Title: “The Impact of Liquidity on Firm’s Profitability”

Supervised by: Mr. Muhammad Awais Aslam

Submitted by: Irfan AsgharSection-B2011-ag-1400Semester 7thMBA 3.5 Years

Institute of Business Management Sciences

UNIVERSITY OF AGRICULTURE FAISALABAD

Abstract

The present study aims to investigate the impact of liquidity on profitability so that every firm

has to maintain this relationship while in conducting day to day operations. This study examine

the impact of liquidity on firm’s profitability of chemical firms that are listed in Karachi Stock

Exchange for the period of 5 years from 2009 to 2013. Current ratio, Quick ratio and Liquid

ratios are used as on the other side Return on Asset (ROA) used as indicators of firm’s

profitability. Multiple Regressions is used to determine the impact of liquidity on firm’s

profitability. The result of the study shows that there is significant impact of current ratio on

return on asset and there, but quick ratio and liquid ratio have weak impact on ROA. The main

results of the study demonstrate that each ratio (variable) has an impact on the financial positions

of enterprises.

Key words: Liquidity ratios, Return on Assets, Regression analysis

1. Introduction

Chemical sector plays a fundamental role in the economic development of any nation. The global

business of chemical forms the structure of the modern world. It converts essential raw materials

into more than 70,000 various products, for industry as well as the goods of consumers that

people depend on in their daily life. The modern chemical industry can be divided into four wide

categories, including basic chemicals, specialty chemicals, life sciences, and consumer products.

The cause for its outstanding success is the constant scientific and technological advances and

breakthroughs, which have led to the expansion of new products and procedures.

During the time of independence, chemical industry in Pakistan was almost non-existent. Some

traditional sectors have been developed over the years. However; the Chemical Industry in

Pakistan is still at an emerging phase.

As far as the classification of the Chemical industry development of Pakistan is concerned, it can

be classified into two sectors.1) the primary sector and 2) the secondary sector. Primary sector

industries are at a large-scale. They are capital intensive industries that comprise refineries,

natural gas, petrochemicals, metallurgical and projects based on mineral. They also supply feed

stocks to the secondary chemical industry. Secondary industries are based on feed stocks which

are either derived from primary sector of industries, or other different sources of raw materials.

These industries are less capital intensive and they are based on high, medium or less advanced

technologies. Discussing the consolidated figures for imports & exports such as chemicals,

fertilizers, plastics, rubber, medicines, dyes & pigments, soaps & detergents, and the section of

chemicals for the period from 2004-05 to 2010-11. Imports increased from 768 Million US $ in

2004-05 to 5,166 Million US $ in 2010-11 .On the other hand increment in exports was shown

from 118 Million US $ in 2004-05 to 411 Million US $. Chemical shares in the total imports

were about 15% while its share in exports was about 2.3%. The total imports of plants and

equipment used for the manufacture of chemicals contributed about 23% of overall imports of

Pakistan. The combined shares of the two categories like plants/equipment’s and chemicals were

about 38% of country’s general imports and among major contributors of country’s imports.

For the recent development in the chemical sector of Pakistan, it must create its own capability

and accomplish self-sufficiency in project design, engineering as well as the construction

management required for the commercialization of technologies. There is a need to develop

qualifications in the creation of medium and high technology based chemicals for export, along

with the present industrial structure based on low technology resource based products. Above all,

Pakistan must provide suitable inducements to entrepreneurs for the enlargement of an export-

oriented chemical industry. Now there are many companies and small units are produced

chemical products in Pakistan and 34 companies are listed in Karachi Stock Exchange (KSE) and

this study is based on the chemical sector of Pakistan listed in Karachi Stock exchange

Profitability and liquidity are the most prominent issues in the corporate finance context.

Financial liquidity is not straight it has many aspects, although generally financial liquidity refers

to current assets and current liabilities management. Financial liquidity with profitability are two

main activities of enterprise, and company should treat as equally important in order to function

efficiently. The growth of the financial liquidity may negatively affect the profitability because if

the company has high liquidity than some capital will be frozen in current assets and it may

negatively affect the profitability. Decision on the liquidity or profitability it’s all about planning

which is very important for the efficient working of firm. For efficient performance of the firm,

there must be proper flow of funds. This fund is called working capital which is equally defined

as the net current assets, or the current assets less the current liabilities (Prasana, 2000).

Liquidity has been a source of worry for the management of the firm. Liquidity plays an

important role in the successful functioning of a firm. When we say about the liquidity of an

asset its mean that how quickly it can be transformed into cash. When we referring to company

liquidity is the condition which shows that firms are able to pay its current liabilities and it is

measured by different financial ratios. Liquidity ratios are used for liquidity management in

every organization in the form of current ratio, quick ratio and Liquid ratio that greatly effect on

profitability of organization

Profitability is a measure of the amount by which a company’s revenue exceeds its relevant

expenses. The profitability of a firm means its ability to generate income which surpasses its

liabilities. Profitability is usually measured by different ratios such as ROA, ROE. Profitability

ratios shows that how effectively management can make profits from the sales. Profitability

ratios are very important for the company because potential investors are interested in the

dividends and market price of the stock, so they focus on profitability ratios. But managers are

more interested in measuring the operating performance in terms of profitability. So a low profit

margin leads to ineffective management and we may lost our potential investors.

Efficient liquidity management includes planning and controlling current assets and current

liabilities in such a manner that eliminates the risk of the inability to meet due short-term

obligations, on one hand, and avoids excessive investment in these assets, on the other. A firm

must ensure that it does not suffer from lack-of or excess liquidity to meet its short-term

obligations. Therefore firm should try to maintain a balance between liquidity and profitability.

Because if firm has not more liquid assets than it suffer from low liquidity position and if it has

high liquid assets than it reduce the firm’s profitability. The firm’s liquidity should not be too

high or too low. Excessive dependence on liquidity indicates the accumulation of idle funds that

don’t fetch any profits for the firm (Smith, 1980).On other side, insufficient liquidity might be

damage the firm’s goodwill. Hence in this study we will examine the impact of liquidity on

profitability of listed chemical companies in Pakistan.

Research Question

The concept of Liquidity has been a source of worry to the management of firms of the

uncertainty of the future.

Increasing profitability would tend to reduce firm’s liquidity and too much attention on liquidity

would tend to affect the profitability (Smith, 1980). Saleem and Rehman (2011) they conclude

that liquidity ratios affect the profitability ratios and profitability is improved for oil and gas

sector that hold some liquid assets. Shahchera (2012), Bordeleau and Graham (2010) also find

that liquidity is improved for the banks which hold some liquid assets. Niresh (2012) conclude

that there is no significant relationship between liquidity and profitability. Some argued that

liquidity not affect the profit ability so the question is:

Is Liquidity has impact on profitability?

In this study we find the impact of liquidity on profitability of chemical sector of Pakistan listed

on Karachi Stock Exchange.

2. Literature Review

Liquidity and Profitability, both are very important topics of finance. So, many researchers of

finance seeks to evaluate the connections between liquidity and profitability and large number of

studies have been conducted to find the relationship between the Liquidity and Profitability. In

research papers, some scholars argued that profitability is more important than liquidity and

others are against this statement, and some of them said that both are equally important.

In the literature review, many researchers said that there is a significant relationship exist

between liquidity and profitability and some said that there is no relationship exist between

liquidity and profitability.

As of one of Pakistani researchers Qasim Saleem and Ramiz Ur Rehman (2011) in his

study of “Impacts of liquidity ratios on profitability” with the samples of 26 Oil and Gas

companies listed on KSE using the data representing the periods of 2004 – 2009 found

that liquidity ratios affect the profitability ratios. They have used CR, QR, LR as

independent variables and ROA, ROE, ROI as dependent variable. They conclude that

liquidity ratios affect the profitability ratios and profitability is improved for oil and gas

sector that hold some liquid assets.

Shahchera (2012) in his study of “The Impact of Liquidity Asset on Iranian Bank

Profitability” with the samples of 17 commercial banks using the data representing the

periods of 2000-2009 find evidence of a non‐linear relationship between profitability and

liquid asset holdings. And conclude that Profitability is improved for banks that hold

some liquid assets, however, there is a point at which holding further liquid assets

diminishes a banks’ profitability.

Other researchers Bordeleau and Graham (2010) also study “The Impact of Liquidity on

Bank Profitability” with the sample of Canadian and American banks from 1997 t0 2009

and also find the non‐linear relationship between profitability and liquidity. The study

conclude that Profitability is improved for banks that hold some liquid assets, however,

there is a point at which holding further liquid assets diminishes a banks’ profitability, all

else equal.

A study has been conducted by Ben-Caleb, Egbide (Ph.D Candidate), Olubukunola,

Uwuigbe (Ph.D), and Uwuigbe, Uwalomwa (Ph.D) (2013) “Liquidity Management and

Profitability of Manufacturing Companies in Nigeria” with the sample of 30

manufacturing companies listed on the Nigeria stock exchange using the data

representing the periods of 2006-2010.Current Ratio and Liquid Ratio is used as

independent variable and Return on capital employed used as dependent variable. The

study revealed that CR and LR are positively associated with profitability and study

conclude that if overall state of liquidity should be improved so as to have a favorable

impact on the profitability.

Niresh (2012) in his study “Trade-off between liquidity & Profitability: A study of

selected Manufacturing firms in Sri Lanka” with the sample of 31 listed manufacturing

firms over the period of five years from 2007 to 2011 found the correlation values to be

negative between profitability and all the liquidity variables. CR, QR, LR is used as

independent variable and Net profit, Return on Capital Employed and ROE used as

dependent variable. This study conclude that there is no significant relationship between

liquidity and profitability.

Bhunia, Khan, and Mukhuti (2011) in the study “A Study of Managing Liquidity” with

the preferred samples of private sector steel companies from the year of 1997 to 2006

found that the optimal of working capital management is could be achieve by firm that

manage the tradeoff between profitability and liquidity. Current Ratio, Liquid Ratio and

absolute Liquid Ratio used as independent variable and Return on Investment used as

dependent variable. Results of this study found that correlation and regression results are

significantly positive associated to the firm profitability.

Some other Pakistani researchers Abdul Raheman, Talat Afza, Abdul Qayyum, and

Mahmood Ahmed Bodla (2010) in the study “Working Capital Management and

Corporate Performance of Manufacturing Sector in Pakistan” with the panel data of 204

manufacturing firms is used which are listed on Karachi Stock Exchange using the data

representing the periods of 1998 to 2007 conclude that Working Capital Management has

a significant impact on profitability of the firms.

Al Nimer, Warrad, and Al Omari (2013) in the study “The impact of Liquidity on

Jordanian banks Profitability through Return on Asset” the study checks financial reports

for overall Jordanian Banks listed on the Amman Stock Exchange (ASE) for the period

2005- 2011 conclude that there is significant impact of independent variable quick ratio

on dependent variable return on asset (ROA). That means profitability in Jordanian banks

is significantly influenced by liquidity. QR is used as independent variable and ROA is

used as dependent variable and there is significant impact of independent variable quick

ratio on dependent variable return on asset (ROA).

Chukwunweike (2014) investigated the association between liquidity and profitability

through “The Impact of Liquidity on Profitability of Some Selected Companies: The

Financial Statement Analysis (FSA) Approach” the population of this study consist of all

companies in the “industrial/Domestic products” industry; that are quoted in the Nigerian

Stock Exchange (NSE).Current Ratio and Quick Ratio used as independent variable and

ROA is used as dependent variable. Result of this study found that there is a significant

positive correlation between current ratio and profitability (ROA) and there is no definite

significant correlation between Acid test ratio and profitability (ROA).

A.Ajanthan (2013) in his study “A Nexus between Liquidity & Profitability: A Study of

Trading Companies in Sri Lanka” using the sample of trading sector consists of 08

trading companies listed in the Colombo Stock Exchange (CSE) over a period of past 5

years from 2008 to 2012 found that there is relationship between liquidity and

profitability and there is significance impact of liquidity on profitability.CR, QR ,LR

used as measure of Liquidity and ROA, ROE are used as measure of Profitability. Results

of this study found that correlation and regression results are significantly positive

associated to the firm profitability.

Kurawa, Abubakar (2014) in the study “An Evaluation of the Impact Of Liquidity on the

Profitability of Nigerian Banks” using the sample size of five banks to cover the period of

the study from 2003 – 2012. Linear regression were used in the analysis and the results

revealed that there is positive relationship between ROA and CBTOTL so also the same

thing with ROE and CBTOTL but, negative relationship between ROE and LATOTA.

The main findings of the study suggest that there is no significant impact between

liquidity and profitability among the listed banking firms in Nigeria.

Lartey, Antwi, Boadi (2013) in the study “The Relationship between Liquidity and

Profitability of Listed Banks in Ghana” by sample size of seven out of the nine listed

banks for the period of 2005-2010 found that there was a weak positive relationship

between the liquidity and the profitability of the listed banks in Ghana.

Agha (2014) in the study” Impact of working capital management on profitability” by

using the data of Glaxo Smith Kline pharmaceutical company registered in Karachi stock

exchange for the period of 1996-2011. In this study return on assets ratio used to measure

the profitability of company and variables of account receivable turnover, creditors

turnover, inventory turnover and current ratio used as working capital management

criteria.

The results of the research show that there is a significant impact of the working capital

management on profitability of company.

3. Research Design and MethodologyThis section explain the data collection, sampling, and research methodology.

3.1. Data Source

The present study used secondary data for the analysis. The data employed in the study is exerted

from the comprehensive income statements and annual financial reports of the sample firms and

financial position of the sample trading companies quoted in Karachi Stock Exchange (KSE)

database. In addition to this, scholarly articles from academic journals and relevant textbooks

were also used.

3.2. Sampling Design

Sampling design is a definite plan for obtaining a sample from a given population. It refers to the

technique or the procedure the researcher would adopt on selecting items for the sample

(Kothari, C.R., 2004). The sample of this study is consists of five years which is from the

financial year 2009-2013.In this study thirty (30) firms of chemical industry has been taken as

sample. All the sample firms are listed in Karachi stock exchange in Pakistan and the data-base

of the study is completely based on secondary data which has been collected from various web

sites and annual financial reports of the sample firms For the purpose of achieving the objectives

of study the Profitability Ratio return on assets is taken as dependent variables and for liquidity

current ratio, quick ratio, and liquid ratio taken as independent variables.

Table-1

Liquidity Ratios/Independent variables

Current Ratio = Current Assets (CA)/ Current Liability (CL)

Quick Ratio = [Current Assets- Inventory]/ Current Liability

Liquidity Ratio = [Cash in hand + Short Term Investment]/ Current Liability

Profitability Ratio/Dependent variable

Return on Assets = Profit after Interest and Tax / Total Assets X100

Notes: Above table shows that profitability is our dependent variable and it is measured by return on assets, and liquidity is independent variable which is measured by current ratio, quick ratio and liquid ratio.

Data Source: Karachi stock exchange

Variables Explanation

Table-1 explain the liquidity ratios as independent variables which are current ratio, quick ratio,

liquid ratio and profitability ratio as dependent variable which is return on asset.

Table 2

Descriptive Statistics of the variables

Variable Mean Std. Deviation Minimum Maximum

Return on Asset .0435598 .1864559 -1.2138 .4625

Current Ratio 1.364732 1.432717 .0181 13.3211

Quick Ratio .9140507 1.299267 .0152 13.3123

Liquid Ratio .4343018 1.164176 .00181 12.5961

NOTE: Table 2 explains the summary statistics of Chemical sector in Pakistan.

Data source: Self calculated on state bank data of Pakistan.

Table 2 enlighten the descriptive statistics of chemical companies in Pakistan Descriptive

statistics means a set of concise illustrative coefficients that reduces given information set, which

can either be a representation of the whole populace or a specimen. The measures used to depict

the information set that are measures of focal propensity and measures of variability or

scattering. Measures of central tendency contain the mean, median and mode, on the other hand

measures of variability contain the standard deviation (or variance), the minimum and maximum

variables. The above table shows the mean, standard deviation, maximum and minimum values

of our dependent and independent variables. Mean is the basic numerical average of a set of two

or more numbers. The mean can be calculated in more than one way. We can calculate the Mean

by using Arithmetic mean and Geometric mean. Standard deviation is used to find the dispersion

in a data set. More dispersion in a data set means higher the standard deviation. Standard

deviation is the square root of variance .Maximum and minimum shows the highest and lowest

value in a data set.

3.3 . Research Methodology

In this research, to test the impact of liquidity on profitability we analyze our data by employing

multiple regressions model. For the regression analysis first we may create a research hypothesis

and then empirical model for the regression analysis.

Research Hypothesis

Hypothesis One

H0: There is no impact of liquidity on profitability.

H1: There is impact of liquidity on profitability.

Empirical Model

Multiple regression analysis was performed to investigate the impact of liquidity on profitability

the model which is used in this study is given below:

Profitability=f (CR; QR; and LR)

It is important to note that the profitability depend upon Current ratio (CR), Quick Ratio (QR)

and Liquid Ratio (LR).The following models are formulated to measure the impact of liquidity

on profitability.

ROA=β0 + β1 (CR) + β2 (QR) +β3 (LR) +ε…. (1)

Where:

ROA stands for return on asset, β0 is the intercept, and β1, β2 and β3 are the regression

coefficient. CR, QR, and LR is Current ratio, quick ratio, and liquid ratio respectively.

4. Research Analysis

This section explain the result and analysis of our research. To find the relationship we take

correlation and to find the impact between liquidity and profitability in this study we analyze our

data by multiple regression models. A well-known statistical software “STATA “is used in order

to analyze the data. For the study, entire analysis is done by personal computer.

Table 3

Correlation among Explanatory Variables for Chemical Sector

Variables CR QR LR

CR 1.0000

QR 0.9610 1.0000

LR 0.8658 0.9238 1.0000

Note: Table 3 explains the correlation results and in the table, CR is stand for current ratio, QR, and LR is quick ratio, and liquid ratio respectively.

Data Source: Self calculated on state bank of Pakistan data.

Table 3 explains the Correlation results of chemical sector of Pakistan. Correlation is used to

measure how two random variables are related. Because standard deviation is always positive,

the sign of the correlation between two variables must be the same as that of the covariance

between the two variables. If the correlation is positive, we can say that variables are positively

correlated. If it is negative, we can say that they are negatively correlated; and if it is zero, we

say they are uncorrelated. Furthermore, it can be proved that the correlation is always between

+1 and -1. The R values were found to be positive between liquidity variables as measured by

current ratio (CR), quick ratio (QR) and liquidity ratio (LR).

Table 4

Impact of Independent Variable on Dependent by Utilizing Multiple Linear

Regressions

COEF. T- VALUE P > [t]

Intercept -0.0335415 -1.38 0.168

CR 0.0956547 2.54 0.012

QR -0.0477885 -0.88 0.379

LR -0.0224742 -0.67 0.502

Notes: R2= 0.1081, Adjusted R2= 0.0898, No of obs. 150, COEF. is coefficient and shows the impact of

independent variable on dependent variable, P > [t] is probability. Intercept depicts that there are other

factors that impact our dependent variable other than variables used in our study.

Data source: Self calculated on state bank of Pakistan data.

The above table shows the regression analysis which is used to test the impact of liquidity on

profitability of listed companies of chemicals sector in Karachi Stock Exchange. The result

shows return on asset is significantly affected by current ratio, but quick ratio and liquid ratio

have weak impact on ROA. According to this regression analysis return on asset is significantly

affected by current ratio because p-value is 0.012.This means that one increase in current ratio

increase the return on asset by 9.56%. Quick ratio has insignificant negative relationship with

return on assets this mean that an increase in quick ratio by one will reduce the return on asset by

4.77%.Liquid ratio also insignificant negative relationship with return on assets this mean that an

increase in liquid ratio by one will reduce the return on asset by 2.247%.

Hypothesis Testing

No. Hypothesis Results Tool

H0 There is no impact of liquidity on profitability. Rejected Regression

H1 There is impact of liquidity on profitability. Accepted Regression

Conclusion

Liquidity plays an important part in the firm’s performance and the purpose of this research

study is to determine the impact of liquidity on profitability of chemical sector in Pakistan. For

this purpose 30 chemical firms selected as study sample and data is collected for the period of

2009-2013. First of all data is tested for correlation in order to check the association between

explanatory variables. The results show that there is high correlation between independent

variables. Multiple linear regression model is used to test the relationship among dependent and

independent variables and the results reveal that current ratio has a strong and positive impact on

liquidity while quick ratio and liquid ratio have negative and insignificant impact on ROA. Since

liquidity has impact on profitability of the firms of chemical sector that’s why we accept H1.

Recommendations

Based on the conclusions drawn from the findings of this study, the researcher recommends that

firms should maintain a moderate level of liquidity that does not threaten their going concern

status, and yet allows them to make adequate profits on their investments. This is because when

there is no significant impact between liquidity and profitability then firm may freeze its capital

in its current asset which is not favorable for the company. In this case firm may utilize its

capital for profit. Thus, firms should try to find an optimum balance between liquidity and

profitability. According to some studies Bordeleau and Graham (2010), Shahchera (2012) they

conclude that Profitability is improved for firm’s that hold some liquid assets, however, there is a

point at which holding further liquid assets diminishes a firm’s profitability. So firms should try

to find the optimum level between liquidity and profitability.

Recommendation for Future Research

 I carry out the research on the topic of impact of liquidity on the profitability of chemical sector

of Pakistan. In order to expand this topic it should be look at by other researchers, as this area

demand a lot of work for development. The present study is confined only to the listed chemicals

firms in the chemical sector of Pakistan. Findings and conclusions were drawn with the help of

secondary data. Due to the shortage of time data representing the period of 5 years and it should

be given for a long period of time in order to get more meaningful and better results.

Furthermore, there is clearly enormous scope for more research work in the present study.

Therefore, I suggest the following for further research:

This study may be very useful for the financial managers of chemical industry in framing

policies for managing the firm’s liquidity and profitability but there are 580 companies

listed in Karachi stock Exchange (KSE) under 36 sectors. This study only covers the

chemical firms in chemical sector. Therefore, further investigation is required to examine

the impact between liquidity and profitability of firms in the different sectors.

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