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Liquidity-profitability tradeoff: an empirical

investigation in an emerging market.
Publication: International Journal of Commerce & Format: Online - approximately 5350
Management words
Publication Date: 01-JUN-04 Delivery: Immediate Online Access
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Article Excerpt
This study empirically examines the relation between profitability and liquidity, as measured by
current ratio and cash gap (cash conversion cycle) on a sample of joint stock companies in Saudi
Arabia. Using correlation and regression analysis the study found significant negative relation
between the firm's profitability and its liquidity level, as measured by current ratio. This
relationship is more evident in firms with high current ratios and longer cash conversion cycles.
At the industry level, however, the study found that the cash conversion cycle or the cash gap is
of more importance as a measure of liquidity than current ratio that affects profitability. The size
variable is also found to have significant effect on profitability at the industry level. Finally, the
results are stable over the period under study.

INTRODUCTION

Efficient liquidity management involves planning and controlling currant assets and currant
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. This is
due in part to the reduction of the probability of running out of cash in the presence of liquid
assets.

The working capital approach to liquidity management has long been the prominent technique
used to plan and control liquidity. The working capital includes all the items shown on a
company's balance sheet as short-term or current assets, while net working capital excludes
current liabilities. This measure is considered a useful tool in accessing the availability of funds
to meet current operations of companies. However, instead of using working capital as a measure
of liquidity, many analysts advocate the use of currant and quick ratios, which have the
advantage of making temporal or cross sectional comparison possible.

However, the ultimate measure of the efficiency of liquidity planning and control is the effect it
has on profits and shareholders' value. Thus, this study attempts to examine the relation between
liquidity and profitability using a sample of Saudi joint stock companies. Second, the study aims
at directing the attention to the importance of active management of liquidity. This aspect is
more important given the number of non-profitable Saudi companies, and the dire need to
improve profitability.

To carry out these objectives the remainder of this paper is organized as follows: the next section
reviews the literature for relevant theoretical and empirical work on liquidity and cash
management and its effect on profitability. Section three describes the sample and the
methodology followed in this study. Section four portrays and discusses the statistical results,
while section five explores the implications of the study. The final section, section six, concludes
the paper.

LITERATURE REVIEW

Working capital represents a safety cushion for providers of short-term funds of the company,
and as such they view positively the availability of excessive levels of working capital and cash.
However, from an operating point of view, working capital has increasingly been looked at as a
restraint on financial performance, since these assets do not contribute to return on equity
(Sanger, 2001). Furthermore, liquidity management is important in good times and it takes
further importance in troubled times. The efficient management of the broader measure of
liquidity, working capital, and its narrower measure, cash, are both important for a company's
profitability and well being. In the words of Fraser (1998) "there may be no more financial
discipline that is more important, more misunderstood, and more often overlooked than cash
management." However, as argued vividly by Nicholas (1991,) companies usually do not think
about improving liquidity management before reaching crisis conditions or becoming on the
verge of bankruptcy.

Survey of working capital and cash management literature, however, shows that instead of
linking liquidity and cash management to a known efficiency or profitability measures, the
majority of research, especially the earlier efforts, attempts to develop models for optimal
liquidity and cash balances, given the organization's cash flows. The earlier cash management
research focused on using quantitative models that weight the benefits and costs of holding cash
(liquidity). Under this category falls Baumol's (1952) inventory management model and Miller
and Orr's (1966) model which recognizes the dynamics of cash flows. The benefit of these earlier
models is that they help financial managers understand the problem of cash management, but
they do require assumptions that may not hold in practice.

Similarly, Johnson and Aggarwal (1988) support a treasury approach to cash management, which
concentrates on flows which entail that cash collection and payment cycles must be broken into
their constituent parts. Management then should review the time needed for each link in the
collection and payment cycles. Some policy outlines, similar to these, were proposed by
Schneider (1988) by arguing that cash management should include analytical review of the
procedures followed in managing working capital. These include granting of credit, managing
balances, and collecting payments when due.

The subsequent and more practical approaches to liquidity management focused on working
capital requirements and levels of desired liquidity as measured by current ratio and its variants.
The finance textbooks and literature covered the techniques and approaches aimed at managing
working capital and its individual components. Again most of these approaches attempt to
develop an optimal level of working capital components under certain assumptions, albeit less
restrictive than their earlier counterparts used to facilitate development of cash management
techniques.

Various other techniques have been suggested to improve liquidity and cash positions and to
increase the efficiency of their management and in turn 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).

However, as measures of liquidity, both the working capital and liquidity ratios have tome under
criticism for various reasons. Hawawini et al. (1986), for example, argue that the concept of
working capital requirement is a better measure of a firm's investment in its operating cycle than
the traditional concept of net working capital. Similarly, Finnerty (1993) points out that the
traditional liquidity ratios, such as the current ratio or quick ratio, include both liquid financial
assets and operating assets in their formula. Thus, from an ongoing concern point of view, the
inclusion of operating assets which are tied up in operations is not useful. Kamath (1989),
however, argues that both current and quick ratios are deficient due to their static nature and the
inadequacy of using them as measures of future cash flows and liquidity.

These shortcomings of working capital and liquidity ratios have led researchers and analysts to
advocate other measures of liquidity that are more indicative of cash availability. The net cash
conversion cycle, or the cash gap has been suggested by many as a possible supplement or
replacement to the working capital and current ratios as measures of available liquidity (see
Gitman (1974), Richard and Laughlin (1980), Boer (1999), and Gentry et al., (1990).

It is generally argued that this approach is more practical due to the dynamic nature of cash
cycles and the many complications and tradeoffs involved. Some authors, such as Kamath
(1989), suggest that cash gaps can be used to replace or supplement liquidity ratios (current ratio
and quick ratio) in measuring and predicting the nature and pattern of future cash flows. The
static current ratios alone fall short of adequately predicting future cash flows. Other studies,
such as Kolay (1991), differentiate between short-term and long-term strategies that improve
financial position and cash management policies.

The cash gap, known also as cash flow cycle or cash conversion cycle, measures the length of
time between actual cash expenditures on productive resources and actual cash receipts from the
sale of products or services. Thus, this definition for cash conversion cycle indicates that a
shorter cash cycle or gap is desirable since the larger the cash cycle or gap the greater the need
for external financing and the greater the financing costs to be borne in form of explicit interest
costs or implicit costs of other financing sources, such as equity. The interest cost is more
expensive in Saudi Arabia, than in other countries, because of the absence of tax savings
(national companies incorporated in Saudi Arabia are not required to pay taxes, they instead pay
zakat (level or fixed percentage tax required by Islamic sharia).

To emphasize the importance of managing liquidity, Loeser (1988) tapped the extreme in order
to reduce the cash cycle. Loeser recommended assessing interest charge at the prime rate to
outstanding accounts receivable and unbilled revenue in order to encourage responsible
employees and departments within companies to put every effort necessary to collect
receivables, and thus reduce cash gaps. This same approach was expressed recently 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.

The direct effect of liquidity is not only on the cash position and the troubles it may cause to
financial managers, but it rather effects the company's profits in a more direct way. This direct
effect stems from the need of the company to borrow to finance the working capital requirements
and cash gaps. For example, if a company has a cash gap of 100 days, this means that the
company has to borrow an amount equivalent to 100 times the daily cost of sales. The borrowing
cost reduces both pretax and after-tax profits by equal amounts. In Saudi Arabia the feature of
borrowing cost as a cheap source 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.

Shin and Soenen (1998) investigated the relation between the firm's net trade cycle and its
profitability, using a large sample of American firms during 1975-1994. The study found a
strong negative relation between the length of the firm's net trade cycle and various measures of
profitability, including market measures, such as stock returns, and operating profits. Similarly,
this study attempts to examine the relationship between operating profitability and liquidity
measures. Unlike previous studies, an attempt is made here to study the effects of various levels
of liquidity, in its broader or narrow sense, on a company's profitability.

DATA AND METHODOLOGY

Since the aim of this study is to examine the relation between profitability and liquidity, the
study makes a set of testable hypotheses. First, this study assumes that there may be a
relationship between profitability of the company and its liquidity profile, since the later effects
the former in a direct way, as a result of the external financing costs or savings thereof. Due to
these elements of costs and cost savings this relationship is most likely be negative. Thus, the
first hypothesis of this study can be stated as follows:

Hypothesis 1

There is a possible negative relation between liquidity of a company and its profitability.
Companies with relatively high levels of liquidity are expected to post low levels of profitability
and vise versa.

Secondly, profitability, on the other hand, may be a function of the size of companies (measured
in terms of sales or total assets). The company size may affect liquidity, cash gaps and, hence,
profitability in different ways. On the one hand, large companies may be able to buy inventory in
large quantities in order to get quantity discounts. Further, because of their size, large companies
may qualify for quantity discounts from suppliers with relatively small inventory levels. On the
other hand, large companies may be able to get favorable credit terms from their suppliers in
terms of longer credit periods. Moreover, large companies may have more success in their
receivables collection efforts relative to small companies. All these factors may push liquidity
levels and cash gaps of large companies to levels lower than that of small companies. On the
contrary, small companies are usually not able to obtain as much inventory to qualify for
quantity discounts as their large counterparts do. Additionally, small companies make efforts to
pay within discount periods in order to benefit from cash discounts and to avoid severing their
relations with their suppliers. These factors may force small companies to have higher liquidity
levels and larger cash gaps. Accordingly, this study states the following hypothesis:

Hypothesis 2:

A positive relation may exist between the company size and its profitability. This may be due to
the ability of large companies to reduce liquidity levels and cash gaps.

Third, liquidity and cash gaps may differ among industries and among countries and may depend
on the prevailing economic conditions. Sometimes traditions and the nature of business set the
typical working capital requirements and the cash gap in a given industry. Some industries have
inherently high levels of working capital requirements and large cash gaps than others, while
some may require low levels of working capital and shorter or even negative cash gaps, which
indicate their ability to obtain cost-free capital from their customers. Hawawini et al. (1986)
examined a sample of 1181 American firms from thirty-six industries over a period of nineteen
years and found significant and persistent industry effects on a firm's investment in working
capital. The ability to operate with low levels of working capital and obtaining cost-free capital
may have direct positive bearing on profitability. Thus, this study states the following
hypothesis:

Hypothesis III

Need for working capital and liquidity is influenced by the industry in which the company
operates. Capital intensive industries require low levels of working capital and tend to have
smaller cash gaps than their labor-intensive counterparts. Accordingly, liquidity requirement is
expected to have no significant negative impact on profitability of capital--intensive industries,
while such effect is expected in labor- intensive ones.

To test these hypotheses this study uses the following methodology:

1. The study first estimates the cash gap for each company and for each year of the sample
period as follows:

Cash Gap = Days in Inventory (DII) + Days in Accounts Receivable (DIR)--Days in Accounts
Payable (DIP)

The components of the cash gap are calculated as follows:

--Inventory turnover = cost of goods sold/average inventory

--Number of days in inventory = 365/inventory turnover

--Number of days in Receivables = Receivables/average daily sales

--Number of days in Payables = Payables / average daily purchases

2. Correlation analysis to identify the association between profitability and liquidity indicators
and other related variables

3. Regression analysis to estimate the causal relationship between profitability variable, liquidity
and other chosen variables

The data for this study comes from a sample of Saudi joint stock companies. Overall, 29 joint
stock companies that are publicly traded and provide annual audited financial reports are
selected. This sample encompasses three basic Saudi economic sectors. Table 1 shows the
sample by sector over the period 1996-2000. However, due to unavailability of data in some of
the years for some companies and sectors, the distribution of the sample is not homogenous over
the sample period.

The sample does not include electricity and banking sector companies. The former is regulated
and has undergone major structural changes during the sample period, while the banking sector
activity does not fit the issues at hand. It should be mentioned that some problems are
encountered in collecting the data for this study. First, most cement companies in the Kingdom
do not disclose sales revenue. Second, most companies do not report the purchases figure or
detailed cost of goods sold figures. Thus, the sample is restricted to those companies for which
purchases figure can be calculated and the sales figures are available. Both components are
necessary to calculate cash gaps. Nevertheless, the total sample represents about 50 percent of
the total number of Saudi publicly held companies (excluding Banking and electricity
companies). Thus, the final sample includes the most important joint stock companies in Saudi
Arabia (Sec Appendix A to this study for a list of the companies included in the sample).

RESULTS AND ANALYSIS

The following notations are used throughout this study:

S= net sales

TA= Total assets

CG= Cash gap in days

CR= Current ratio

LOGS= Logarithm...