Liquidity and Profitability Analysis by using simple rank correlation:

In the following table the relationship between liquidity and profitability is analyzed with the
help of rank correlation.
Source: Financial statements of TEPL (calculated values)
Table4:

Year
2006
2007
2008
2009
2010
2011
2012
2013
2014

CATA
CA
TA
CE
EBIT
%
1224064 1306444 1306444
6
4
4 100769
93.69
8001458 8686469 1955402
99629
92.11
1162998 1256157
6
1 2506725 454536
92.58
1210143 1320741
1
1 3325787 670157
91.63
3860582 3953740
143474
0
5 5686767
9
97.64
4690313 5017813 5017813 430751
7
7
7
7
93.47
3768188 4143651 4143651 530704
0
7
7
5
90.94
4655762 4924779 4924779 187502
8
1
1
3
94.54
2911533 3190568 3190568 179451
3
5
5
2
91.25

Rank on
CATA(x1
)

Retur
n on
CE%

3
6

0.5
2.6

Rank on
ROCE(x
2)

d=x1
-x2

d^2=(x1
-x2)^2

8
7

-5
-1

25
1

12.5

13.7

36

17.2

5.9

-1

8.8

25

2.6

-4

16

0.4

-2

4
112

The relationship between liquidity (measured by CATA) and profitability (measured ROCE) of
TEPL over the period of 9 years is presented in Table-4. This relationship is established by using
Spearman's Rank Correlation Coefficient. The rank correlation between Current assets to Total
assets (CATA) and Return on Capital Employed (ROCE) is computed by applying the formula
r (rank) =1-(6 sigma (d2)/n(n2-1) where d=difference in rank and n = number of pairs of
observations. Putting the respective values of d and n in rank correlation formula above we
obtain r = 0.067 which indicates that there is a low positive correlation between liquidity and
profitability of the company.
To find out the significance of the above result we test the hypothesis as under:
Null Hypothesis: There is no significant direct relationship between Liquidity and Profitability
of TEPL i.e. p=0.

Alternate Hypothesis: There is a significant direct relationship between Liquidity and

Profitability of TEPL i.e. p0
tp,n-2 =r*under root (n-2)/under root (1-r2)
By substituting the values of n=9 and r=0.067 we get t=0.18.
Since computed value of t (0.18) is less than the table value of t (i.e. 2.365 at 5% level and 3.499
at 1% level of significance), the null hypothesis, H0: p=0 is accepted both at 5% and 1% level of
significance and thus, the alternative hypothesis, H1:p 0 is rejected both at 95% and 99% level
of confidence. Therefore, we may conclude that there is no direct significant relationship
between liquidity and profitability of the firm under study. This relationship is not statistically
significant both at 5% and 1% level.
Multiple Regression Analysis:
In order to find out the influence of liquidity ratios under consideration on profitability of the
firm the following linear multiple regression model is used where Dependent variable is y and
independent variables are (x1, x2, x3, x4, x5, x6)
y = Return on Capital Employed (ROCE),
x1= Current Ratio (CR),
x2= Quick Ratio (QR),
x3= Current assets to Total assets (CATA),
x4= Working Capital Turnover Ratio (WCTR),
x5= Inventory Turnover Ratio (ITR) and
x6= Debtors Turnover Ratio (DTR).
In this study CR, QR, CATA, WCTR, ITR and DTR have been taken as the explanatory variables
and ROCE has been used as the dependent variable.
For selecting the explanatory variables the correlation matrix is constructed giving the
correlation coefficients between the explanatory variables and the dependent variables. It
revealed that there is a strong correlation between all the variables and are used in multiple
regression analysis.

Liquidity and Profitability Analysis by Using Linear Multiple Regression.

Year
2006
2007
2008
2009
2010
2011
2012
2013
2014

Retur
n on
CR(x1 QR(x ROTA(X WCTR(x ITR(x DCR(x
CE(y) )
2)
3)
4)
5)
6)
0.005
0
1.8
0.68
0.003
10.49
2.13
2.39
0.026
0
1.19
0.97
0.006
7.35
3.06
1.75
0.125
0
1.13
0.83
0.024
10.11
6.03
2.69
0.137
0
1.26
0.98
0.036
5.82
4.85
2.353
0.172
0
1.12
1.03
0.024
11.39 16.75
5.93
0.059
0
1.11
1.04
0.059
22.62 32.21
5.13
0.088
0
1.63
1.06
0.088
2.38
4.25
1.72
0.026
0
1.27
0.88
0.026
5.07
3.67
6.24
0.004
0
1.39
0.76
0.039
5.39
3.22
7.85

The multiple regression equation is

Y=b0+b1x+b2x2+b3x3+b4x4+b5x5+b6x6 where b1, b2..........., b6 are the coefficients of x1, x2,,
x6.
The output of the multiple regression is shown in the below picture.
The Multiple Regression is performed by using SAS 9.2 version and by writing the code
The code used was:
Proc reg data= work. Analysis;
Model ROCE=CR QR CATA WCTR ITR DCR;
run;

quit;
Here Analysis is the Input Data set and Work is the Temporary Location of storing Data
files and when the regression was performed the output was as follows

From the output the multiple regression equation is

Y=3.43-0.26x1-2.32x2-4.23x3-0.13x4+0.09x5-0.09x6
R-squared is a statistical measure of how close the data are to the fitted regression line. It is also
known as the coefficient of determination, or the coefficient of multiple determination for
multiple regression.
The definition of R-squared is fairly straight-forward; it is the percentage of the response
variable variation that is explained by a linear model. Or:
R-squared = Explained variation / Total variation
R-squared is always between 0 and 100%:

0% indicates that the model explains none of the variability of the response data
around its mean.
100% indicates that the model explains all the variability of the response data around
its mean.

R2 in this model is 98.16% which indicates that 98.16% of variation in dependent variable Return
on Capital Employed is explained by the six Independent variables (Current Ratio (CR), Quick
Ratio (QR),
Return on Total Assets (ROTA), Working capital Turnover Ratio (WCTR), Inventory Turnover
Ratio (ITR), Debtors Conversion Ratio (DCR))
You can calculate a regression equation by using the same number of data points as you have
equation coefficients. However, the regression equation will not be as universal as a regression
equation calculated using three times the number of data points as equation coefficients.
To correct the R2 for such situations, an adjusted R2 takes into account the degrees of freedom of
an equation. When you suspect that an R2 is higher than it should be, calculate the R2 and
adjusted R2. If the R2 and the adjusted R2 are close, then the R2 is probably accurate. If R2 is much
higher than the adjusted R2, you probably do not have enough data points to calculate the
regression accurately.
The formula for adjusted R2:

Adjusted R2 =

=92%

Where n is the number of data points and m is the number of independent variables.
Then in the output the t value for all the independent variables or Parameter estimates is greater
than 1.96 at 95% Level of Significance. It indicates that all the independent variables are
significantly contributing in explaining the dependent variable.
The multiple correlation coefficient of ROCE on CR, QR, CATA, WBTR, ITR and DTR is 0.98
which reveals that the profitability of the firm was highly influenced by those explanatory
variables. The value of R2 indicates that the explanatory variables taken together contributed
about 98% of the variations in the profitability of the company. The regression analysis results
also show that goodness of fit of the regression equation is statistically significant at 5% level.