Liquidity is the ability to meet unexpected and expected demands for cash. It is more explicitly the ability of a company to meet the cash demands of its policy and contract holders with no or negligible loss (Donna R. Claire et al 2000). The assets and liabilities of a company reflect its liquidity profile. Since liquidity risk is inherent in the financial institutions, one must be able to understand measure, monitor and manage this risk.
What is Liquidity Risk?
According to Donna R. Claire et al (2000 p.5) 'liquidity is the ability to meet expected and unexpected demands for cash through ongoing cash flow or the sale of an asset at fair market value'. Liquidity risk is the risk that at a point in time an entity will be in short of cash or liquid assets to attain its cash obligations. A run-on-the-company event is an example of loss due to this risk which causes the collapse of an institution. This type of event can occur during a Depression where most customers ask to have their cash paid immediately and that demand exceeded cash reserves. Other less dramatic losses can occur when a company needs to borrow unexpectedly or sell assets at an unanticipated low price.
1.2 What is Profitability?
Profitability is defined as the ability of a company to generate income which surpasses its liabilities. Profitability is measured by different ratios such as, price to earnings ratio, Return on Equity (ROE) and Return on Assets (ROA) amongst others (Abuzar M. A. Eljelly 2004). The measurement of profitability is essential to every company. Insurance regulators either encourage profitability, when concerned with solvency, or seek to limit it, when regulating rates. To investors and insurers, profitability plays an essential role. To policyholders of a stock insurer it sounds like markup, while to those insured by a mutual company it has no impact (Charles L. McClenahan 1999). Profitability is subject to consistent and accurate determination under a given set of conventions and accounting rules. Profits are important to investors and management as sources of dividends and growth (Eugene and Kenneth 2000). Profits provide better security against insolvency to insurers and regulators.
1.3 What is Liquidity Management?
Liquidity management requires the assurance that a sufficient balance of cash and other working capital assets, receivables and inventories are ensured. If there is an inadequacy in the level of liquid assets, the company's operating risk will be enhanced, leading to loss of liquidity. The company's profitability is affected by the maintenance of working capital assets which generates costs. A company may encounter problems with timely repayment of its liabilities, if its level of liquidity assets is too low. Therefore, the level of liquid assets cannot be too low (Grzegorz Michalski 2008 p.129).
Figure 1: Liquidity level vs. profitability
Source: Graham J.E., 2001. Firm Value and Optimal Level of Liquidity. New York: Garland, pp. 4-6.
As shown in fig 1, a surplus of liquid assets may negatively affect the company's profitability as well. This is because the surplus of liquidity assets can become a source of ineffective utilization of resources when the market risk remains stable. The company should increase the level of liquid assets together with an increased risk of daily operations so as to exceed the required levels as this will protect the company against adverse consequences of unavailable liquid assets (Grzegorz Michalski 2008 p.130). The profitability of liquidity management decision can be measured in two ways:
To check how it affects the net profit and its relation to equity, total assets, or another item of assets.
To assess profitability relative to the value of the company
1.3.1 Importance of Liquidity Risks Management
A company needs to manage its liquidity risk effectively. Neglecting its management may result to serious consequences, starting with failures and bankruptcy. This situation may cause companies to become insolvent, consequently having to find considerable amount of fund in a short period of time thus more expensively (Sharma Paul et al 2006). A liquidity short fall in a company can result in a system-wide repercussion. Poor management of the risks is so drastic that local and international supervisory committees are continuously seeking for solutions and ways to deal with this risk.
1.4 What is Liquidity Measurement?
Liquidity management process can considerably enhance profitability through proper planning such as improved loan strategies and pricing, higher yields on investments and a reduction of funding costs. For any financial institution, liquidity is defined as "having money when you need it to meet loan commitments and funding replacements." Further enhancing this definition: "liquidity for a financial institution is its ability to raise cash quickly (within 30 days), without principal loss and at a reasonable cost." (George K. Darling march 1999)
Managers of financial institutions need a liquidity measurement process that provides answers to the following questions:
1. How much liquidity does a company have? (The amount of cash the company can raise quickly at a reasonable cost?)
2. How much liquidity does the company need to cover expected volatility of its funding base?
3. How the liquidity of companies' carried/invested? Whether the yield on the liquidity portfolio be improved?
4. What are the sources of reliable, cost effective funding the company has available to provide a "just in time" inventory of funding?
5. How the current liquidity position relate to the funding needs of the company?
6. What are the implications of the current liquidity position and expected funding requirements for investments?
Any approach used for liquidity measurement and management should allow financial managers to answer the above questions (George K. Darling march 1999).
1.5 Liquidity issues in Mauritius
There are 16 Insurance companies in the local markets. Each Insurance company in Mauritius has their own structures and policies to manage all the risks in their operations including liquidity and have to consider the guidelines on liquidity provided by the Financial Services Commission and section 23 of the Insurance Act 2005. Insurance companies have to develop a contingency plan which should help them manage their liquidity on a global consolidated basis. Recent technological and financial innovations have provided Insurance companies new means to finance their activities and to manage their liquidity.
The liquidity of insurance companies should usually be well planned since the frequency, timing and severity of insurance claims and benefits are quite uncertain (Levene 2003). Insurance companies obtail their liquidity through underwriting, investment income and asset liquidation (Holden and Ellis, 1993).
Underwriting is calculated as premium revenues subtract payments and operating expenditures
Investment income consists of dividends, realized capital gains on stocks and coupon payments and principal payments on bonds
Assets liquidation is primarily concerned with stock sales and bonds on the financial markets
1.6 The aim and objective of the dissertation
The aim and objective of this dissertation is to investigate the relation between profitability and liquidity within the Mauritian contest and using an econometric model. The Insurances' preference of high return on assets to increase their profitability affects their liquidity positions. Finally, the same model will test the impact of liquidity on profitability at Mauritius Union Assurance Company ltd.
1.7 Outline of the study
1.7.1 Chapter; 1 Introduction
The introduction gives an overview on liquidity risk and explains why it is an important area for research. It gives a clear and concise statement of the aim and objective of this dissertation.
1.7.2 Chapter 2; Literature Review
This chapter is wholly a review of existing literature on liquidity and any relevant article related to liquidity issue has been considered. This will help to put the proposed research in a relevant contest and ensure that up-to-date techniques are used.
1.7.3 Chapter 3; Methodology
This chapter describes the methods and estimation techniques used to compute estimates of the parameters in the model and explain the equations being used. It covers the sources of data collection. Also, the limitations of the study should be outlined.
1.7.4 Chapter 4; Result and Discussion
Chapter 4 presents the "Analysis of data and findings". Tables, graphs and figures are usually used in the chapter to better illustrate the results of the research work. The results should be analyzed and discussed. It should provide some comparison, confirming or contradicting expectations.
1.7.5 Chapter 5; Conclusions and Recommendations
This part presents a conclusion reached based on the findings of the previous chapter. Finally, some suggestions for further research in liquidity will be presented.
