MBA (finance) – research
MBA (finance) – research
Volume of 13000 – 14000 pages (50 pages)
The financial management can be divided into two main categories based on its functionality; acquisition and investment of funds. An adequate amount of funds has to raise and allocate to get the desired amount of profits and bring the highest value to its shareholders and this process includes long-term leverage management and short-term liquidity management.
In private organisation finance, liquidity management refers to controlling of liquidity assets in order to maintain healthy cash flow without being interrupted to its main operations. The liquidity is the ability to trade an asset as its current market price and it is important to keep a balance between highly liquidity assets and lower liquidity assets as it affects the organisation’s profitability. On the other hand, stakeholders are keen to keep watching on liquidity risk involves in normal business operations. The liquidity risk refers to the inability to meet short-term debt obligations and therefore investors, management, and creditors are using liquidity management ratios to evaluate the level of liquidity risk within the organisation. The liquidity management therefore describes the efforts involved in reducing the liquidity risk of an organisation.
Working capital management is part of financial decision making which involves controlling gross current assets like cash, inventory, receivables and short-term payables. The main issue with this short-term liquidity management is to keep a balance between lower profitability current assets and financial slack generating. Since high liquidity assets are normally generating lower profit than the fixed assets, investment in the working capital does not increase the sales or production. The issue would be a result of high investment in working capital tend to increase the cost of maintenance rather increase of production capacity and therefore not directly adding value to the organisation. According to Eljelly (2004), management of efficient level of liquidity level is of extreme relevance for the organisation’s profitability and its long-term sustainability. The going concern concept establishes the assumption that the organisation will continue its business for the foreseeable future, means it will not halt its operations and liquidate its assets in near term. Thus, it will give enough confidence to the stakeholders to make decisions of the business. Eljelly (2004), further explains that liquidity management is important in good times and even more important in crisis time.
Financial performance of the firm reflects the effectiveness of operational activities and policies in monetary terms. The results mainly depend on the internal and external factors and there are different parameters are used to evaluate the performance of the organisation, including return on investment, return on assets, profitability, gearing, and net assets value. The ultimate objective of the evaluation of the financial performance of the firm is to make sure that funds allocated to assets are generating efficiently in the primary business model in order generate profit and increase shareholders value.
1.2 Research Aim
This study aims at investigating how different liquidity management techniques and long-term leverage management can improve the overall financial performance of the firm including its profitability and make recommendations based on findings.
Following question will be answered during the study,
01. What extent does the high liquidity assets have an effect on the financial performance of the firm?
02. How does management can determine the right amount of working capital requirement and scale with non-current assets?
03. What techniques can be used effectively manage cash cycle of the business?
Also, the study will observe the impact of overtrading on the long-term financial leverage and the question would be answered,
04. What action can be taken for balancing the overtrading impact on high financial leverage?
1.3 Research Objectives
The research objectives are aligned with the main research theme and will be focus on the liquidity management and its impact on the financial performance of the private limited companies. Therefore the main objectives can be categories as below.
01. Identify the most important indicators of liquidity management and their impact on the profitability of the company including the relationship in different timeframes.
02. Critically analyse literature pertaining the liquidity management, leverage, gearing, overtrading, profitability and overall financial performance and their correlation.
03. To know how profitable business could lead to insolvency and factors including overtrading that might bring the company to high leverage position.
04. Suggest recommendations based on the facts for better finance management which can adapt to the managers in short term and long term.
2.0 Literature review
This section will discuss the theoretical concepts of the main study area related to liquidity and profitability and the broad definitions of other key variables.
Managing finance in short term and long term plays a vital role in the sustainability of an organisation. The right amount of funds has to allocate for each resource in order to get maximum return of it as the shareholders who are always looking for a maximum return on their investment. The key is to keep the right balance between profitability and solvency. In general, shareholders of private limited companies want to establish how much profit their business making means how much retained from revenue after deducting all the expenses and that represent their return on the capital invested. They can either withdraw the profit for their own use or reinvested into the business as it helps to expand the organisation.
One of the key variables of this study would be the profitability of the organisation. According to Pimentel et al (2005), profitability could define as the final economic success indicator achieved by the organisation in return for the equity capital invested by the shareholders. This will be determined by the net profit calculation of financial accounting and one of the propulsive element of the investment.
In order to measure the profitability of an investment, there are many of ratios which use by the investors. Return on equity is one of the main ratio popular among the investors and which indicated how well the company used the investment to make earning growth. Therefore ROE uses as the measure of economic success.
In accounting liquidity, it measures the ability to fulfill the short-term debt obligations of the company. Shim and Siegel (2000) explain that liquidity is the company’s capacity to liquidate maturing and it is necessary to maintain an adequate amount of liquidity assets as a primary objective of the company in order to continue its business without interruptions. According to Gunasekaran et al., (2004), the effectiveness to cash generating from material turns in to sales is reflect the organisation’s ability to make the targeted return out of investment and maintain an adequate amount of working capital.
By adopting the acceptable working capital theory, the company can improve its liquidity. (Richards and Laughlin, (1980) identified three main factors that influence the firm’s access to cash: 1) cash held by account receivable for the delivered goods; 2) cash invested in form of inventory which is still work in progress; 3) cash may be available if supplier payments delayed. These three factors which directly affect firm’s cash flow can be manipulated by the operating decisions, even though regular financial decision taken by finance department Özbayraka and Akgün (2006). The effective cash flow cycle can improve the liquidity ratio of the firm. There is no such golden rule for how much should keep as the company’s liquidity ratio, though it is widely accepted that it is desirable to keep the ratio higher than 1.00. According to Morrel (2007), keep the liquidity ratio higher than 1 represent that the company is able to meet its short-term liability by using short-term liquidate assets and anything below 1 might indicate that there are insufficient funds to fulfill the obligations in short term. Having said that there is no golden ratio, Matarazzo (2003) explains that if an analyst based on the balance sheet of a company may find that company’s liquidity ratio is less than 1 and he shall not consider it as the company may not able to pay its debt on time. He further expresses that liquidity ratio would act as an indicator which shows independence of the company against its creditors and ability to face unexpected challenges or a crisis situation.
On the other hand, high liquidity ratio may not be the case of financial mismanagement. Matarazzo (2003) describes that if the company maintain a high level of liquidity ratio, it may indicate wise financial management depends on the situation, which may reduce the financial cost of bank borrowings and get cash discounts from suppliers.
2.3 Correlation in Liquidity and profitability
In working capital management, solvency and liquidity are different concepts closely interrelated to each other and according to Maness & Zietlow (2005), low level of liquidity may lead to increase to financial cost as well as incapability to settle short-term liabilities. Gitman (2003), explains that if the company is unable to keep a positive net working capital margin, means current assets exceeds current liabilities, may lead to insolvency. Therefore he suggests that the company should maintain the net working capital at a satisfactory level in order to run its operations smoothly. Arnold (2008) describes that keeping higher liquidity level especially by cash will able to bring advantages like the ability to survive in uncertain downturns, provides payment for usual everyday expenses and get cash discounts from suppliers.
The high liquidity is generally accepted as a financial strength of the company. But Assaf Neto (2003) express that sometimes high liquidity may undesirable as a low due to the fact that current assets are generating low profits than the fixed assets. The arguments are based on the consequences of the fact that opportunity cost of current assets are higher than the fixed assets since the financial cost and additional maintaining cost of current assets are reasonably higher than the non-current assets.
The conflict of tradeoff liquidity and profitability is, therefore, one major problem that finance managers are facing. Perobeli et al, (2007) say that decision about keeping the appropriate level of liquidity should be based on a number of dilemma such as larger resources allocated to current assets is lower the solvency risk also the profitability and having lower net working capital forced to use long-term funds to less profit making assets. This argument is aligned with the general economic theory of the risk and reward, which is a higher risk are typically associated with the high potential return. And higher liquidity involves less risk means less profitability.
2.4 Overtrading, financial leverage, and solvency
Overtrading arises when the company tries to expand its business in the too short period of time without having enough equity to support for it. This leads to the company to borrow more money from outside sources and cause more debt obligations. Ward (2010) explains that overtrading is one area which needs to closely monitor since it causes financial troubles for many companies. Thus, the cash flow generating from the new business must carefully manage in short-term in order avoid any events like manufacturing or delivery delay, customer payment collection delays, the high cost of sales and less net profits. Since this entire rapid expand of operating activities directly influence the organisation’s working capital, it must be carefully monitored and control to avoid negative impacts from it. Ward (2010) suggest that in order to reduce the bad impact to the company, it has to follow a growth policy which will ensure the correct long-term financing has been used. Management may decide to sell non-current assets which bring fewer profits to the firm to increase the working capital strength and reduce the pressure on supplier payments and collection from customers. The growth plan will monitor how rapidly firm increase its business without having enough long-term financing and will alert for changing the phase.
2.5 Managing risk by measuring financial performance
Financial statements are the primary data collection source for analysing the financial performance of the firm which can use to make the decision and manage the risk associated with that (Crane L.A, 2000). The management supposed to follow-up and make appropriate decisions over the control of the operation in order to achieve the goals of the firm. This control process is to provide the guide to monitoring activities to ensure that the desired outcome has been accomplished and any variation is addressed. According to Robbins (2000), there are three main steps are consistent with the control process and they are; 1) evaluating the actual financial performance 2) comparing actual against the budgeted or industry standards 3) take decisions to correct deviations. The two problems in control and evolution are to get the adequate amount of quantifiable objectives and valid information are providing timely manner. Without these two variables, the making strategic decision would be challenging under any circumstances.
According to Jain (2003), the financial performance measurement has to be based on the analysis which used relevant information under consideration of the total information available in the financial statements. Then, the analysis is involved in arranging information in the way that the relationship of the different verticals to appear and interprets the findings by giving conclusion and inferences.