International Journal of Accounting and Financial Management Research (IJAFMR) ISSN 2249-6882 Vol.

3, Issue 1, Mar 2013, 223-230 TJPRC Pvt. Ltd.

MORTAALS COMPREHENSIVE TEST-A MEASURE OF PROFITABILITY AND LIQUIDITY

V. SREEDEVI1 & P. LOVELIN AUGUSKANI2
1

Professor & Head, Department of Management Studies, Loyola Institute of Technology and Science, Loyola Nagar, Thovalai, Tamil Nadu, India
2

Research Scholar, M.S.University, Tamil Nadu, India

ABSTRACT
Liquidity management is gaining more importance and receives serious acceptance all over the world, especially with current financial crisis. It plays a significant role for the successful functioning of a business firm. A study of liquidity is of major importance to both the internal and external analysis because of its close relationship with day to day management of a business. Liquidity management, especially at the wake of the global financial crisis, has become a major source of concern for business managers due to expensive bank loan, narrow down of the financial markets and the reluctance of the public to invest in the share of companies. The reason for increased industrial sickness is poor management of liquidity. Owing to the changes brought about by liberalization of the Indian Economy, a large number of enterprises which existed in a virtually non-competitive environment started facing increasingly severe competition and found it difficult to sustain its operations uninterruptedly. This paper examines the impact of liquidity on profitability.

KEYWORDS: Profitability, Liquidity, Leverage, Financial Analysis, Activity, Working Capital INTRODUCTION
The sustained growth of an operation depends, to a great extent, on the efficiency of liquidity management. The rising profit of a firm may mislead stakeholders about high rate of growth, which may be unsustainable due to the problem of liquidity in the company. This leads to constant erosion of liquidity and even makes a company sick. The ultimate outcome of continuous illiquidity is bankruptcy. Profit earning is the main objective of every business concern. The measure of profitability is the overall measure of efficiency and control. It is the main objective of every concern to earn maximum profit not only in absolute terms but also in relative terms. Profit is an absolute measure of earning capacity and profitability is the relative measure of earning capacity. Liquidity is the ability of the company to meet its cash obligations on due dates and to exploit sudden opportunities in the business that can be captured by the finance manager when he maintains adequate liquidity to seize opportunities. A company that cannot pay its creditors on time and continues not to honor the supplier of credit, services and goods can be declared as sick company. Inability to meet short term liabilities may affect the reputation too. Lack of cash or liquid assets on hand may force a company to miss the incentives given by supplier of credit, services and goods. Loss of such incentives may result in higher cost of goods which in turn affects the profitability of the business. So there is always a need for the company to maintain certain degree of liquidity. It depends on the nature of the business, scale of operations, location of the business and such other factors. Every stakeholder is interested in the liquidity position of the company. Supplier of goods will naturally check the liquidity of the company before selling goods on credit.

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Employees also take interest in the liquidity to know whether the company can meet its employees related obligations like salary, pension, provident fund etc. Shareholders are keenly interested in understanding the liquidity and its huge impact on the profitability. Shareholders may not like high liquidity as profitability and liquidity are inversely related. However shareholders are also aware that non-liquidity will deprive the company of getting incentives from the suppliers, creditors and bankers. All operational processes and managerial decisions are directed towards that profit. The economic survival and strength of a firm depends upon the profitability without risk. Thus efficient liquidity and profitability management in corporate business life is important for the smooth running of the business. The liquidity and profitability can be measured properly by analyzing the financial statement of the company.

REVIEW OF LITERATURE
Liquidity of a firm refers to its ability to pay short term liabilities from the short term assets. Current assets of the firm are defined as those assets that are convertible into cash within a short period of time. Liquidity denotes the firms capacity to pay its short term obligation on time. It depends on the level of current assets owned by the firm. There are three prominent measures of liquidity. They are Current ratio, Quick ratio and cash ratio. According Hrishikes Bhattacharya, a firm can maintain liquidity if it holds assets that could be shifted that could be shifted or sold quickly with minimum transaction cost and loss in value. The test of liquidity is the ability of the firm to meet its cash obligations when they are due and to exploit sudden opportunities in the market. Profitability ratios refers to those financial metrics that are used to assess a businesss ability to generate earnings (Rajiv Srivastava etl.2008). Solomon, E and Springle J. remark that whenever one speaks of a firms liquidity, he tries to measure firms ability to meet expected and unexpected cash requirements, expand its assets, reduce its liabilities or cover any operating losses. Liquidity is the ability to transform a security into cash. (Khan M .Y. etl.2004) Teresa A Johns paper on accounting measures of corporate liquidity, leverage and costs of financial distress examines the relationship between the costs financial distress to the level of corporate liability maintained and leverage. Overall study results show that there is evidence of consistency with the hypnotized positive relationship between corporate liquidity and financial distress costs, and the negative relationship between corporate leverage and financial distress costs. Abuzar M.A.Eljellys (2004) study examines the relationship between profitability and liquidity, as measured by current ratio and cash gap (cash conversion cycle) on a sample of joint stock companies in Saudhi Arabia. The study found significant negative relationship between the firms profitability and its liquidity level, as measured by the current ratio. Shin and Soenen (1998) feel that efficient working capital management was very important for creating value for the shareholders. They found a strong negative relationship between lengths of the firms net trading cycle and its profitability. In addition, shorter net trade cycles are associated with higher risk adjusted stock returns. Smith and Bengemanns(1997) study shows that a traditional working capital leverage ratio and a current liabilities divided fund flow display the greatest association with return on investment. Well known liquidity concepts such as the current and quick ratios registered insufficient association whilst only one of the newer working capital concepts and the comprehensive liquidity index indicated significant relationship with return on assets

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Mortaals Comprehensive Test method of ranking has been applied to reach at a more comprehensive assessment of liquidity in which four different ratioss viz, networking capital to current assets ratio, inventory to current assets ratio, liquid assets to current assets ratio and loans and advances to current assets ratio have been computed and combined in a points score. A high value of networking capital to current assets ratio or liquid assets to current assets ratio shows greater liquidity and accordingly ranking has been done in that order. On the other hand, a low inventory to current assets ratio or loans and advances to current assets ratio indicates more favorable liquidity position and therefore, ranking has been done accordingly in that order. Ultimate ranking has further been done on the basis that the lower the total of individual ranks, the more favorable is the liquidity positions of the concern and vice versa.

NEED AND SCOPE OF THE STUDY

The foremost important financial dimensions which a firm would like to analyse are liquidity, profitability, leverage and activity. Financial analysis can be undertaken by the management of the firm or by parties outside the firm like owners, creditors, investors, tax authorities and others. The nature of analysis varies depending on the purpose of analysis. Liquidity position of the company can be examined through financial decision or investment decision. A company can finance its investment by different combination of current and long run services. Economic survival and strength of the company entirely depends on the profitability and liquidity without risk. This will affect the name and fame of the company. Hence the researcher attempts to analyze the relationship between liquidity and profitability.

OBJECTIVES
To measure and compare the liquidity position To measure the relationship between profitability and liquidity To measure profitability To find the direction of changes of current assets, current liabilities and net working capital

MATERIAL AND METHODOLOGY

The information collected for the study is purely on secondary in nature. The data is collected from annual reports, journals, books and websites Sample is Sun paper Mills Limited cheranmahadevi, Tirunelveli District Mathematical and statistical tools like ratio analysis, Rank test, Spearmans rank correlation coefficient time series analysis and Mortaals comprehensive test are used. The limitation of the study is that it is mainly based on internal data and is confined only to two companies.

ANALYSIS AND INTERPRETATION

The secondary data is collected and analyzed carefully for making useful interpretations.

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Table 1: Liquidity Ratios of Sun Paper Mills Limited Year CR 6-May 1.1 7-Jun 1.48 8-Jul 1.14 9-Aug 0.91 10-Sep 1.03 Mean 1.13 Std.deviation 0.19 Source: Secondary Data QR 0.25 0.41 0.33 0.37 0.43 0.36 0.06 CPR 0.03 0.016 0.015 0.012 0.009 0.0164 0.008 CTTR 0.25 0.25 0.298 0.34 0.36 0.299 0.04 ITR 6.87 8.23 7.92 7.08 7.83 7.686 0.52 DTR 27.5 22.05 19.72 10.55 11.42 18.248 6.45

The above table indicates fluctuating trend of CR and shows the average of 1.13.CR is low in 2008-09 and high in 2006-07.The QR is high in2009-10 and CPR is low in 2009-10. CTTR shows increasing trend, the average being 0.299.The ITR and DTR also show a fluctuating trend. Table 2 exhibits that the NWC is negative (current asset is less than current liabilities) in 2008-09. Inventory to CA shows a low liquidity in 2005-06 and high position in 2009-10. Liquid Assets to Current Assets ratio is high in 200910.It shows an increasing trend. Though NWC to sales ratio shows fluctuating trend and it registers high level in 2006-07. Table 2: Mortaals Comprehensive Test NWC to CA Year % Rank (A) Inventory to CA % 77.54 72.03 70.41 59.02 58.8 Rank (B) 5 4 3 2 1 Liquid Assets to CA % 22.46 27.96 29.58 40.97 41.19 Rank (C) 5 4 3 2 1 NWC to Sales Ratio % 1.70 5.5 2.25 -2.37 0.67 Rank (D) 3 1 2 5 4 Total (A+B+C+D) 16 10 10 14 10 5 2 2 4 2

Ultimate Rank

05-06 9.09 3 06-07 32.61 1 07-08 12.6 2 08-09 -9.9 5 09-10 3.12 4 Source: Secondary Data

Return on assets shows fluctuating trend. It is high (12.34) in 2006-07.ROCE is high in 2006-07 (14).Net profit ratio also has fluctuated over the years as shown in Table 3 Table 3: Profitability Ratios Year 6-May 7-Jun 8-Jul 9-Aug Return on Assets (%) 6.93 12.34 2.44 -14.34 Return on Capital Employed (%) 8.524 14 3.12 -21.8 5.23 Net Profit Ratio (%) 5.05 8.04 1.46 -10.05 2.31

10-Sep 3.82 Source: Secondary Data

Table 4 shows that CTTR is an increasing trend. The CTTR is ranked individually. ROCE shows a fluctuating trend. The ROCE is high in 206-07. The difference between ranks is calculated.

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Table 4: Rank Correlation between Liquidity and Profitability CTTR Year % Rank 6-May 25.74 5 7-Jun 25.88 4 8-Jul 29.8 3 9-Aug 34.15 2 10-Sep 36.09 1 Source: Secondary Data ROCE % Rank 8.52 2 14 1 3.12 4 -21.8 5 5.23 3 R1-R2 D D2 3 9 3 9 -1 1 -3 9 -2 4 D2 =32

Table-5 indicates the actual value of current assets and three yearly moving averages. The difference between actual and three yearly moving averages are calculated by using Chi-square test. The chi-square value keeps changing and is not constant. The total chi-square value of net working capital is 365.85 Table 5: Time Series Analysis and Chi-Square Test Current Assets Actual Values (O) Three Yearly Moving Average (E) Current Liabilities Actual Values (O) 818 1254 1796 Three Yearly Moving Average (E) 1041.33 1289.33 1599.3 124.77
2

Net Working Capital Actual Values (O) 657 378 -6 Three Yearly Moving Average (E) 450.33 343 255.33 (O-E)2 E

Year

(O-E)2 E 0.186 0.000006 0.335 0.52

(O-E) E

7-Jun 1475 1491.67 8-Jul 1632 1632.33 9-Aug 1790 1814.6 Total Source: Secondary Data

47.89 0.968 35.91

94.84 3.57 267.47 365.85

RESULTS AND CONCLUSIONS

The current ratio and quick ratio show fluctuating trend. During the year 2008-09 the average current ratio is 1.13 which is far below the standard norm of 2:1. CPR has an average of 0.0164 and this has an indication of low volume of absolute liquid assets. CTTR has an average of 0.29. More than 50% of amount invested in fixed assets and fund for working capital increased every year. The Inventory turnover ratio is high during 2006-07 as a result of proper inventory management. But the average ITR is 0.52 which is below the norm of 2.12 as per CMIE. Proper planning and care should be taken to manage the inventory. The credit policy of the company is good as the DTR average is (18.248) more than the standard (Standard norm is 11).Current liability is more than current assets in the year 2008-09.This shows adverse financial position. There is no correlation between liquidity and profitability. Return on assets, Return on capital employed and Net profit ratio show upward and downward trend. The difference between actual and trend values of current assets is not significant as the calculated value of chi-square is less than the critical value at 5% level of significant. Three yearly moving averages provide a good fit to the data. The difference between actual and trend values of current liability and working capital are significant as calculated value of chi-square is more than critical value of chi-square at 5% level of significance. Since shareholders may not like high liquidity as profitability and liquidity inversely related, the following suggestions are given for consideration to maintain liquidity:-

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The company may increases its most liquid assets by increasing the short term investment The company may concentrate on Inventory management. The details of various components of inventory at a fixed time interval should be introduced to exercise an effective control on the overall items of inventories kept by the company.

Manage inventories efficiently using ERP Packages Incentives may be offered induce debtors to pay up promptly. The company should always try to keep a definite proportion among the various components of working capital

in relation to over all current assets in order to maintain an adequate quantum of liquidity at all times The company must use a series of tests and bench marks The company must have a proper set of liquidity management policies and procedures to improve profits reduce the risk of corporate failure and thus significantly improve its chances of survival. Effective liquidity management will enable organization to derive maximum benefits at minimum cost.

REFERENCES
1. Bardia Dr.S.C (2001): Liquidity of Working Capital: An overview of five Indian petrochemical companies, Economic Administrative Review,Vol.1,No.2,Jaipur,p.p 151-158. 2. Basu S.N(1992): Working Capital Management-Tyre companies The Management Accountant, Vol.27, No.5, Calcutta,P.332 3. George E.Pinales (1990): Elements of Financial Management Third Edition, Harper Collins Publications, New York. 4. Khan,MY andJain,PK Financial Management: Text, Problems and Cases,Tata McGrill publishing company, Newdelhi,2004,p29.20 5. 6. Pandey I.M (2008): Financial Management, Ninth Edition,Vikas publishing House, New Delhi, India. Parashar S.P (1996): Liquidity Management: Principles and Practices (of Managing cash flow, New Delhi, Vision Book (P) Ltd,p.9 7. 8. Rajiv Srivastava and Anil Misra Financial Managemet,Oxfor university press,NewDelhi2008,p27. Ravi M.Kishore (2001) L Financial Management Second Edition, Taxmann allied services (P) Ltd, New Delhi, India. 9. Richard I.Levin and David S.Rubin (1995): Statistics for Management, Prentice Hall of India (P) Ltd, New Delhi, p.738. 10. S.H.PM.Reddy and C.S.Reddy(1999): Liquidity in Small Scale Industries: An Analysis Management Perspective Journal, Vol.2.No. 11. Khatik S.K Dr. and Pradeep Kumar Singh (2003): Liquidity Management in EICHER Ltd-A Case Study, The Management Accountant, Vol.38, No.3pp.217-220. 12. Sur D (2001), Liquidity Management: An overview of Management Accountant, vol.36, No.6, Kolkota, pp. 407-412. five companies in Indian power sector, The

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LIST OF ABBREVATIONS
1. 2. 3. 4. 5. 6. 7. 8. 9. CA-CURRENT ASSETS CL-CURRENT LIABILITIES WC-WORKING CAPITAL NWC-NET WORKING CAPITAL CR-CURRENT RATIO QR-QUICK RATIO CPR-CASH POSITION RATIO ITR- INVENTORY TURNOVER RATIO DTR-DEBTORS TURNOVER RATIO

10. CMIE-CENTRE FOR MONITORING INDIAN ECONOMY 11. ROCE- RETURN ON CAPITAL EMPLOYED 12. CTTR-CURRENT ASSETS TO TOTAL ASSETS RATIO 13. ROA- RETURN ON ASSETS