22-05-2013, 02:34 PM
Analysis of Liquidity and Profitability Trade-off of Selected FMCG (Personal and Skin care Sector) Companies
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Introduction
A firm is required to maintain a balance between liquidity and profitability while conducting its day to day operations. Investments in current assets are inevitable to ensure delivery of goods or services to the ultimate customers. A proper management of the same could result in the desired impact on either profitability or liquidity. Liquidity is a precondition to ensure that firms are able to meet its short-term obligations. The 'liquidity position' in a company is measured based on the 'current ratio' and the 'quick ratio'. The current ratio establishes the relationship between current assets and current liabilities. Normally, a high current ratio is considered to be an indicator of the firm's ability to promptly meet its short term liabilities. The quick ratio establishes a relationship between quick or liquid assets and current liabilities. An asset is liquid if it can be converted into cash immediately or reasonably soon without a loss of value.
Liquidity
In accounting, liquidity (or accounting liquidity) is a measure of the ability of a debtor to pay his debts as and when they fall due. It is usually expressed as a ratio or a percentage of current liabilities. Liquidity refers to how quickly and cheaply an asset can be converted into cash. Money (in the form of cash) is the most liquid asset. Assets that generally can only be sold after a long exhaustive search for a buyer are known as illiquid. Also it can be defined as the ability of an asset to be converted into cash quickly and without any price discount.
In business, economics or investment, market liquidity is an assets ability to be sold without causing a significant movement in the price and with minimum loss of value. Money, or cash, is the most liquid asset, and can be used immediately to perform economic actions like buying, selling, or paying debt, meeting immediate wants and needs. However, currencies, even major currencies, can suffer loss of market liquidity in large liquidation events. For instance, scenarios considering a major dump of US dollar bonds by China or Saudi Arabia or Japan, each of which holds trillions in such bonds, would certainly affect the market liquidity of the US dollar and US dollar denominated assets. There is no asset whatsoever that can be sold with no effect on the market.
Profitability
Profitability means ability to make profit from all the business activities of an organization, company, firm, or an enterprise. It shows how efficiently the management can make profit by using all the resources available in the market. According to Harward & Upton, “profitability is the ‘the ability of a given investment to earn a return from its use.”
Profitability is expressed in terms of several popular numbers, which measure one of two generic types of performance: "how much they make with what they've got" and "how much they make from what they take in "The word profitability may be defined as the ability of a given investment to earn a return from its use. The overall objective of the business is to earn at least a satisfactory return on the funds invested in it, consistent with maintaining a sound financial position. Satisfactory returns depends upon several factors including the nature of business, risk involved in the business, etc. The efficiency of a business concern is measured by the amount of profits earned. The larger the profit the more efficient and profitable the business become. The surplus remaining after total costs are deducted from total revenue and the basis on which tax is computed and dividend is paid. It is the best known measure of success in an enterprise .Profit is reflected in reduction in liabilities, increase in assets, and/or increase in owners' equity. It furnishes resources for investing in future operations, and its absence may result in the extinction of a company. As an indicator of comparative performance, however, it is less valuable than return on investment (ROI). Profit is also called as earnings, gain, or income.
Consequences of low profitability
A profit ratio indicates how effectively management can wring profits from sales. It also indicates how much room a company has to withstand a downturn, fend off competition and make mistakes. Potential investors are interested in dividends and appreciation in market price of stock, so they focus on profitability ratios. Managers, on the other hand, are interested in measuring the operating performance in terms of profitability. Hence, a low profit margin would suggest ineffective management and investors would be hesitant to invest in the company. Thus, a financial manager has to ensure on one hand that the firm has adequate cash to pay for its bills, has sufficient cash to make unexpected large purchases and cash reserve to meet emergencies, while on the other hand, he has to ensure that the funds of the firm are used so as to yield the highest return. This poses a dilemma of maintaining liquidity or profitability as indicated in the figure. The liquidity and profitability goals conflict in most decisions which the finance manager makes. For example, if higher inventories are kept in anticipation of increase in prices of raw materials, profitability goal is approached, but the liquidity of the firm is endangered. Similarly, the firm by following a liberal credit policy may be in a position to push up its sales, but its liquidity decreases. Similarly, there is a direct relationship between higher risk and higher return. A company taking higher risk could endanger its liquidity position. However, if a company has a higher return it will increase its profitability.
Rationale of the Study
The current study aims to understand and assess the qualitative efficiency of liquidity management and liquidity and profitability tradeoff. The study will help us to understand the relationship between liquidity and profitability and also to understand its effect on the efficiency of the companies.
Research Methodology
Research is a diligent and systematic inquiry or investigation into a subject in order to discover or revise facts, theories, applications, etc. Methodology is the system of methods followed by particular discipline. Thus, research methodology is the way how we conduct our research.
Ratio Analysis
Ratio analysis is a widely used tool of financial analysis. It is defined as the systematic use of ratio to interpret the financial statements so that the strength and weaknesses of a firm as well as its historical performance and current financial condition can be determined. The term ratio refers to the numerical or quantitative relationship between two variables. According to Wixon and Bedford “A ratio is an expression of quantitative relationship between two numbers.”
Conclusion
The present study was an attempt to understand and assess the qualitative efficiency of liquidity management and liquidity and profitability tradeoff for the select FMCG companies in personal and skin care segment. The study reveals that with respect to the liquidity ratios all the select five companies had satisfactory result except for ITC that showed very low current ratio for the current year 2010-11.
The current ratios of all the five companies is improving except for ITC whose current ratio is reduced for the year 2011 as compared to in the year 2010.The current quick ratio (2011) is higher than the quick ratio for the year 2010 of all the five companies except the ITC as it reduced to 0.178 from 0.212 among all the five companies it was best for P&G in the year 2006.The debt equity ratio of P&G is satisfactory also the ratio of HUL for the year 2010 & 2011 is also satisfactory. The absolute liquidity ratio of P&G in the year 2003 and 2006 were the best, whereas it is not satisfactory for all the other companies.