IMPACT OF LIQUIDITY RATIOS ON

PROFITABILITY:
With Special Reference to Listed Manufacturing
Companies in Sri Lanka.

By

T.S.L.Rupasinghe

MF/2009/2404

Department of Accounting and Finance

August 2013

Dissertation Presented to the Faculty of Management and Finance

of University of Ruhuna

in Partial Fulfillment of the Requirements for the Degree of

Bachelor of Business Administration

 Acknowledgement.

Very special thanks go to our supervisor lecturer, Mr.K.P.G.V.Gunarathna whose patience

and understanding made this project a nice conclusion for my studies at the Ruhuna
University.

I would also like to thank to all of the lecturers in Department of Accounting & Finance and
love ones for their continuing support during this project with conducting workshops and
seminars relating to the research studies.

i
 Table of Contents

Acknowledgement. .................................................................................................................................. i
Table of Contents .................................................................................................................................... ii
List of Tables .......................................................................................................................................... iv
List of Figures .......................................................................................................................................... v
List of Acronyms ..................................................................................................................................... vi
Declaration ............................................................................................................................................ vii
Certification.......................................................................................................................................... viii
Abstract .................................................................................................................................................. ix
CHAPTER ONE ................................................................................................................................. 1
INTRODUCTION ....................................................................................................................................... 1
1.1 Background of the Study ......................................................................................................... 1
1.2 Research Problem ................................................................................................................... 3
1.3 Research question & Objectives ................................................................................................. 3
1.4 Methodology ........................................................................................................................... 3
1.3 Significance of the Study ......................................................................................................... 4
1.4 Limitations............................................................................................................................... 4
1.7 Summary and chapter organization........................................................................................ 5
CHAPTER TWO ................................................................................................................................ 7
LITERATURE REVIEW ....................................................................................................................... 7
2.1 Liquidity................................................................................................................................... 7
2.1.1 Liquidity Ratios .............................................................................................................. 10
2.2 Profitability............................................................................................................................ 12
2.2.1 Profitability Ratios ......................................................................................................... 13
2.3 Liquidity VS Profitability ........................................................................................................ 14
2.4 Summary and Chapter Organization..................................................................................... 16
CHAPTER THREE ............................................................................................................................ 17
METHODOLOGY .......................................................................................................................... 17
3.1 Introduction .......................................................................................................................... 17
3.2 Data Collection ...................................................................................................................... 17
3.3 Sampling Method .................................................................................................................. 17
3.4 Measurement of Variables.................................................................................................... 18
3.4.1 Current Ratio ................................................................................................................. 18

ii
 3.4.2 Quick ratio ..................................................................................................................... 18
3.4.3 Return on Assets ........................................................................................................... 19
3.4.4 Return on Equity ........................................................................................................... 19
3.4.5 Return on Sales ............................................................................................................. 19
3.5 Data Analysis ......................................................................................................................... 20
CHAPTE FOUR................................................................................................................................ 22
ANALYSIS AND DISCUSSION .............................................................................................................. 22
4.1 Introduction .......................................................................................................................... 22
4.2 Descriptive Statistics ............................................................................................................. 22
4.3 Correlation Analysis .............................................................................................................. 23
4.4 Regression Analysis ............................................................................................................... 24
4.5 Hypothesis Testing ................................................................................................................ 25
CHAPTER FIVE................................................................................................................................ 26
CONCLUSION......................................................................................................................................... 26
REFERENCES .................................................................................................................................. 28

iii
 List of Tables

4.1: Descriptive Statistics of the Variables

4.2: Pearson’s Correlation Coefficient

4.3: Regression Analyses

4.4 : Testing of Hypothesis

iv
 List of Figures

1.1 Conceptual Framework

2.1 Inverse relationships between liquidity and profitability

3:1 Liquidity and profitability measures

v
 List of Acronyms

ROE : Return on Equity

ROA : Return on Assets

ROS : Return on Sales

CR : Current Ratio

QR : Quick Ratio

CSE : Colombo Stock Exchange

vi
 Declaration

I hereby declare that this dissertation is my own work and effort and that, to the best of my

knowledge and belief, it contains no material previously published or written by another

person nor material which has been accepted for the award of any other degree or diploma of

the university or other institute of higher learning, except where due acknowledgment has

been made in the text.

Signature of the student: ________________________________

Name of the student: T.S.L.Rupasinghe

Registration number of the student: MF/2009/2404

Date: 10/02/2014

vii
 Certification

This is to certify that this dissertation submitted by T.S.L.Rupasinghe (MF/2009/2404) in

partial fulfillment of the requirement for the Degree of Bachelor of Business Administration
in Accounting at the Faculty of Management and Finance of the University of Ruhuna is a
record of the own work carried out by the student under my supervision. This dissertation has
been submitted with my approval.

____________________________

Supervisor

K.G.P.V.Gunarathna

Department of Accounting and Finance

Faculty of management and Finance

University of Ruhuna

____________________________

Head, Department of Accounting and Finance

Faculty of management and Finance

University of Ruhuna

viii
 Abstract

The ultimate goal of the companies is to enhance the wealth of the shareholders. For that
purpose the liquidity and profitability plays the vital and crucial role. Especially the liquidity
and its management are caused to great extent of the growth and profitability of a firm. The
liquidity management becomes most important one as the inadequate liquidity may injurious
to the smooth operations of the firm as well as the excess liquidity can be disturbed to
achieve the greater profits.

In this way, the present study is aimed to investigate the relationship between liquidity
and profitability. The analysis is based on 15 manufacturing companies listed on the
Colombo Stock Exchange over a period of past five years from 2008 to 2012. Correlation and
regression analysis as well as the descriptive statistics were applied in the analysis and
findings suggest that there is a significant relationship exists between liquidity and
profitability while Quick ratio has not significant relationship with the ROE among the listed
manufacturing companies in Sri Lanka. However there has a low degree of influence in
liquidity on the profitability of manufacturing companies.

Key words: Liquidity, Profitability, Manufacturing sector, Sri Lanka

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 1 CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

In the present economic world, financial crisis affects to most of the countries’ economic
situations. This situation can be seen in the considerable number of developing countries as
well as developed countries economy (Ajao & Obida, 2012). As the result of this financial
crisis, most of the countries in the world become as debtors in another countries and various
international organizations such as International Monetary Fund, World Bank. Within this
situation, the liquidity concept become as the most significant in the economy (Lamberg &
Valming, 2009).

When concerning about that financial crisis this situation similar for the companies
also. The main reasons for that is higher level of inflation rate and disadvantageous foreign
exchange rates (Ajao & Obida, 2012). The actual value of the money is declined as above
factors. Hence managers have the higher responsibility relating with the maintaining
sufficient liquidity level within the company. However the business owners and managers in
overall the world devise policies to enhance the profitability level and shareholders’ wealth in
organizations. As there has a financial crisis situation, to perform the day to day financial
requirements managers need to maintain adequate level of liquidity level within firms
(Eljelly, 2004).

The meaning of maintaining liquidity assets within the firm is the opportunity cost of
earning profitability (Nandi, 2012). The liquidity management can be identified as the
backbone of the company. Without maintaining adequate liquidity level within the firm,
managers cannot predict their future. If the firm cannot earn any profit, it is considered as the
sick. But if the firm has not any liquidity, it is downfallen and then died. As that matter,
liquidity is the pre-requisite for determining the survival of the company (Nandi, 2012).
Hence the liquidity management is become as more significant role rather than other
activities.

Various parties are concerning about the financial activities of the firm for making
better decisions. Following parties are highly concerning about the liquidity position and

1
profitability level based on the following reasons. Shareholders are the owners of the listed
companies. They invest their money on shares to make a higher return from the investment.
Hence they primarily concern about the liquidity position of the company, because liquidity
level affects to determine the profitability level of company ( Rehman, 2012). As the above
reasons, liquidity and profitability of the firm is very important for the prospective investors
as well.

Managers are the decision makers of the company. They need to get more better and
favorable decisions for the company Hence, managers should concern about the both short
term and long term financial positions of the company because, short term is the foundation
for long term activities and survival. Managers have a responsibility to ensure the
continuously operation of production cycle in efficiently and solve the short term financial
obligations in promptly as well as enhance the profit level to ensure the prosperity of firm.
Hence the lack of or excess liquidity is not favorable to the company in the present or future
time.

Further, this relationship is significant for the creditors. Creditors can be divided in to
two parts based on the maturing period as short and long term creditors. Short term creditors
will check the liquidity of company before selling goods on credit. They expect to get money
within short term period for their selling items. To fulfill it’s as they wish, company should
be maintained sufficient level of liquidity assets. Long term creditors also concern about the
liquidity position for receiving interest income and concern about the profitability level for
the security of lending capital amount.

Employees and trade unions are concerning about the liquidity level of the company.
Because they need to know whether the company can meet its employee related obligations–
salary, pension, provident fund, etc. For pay that obligations, company should ensure the
smooth of production process. As well as the profitability level is highly impacted to
determining the security of jobs, promotions, salary increments etc. Hence the excess or lack
of liquidity level may not be good for employees.

After analyzing the above factors, can be identified that the liquidity is very
significance criterion. Because of most of the parties get better decisions by considering the
liquidity position of the companies. A company needs to maintain adequate level of liquidity
because liquidity is greatly affected to the profitability as the close relationship among them.
As the result of that, when one variable is increased, other variable is decreased.

2
 There has not standard or formal rule to determine the best suited liquidity level for
the companies. It depends on the balance sheet situations of the firms (Ajao & Obida, 2012).
However if firms with low current assets it will be a problem for the continuous operations.
Instead of low balances, if companies have the much more liquidity assets rather than daily
requirements, it is also badly affected for the profitability purpose (Horne & Wachowicz,
2000).

1.2 Research Problem

Many studies in the literature are based on developed countries. Therefore, those
findings cannot be applied to the Sri Lankan context since, the nature of economic activities,
economic conditions, of developed countries are different from in developing countries.
Moreover, few studies have been conducted to analyze the association between liquidity and
profitability of manufacturing industry in Sri Lanka. After considering above factors, this
study tries to fill this gap by doing research on manufacturing companies in Sri Lanka.

1.3 Research question & Objectives

The question of the study is,

How liquidity ratios affects on profitability of listed manufacturing companies in Sri Lanka?

The main objective is to identify of the impact of liquidity ratios on profitability of listed
manufacturing companies in Sri Lanka. Researcher expected to use two types of liquidity
ratios for achieving above objective. In here, current ratio and quick ratio is used for
calculating the liquidity position of companies.

1.4 Methodology

This study is based on secondary data. The data used for this study have been collected from
the published annual reports of selected companies. For this study, fifteen manufacturing
companies were selected for a period of five years from 2008-2012.

To measure the liquidity position, use two liquidity ratios. Current ratio and quick
ratio is used as the liquidity ratios. Return on Assets, Return on Equity and Return on sales
are the profitability ratios that are used for this study. Liquidity ratios are implemented as the
independent variables and dependent variables are the profitability ratios.

3
 Profitability
Liquidity

ROE
Current Ratio
ROA
Quick Ratio
ROS

Figure 1.1 Conceptual Framework

1.3 Significance of the Study

The findings of this are significant for the internal and external parties of the organization for
making favorable decisions. Because of some persons have not well understanding about the
degree of impact in each element on the profitability level. As this study targeted developing
countries’ manufacturing companies, managers and investors can apply the findings of this
study in making decisions.

Furthermore, the findings of this study can be used to realize the theories relating with
the liquidity and profitability relationship. Because of this described the above relationship
with using one by one ratio.

1.4 Limitations

This study focuses to identify the relationship between liquidity and profitability of listed
manufacturing companies in Sri Lanka. However, not all of the manufacturing companies are
listed in the Colombo Stock Market. Hence, the finding of the study cannot be generalized to
the entire manufacturing industry in Sri Lanka.

Researcher provides the conclusion about the impact of liquidity ratios on

profitability, only by using published annual reports. The accuracy of the data included in the
financial statements may be high. But cannot be trusted worthy in hundred percent of the
transparency and correctness of the rupee values in the transactions. The auditors also

4
checked the sample of transactions. Hence the actual situation might be changed from
financial statements. Therefore, the validity can be limited as this reason.

Liquidity level is not only one factor for affecting to determine the profitability of
manufacturing companies. Seasonal changes, price levels or competitors’ activities
can be influenced to the profitability level. But this study focuses only the impact
from liquidity position. This is also can be mentioned as the limitation for this one.

1.7 Summary and chapter organization

The basic idea relating with the research study can be obtained from the introduction chapter.
Because this describes about the background, objectives, problems as well as limitations
which are binding with the research study.
This chapter is mainly categorized under the headings of the background, objectives,
problems & questions, significance and limitations of the study. This study is conducted by
targeting liquidity and profitability relationship of manufacturing companies in Sri Lanka.

Relating with the topic of this study mainly focused about the liquidity and
profitability concepts, definitions and significance of them. For that selected fifteen listed
manufacturing companies in Sri Lanka.

1.7.1. Chapter Organization

1.7.1.1. Introduction chapter
Discuss about the basic things related with the research topic. Especially, main variables of
the study and other important factors are described through this chapter.
1.7.1.2. Literature Review

By analyzing previous research articles, described about the various definitions, concepts,
findings, relationships and other things related with the research topic via this chapter.

1.7.1.3. Methodology

Through this chapter discussed about the procedure of doing this study. The method of
sample selection, data collection, and data analysis and data interpretation are described
through this.

1.7.1.4. Results and analysis

Identify the relationship between independent and dependent variables of the research topic
are the basic objective of this chapter. For that purpose descriptive statistics, correlation
analysis and regression analysis techniques are used.

5
 1.7.1.5. Conclusion

The findings are summarized through this chapter. Recommendations are also provided via
this.

6
 2) CHAPTER TWO

2 LITERATURE REVIEW

This chapter reviews literature relating to the liquidity ratios and profitability from previous
studies. Through this chapter, it mainly focuses about meanings, significance and findings of
the liquidity and profitability variables.

2.1 Liquidity

There have the various definitions for the liquidity. The simply meaning of the liquidity is the
ability of converting assets in to the cash quickly at the lowest possible cost. When analyzing
previous research articles can be identified more definitions and concepts relating with the
liquidity.

Bolek & Wilinski (2012) defined the liquidity in three contexts such as, assets, asset-
equity and cash aspects of financial liquidity. The financial liquidity of company’s assets is
categorized under the assets aspect. They explained liquidity concept as the ability to convert
the assets in to cash within lowest possible time and cost.

Herald, (2012) explains that the liquidity of an asset means how quickly it can be
transformed in to cash. Further he describes this concept is combined with the short term
maturing obligations. Through his research, he emphasized that liquidity assets are needed to
resolve the short term maturing obligations.

Brahma (2012) stated, liquidity is the ability to meet current obligations and sudden
expenses. Hence, pointed out the importance of maintaining appropriate level of liquidity
assets within firm by his research study.

Liquidity resources including cash balances provide the protection for the company
against the financial problem. In most generally and frequently use the financial liquidity
concept with concerning mutual relationship between current assets and current liabilities. In
the company financial liquidity has in better level when large part of the assets is representing
the liquid assets. If an enterprise needs to maintain higher level of liquidity, it needs to
maintain large volume of cash and other liquidity assets and small portion of current
liabilities (Bolek & Wilinski, 2012).

7
 Liquidity management is important for the manufacturing companies, as large portion
of total assets are represented by current assets (Home and Wachowitz, 2000). Because of the
main activity of manufacturing companies is converting raw materials in to the finished
goods. Hence there has the large portion of current assets within firm. The time gap between
converting raw materials in to finished goods and convert them in to the money are high.
Therefore those companies have to maintain sufficient level of liquidity assets within firm to
satisfy the current obligations. When converting liquidity assets into cash, the conversion
cost should be minimized. The spent time, money and effort should be minimized on this
purpose.

The Liquidity may be kept in various forms by firms, such as cash in hand and cash at
bank in current assets, reserve drawing power under a cash credit or overdraft arrangement
and short term deposits (Nandi, 2012).

According to the economic and financial analysts, four possible reasons behind to
hold liquid assets within firms are, transaction motive, the precautionary motive, tax motive
& agency motive (Qasim,Ramiz, 2011). Those are the very essential day to day activities and
unpreventable legal obligations.The liquidity plays an important role for the success of
business firms, since it has a close relationship with day-to-day operations. Particularly, there
is no any specific rule for determining the standard level of liquidity level for firms. It
depends on the nature of the business (Ajao & Obida, 2012). Therefore, a firm should keep a
sufficient liquidity level instead of maintaining deficit or surplus level. Pandy (2005) points
out some important factors that influence to the liquidity requirement of the company. Those
are nature & size of the business, manufacturing cycle, business fluctuations, production
cycle, turnover of circulatory capital, credit terms, growth & expansion activities, operating
efficiency and price level changes.

Kamath, Srinivasan & Kim (1986) state that , to ensure the proper operation of trading
cycle, responsible parties should calculate the best suited amount of cash to their level of
activities and also they need to plan the dates of payments and collections of receivables with
reducing transformational cost. It is therefore essential to establish the right level of
disposable assets to short-term financial investments at companies. Holding the wrong
amount in cash or cash equivalent may interrupt the normal flow of business activities.

Maintaining wrong amount of current assets may be interrupted to the day to day
business activities. As well as the wrong safety margin is caused to miss the unexpected

8
advantage investment opportunities and as this reason cannot be met unexpected financial
requirements. Hence the proper liquidity management is provided the facilities for the smooth
running of production process and avoids any treasury gaps (Kamath, et al, 1986).

Home & Wachowiz (2000) stated that if the firm has fewer current assets it may be a
problem for continuing operational activities and if the current assets are too much it may be
reduced the return on investment. Hence both of the increment and recession are not good for
the company.

The required liquidity level for the each business firm depends on the balance sheet
situation of the firm (Banso & Dardac, 2004). Accordingly the article of Bank of Jamaica in
2005, Liquid assets should be consisted with following attributes: diversified, residual
maturities appropriate for the institution’s specific cash flow needs; readily marketable or
convertible into cash; and minimal credit risk.

However the liquidity level is determined by the balance sheet conditions and it may
be affected to the short term obligations and long term success as well as to the survival. As
well as some thinkers believe that liquidity has more importance because companies with low
profitability or even without profitability can serve economy more than companies without
liquidity (Farzane).

Palom & Prat (1984) identified that keeping liquid assets within the firm is an
opportunity cost if the benefits on maintaining them within firm are lower than the return on
productive investments. However this is prevented the transformation cost or immediate
purchasing cost of financial assets as well as from the disadvantageous taxation (Palom &
Prat, 1984).

John (1993) expressed that the considerable number of total assets are represented by
the liquid assets. Hence it is affected to the profitability and to company risks.

However, Kim et al. (1998) said that, if there has an optimal market conditions need
not to maintain excess liquidity level within firm. Because of they can cover any shortfalls
from the capital market under a fair price levels. This statement is correct one because excess
liquidity level means the opportunity cost of profitability. Further Kim et, al (1998) identified
two reasons for maintaining excess level of liquidity within firms. First one is, decrease the
firm’s dependence on costly external financing and other one is, they can get the advantages
from unforeseen future investment opportunities. However, in the actual situation the optimal

9
market conditions are very seldom and firms like to hold excess liquidity level within firms
for facing unforeseen opportunities.

Further Petereson & Rajan (1997) identified that, the management of liquid assets is
particularly importance for the small and medium sized companies. Because of most of those
companies’ assets are in the form of current assets. Current liabilities are the main source of
external finance. As the above fact, the liquidity management is become more useful and
significant tool of large, medium and small scale companies.

2.1.1 Liquidity Ratios

Financial ratios are provided the more meaningful information for the decision
makers. Ratios are the combination of two variables. Hence the validity of the ratios is
increased rather than other data.

Liquidity ratios determine the ability of a firm to generate the cash flow in the year
and compared it with short term obligations. This is provided the clear picture if the firm has
a problem relating with the short term debt paying ability (Saleem & Rehman, 2011).

Most of the organizations use Current ratio and Quick ratio as the liquid ratios and
those are greatly affected to the profitability of organization. Liquidity ratios combine with
the cash and near cash assets in one side of the business and the immediate payment
obligations on the other side. Inventory and receivables from customers are the main parts of
near cash assets. (Qasim & Ramiz , 2011).

To measure the short term success, analysts use the liquidity ratios. But there have
some limitations of this. If the firms’ sales are occurred in seasonally, the correct value of
receivables and inventories cannot be predicted. All of the liquidity ratios are not uniform and
differ on industry characteristics (Gibson Charles, 1991).

2.1.1.1 Current Ratio

Current ratio is the most common and oldest measure of cooperate liquidity (Sanna &
Valming, 2009). Beaver (1996) stated that the current ratio was firstly used for evaluating the
credit- worthiness of the companies. This ratio is the most frequently used technique for
measuring the liquidity. From this ratio can be measured the ability of covering current
liabilities by using current assets (Czekai & Dresler, 2001). As a benchmark, companies keep
value of 2:1 for current ratio (Maness & Zietlow, 2005). It means, companies need to hold
twice of the current assets value as the current liabilities. The meaning of higher value of the

10
current ratio, the higher this ability is (Bolek & Wilinski, 2012). This ratio provides good
picture for the relationship between current assets and liabilities. Because of all the current
assets and current liabilities are included in this ratio.

Most of the companies use this ratio to calculate the liquidity position of each
company. This ratio is represented the large portion of assets in total assets. Cash and cash
equivalents, trade and other receivables, inventories and amount due from related parties are
related with the current assets. Current liabilities are consisted with the trade and other
payables, amount due to related parties, bank overdrafts and interest bearing borrowings. All
of those assets and liabilities have the short term maturing period.

The value of the current ratio is significance for most of the parties’ decisions.
Managers of the company can evaluate the existing and future financial strengths of the
company through this ratio. As well as this provides good indication about the short term debt
paying ability, the requirement of changing policies relating with the debtors, creditors,
inventories and bank activities also.

Especially, trade suppliers are concerning about this ratio. Because of they provide
goods to companies with short term maturing period. Hence, they highly concern about the
liquidity position of the company. Therefore current ratio is provided highly support to get
better decisions.

To predict the current and future profitability and ascertain the success of company,
existing and prospective investors are also concerning about this ratio.

2.1.1.2 Quick Ratio

Acid test ratio is used as another name for identifying the quick ratio. This is included only
the higher liquid assets. The least liquid assets include in the current assets are the inventory.
Therefore this ratio shows the degree of relationship between most liquid assets and liabilities
(Bolek & Wilinski, 2012). Inventory and prepayments are excluded from this ratio. Other all
current assets and liability components are included in this ratio (Saleem & Rehman,
2011).Hence this shows the relationship between more liquid assets and current liabilities. As
the rule of thumb, the ratio for this is the 1:1.

As only used the more liquidity assets for this, can be got more clear picture about the
management of liquidity in each company. To get more favorable decisions to internal and
external parties, this ratio is provided the highly support (Drake).

11
 Inventory cannot be converted in to cash quickly to meet unexpected events. As well
as the prepaid expenses cannot be converted in to cash. Hence, that is not really indicative of
the firm’s ability to repay its’ urgent liabilities. For this ratio, assumed that trade receivables
can be converted in to cash quickly. By using this can get more realistic decisions relating
with the company (Drake).

When comparing different size of companies’ financial statements data, Huff, et al

(1990) found the differences in liquidity ratios of small and large scale businesses. Further he
identified that companies little or no inventory caused to lower current ratio as the lower level
of current assets. Not only above he also identified that most of the small companies have the
negative working capital balance rather than large scale businesses. Hence the comparison of
current ratio by using large scale businesses is more meaningful because there has not much
variation. However the current and quick ratios are widely used ratios by most of the internal
and external parties.

2.2 Profitability

Profit is the very important for all businesses, Because of the survival is depended on this
factor. Profitability plays as a tool in measuring the management efficiency in the use of
organizational resources by adding value to the business firm.

When company’s revenue exceeds its’ expenses, it can be defined as the profitability.
This one is used as the tool for measuring management’s ability to create earnings from the
revenue generating activities and to measure the operating performances. Potential investors
concern about this to predict the dividends values and level of appreciation in stock prices
(Bolek & Wilinski, 2012).

Ajao & Obida, (2012), mentioned that a company should earn profit to ensure the
survival and growth over a long period of time. Further he mentioned that the profit is
essential, but all management decisions should not be profit centered.

Profitability provides more valuable information to get favorable decisions. That

information is always used by investors, managers and financial statement analyzers to get
known about the dividend payment, for measuring management efficiency and to predict and
evaluate the made decisions (Saghafi and Aghayie, 1994).

12
2.2.1 Profitability Ratios

There are several ratios that can be used for evaluating profitability of a business. Those
ratios are commonly used for identifying the adequacy of profits to satisfy various parties’
expectations. Most of the ratios are calculated with combining assets, sales and shareholders’
equity. By using these ratios, managers can get good decisions or can be revised the existing
policies if the existing ones are not suited to the company’s activities. Also the profitability
ratios can be used for measuring efficiency of managers.

The profitability ratios are used to evaluate the managers’ efficiency relating with the ability
to create earnings from revenue generating activities within the firm. Potential investors focus
about the profitability ratios as they interested in dividends and appreciation in share prices
(Ajanthan, 2013).

1.2.1.1 Return on Assets (ROA)

Return on Assets ratio expresses that the gross income earned by the company with using
current and noncurrent assets of the company. This ratio suggests that, higher level of returns
should be earned by using higher level of assets. Through the ROA can be measured the
managers’ efficiency relating with the handling company’s assets for earning income (Ajao &
Obida, 2012).

To calculate the ROA, use the profit before deducting tax and interest expenses. The
reason to add back the interest expenses on borrowed funds is as follows. The efficient use of
the resources is not affected by the method of financing. To remove the effects of external
policy the income tax are added back to the profits. The simply mean of this ratio is, this ratio
provides an indication about the efficiency of using assets to earn profits with removing
external impacts (Bolek & Wilinski, 2012).This ratio is very importance for the managers.
Because of this ratio provides best indication about the efficiency of policies (Ajao & Obida,
2012).

1.2.1.2 .Return on Equity (ROE)

Companies’ capital structure is consisted with both debt and equity capital. Equity
holders are the owners of the company and they have the higher risk relating to their
investments. Because of they do not earn fixed rate of income/ benefits for their investment.
But the risk relating to the receiving interest for the debt money is differed from the equity
investment. Because of debt holders can earn fixed rate of income for their investments. A

13
return on shareholders’ equity is calculated for identifying the profitability of shareholders’
investments (Ajao & Obida, 2012).

The final answer of this ratio is very significance for the shareholders. They can
predict their future earnings from this ratio. Also they can more better decisions relating with
the company. This ratio is very importance for the prospective investors also.

After calculating this ratio, managers can get good decisions establish policies as well
as can revise the existing policies. Because of they have a higher responsibility to satisfy the
owners of the company. The value of this ratio is greatly affected to attract and retain equity
investors to the company.

1.2.1.3 Return on Sales (ROS)

This is also identified as the profit margin ratio or net profit ratio. This is also used for
measuring the operating performance of the firm. By using this ratio, measured the net profit
received from the sales. The profit margin is arisen as the result of selling the products of
company. The company’s profitability level can be expressed clearly via this ratio (Barad,
2010).

From this ratio measured that how much profit is earned from the selling activity. The
efficiency of doing sales and earning profits can be measured through this. Profit before tax is
got for this, as income tax is not combined with the earning profits from the sales (Bolek &
Wilinski, 2012).

2.3 Liquidity VS Profitability

Liquidity and profitability are two main concepts which are significance for the company
(Szczepaniak, 1996). To maintain the higher level of liquidity position within the firm, needs
to hold large share of current assets, especially in cash balances in the company. When
increasing the liquidity position of the company, increased the ability of paying short term
maturing obligations without any delays. As well as can be obtained the discounts from
suppliers and clients and can be obtained loans from the lenders with holding good trust
among them. Further, can be reduced the insolvency risk as maintain higher liquidity position
within firm. Liquidity can be considered as the backbone of the success in company (Saleem
& Rehman, 2011).

Gajdka and Walińska (2008) stated that, the maintaining too big share of current
assets within firm may be impacted in disadvantageously for the profitability purpose. Cash

14
in hand, trade creditors and inventories are the main components of the current assets. The
excess current assets hold within company to face for the unexpected events. The receivables
from the trade creditors are the potential asset. Because of there has no guarantee about the
receivable amounts from the debtors. Inventories included in the current assets cannot be
converted in to cash quickly. Hence the cash in hand plays the vital role for fulfill the
liquidity requirements of the firm.

The surplus of cash, inventories and receivables included in the current assets are
caused to generate the cost of lost opportunities. The mean of the opportunity cost is the loss
of profit which can be earned from the investing in other profitable ways. These excess
current assets can be used to purchase required fixed assets such as buildings, equipments,
furniture etc. If the firm use excess assets for achieve such as requirements, it may be the
saving source of the firm (Gajdka and Walinska, 2004).

On the other hand, these excess current assets can be invested in another profitable
investment sources such as deposits, invest in shares etc. This may be the additional income
source for the company. Actually the excess inventory stock is affected to increase the
expenses of company. Because of the insurance fees, security fee as well as the cost of
deterioration of the goods is increased as the excess inventory stock (Gajdka and Walinska,
2004).

The generally accepted theory is there has an inverse relationship between liquidity and
profitability of the company. Because one variable is increased, other one is increased
(Saleem & Rehman, 2011). This inverse relationship can be shown as follows.

Profitability

Minimal level of liquidity Liquidity

Figure 2.1 Inverse relationships between liquidity and profitability
(Gajdka and Walinska, 2004).

15
The excess liquidity level is caused to reduce the profitability level. As well as the
inadequacy liquidity position affected in badly for the smooth running process of the
company. Hence the optimal level of liquidity and profitability level should be maintained for
ensure the continuous operations and development of the company (Wojciechowska, 2001).

2.4 Summary and Chapter Organization

The literature Review chapter provides the theoretical knowledge about the concepts
including in the each topic. The findings of the previous research articles are also discussed in
detaily through this part.

Relating with the topic of this study, most of the research articles were analyzed.
Liquidity and profitability are the main two concepts of this study. When analyzing the
previous articles, could be seen that there were some similarities among the definitions. Most
of the previous studies were done by targeting service sector on developed countries.
Obtained more information and other relevant things by referring most of the previous
research articles which done on the above topic.

However those definitions, theories, findings, assumptions can be applied to the

manufacturing sector in developing countries also. Through this part descriptively discussed
about these things.

16
 3 CHAPTER THREE

3. METHODOLOGY

3.1 Introduction

This chapter discusses about the procedure for sample selection and the method of data
collection, as well as the models used to analyzing the collected data are also presented from
this chapter.

Based on the information of the method section the procedure of measurement in

validity and significance can be determined. Because through this part, the data collection
method, analyzing method and other things related with the analysis are described. Hence, in
this part should be included clear and precise description relating to the way of experiment is
done, reasons or selecting specific experimental procedures, how find out the answers for the
research questions as well as the procedure for analyzing the results is also discussed through
this chapter

3.2 Data Collection

Through this study mainly focused about the liquidity and profitability variables in listed
manufacturing companies in Sri Lanka. This study used secondary data extracted from the
published financial statements of the selected companies for the period of five years, from
2008 to 2012. For obtaining information, study used the income statements and balance
sheets of the selected companies. In some cases, some data and information have been
extracted from the websites of the sample firms.

3.3 Sampling Method

This study targeted the listed manufacturing companies on Colombo Stock Exchange (CSE),
Sri Lanka. The study composed of fifteen manufacturing companies from the manufacturing
sector of CSE for the period of five years from 2008 – 2012.

In CSE, 283 companies are listed under the 20 sectors (at the date of 04.11.2013).
Among them 39 companies are listed under the manufacturing sector. Out of 39 companies,
15 manufacturing companies were selected to gather the secondary data. Those companies
were selected on random basis and concerned about the availability of information.

17
 To select the manufacturing firms for the research purpose, listed all manufacturing
firms in orderly the market capitalization. Then removed the some listed companies from this
order which are not published annual reports for the period of 2008-2012. Then assigned the
random numbers for this order and selected 15 companies from that list by applying the
random selection method.

3.4 Measurement of Variables

This study focused to identify the behavior of liquidity and profitability variables. Liquidity
was used as the independent variable and profitability was practiced as the dependent
variable. Current ratio and Quick ratio were used to measure the liquidity position of each
company and Return on assets, Return on equity and Return on sales were used for calculate
the profitability level of the firms.

3.4.1 Current Ratio

Current ratio shows the relationship between current assets and liabilities. Mainly, current
assets are consisted in inventory, cash and cash equivalent, trade and other receivables,
amounts due from related parties and short term investments (Bhunia & Brahma, 2011).
When analyzing the annual reports of selected companies, can be seen that trade and other
payables, amount due to other parties, current tax liabilities and borrowings are represented
the current liabilities in most companies’ balance sheets.

This ratio is calculated by dividing current assets from current liabilities (Maness &
Zietlow, 2005). As the rule of thumb there should be a 2:1 relationship. This ratio is most
widely used to analyze the short term liquidity of the firm (Bhunia & Brahma, 2011).

Bolek & Wilinski (2012), Ajanthan (2013), Saleem & Rehman (2011), Uwalomwa & Caleb
(2013), Niresh (2012), Bhunia & Brahma (2011) applied this ratio to measure the liquidity
position in their studies.

3.4.2 Quick ratio

Quick ratio is another variable under the independent variable. This one is represented the
most liquid assets. The ability of paying short term liabilities by using most liquid assets is
represented through this (Bolek & Wilinski, 2012).

The least liquid asset including in the current assets is the inventory. To obtain the
most liquid measure on the basis of high maturity, removed the inventory from the group of
current assets (Bolek & Wilinski, 2012).
18
 Foe doing he research studies relating with the liquidity level, the quick ratio is
applied by the most of researchers. Bolek & Wilinski (2012), Chamberlain (2009), Vishnani
and Shah (2007), Saleem & Rehman (2011), Niresh (2013) are some researchers who used
that ratio to measure the liquidity level.

3.4.3 Return on Assets

This ratio presents the relationship between profits and assets of the company. Through this
can be measured the efficiency of using assets to earn profits of the firm. To calculate this
ratio obtained the data from both the income statement and the balance sheet. This ratio is
useful for comparison purpose. To compare the present time results with past periods or with
other companies in the industry, this ratio can be used. Ajao & Obida (2012), Martínez &
Garcia (2003), Ajanthan (2013) used this ratio to measure the profitability level in their
research studies.

3.4.4 Return on Equity

This ratio measure the returns obtained by shareholders of the company. For this get the
residual profit after deducting all expenses. This ratio represents the level of productivity
earned from the investing owners’ contribution. This can be used as the tool for evaluate the
shareholders’ contribution. This is importance for attracting investors to the company (Barad,
2010).

Ajao & Obida (2012), Saleem & Rehman (2011), Bolek & Wilinski (2012) were
applied this ratio to investigate the relationships through their studies.

3.4.5 Return on Sales

This shows the efficiency of current operations for earning profits of the company. Profit
margin is resulted from the sale of its’ products. Hence sales revenue comes become as the
key figure in income statement. The best way of calculating the efficiency of earning profit
from the sales is the express them as a percentage of net sales (Barad, 2010). Niresh (2013),
Saleem & Rehman (2011) used this ratio for doing the research studies.

When discussing about the methods of calculating liquidity and profitability levels
under the above ratios, it can be described as follows. Current ratio is the link between current
assets and current liabilities. Hence it is calculated by dividing current assets from current
liabilities. Quick ratio is represented the most liquid assets. When calculating the quick ratio,

19
deducted the inventory from current assets and that value is divided from the current
liabilities.

Liquidity Ratios and its’ calculations

Ratio Symbol Method Hypothesis

Current Ratio CR Current Assets / Current Liabilities 2:1

Quick Ratio QR (Current Assets- Inventory) / Current 1:1

Liabilities

Profitability Ratios and its’ dimensions

Ratio Symbol Method

Return on Assets ROA Net profit before tax and interest/ Average total
assets* 100

Return on Equity ROE (Net profit after tax – Preference dividends)/ Average
total equity *100

Return on Sales ROS Net profit/ gross sales * 100

Table 3:1 Liquidity and profitability measures

3.5 Data Analysis

The main purpose of this research is to study the relationship between liquidity and
profitability of listed manufacturing companies in Sri Lanka. In order to evaluate the
profitability, ROA, ROE and ROS have been used separately. Current ratio and quick ratio is
used for measuring liquidity position of each company. Following hypothesis was designed
to study the relationship between liquidity and profitability. The research model can be
represented as follows,

P= β0+ β1 LR+ ε……………

P = Profitability

L = Liquidity

20
Under this three models are used to analyze the relationship between liquidity and the
profitability.

ROE = β0+ β1 CR+ β2 QR ε (I)

ROA = β0+ β1 CR+ β2 QR ε (II)

ROS = β0+ β1 CR+ β2 QR ε (III)

Hypothesis

H0: There is no relationship between liquidity and profitability.

H1: There is a relationship between liquidity and profitability.

Descriptive statistics method was used to identify the mean, maximum, minimum and
standard deviation values of the entered data. From this can be identified as the whole how
companies maintain liquidity levels within company and the level of profitability.
Correlation analysis is used as a tool for identifying the nature and extent of the relationship
between variables. In here checked the Pearson correlation coefficients and the significance
under the two tailed diagrams for identifying the validity and reliability of used data.
Furthermore used the Anova test for measured the F value and its’ significance relating with
the link between liquidity level and profitability level. The extent of correlation between
current ratio and quick ratio was also studied through this study.

21
 4 CHAPTE FOUR

4. ANALYSIS AND DISCUSSION

4.1 Introduction

The collected data from secondary sources are presented and analyzed in this chapter. As
mentioned in the methodology chapter. Particularly, descriptive analysis, correlation analysis
and regression analysis are to be employed in order to reach towards the objectives of the

4.2 Descriptive Statistics

Descriptive statistics that are displayed in table 4.1 show clear and precise information
relating with the company’s activities. As a whole this provides information for the selected
industry. By handling this statistics can be got basic idea about the behavior of industry.

Table 4.1: Descriptive Statistics of the Variables

Minimum Maximum Mean Std. Deviation

CR 0.35 2.9 1.44 0.64
QR 0.06 2.17 0.81 0.47
ROE -0.1 0.34 0.08 0.07
ROA 0.00 0.37 0.11 0.07
ROS -0.17 0.64 0.06 0.11
Source: Research data

The descriptive statistics show that over the period under study, the criteria used for
measuring profitability including Return on Equity, Return on Assets and Return on Sales
averaged 0.08, 0.11, and 0.06 respectively. Furthermore, the mean value of the Current ratio
was 1.44 and Quick ratio was the 0.81 value. The standard deviation values of the liquidity
measures were found to be higher than the profitability measures. Thus, it reveals the high
volatility of liquidity measures used than profitability measures in the study.

Mean values of liquidity ratios did not reach to the standard conventional rule of 2:1
for Current ratio and 1:1 for Quick ratio. This indicates that on the average, manufacturing
companies in Sri Lanka may find it difficult to meet their short-term obligations. However,
some companies have recorded 2.9 and 2.17 for current ratio and quick ratio in respectively.

22
It means, some companies have the good ability to face for the short term obligations well
without any problem.

4.3 Correlation Analysis

To analyze the correlation between independent and dependent variables, the Pearson’s
correlation coefficient was used. From this quantified the strength of the relationship between
independent variables. If the relationship is closed to the 1, there has the stronger relationship
among two variables. (Lamburg & Valming, 2009).

Table 4.2: Pearson’s Correlation Coefficient

Liquidity Profitability
Variables CR QR ROE ROA ROS

CR 1 0.873** 0.207 0.311** 0.301**

QR 0.873** 1 0.146 0.262** 0.258*

ROE 0.207 0.146 1 0.722** 0.674**

ROA 0.311** 0.262* 0.722** 1 0.682**

ROS 0.301** 0.258* 0.674** 0.682** 1

Source: Researched data
** Significant at the 0.01 level, * significant at the 0.05 level

Table 4.2 indicates the relationship between the various independent and dependent
variables used in the study. As it is observed in the table, the correlation values of all ratios
were found to be positive between independent and dependent variables. The

Current ratio and Quick ratio was used as the liquidity ratios. There has the strong
and positive relationship among those two ratios. The R value among them was 0.873 and it
was closed to the 1.

This analysis shows the positive relationship between the liquidity and profitability
variables. The Current ratio and Quick ratio is highly linked with the ROA rather than other
variables. The effect from the Current ratio and the quick ratio to the ROE is lower than the
effect to the ROS. Hence, the changes of the liquidity ratios are highly affected to the
determine profitability of manufacturing companies in Sri Lanka.

23
4.4 Regression Analysis

Table 4:3 Regression Analyses

Model I Model II Model III

F Value 1.814 3.863 0.048
Sig. 0.17 0.025 0.097

R2 0.048 0.033 0.091

β
CR 0.335 0.345 0.319
QR -0.147 -0.039 -0.021

Std. Errors
CR 0.027 0.026 0.04
RQ 0.036 0.036 0.054
Source: Researched data

The overall significance of the model was assessed by the values in the ANOVA test.
Relating with the table 4.3, Model I has the 0.17 significance level and F value of it got the
1.814. This model is exceeded the significance level.

Model II has the 0.025 significance and 3.863 values have for the F value. The
significance level of this model is lower than 10% and this model is significance one. Then
model III also in the significance level. Because of that value is the 9.7%.

The significant values of the F is less than 10% in model II and model III .In this case
it reveals that CR and QR have a considerable significant impact on ROA at 10 percent level
of significance. However, it should be concerned here that there may be some other factors
and variables which can be impacted on determine the profitability level, which need to be
studied.

In relating with table 4.3, the R2 value is represented the degree of impact from
independent variable to determine the behavior of dependent variable. As the above figures,
4.8% impact from liquidity ratios have to determine the returns for the equity holders. There

24
has 3.3% level impact from liquidity ratios to change the returns from the sales. Furthermore
9.1% impact has the liquidity ratios to change the returns from sales.

The remaining part of the variance in profitability is related to other variables which
are depicted in the model

The β values show in the 4.3 table, there has the highest contribution in Current ratio
to prediction of ROA with the value of 34.5%. The contribution of Current ratio has the
33.5% and 31.9% respectively for determine the ROE and ROS values. There has the
considerable level of contribution from Current ratio to determine the returns for equity
holders, assets and from sales.

However, the contribution of Quick ratio has negative values for all profitability
ratios. Hence the Quick ratio’s contribution is negative relating with the profitability ratios.

4.5 Hypothesis Testing

Table 4.4 : Testing of Hypothesis

No Hypothesis Predicted sign Actual sign Accepted/ Rejected

H0 There is no significance relationship between liquidity and profitability Accepted Rejected Rejected

H1 There is significance relationship between liquidity and profitability Rejected Accepted Accepted

Source: Research data

25
 5 CHAPTER FIVE

CONCLUSION

Liquidity management is very important part in financial management decision. The expected
achievements can be carried out if the firms manage the interrelationship between liquidity
and profitability. This study examined the relationship between liquidity and profitability in
the manufacturing companies in Sri Lanka. The study covered 15 listed manufacturing firms
over the period of past five years from 2008 to 2012 and the major findings of the study are
summarized below:

The correlation values were found to be positive between all liquidity ratios and
profitability ratios. This finding is confirmed by Ajanthan (2013), Caleb & Uwalomwa
(2013), Amalendu and Sri (2001), Vijaykumar (2011) from their research studies. Among
them the highest correlation value can be seen in the Current ratio and the Return on Assets.
The least correlation value has the Quick ratio and Return on Equity.

Furthermore there has a significant relationship between Current ratio and Quick
ratio with the Return on Assets and Return on Sales. But there has an insignificance
relationship between Quick ratio and the Return on Equity. Hence, null hypothesis was
rejected and the research hypothesis was accepted. That is, there is significance relationship
between liquidity and profitability among the listed manufacturing companies in Sri Lanka.
Further this finding was confirmed by the Ajanthan (2013) and Priya & Nimalathasan (2013)
through their studies.

The mean values of current ratio and quick ratio were found to be 1.44, 0.81
respectively of the manufacturing companies in Sri Lanka. The standard for the Current ratio
is 2:1 and Quick ratio is 1:1. It shows that, the liquidity ratios are in lower level rather than
the rule of thumb level. This situation also confirmed by the Caleb & Uwalomwa (2013),
Niresh (2012) via their research study. The firm managers need to concern about the liquidity
requirements of the companies. Because the production cycle of the operations has get the
longer period.

Finally, the results of the study found that correlation and regression results are
significantly and positively associated to the firm’s profitability (except the relationship
between Quick ratio and the Return on Equity). Furthermore the contributions of liquid ratios

26
are in higher level for enhancing the returns on assets rather than for other variables. This
finding is confirmed by the Ajanthan (2012), Priya 7 Nimalathasan (2013). As the finally,
can be said that the implication of the above is that liquidity has low degree of influence on
the profitability of manufacturing companies in Sri Lanka. This also confirmed by the Caleb
& Uwalomwa (2013).

27
 6 REFERENCES

Ajanthan, A. (2013). A nexus between Liquidity and Profitability. Journal of Business and
Managementement.

Aloy Niresh, J.(2012).Tradeoff Between Liquidity and Profitability. Journal of International

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Ben- Caleb., Eg Bide., Olubukuola., Uwuigbe.,Uwuigbe.,Uwalomwa.(2013).Liquidity

Management and Profitability of Manufacturing Companies in Nigeria.Journal of
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Curtis, V.L., Samuel- Antwi., Eric- Kofi. (2013). The Realtionship Between Liquidity and
Profitability of Listed Banks in Ghana. Journal of Business and Social Science.

Malendu Bhunia,A., Sri Bidham- Brahma. (2011).Importance of Liquidity Management on

Profitability. Asian Journal of Business Management, 3(2), 108-117.

Owolabi., Sundry- Ajao., Obida. (2012). Liquidity Management and Cooperate Profitability.
Journal of Business Management Dynamics, 10-25.

Priya, K., Nimalathasan, B. (2013).Liquidity Management and Profitability. Journal of

Technological Exploration and Learning.

Qasim Saleem.,Ramiz Ur Rehman.(2011).Impacts of Liquidity ratios on Profitability. Journal

of Research in Business, 95-98.

Sanna-Lamburg., Sandra Valming. (2009). Impact on Liquidity Management on Profitability.

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