Liquidity Ratio Analysis

Liquidity Ratio AnalysisLiquidity balance is a measure of the ability of the smart set to transform immediately of its assets into all any(prenominal) other asset and suffer their unretentive term obligation cod on time. This is among the authorized measurement which involve planning and control conditionling the genuine assets and up-to-date liabilities. gold is among the truly liquid assets comp are to fixed asset which is illiquid.Liquidity proportion analysis of the confederation must be do first in analyzing the alliances pecuniary beat. This is re redressable to the serious problems that might arise much(prenominal) as potential insolvency and mismanagement by the manager. The commonly liquidness ratio used are up-to-date ratio and quick ratio for a quick check of fluidness, but at that place are excessively other grammatical constituent to capture better understanding of come withs ability to make wagess to other parties much(prenominal) as int erchange bicycle, work upper-case letter of the United States, accounts receiv qualified, inventories, current liabilities.Besides the use of the liquid ratio as determinant of rigids ability to pay for short term debt, it excessively potbelly be used to avoid of excessive holding of gunstock. The pecuniary analysts commonly used the specific liquidity ratio much(prenominal) as current and quick ratios, which intromit them to make temporal or cross sectional equivalence which is within the company itself or other companies in the industries.As part of it, another concept that as well as commonly used to identify the liquidity of the company is working(a) swell which is deliberate by deducting the current liabilities of the firm from the current liabilities. The working seat of government is very important measurement in determining financial stability for the company. It is health for the company to score more current assets over its current liabilities suppose to be practiced by the company.The company postulate to stress on the liquidity management because from the previous research on companys balance sheet story in Spanish raise that 69 percent of the assets is current asset and 52 percent of liabilities oppose 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 draw one of their main outside(a) financial loans because the company failed to obtain the long term fund from the till and other quotationors. This is also supported by other researcher such as Whited (1992), Petersen and Fazzari (1993) that state that current liabilities become one of re man-made lakes due to their financial constrain. Also research do 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 select financial problems. The efficient liqui dity 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 get of current assets, the company allow pose the problems to pay back the acknowledgementors 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 bound of bankruptcy. Furthermore, it is important to support liquidity management in good times and it commands further importance in troubled times.The useful of liquidity ratioLiquidity ratio as part of news report confine 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 cheer. Ac cording Palepu et al (2003) analysis done may be within company itself, or for the particular firm but compare for several(prenominal) years, compare the very(prenominal) ratio for the different company in same labor.From previous studies, they found that accounting ratio also useful in providing culture 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 expectant 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 crown and change. 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 fate of techniques could be applied to improve liquidity and hard currency positions, at the same time it can addition the efficiency of their management. At the end it would result in high positivity. These intromit credit insurance (Brealey and Myers, 1996 Unsworth, 2000 and Raspanti, 2000), factoring of receivables (Brealey and Myers, 1996 Summers and Wilson, 2000).The consequence of liquidity managementThe efficiency of liquidity planning and control which allow in liquidity management, working capital and cash management have world-shaking effect towards the profits. Actually, the near important is to have efficient liquidity management and the next, profitableness lead follow as well.The important of companys liquidity can be seen from different perspectives. Basically the idea of companys liquidity laid on the departure concern concept which not involved any default in near future. The first political party who kindleed on companys liquidity is short term lenders. These lenders provokeed on paym ent made on the debt and short term obligation because they can reasonably pass judgment 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 approach to the company. The company actually has forgone the interest income from short term investment if they hold a lot of senseless cash.On the other hand, it is also necessary for company to hold cash to make immediate payments in the case to under lift out rapidly the nigh desirable projects, and to deal without major disruptions with unforeseen problems. The amount of cash depend on expected growth and faces jeopardy, the higher the expectation, the more the company must have a cushion of ready cash. The surplus cash on hand allow company to pass on wages of new opportunities quickl y. 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 append assets for all in the early 1990s. another(prenominal) country such as Germany, France and Italy, also shown the very significant amount of payables which represents more than a fag end 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 m ade up of account payables(Kohler et al., 2000 Guariglia and Mateut, 2006).In fact, payables are also important factor in rising 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 join on their reliance on inter-firm credit to avoid bank credit rationing.However, account payable does not submit 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 wisecrack. anterior researchers have viewed the kind trade-off in the midst of inventories and payables such as Nadiri (1969), Schwartz (1974), Ferris (1981) and Emery (1987)). Only Emery (1987) considers explicitly the trade-off among trade credits and inventories but his pack does not include th e deterministic variable demand framework. More recently, the take from Daripa and Nilsen (2005) has theoretically examined 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 in that respect are dearth or excessive in receivables or stock-taking it usually will reflected to production, sales efforts, fixed assets or other management decision parameters, not liquidity alone. As highlighted sooner, receivables and inventory reflected to sales and production strategies. functional 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 field of honor1. To examine methodically by separating into parts and surveying their interrelations.2. Chemistry To make a chemical analysis of.3. factor invite working capital such as business indicators, industry effect, operating cash flows, growth luck for a firm, firm performance and size of firm. The field of operation has clearly place that determinant of working capital1. 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 direct cash flowEarnings before depreciation minus assesses. Measures the cash generated from achievements, not counting capital spending or working capital requirements. for both interlock liquid balance and working capital requirements. However, Capital requi rementsFinancing required for the operation of a business, composed of long-term and working capital plus fixed assets. some variables unable to puddle 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 determine internal factors were operating cycle Operating cycleThe 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 dissemble 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 d ummy owners of real estate). and level of economic activity were recognize as external macroeconomicn. (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 conclusion 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 intent, Inventory Turnover in Days, Average Payment Period and Cash bed cover on the Net Operating Profitability of firms has a strong invalidating relationship between above working capi tal 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 do ne on merchandising and manufacturing companies and found that merchandising industry has shorter ccc than manufacturing industries. He also investigate the relationship between the continuance of the CCC and the size of the firms and the findings indicated there is a significant negative correlational statistics 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 gross salesThe amount a seller receives from the buyer after follows associated with the sale are deducted.NotesThis 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 profita bility 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 induce a positive value for the shareholders by reducing the cash gap up to an optimal levelTo 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 trusty 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 hoard the payment so that the cas h collecting process will organized eventually.Critics and disadvantages on liquidity ratioBesides 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 randomnes s 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 set back 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 anatomy 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 longitudinal the gap the longer company has to rely on the external financial backing. The result was company will suffer of increase interest cost.In Saudi Arabia the interest cost is more expensive in due to the absence of measure 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 acquire 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 comparing among company and across industry as mentioned by Abdullah and Ismail (2008) . The reason is because the different of accounting method and give-and-take 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), with out the standardize guideline, companies will only key out 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 unwrap 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 positionLiquidity and profitabilityThere are a lot of research done to identify the significant relationship between liquidity management a nd companies profitability. enjoin from previous studies supported the fact that aggressive working capital policies could increase the profitability of the company. Jose et, al (1996) turn up 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 versatile 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 chinaware companies and found that the less cash gap period, the bette r 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) EBITSee Earnings Before Interest and TaxesEBITSee 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 l ess 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 magnetic declination 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 p rofitability 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 rel ationship between debt used by the firm and its profitability.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 manageme nt 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 .ConclusionIt 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 l evel 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.