Magazine 2017
International Peer-Reviewed Journal
RESEARCH HORIZONS, VOL. 7 SEPT. 2017
COMMERCE
THE RELATIONSHIP BETWEEN LIQUIDITY AND PROFITABILITY:
AN EXPLORATORY STUDY OF
PHARMACEUTICAL COMPANIES IN INDIA
*Dr Arvind A Dhond
ABSTRACT
A firm is required to maintain a balance between liquidity and profitability while conducting its day-to-
day operations. This paper analyzes the relationship between liquidity and profitability in a group of
companies comprising the major pharmaceutical companies in India between 2011 and 2015. The aim of
this work is to verify the relationship between these two indicators over the short term, and also to
observe their relationship. Using the financial data published by the companies, the relationship was
studied with the help of statistical procedures. Surprisingly the results indicated a significant positive
correlation between liquidity and profitability on the short run, contradicting the main literature in financial
management
Keywords : Liquidity, Profitability, Funds, Ratio, Dilemma, Short Term. nt.
Prologue
Modern days finance manager has to manage financial resources judiciously. The liquidity and profitability
goals conflict in most decisions which the finance manager makes. Often a challenge usually arises in deciding
whether to favor liquidity or profitability. It is not possible to favour both in one single decision. The more
liquidity a firm maintains, the lesser profitability will be achieved. Likewise, the lesser liquidity the firm decide to
maintain, the more financial resources it is able to channelise towards its fixed capital investments which eventually
leads to more profitability. Thus a financial manager has to ensure on one hand that the firm has adequate cash
to pay for its creditors, has sufficient cash to make unexpected large purchases and cash reserve to meet
emergencies, while on the other hand, he has to ensure that the funds of the firm are used so as to yield the
highest return. This poses a dilemma of maintaining liquidity or profitability. A proper management of liquidity
could result in the desired impact on profitability and vice-versa.
Parameters of the Study
(a) Liquidity is a precondition to ensure that firms are able to meet its short-term obligations. The ‘liquidity
position’ in a company is measured based on the ‘current ratio’ and the ‘quick ratio’.
(b) Profitability is a measure of the amount by which a company’s revenues exceeds its relevant expenses. The
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profitability position’ of a company is measured using the ‘gross profit margin’ and the ‘net profit margin’.
Review of Literature
a) Hyun-Han Shin and Luc Soenen (1998) have focused their study on efficiency in working capital management
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and corporate profitability of 58,985 firms covering a period from 1975-1994. The study found that there
exist a strong and positive relationship between liquidity and profitability.
(b) Marques and Braga (1995) confirmed the inverse relationship between liquidity and profitability for a
sample of food companies.
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International Peer-Reviewed Journal
c) Blatt (2001), found a negative relationship between liquidity and profitability, measured by Dynamic Model
and profitability.
RESEARCH HORIZONS, VOL. 7 SEPT. 2017
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d) Eljelly (2004) elucidated that efficient liquidity management involves planning and controlling current assets
and current liabilities in such a manner that eliminates the risk of inability to meet due short-term obligations
and avoids excessive investment in current asset.
Rationale of the Study
The work is justified because all the researched concepts are widely known and accepted, i.e. there is a wide
literature inside the financial management area regarding the concepts of liquidity and profitability. There is a
need felt for the present study to study the relationship between liquidity and profitability because of differences
in the inferences of results obtained as indicated in the review of literature so as to reconcile their findings with
logical conclusion, however for a different group of companies from a different business segment and into a
different period.
For this purpose the liquidity and profitability ratios of five pharmaceutical companies over a five year period
were computed and analysed in order to understand the relationship between liquidity and profitability.
Objectives of the Study
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a) To study the inter-relationship of liquidity and profitability in the pharmaceutical sector.
b) To compute the profitability, liquidity and solvency ratios of the select sample firms.
c) To analyse liquidity and profitability ratios of five pharmaceutical companies over a five year period and
draw inferences therefrom.
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Hypothesis
Hypothesis: On the short term the relationship between liquidity and profitability is negative.
The research paper aims at testing the research question - Is there a negative relationship between liquidity and
profitability on the short run?
Research Methodology
This study is an analytical research. The sample size of the study is five years from 2011 to 2015 wherein five
companies from the pharmaceutical sector which are listed on BSE are selected based on ‘Top Global Pharma
Companies’ industry ranking. The secondary data is collected from the records of the select units from the
published financial statements in the company’s annual reports which included the Balance Sheet and Profit
and Loss Account of the company. Further analysis of the data is made using certain financial tools and
techniques as ratio analysis as well as assessment of the statistical significance of such data is undertaken using
the Pearson’s Correlation coefficient.
Data Analysis and Findings
Table-1: Analysis of Financial Data of Select Pharmaceutical Companies
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RESEARCH HORIZONS, VOL. 7 SEPT. 2017
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Source: Data Computed by Researcher)
INFERENCES AND DISCUSSION OF THE RESULTS OF HYPOTHESIS TESTING
The results of correlation between liquidity and profitability testing of the above five pharmaceutical companies
shows in sixteen out of twenty cases there exists a positive correlation and in only four cases there is a negative
relationship. Except in four instances, there is a positive correlation between the movement in the profitability
ratios and the liquidity ratios.
On testing the hypothesis in order to determine whether the short term relationship between liquidity and
profitability is negative. This hypothesis was rejected for 80 percent (16 out of 20 instances) of the cases for the
studied group; as the correlation between the two variables was significantly positive. Hence it can be concluded
that there exists a strong and positive relationship between liquidity and profitability in the short term.
The results indicated that for the studied companies, on the short term the higher the liquidity level of the
company, the higher is its profitability. The correlation between liquidity and profitability ratios indicate that
liquidity and profitability could goes hand-in-hand. It contradicts the usual findings from the literature, indicating
that for this sample of pharmaceutical companies the dilemma between liquidity and profitability on the short
term does not exist.
The reason for this different result is that the pharmaceutical sector may differ from the segments analyzed in
other studies. The operation of the pharmaceutical sector demands a high amount of current expenses thus a
higher level of working capital may be directly related to the capability of reducing the costs, and thus being
able to obtain higher profits.
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UTILITY OF THE STUDY
RESEARCH HORIZONS, VOL. 7 SEPT. 2017
Despite the limited scope of this study, the observations would suggest that a company while planning working
capital need not maintain a trade-off between the two as is usually felt. In the light of the above, financial
managers would need to reflect on the implications of each decision that usually involves a trade-off between
liquidity and profitability. It would also be useful to assess the effect of one decision involving this trade-off vis-
à-vis another, so that an overall view can be taken.
LIMITATIONS OF THE STUDY
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a) The study is for a short term period of five accounting years from 2011 to 2015.
b) The main constraint of this study is considered as the data used is secondary.
c) The data was collected based on the company annual report. Hence its accuracy depends on honesty in
reporting of accounting information.
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EPILOGUE
According to Chandra (2001, p.72), normally a high liquidity is considered to be a sign of financial strength,
however a high liquidity can be as undesirable as a situation of low liquidity. This would be a consequence of
the fact that current assets are usually the less profitable than the fixed assets. It means that the money invested
in current assets generates lesser returns then fixed assets, representing thus an opportunity cost. Besides that,
the amount employed in current asset generates additional costs for maintenance, thus thereby reducing the
profitability of the company. It is therefore an important task for the financial manager to achieve the appropriate
balance between adequate liquidity and a reasonable return for the company. The financial health of the
company can be improved if stringent control is exercised on raw materials, stores and spares, finished goods,
collection of receivables and also by reducing the unprofitable investment blocked in current assets as well as
reducing the unwarranted overdraft and short term bank borrowings. Management of working capital has
indeed achieved a higher importance in the management of corporate finance due to its impact on profitability.
BIBLIOGRAPHY
Balakrishnan, “A Case Study of Financial Performance of Public Sector Petroleum Industry”, The Management
Accountant, 2005, pp. 172-174.
Blatt, A. (2001) Balance Sheet Analysis: Structure and Evaluation of Statements Financial. Sao Paulo :
Makron Books, (Original Work in Portuguese Language).
Chandra Prasanna (2001). ‘Financial Management’. Tata McGraw-Hill Publishing Company Limited, New
Delhi.
Dr. S.N. Maheshwari (2001), ‘Principles of Management Accounting’. Sultan Chand Sons, New Delhi.
Eljelly. A, “Liquidity - Profitability Tradeoff - An Empirical investigation of Belgian Emerging Market”
International Journal of Commerce and Management Vol. 14 No.2, 2004, pp 48 - 61.
Harbans Lal Verma, “Management of Working Capital”, Deep and Deep Publication, New Delhi, 1989.
Hyun-Han Shin and Luc Soenen, “Working Capital Management in Loss-Making Companies”. The
Management Accountant April 1998, pp.137-139.
Marques, J. A. C., & Braga, R. (1995) Dynamic Analysis of Working Capital: Model Fleuriet. RAE - Journal
of Business Administration. 35 (3) 49-63, (Original Work in Portuguese Language).
th
M. Pandey, ‘Financial Management’, 9 Vikas Publishing Private Ltd.
S.C. Kuchhal (1993). ‘Financial Management - An Analytical and Conceptual Approach’. Chaitanya Publishing
House, Allahabad.
Annual reports of select companies.
*
Associate Professor In Commerce, St. Xavier College ,CST Mumbai-4000001.
Email-Id arvinddhond@gmail.com
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