A firm is required to maintain a balance between liquidity and profitability while conducting its day to day operations. Liquidity is a precondition to ensure that firms are able to meet its short-term obligations and its continued flow can be guaranteed from a profitable venture. The importance of cash as an indicator of continuing financial health should not be surprising in view of its crucial role within the business. This requires that business must be run both efficiently and profitably. In the process, an asset-liability mismatch may occur which may increase firm's profitability in the short run but at a risk of its insolvency. On the other hand, too much focus on liquidity will be at the expense of profitability and it is common to find finance textbooks (for e.g see Gitman, 1984 and Bhattacharya, 2001) begin their working capital sections with a discussion of the risk and return tradeoffs inherent in alternative working capital policies. Thus, the manager of a business entity is in a dilemma of achieving desired tradeoff between liquidity and profitability in order to maximize the value of a firm.
Small businesses are viewed as an essential element of a healthy and vibrant economy. They are seen as vital to the promotion of an enterprise culture and to the creation of jobs within the economy (Bolton Report,
1971). Small Medium-Sized Enterprises (SMEs) are believed to provide an impetus to the economic progress of developing countries and its importance is gaining widespread recognition. Equally in Mauritius the SMEs occupy a central place in the economy, accounting for 90% of business stock (those employing up to 50 employees) and employing approximately 25% of private sector employees (Wignaraja and O'Neil, 1999; CSO, 2003; NPF, 2004). Storey (1994) notes that small firms, however, they are defined, constitute the bulk of enterprises in all economies in the world. However, given their reliance on short-term funds, it has long been recognized that the efficient management of working capital is crucial for the survival and growth of small firms (Grablowsky, 1984; Pike and Pass, 1987). A large number of business failures have been attributed to inability of financial managers to plan and control properly the current assets and current liabilities of their respective firms (Smith, 1973).
Some research studies have been undertaken on the working capital management practices of both large and small firms in India, UK, US and Belgium using either a survey based approach (Burns and Walker, 1991; Peel and Wilson, 1996) to identify the push factors for firms to adopt good working capital practices or econometric analysis to investigate the association between WCM and profitability (Shin and Soenen, 1998; Anand, 2001; Deloof, 2003).
Leverage and profitability
Debt is one of the tools used by many companies to leverage their capital in order to increase profit. However, the affectivity of debt to increase profitability varies between companies. The ability of the company's management to increase their profit by using debt indicates the quality of the management's corporate governance. Good corporate governance shows the companies' performance on their use of debt to increase their profit (Maher and Andersson, 1999).
One method that can be used to measure the effectiveness of debt to maximize the profit is by using Du Pont chart analysis. Du Pont chart analysis can describe the relationship between profitability and the use of debt as reflected by return on equity ratio of a company. The proper use of debt can raise the return on equity ratio. This means that the company's management can make use of the debt to increase the profit. It also can indicate the ability of company's management to maximize its operation on assets in making profit (Brigham and Ehrhardt, 2005).
However, profitability might not only be affected by debt. Other factors might affect the profitability of the companies whether they are internal factors or external factors. Internal factors are reflected by operating decisions and companies' size, while external factors are reflected by the type of industry that the companies run its business and the macro factors that might affect directly to the companies' performance.
Profitability can be affected by operating decisions when the assets are used effectively to increase profit. Operating decisions can indicate the effectiveness of the companies' management in making the profit from the assets used. Therefore operational efficiency can be achieved by dividing sales or revenue with total assets (Sari, 2007). However, to increase the assets to generate more profits, companies might use leverage. One type of leverage that companies use is debt. When debt is used to expand the companies by adding more operational assets, then it can generate more cash flows which are expected to increase the value of return on equity ratio (Brigham and Ehrhardt, 2005).
Moreover, return on equity can also be useful in comparing the profitability of the company to the other company in the same industry (www.investopedia.com). This is important because different industry might produce different profitability. As it is explained by Michael Porter that industry presents different pattern of profitability due to different forces that the industry exposed to such as concentration, entry barriers, and growth (Spanos, Zaralis, and Lioukas, 2004).
1.1 Knowledge Gap
There are number of researches focusing on the impact of liquidity and leverage on the profitability. But none of the research till now works on the efficiency of liquidity and leverage to increase the profitability of the organization in the food industry of Pakistan. That shows clearly a gap and this study intended to fill the said gap.
1.2 Problem statement
The study is focusing to investigate the impact of liquidity and leverage on the profitability of the organization.
1.3 Objective of the study
The study has the following specific objectives:
To find out the linkage between liquidity, leverage and profitability.
To assess the influence of liquidity and leverage on profitability.
To ascertain the most prominent liquidity and leverage dimensions that affect profitability.
To study the direct and indirect effect of liquidity and leverage variable on profitability.
1.4 Significance of the study
Topic of leverage liquidity and profitability is today burning issue. This study will help managers of these two companies and other companies to generate profits for their companies by handling correctly the liquidity and leverage and keeping each different component and many others to an optimum level.
Most firms have a large amount of cash invested in working capital through financing mix. It can therefore be expected that the way in which liquidity and leverage are managed will have a significant impact on the profitability of firms.
2. REVIEW OF LITERATURE:
The literature review (1) introduces the subject of (study influence of working capital management or liquidity and leverage on profitability). (2) Highlights the dilemma (that we do not have an excellent theoretical structure for understanding what working capital leverage and profitability is). (3) Review the work ended so far on the subject in a way that influence the person who reads that the examiner has done.
2.1 LIQUIDITY AND PROFITABILITY
The liquidity is expressed as the "managing current assets and current liabilities, and financing these current assets." Liquidity is important for creating value for stockholders. Management of Liquidity was initiated to have a major impact on effectiveness of studies in different countries
Deloof [5, p. 573] used an analysis of 1,009 immense Belgian non-financial organizations for a period of 1992-1996 in order to find the impact of liquidity on profitability of the firm. With the help of statistical techniques (regression and correlation) and results of the study indicated that earnings before interest & tax and the average collection time, inventories are significantly negatively related with accounts payable. He recommended that firms can increase the profitability average collection period and inventories.
Ghosh and Maji [8, p. 1] researched that how effective is the working capital association of Indian cement organizations during 1992 to 2002. for this purpose three index principles were measured - performance index, consumption index, and on the whole efficiency index these measures are used to check the effectiveness of liquidity management they also examined the strength of achieving target level of competence by individual organizations and through this that found that firms efficiency is notably improved during this period.
Eljelly [9] examined the relationship between liquidity and profitability, as of 929 joint stock corporations of Saudi Arabia. Results of the study indicated significant relationship between profitability and liquidity intensity. This relationship is higher in organizations with grand current ratios in addition to extended cash conversion series. He also concluded that the cash gap determine liquidity more than current ratio however current ratio affects productivity. The firm size variable was also found to have major outcome on effectiveness at the industry level.
A study by Lazaridis and Tryfonidis [1, p. 26] results that there is a statistically relationship among profitability, with the gross working profit, cash transfer cycle, accounts receivables, accounts payables, and inventory in a cross sectional investigation by using a test of 131 organizations scheduled on the Athens Stock Exchange for the time of 2001 - 2004 . Their analysis showed that firm can get profit through the cash exchange cycle and through maintaining each factor of the exchange cycle (accounts receivables, accounts payables, and inventory) correctly.
Raheman and Nasr [2, p. 279] analyzed the effect of different variables of running capital organization as well as average set of period, inventory income in days, average imbursement period, cash conversion cycle, and present ratio on the net working profitability of Pakistani organizations. They used data for 94 Pakistani organizations listed on Karachi Stock Exchange for from 1999 - 2004 and concluded that there is a significant negative relationship between working assets management and effectiveness of the organization. They also concluded that productivity of the firm decreases with the increase in cash cycle and recommended that managers should decrease this cash conversion cycle in order to generate positive net worth for share holders.
Falope and Ajilore [10, p. 73) used data for 50 non-profit firms of Nigeria form 1996 -2005 and developed panel figures econometrics in a combined regression, where time-cycle and cross-sectional interpretation were joint and estimated. According to them operating effectiveness is significantly related with the average set of period, inventory revenue in days, average imbursement period and hard cash conversion cycle in these Nigerian firms. Moreover, they found insignificant difference in the effects of functioning capital management among large and small organizations.
Mathuva [11, p. 1] checked the influence of functioning capital management workings on corporate productivity by using a section of 30 organizations listed on the Nairobi Stock Exchange (NSE) from 1993 to 2008. Through Fixed effect model he found that there exists a highly significant negative relationship cash cycle (accounts collection period) and productivity of these organizations he also concluded that taken to exchange inventories into retailing (the inventory conversion time) is significantly and positively related to the effectiveness. Another important finding of this study was that time it acquire the organization to pay its creditors (standard payment period) is significantly positively related to the productivity of these organizations.
In summary, the literature review indicates that working capital management impacts profitability of the firm but there is still some ambiguity regarding the appropriate variables that might serve as proxies for working capital management. The present study investigates the relationship between a set of such variables and the profitability of a sample of unilever and nestle firms.
