TRADE-OFF BETWEEN LIQUIDITY & PROFITABILITY: A STUDY OF SELECTED MANUFACTURING FIRMS IN SRI LANKA

Abstract

ABSTRACTProfitability and liquidity are the most prominent issues in the corporate finance literature. The ultimate goal for any firm is to maximize profitability. However, too much attention on profitability may lead the firm into a pitfall by diluting the liquidity position of the organization. In this way, the present study is initiated to find out the cause and effect relationship between liquidity and profitability. The study covered 31 listed manufacturing firms in Sri Lanka over a period of past 5 years from 2007 to 2011. Correlation analysis and descriptive statistics were used in the analysis and findings suggest that there is no significant relationship between liquidity and profitability among the listed manufacturing firms in Sri Lanka.Keywords: Liquidity, Profitability, Corporate Finance, Manufacturing Firms.INTRODUCTION:Profitability and liquidity are the most prominent issues that management of each organization should take studying and thinking about them into account as their most important duties. Liquidity refers to the ability of a firm to meet its short term obligations. Liquidity plays a crucial role in the successful functioning of a business firm. A study of liquidity is of major importance to both the internal and external analysts because of its close relationship with day to day operations of a business (Bhunia, 2010). A weak liquidity position poses a threat to the solvency as well as profitability of a firm and makes it unsafe and unsound.Profitability is a measure of the amount by which a firm's revenues exceeds its relevant expenses. Potential investors are interested in dividends and appreciation in market price of stock, so they pay more attention on the profitability ratios. Managers on the other hand are interested in measuring the operating performance in terms of profitability. Hence, a low profit margin would suggest ineffective management and investors would be hesitant to invest in the company.The liquidity and profitability goals are contradictory to each other in most decisions which the finance manager takes. For example, the firm by following a lenient credit policy may be in a position to increase its sales, but its liquidity may tend to worse. In addition to this, referring to the risk return theory there is a direct relationship between risk and return. Thus, firms with high liquidity may have low risk and then low profitability. Conversely, firm that has low liquidity may face high risk results to higher return. Consequently, a firm is required to maintain a balance between liquidity and profitability in its day-to-day operations.RESEARCH PROBLEM:Maintaining a proper liquidity indicates that funds are confined to liquid assets thereby making them unavailable for operational use or for investment purposes for higher returns. Thus, there is an opportunity cost associated with the maintenance of those liquid assets and this might affect the overall profitability of the firm. In other words, increasing profitability would tend to reduce firm's liquidity and too much attention on liquidity would tend to affect the profitability (Smith, 1980). Therefore, firms should always strike to maintain a balance between conflicting objectives of liquidity and 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 the other hand, insufficient liquidity might damage the firm's goodwill, deteriorate firm's credit standings and that might lead to forced liquidation of firm's assets. Hence, the present study is initiated to identify the trade-offbetween liquidity and profitability of listed manufacturing firms in Sri Lanka.OBJECTIVES:The objectives are directed towards the following;* To identify the nature and extent of the relationship between liquidity and profitability.* To find out the factors other than liquidity influence on profitability. …