ROE is no significant effected by three ratios current ratio, quick ratio and liquid ratio while ROI is greatly affected by current ratios, quick ratios and liquid ratio. The main results of the study demonstrate that each ratio (variable) has a significant effect on the financial positions of enterprises with differing amounts and that along with the liquidity ratios in the first place. Profitability ratios also play an important role in the financial positions of enterprises. Every stakeholder has interest in the liquidity position of a company. Suppliers of goods will check the liquidity of the company before selling goods on credit. Employees should also be concerned about the companyrsquo;s liquidity to know whether the company can meet its employee related obligations–salary, pension, provident fund, etc. Thus, a company needs to maintain adequate liquidity so that liquidity greatly affects profits of which some portion that will be divided to shareholders. Liquidity and profitability are closely related because one increases the other decreases.
Keywords: Liquidity ratios, Return on Investments, Return on equity, Return on Assets, Regression analysis
INTRODUCTION
Liquidity management is very important for every organization that means to pay current obligations on business, the payment obligations include operating and financial expenses that are short term but maturing long term debt. Liquidity ratios are used for liquidity management in every organization in the form of current ratio, quick ratio and Acid test ratio that greatly affect on profitability of organization. So business has enough liquid assets (Cash, Bank) to meet the payment schedule by comparing the cash and near-cash with the payment obligations. Liquidity ratios work with cash and near-cash assets (together called 'current' assets) of a business on one side, and the immediate payment obligations (current liabilities) on the other side. The near-cash assets mainly include receivables from customers and inventories of finished goods and raw materials. The payment obligations include dues to suppliers, operating and financial expenses that must be paid shortly and maturing installments under long-term debt.
Liquidity ratios measure a business ability to meet the payment obligations by comparing the cash and near-cash with the payment obligations. If the coverage of the latter by the former is insufficient, it indicates that the business might face difficulties in meeting its immediate financial obligations. This can, in turn, affect the companys business operations and profitability. The Liquidity versus Profitability Principle: There is a trade-off between liquidity and profitability; gaining more of one ordinarily means giving up some of the other.
LITERATURE REVIEW
Operating cash flows generate by assets will affect continuing firm liquidity. It is not only because of the value of liquidation (Soenen, 1993). Firms with fewer current assets will having problem in continuing their operations while if the current assets are too much, it shows the return on investment is not in perfect condition. (Horne and Wachowicz, 2000). Since optimum cash levels are influenced by the factors outside the preventive concept of treasury, the company must think broad and take serious operational decisions on how to the profit opportunities that is available in cash flow process.
Here are the methods help to compute liquidity in business organization. We can determine how liquid the firm is by using ratio analysis. To find a ratio of current assets to current liabilities is by current ratio. Quick ration will permit know whether can disburse their current debt, exclude to sell any inventory. Itrsquo;s vital for anorganization to concern on this because, if they need to sell inventory, they also need a customer to buy that inventory. (Chinmoy Gosh 2009).
The economics and finance literature analyze four possible reasons for firms to hold liquid assets; the transaction motive Miller and Orr 1966, the precautionary motive Opler, Pinkowitz, Stulz, and Williamson 1999, the tax motive Foley, Hartzell, Titman, and Twite 2007 and finally the agency motive Jensen 1986. Analysts use liquidity ratios to make judgments about a firm, but there are limitations to these ratios. The liquidity of a firms receivables and inventories can be misleading if the firms sales are seasonal and or the firm uses a natural business year (Gibson, Charles H. 1991 Financial Statement Analysis p.261 Cincinnati, OH: South-Western College Publishing).
Cash flow ratios determine the amount of cash generated over a period of time and compare that to short-term obligations. This gives a clearer picture if the firm has a liquidity problem in connection with its short-term debt paying ability. Operating cash flow is computed by dividing cash flow from operations by current liabilities. This shows the companys ability to generate the resources needed to meet current liabilities (Mills, Vamamura: Journal of Accountancy 1998). Firms with
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