Liquidity Ratio Analysis

Liquidity Ratio Analysis Liquidity ratio is a measure of the ability of the company to transform immediately of its assets into any other asset and pay their short term obligation due on time. This is among the important measurement which involve planning and controlling the current assets and current liabilities. Cash is among the very liquid assets compare to fixed asset which is illiquid. Liquidity ratio analysis of the company must be done first in analyzing the companys financial position. This is due to the serious problems that might arise such as potential insolvency and mismanagement by the manager. The commonly liquidity ratio used are current ratio and quick ratio for a quick check of liquidity, but there are also another component to have better understanding of companys ability to make payments to other parties such as cash cycle, working capital, accounts receivable, inventories, current liabilities. Besides the use of the liquidity ratio as determinant of firms ability to pay for short term debt, it also can be used to avoid of excessive holding of inventory. The financial analysts commonly used the specific liquidity ratio such as current and quick ratios, which allow them to make temporal or cross sectional comparison which is within the company itself or other companies in the industries. As part of it, another concept that also commonly used to identify the liquidity of the company is working capital which is calculated by deducting the current liabilities of the firm from the current liabilities. The working capital is very important measurement in determining financial stability for the company. It is health for the company to have more current assets over its current liabilities suppose to be practiced by the company. The company needs to stress on the liquidity management because from the previous research on companys balance sheet composition in Spanish found that 69 percent of the assets is current asset and 52 percent of liabilities represent current liabilities (La Porta et al, 1997). According to Petersen and Rajan (1997), the high percentage of current liabilities due to the reason that the current liabilities become one of their main external financial loans because the company failed to obtain the long term fund from the bank and other creditors. This is also supported by other researcher such as Whited (1992), Petersen and Fazzari (1993) that stated that current liabilities become one of resources due to their financial constrain. Also research done in US by Elliehhausen and Wolken (1993), Petersen and Rajan (1997) found that the US small and medium firm size depend on current liabilities when they have financial problems. The efficient liquidity management is particularly important for the big companies as well as small companies. It is rather important in small companies as highlighted by Peel and Wilson (1996). If a companys current liabilities exceed the amount of current assets, the company will face the problems to pay back the creditors in the short term. If this problem persists, the company could end up into bankruptcy. As stated by Nicholas (1991) that companies that did not concern to improve liquidity management until it was too late and reaching crisis conditions or end up on the verge of bankruptcy. Furthermore, it is important to have liquidity management in good times and it takes further importance in troubled times. The useful of liquidity ratio Liquidity ratio as part of accounting ration is important tools in financial analysis. Basically, these ratios used to identify the ability of the firm to pay it debt, to evaluate company performance as well as to access company value. According Palepu et al (2003) analysis done may be within company itself, or for the particular firm but compare for several years, compare the same ratio for the different company in same industry. From previous studies, they found that accounting ratio also useful in providing information for decision making process (Houghton, and Woodliff, 1987, Thomas and Evanson (1987, Lewellen, 2004). For some instant, liquidity ratio also useful in predicting business failures (Beaver, 1966; Altman (1968). The excess in working capital represents a safety cushion for providers of short-term funds of the company such as creditors, bank. This is also viewed positively the availability of excessive levels of working capital and cash. However, from an operating point of view, this excessive of working capital has been looked as a restraint on financial performance because these assets do not contribute to return on equity (Sanger, 2001). A lot of techniques could be applied to improve liquidity and cash positions, at the same time it can increase the efficiency of their management. At the end it would result in high profitability. These include credit insurance (Brealey and Myers, 1996; Unsworth, 2000; and Raspanti, 2000), factoring of receivables (Brealey and Myers, 1996; Summers and Wilson, 2000). The effect of liquidity management The efficiency of liquidity planning and control which include liquidity management, working capital and cash management have significant effect towards the profits. Actually, the most important is to have efficient liquidity management and the next, profitability will follow as well. The important of companys liquidity can be seen from different perspectives. Basically the idea of companys liquidity laid on the going concern concept which not involved any default in near future. The first party who interested on companys liquidity is short term lenders. These lenders interested on payment made on the debt and short term obligation because they can reasonably expected to be paid. For their own security, lenders would prefer the company with a high liquidity as their protection. For the investors and management, holding large cash balances is not the benefit activities in the company. Besides the problem due to the existence of the cash, this cash also become as extra cost to the company. The company actually has forgone the interest income from short term investment if they hold a lot of surplus cash. On the other hand, it is also necessary for company to hold cash to make immediate payments in the case to undertake rapidly the most desirable projects, and to deal without major disruptions with unforeseen problems. The amount of cash depend on expected growth and faces risk, the higher the expectation, the more the company must have a cushion of ready cash. The surplus cash on hand allow company to take advantage of new opportunities quickly. A healthy cash position helps stemming from new products, changing customer tastes or changing market conditions. Another factor to be considered for keeping on hand other liquid assets such as receivables is as a part of sales strategy of the firm. Companies usually offer their customer to take 30, 60, 90 days or more to pay for their purchases. This is to encourage immediate purchase of the customer in the big amount. Account payables are a major element of corporate finance. According to Rajan and Zingales (1995) the aggregate amount of payables in American firms was a significant part (17.8%) of total assets for all in the early 1990s. Other country such as Germany, France and Italy, also shown the very significant amount of payables which represents more than a quarter of total corporate assets, in United Kingdom payable also show significant value which represent 70% of total short-term debt (credit extended) while 55% of total credit received by firms is made up of account payables(Kohler et al., 2000; Guariglia and Mateut, 2006). In fact, payables are also important factor in emerging economies, like China, due to limited support from the banking system. The companies depending more on credit on purchases compared to other forms such as bank loans as highlighted by Ge and Qiu, (2007). Similar to Atanasova and Wilson (2004) find that smaller UK companies tend to increase their reliance on inter-firm credit to avoid bank credit rationing. However, account payable does not need fully attention for the company since it does not consumes resources but serve as short term of source of finance. The benefits arise that it could reduce the cash gap. Previous researchers have viewed the relationship trade-off between inventories and payables such as Nadiri (1969), Schwartz (1974), Ferris (1981) and Emery (1987)). Only Emery (1987) considers explicitly the trade-off between trade credits and inventories but his study does not include the deterministic variable demand framework. More recently, the study from Daripa and Nilsen (2005) has theoretically investigated how this trade-off could affect the terms of credit agreements. In their model, suppliers offer trade credit as an incentive to buyers to hold higher inventories. Normally, managements concerned with liquidity but they cannot only concern liquidity as single element because when there are shortage or excessive in receivables or inventory it usually will reflected to production, sales efforts, fixed assets or other management decision parameters, not liquidity alone. As highlighted before, receivables and inventory reflected to sales and production strategies. Working capital is also important factor in liquidity management due to its effect on the profitability and risk of the firm. Specifically, the investment in working capital is highly related with tradeoff between profitability and risk which means that if the company decides to increase the profit, they have to face the increase in risk as well as stated by Smith (1980). There are a lot of determinants of working capital such as stated by Chiou and Cheng (2006) in their study: 1. To examine methodically by separating into parts and studying their interrelations. 2. Chemistry To make a chemical analysis of. 3. factor influence working capital such as business indicators, industry effect, operating cash flows, growth opportunity for a firm, firm performance and size of firm. The study has clearly identified that determinant of working capital 1. To represent in a picture or sculpture. 2. To represent in words; describe. See Synonyms at represent. consistent results of leverage and operating cash flow Operating cash flow Earnings before depreciation minus taxes. Measures the cash generated from operations, not counting capital spending or working capital requirements. for both net liquid balance and working capital requirements. However, Capital requirements Financing required for the operation of a business, composed of long-term and working capital plus fixed assets. some variables unable to produce consistent conclusions for net liquid balance and working capital requirements of firms like business indicator, industry effect, growth opportunities, performance of firm, and size of firm. Similar study has been done by Nazir and Afza (2008) which have used both external and internal factors to explore the determinants of working capital requirements of a firm. They identified internal factors were operating cycle Operating cycle The average time between the acquisition of materials or services and the final cash realization from that acquisition. operating cycle , operating cash flows, leverage, size, ROA, Tobins q and growth while industry dummy Sham; make-believe; pretended; imitation. Person who serves in place of another, or who serves until the proper person is named or available to take his place (e.g., dummy corporate directors; dummy owners of real estate). and level of economic activity were recognize as external macroeconomic n. (used with a sing. verb) The study of the overall aspects and workings of a national economy, such as income, output, and the interrelationship among diverse economic sectors. factors. From the study, they found that operating cycle, leverage, ROA and q had a significant influence on the working capital requirements. Their finding further revealed that working capital management practices are also have significant related to industry and different industries are following different working capital requirements. Another study has been done on impact of the different variables of working capital management by Rehman (2006). The study have recognize that the variable including Average Collection Period, Inventory Turnover in Days, Average Payment Period and Cash gap on the Net Operating Profitability of firms has a strong negative relationship between above working capital ratios and profitability of firms. Another element of liquidity management that is also important is cash gap which has high relationship with working capital. This is supported by Gitman (1974) that mentioned that cash gap is among important factor in working capital management. Cash gap or cash gap can give significant effect towards companies profitability. The shorter the period, companies could generate high volume of profit. The value of the firm also increase with the reduction on number of days for which the account are outstanding (Teruel and Solaano, 2007). Investment in inventory and trade debtor which customers still owe to the company are not being able to pay off any of the companys obligations. It will affect as an increase in the working capital if a company is not operating in the most efficient manner. The slow collection as cash will affected the cash collection cycle. Uyar (2009) examined the relationship between types of industry with cash gap. The study is done on merchandising and manufacturing companies and found that merchandising industry has shorter CCC than manufacturing industries. He also investigate the relationship between the length of the CCC and the size of the firms and the findings indicated there is a significant negative correlation Noun 1. negative correlation a correlation in which large values of one variable are associated with small values of the other; the correlation coefficient is between 0 and -1 indirect correlation between the length of CCC and the firm size, in terms of both variable net sales Net Sales The amount a seller receives from the buyer after costs associated with the sale are deducted. Notes: This amount is calculated by subtracting the following items from gross sales: merchandise returned for credit, allowances for damaged or missing goods, freight and total assets. Furthermore, the study by Uyar(2009) investigate the correlation between the length of CCC and the profitability of the company. The finding showed there is a significant negative correlation between these two variables. In addition, the study by Rehman (2006) stated that managers can create a positive value for the shareholders by reducing the cash gap up to an optimal level To underline the importance of managing liquidity, Loeser (1988) mentioned the extreme way in order to reduce the cash cycle. Loeser recommended interest to be charged at the prime rate to outstanding accounts receivable and unbilled revenue. This is to encourage responsible employees and particular departments within companies to put every effort necessary to collect receivables, and thus reduce Cash gaps. Similarly, study by Fraser (1998) who argues that liquidity and Cash gap management starts with a simple task for financial managers by making certain that their billings, collections, and payables systems are operating efficiently. Management must be certain with the procedures of collecting the payment so that the cash collecting process will organized eventually. Critics and disadvantages on liquidity ratio Besides the benefit in liquidity management and working capital, it also arise some critics such as stated by Hawawini et al. (1986) argue that in order to get the relevant analysis result, it is a better for the firm to apply the concept of working capital investment in its operating cycle rather than the usage traditional concept of net working capital. This argument also supported by Finnerty (1993) which mentioned that the current ratio and quick ratio calculated in traditional liquidity ratios include both liquid financial assets and operating assets in their formula. This is according an ongoing concern point of view that identified inclusion of operating assets which are tied up in operations is not useful. Subsequently, Kamath (1989) argues that both current and quick ratios are static analysis in nature because the usage of past performance. These two ratios have the lack of information on the future cash flows and liquidity. There was suggestion by Gitman (1974), Richard and Laughlin (1980), Boer (1999), and Gentry et al., (1990) to replace the use of liquidity ratio with cash gap as a measure of available liquidity. This is due to the dynamic nature of cash cycles and also involved tradeoffs. As suggest by Kamath (1989) the Cash gaps (cash gap) can be used to replace or s liquidity ratios in measuring and predicting the nature and pattern of future cash flows. The Cash gap measures the length of time between actual cash payment on productive resources especially from the raw material and actual cash receipts from the sale of products or services. It is good for the company to have a short Cash gap because the longer the gap the longer company has to rely on the external financing. T he result was company will suffer of increasing interest cost. In Saudi Arabia the interest cost is more expensive in due to the absence of tax savings. Instead of paying taxes, national companies incorporated in Saudi Arabia are not required to pay zakat (level or fixed percentage tax required by Islamic shariah). This is due to the characteristic of borrowing cost which is as a cheap basis of financing loses its tax advantage since there is no tax on Saudi companies profits. Likewise, reducing cash gaps by any number of days will add equally to the pretax and after-tax profits. Although the liquidity ratios is a very useful mechanism to analyze financial position of the companies, the usage of these ratio must be with discretion and caution especially in making comparison among company and across industry as mentioned by Abdullah and Ismail (2008) . The reason is because the different of accounting method and treatment used by the different companies, also different in ratio definition. Subsequently the mislead comparison be made. To avoid the mislead use, the standardize guideline is required. According to Gibson and Boyer (1991), without the standardize guideline, companies will only disclose the ratio that only benefit them. Due to the lack of guideline and standard, study done in Malaysia found that only some of the company disclosure a comprehensive of financial ratio. The study also disclosed that there are differences in choice of ratio, method of calculated the ratio among the companies. This situation doesnt allow for any comparison among the company. The researcher also found that the good performance companies tend to disclose more information as signal of their good quality to attract attention of investors. Gibson (1982) the lacks of ratio disclosure discourage the information user to know about the financial position because most of the important financial ratios were not discloses. Furthermore, most companies disclose the ratios that only favorable to benefit their position Liquidity and profitability There are a lot of research done to identify the significant relationship between liquidity management and companies profitability. Evidence from previous studies supported the fact that aggressive working capital policies could increase the profitability of the company. Jose et, al (1996) proved that the US companies incurred high profit which benefit from aggressive working capital policies. In addition, Shin and Soenen (1998) identified that there is strong negative relation between the period of the firms net trade cycle and various measures of profitability. The study was done using a large sample of American firms during 1975-1994, found that reducing the net trade increase companys profitability. The study also includes market measures, such as stock returns, and operating profits. Previous research evidence that aggressive working capital management that heavily invested in high inventory level could enhance profitability of the company as highlighted by Wang (2002) who done the research for Japanese and Taiwan companies and found that the less cash gap period, the better operating performance. The research also had done in any other country such Deloof (2003) in Belgian companies which find the company could improve the profitability by reducing the number of days of account receivable outstanding as well as at the same time reducing their inventories. However, according the study by Uyar (2009) examined the relationship between types of industry with cash gap. The further finding showed there is significant negative correlation between the length of CCC and the profitability. Similar to Ramachandran and Janakiraman (2009) also found negative relationship between Earnings before Interest and tax (EBIT) EBIT See: Earnings Before Interest and Taxes EBIT See earnings before interest and taxes (EBIT). and the cash gap. The study revealed that calculation EBIT shows how to manage the working capital of the firm. The negative relationships reflect to the lower gross EBIT was related with an increase in the accounts payable days. Thus the study identify that less profitable company will take advantage to pay for a longer to pay their bills. At the same time company also taking advantage of credit period granted by their suppliers. The study also found that there is the positive relationship between average receivable days and firms EBIT that suggested that less profitable company will try to pursue a decrease of their accounts receivable accounts receivable n. the amounts of money due or owed to a business or professional by customers or clients. Generally, accounts receivable refers to the total amount due and is considered in calculating the value of a business or the business problems in paying days in order to reduce their cash gap. The advantages of high inventory level are reducing in cost of possible interruption in the case of scarcity products. It can overcome the problem of price fluctuation; reduce supply cost (Binder and Maccini, 1991). The other advantages associated with high level inventory that allow trade credit which act as effective price cut (Brennan et. al, 1988; Petersen and Rajan, 1997), also encourage customer to purchase their resources at the lower price. As highlighted by Emery (1997). The company also could benefit long term relationship with the customers as mentioned by Ng et, al (1999). On the other hand there is contrary argument on aggressive policies that minimize on working capital which state that it would affect the profitability of the company as stated by Wang (2002) that if the inventory level is least, the company could face reduction in its sales. Similar to Ganesan (2007) that done the research on relationship of efficient capital management and profitability in telecommunication company that he identified that the efficiency working capital management was negatively associated to the profitability and liquidity. From the finding, it shows that when the working capital management efficiency was improved by decreasing days of working capital, there was improvement in profitability of the firms in terms of profit margin. Padachi (2006) examined the trend in working capital requirement and profitability of firms. This study is done to identify the causes for any significant differences between the industries. The finding reveals that high investment in inventories and receivables was associated with lower profitability. It has a significant negative effect between the inventories investment and profitability. The findings also recognized that an increasing trend in the short-term component in the short-term component of working capital financing. This finding also agreed by Raheman and Nasr (2007) also studied on the effect of working capital on liquidity towards profitability of the company. Further the study done also recognize that there was a negative relationship between liquidity and profitability of the company. Also, they find that there is a positive relationship between size of the company and its profitability and significant negative relationship between debt used by the firm and its profi tability. The similar study also done by Afza and Nazir (2007a) and they also found the same finding as previous research. In line with the study Afza and Nazir (2007b) further investigated the relationship between the aggressive/conservative working capital policies profitability as well as risk of public limited companies. The finding reveals that a negative relationship between the profitability measures of companies and degree of aggressiveness of working capital investment and financing policies. The companies will occur negative returns if they follow an aggressive working capital policy. Another study by Lazaridis and Tryfonidis (2006) that investigated the relationship of profitability which measured through gross operating profit and working capital management. The results of the study showed that there was a negative relationship between profitability and the cash gap which was used as a measure of working capital management efficacy. In order to generate can create profits for their companies, the management must handling correctly the cash gap and keeping each component like accounts receivables, accounts payables, inventory to an optimum level. Samiloglu and Demiraunes (2008) analyzed the effect of working capital management (which highlighted accounts receivable period, inventory period and leverage) on the profitability of the firms. The study depicted working capital has a negative effect on profitability of the companies profitability . Conclusion It is very important and first step taken to study the role of liquidity management policies on profitability of a company. Normally, the company decision whether they can face higher risk due to achieve higher profit. Iif a company desires to absorbed a greater risk for bigger profits and losses, it could reduces the size of its working capital in relation to its sales. If the main interest of the companies is improve its liquidity, it increases the level of its working capital. Therefore, a company should identify a balance between liquidity and profitability (Vishnani . Shah, 2007). . Before the companies adopt any method to increase the profitability, they should evaluate the tradeoff between expected profitability and risk on inventory investment. They have to make sure that the increase in profitability is more than the risk involved.