Running head: RELATIONSHIP OF LIQUIDITY AND PERFORMANCE1

Relationship of Liquidity and Profitability of Private Banks Listed at PSX

School of Accounting & Finance, University of Central Punjab

Javaria Qais

Zainab Zahoor

Syed Musawar Hussain

RELATIONSHIP OF LIQUIDITY AND PERFORMANCE 2

Abstract

This study investigates the relationship of liquidity and financial performance (in terms of

profitability) by using panel data of private banks listed at ‘Pakistan Stock Exchange (PSX)’ for

the period of 2011to 2015. Four parameters have been selected by researchers for measuring

liquidity and profitability: two for each, which are Cash and Cash Equivalents to Liabilities

(CCL) and Net Loans to Assets (NLTA) for liquidity and profitability being measured by

Earnings Per Share (EPS) and Return on Equity (ROE). Johansen co-integration and ‘Pearson’s

correlation coefficient’ of variables was used to identify the direction of relationship. The

findings revealed that there is a weak positive relationship between liquidity and ROE while

there is strong negative relationship between liquidity and EPS. Co-integration determined by

long run parameters: showed that there is long run co-integration between NLTA and ROE and

there is no long run co-integration between CCL and EPS.

Keywords: Financial performance, Johansen’s co-integration, Liquidity, Pearson’s

correlation, Unit root test

RELATIONSHIP OF LIQUIDITY AND PERFORMANCE 3

Introduction

This study included the correlation of liquidness and productivity of private sector banks

of ‘Pakistan Stock Exchange’. To investigate that relationship, we drawn a sample from these

banks on the basis of convenient data availability from 2011 to 2015. Data has been taken from

‘State Bank of Pakistan’.

Banking sector is a big contributor towards country’s economy. As according to many

previous researches concluded as financial sector of a country and the economy of the country

overall, there existed significant relationship. Aurangzeb (2012) stated that the economies who

have good financial stability, financial policies and systems are tend to have more growth and

high tendency for the development of the economy of the country. The researcher in this study

has chosen private banks listed at Pakistan Stock Exchange (PSX), studying the financial

performance of the banking sector with respect to specific variables. The financial statement

analysis is the basic tool for analyzing the company’s performance and the financial position of

the company. The financial analysis can be done in many ways like the Trend analysis, the

Percentage analysis and the ratio analysis. Yeh (1996) states the financial ratios are now known

as the most used tool for analyzing the performance. Analyzing the performance by ratio analysis

helps to compare with previous years as well as the other companies of same industry and the

industry overall. In this study the researchers have also used the different ratios from banks’

financial statements for measuring the relationship of selected dependent and independent

variables of the banks.

The researchers in this paper tries to figure out the relationship between liquidity and the

financial performance. For this research the variables selected for finding the relationship of

liquidity and financial performance. In this research the liquidity of banks is considered as one
RELATIONSHIP OF LIQUIDITY AND PERFORMANCE 4

variable and measured by two liquidity ratios as ‘cash asset ratio (as CCL)’ and ‘advances Net of

provisions to total assets (as NLTA)’ and for profitability of the banks measured by ‘return on

equity’ and ‘earnings per share’.

According to Kumbirai and Webb (2010) ratio of NLTA communicates percentage of

assets which financed by loan and higher the ratio means that high amount of assets is financed

by loan and the bank has less liquidity position. Vodova (2011) states that higher the ratio of

NLTA expressed as less liquidity position, for a company to pay for its debts. Aziz, Husin, and

Hashmi (2016) states that the loans to total assets ratio is useful for banks to find out that what

level of loans/advances are out of the total assets of banks.

The cash asset ratio tells us about the liquidity of the company that how much there

highly liquid assets are able to pay for their one liability. The non-financial sector named this

ratio as Current Ratio. Vodova (2011) explained that the cash ratio tells us about the liquid assets

in the total liabilities of the company, that how many highly liquid assets are there to pay the

obligations of the company. The higher the ratio is mean that high liquidity position of a

company is and the more liquid assets are available to pay for the liabilities of the company.

ROE is the profitability ratio that measures the performance of company in financial

terms as it shows the percentage of earnings out of the shareholder’s equity. De Wet and Du Toit

(2007) tells that the ROE is most widely used financial ratio all over the financial analysis. Many

other researchers have proofed this as shown in the literature of this article that ROE is

extensively used for measuring profitability. It is the important ratio for analysis of the

performance from the investor point of view.

EPS is the financial ratio to determine the profitability of company as it tells us about the

amount of earnings a company earns on one share held by company. Murugesu (2013) shows
RELATIONSHIP OF LIQUIDITY AND PERFORMANCE 5

that EPS is one of the indicator of financial performance and the market price of the share of the

company is usually effected by the earning per share of the company means that when the

earning per share is high the investor would like to invest in that company and ultimately the

market share price of the company will go up. The earning per share is the total amount of return

the owner gets out of his/her investment in the stock.

Every study which the researcher does is not without any purpose and aim. In this study the

researcher tries to fulfill the following objectives from this research:

1. To determine relationship between liquidity and financial performance.

2. To assess the relationship between CCL and ROE

3. To calculate the relationship between CCL and EPS

4. To determine the relationship between NLTA and ROE.

5. To explain the relationship between NLTA and EPS.

The extent to which liquidity is related to financial performance should be determined.

Management of liquidity should be balance with successful measures for the sake of stability of

it and to provide more assistance towards the whole financial progress of the corporations. The

best measurement for liquidity is statement of financial position. In spite of, the financial crisis

of 2007 (late summer) had been upset the whole financial markets. Whole of the market could

not reach out of it. Moreover, recent ‘Nigeria Banking Credit Crisis’ made monetary and

regulatory policy in-efficient to work. And all problems, being faced by corporation were due to

misconstrued by the linkage of liquidity management and its effects on working capital, cash

management and no doubt, on financial performance. Classical example in ‘Uchumi Super-Mart

Ltd.’, according to its annual report of 2005, it was describing with tight cash flow position

which has been created difficulties for maintain its relationship with suppliers. In response to this
RELATIONSHIP OF LIQUIDITY AND PERFORMANCE 6

problem, this study proposes the linkage between liquidity and financial performance. We try to

find out on which extent, there is a relation of liquidity with financial performance of

corporations by examine thoroughly of both of them.

Significance of this study is concern for those who are interested linkage between

liquidity and financial performance. This relation cannot be ignored by managerial perspective.

Investors can make decision from this logical relation, whether to invest or not. Moreover, it can

also be useful for other researchers to study ahead. As this relation is not for only structural

description, but also the signal of good performance for the company and by these signal

stakeholders can easily able to understand about company key characteristics and preferences.

This research objective is to inspect relationship of liquidity and financial performance of

private banks listed at PSX. This research paper is very much different from previous studies of

Pakistan on private banks Maqsood, Anwar, Raza, Ijaz, and Shouqat (2016) and Khan and

Mutahhar Ali (2016), because this study has used the different variables than these studies, as in

this study the profitability of banks is measured by the Return on Equity and Earning per Share

while in Maqsood et al. the profitability is also measured through return on assets of the banks

and in Khan and Mutahhar Ali (2016) the profitability of banks is measured through gross profit

margin and net profit margin.

Literature Review

Maqsood, Anwar, Raza, Ijaz, and Shouqat (2016) stated that the liquidity of firm and

profitability are the major parts for the long worthiness of business, they both needs to be in

balance. As it shows that the liquidity and profitability and profitability have a significant

relationship and goes in one direction at same time. The liquidity has a strong impact on the

investment in business. Odalo and Achoki (2016) explained the financial ratios that how they are
RELATIONSHIP OF LIQUIDITY AND PERFORMANCE 7

linked with the shareholders wealth. It shows that ROE is so helpful for the shareholders to

invest in the company and it is the ratio which can persuade the shareholders for having

attraction in the investment. It concluded the results by showing that there is a significant

relationship between the liquidity and ROA of the company.

Demirgünes (2016) said that ROE is very appropriate tool to measure the firm

performance especially of the financial sector firms as it gives the true results of the firms’

strength at present time. They have taken the ROE and ROA as dependent variables for

performance but didn’t include the cash conversion cycle in the model used. Tseganesh (2012)

argued that good liquidity risk management in banks helps them in making the good flow of cash

management which smoothes the flow of business and when the cash flow management are in

manner the profitability of the bank will be enhance respectively which are uncertain and

unpredictable and influenced by the outside factors.

Khan and Mutahhar Ali (2016) revealed that the convertibility into liquidity profitability

is essential. The company which has high liquidity has the more profitability as well. Stating that

liquidity is more important than profitability as it determines or shows the survival of the

business. Through the analysis it shows that liquidity has a insignificant relationship with the

profitability. Saleem and Rehman (2011) explained the principal of liquidity and profitability

which shows that there is a tradeoff between these two variables of the company as one of them

increases the other decreases or vice versa like the liquidity decreases the profitability increases.

Liquidity measures the ability of the firm to pay its obligation by having the comparison of the

cash and the cash equivalents against the obligations or debts of the firms.
RELATIONSHIP OF LIQUIDITY AND PERFORMANCE 8

Malik, Awais, and Khursheed (2016) explained the liquidity as the major factor of the

business as it shows the ability of the firm. It defines the liquidity management as a technique or

a procedure adopted by the business to manage its assets in order to pay its short term and long

term obligations. When the company tries to manage it debtors effectively it must keep in

balance the creditors of business which is essential to maintain its liquidity position. The results

concluded that there is a significant relationship between the liquidity and the return on assets.

Salim and Bilal (2016) referred the liquidity as the ability of the company to convert its assets

into cash and then pay that cash for its obligation. They referred this term as market ability. This

study discussed the problems of bank liquidity and their impact on the financial performance in

terms of the profitability, as the major function or element of banks is the replacement of the

securities. It is tried to fill the gap by noticing or examining the liquidity management of the

Omani’s banks.

Methodology

Data Source

Data of this research paper is secondary. From 2011 to 2015, data were taken from yearly

published reports of the selected banks. Some annual reports are not giving such details which

were needed for this study so, website of ‘State Bank of Pakistan’ is used for the collection of

data of the banks.

Sample Size

The population is private banks listed at PSX but it is difficult to collect the data of all of

the listed banks so the sample of five banks has been taken from the population of this study. The

sample is drawn because all items of the population are not available so the researcher has drawn

sample of all available items.

RELATIONSHIP OF LIQUIDITY AND PERFORMANCE 9

Mode of Analysis

In this study the Pearson’s correlation coefficient tool is used in order to figure out the

relation between liquidity and profitability. For finding the relationship the liquidity is taken as

the one variable for study and profitability is taken as the other variable for finding the relation.

Models of Study

1. Johansen co-integration test

2. Pearson’s correlation coefficient is used to find out the relationship of variables:

Where;

Y= financial performance which is measured by EPS and ROE

X= liquidity position which is measured by CCL and NLTA

Conceptual Framework

Liquidity Profitability

Cash and cash equivalent to liabilities Return on equity

Net loans to total assets ratio Earnings per share

Fig 1: Research Model

Hypotheses

The following hypothesis has built up for testing the relationship of liquidity and

profitability.

H1 a: There exists significant relationship between CCL and ROE

H1 b: CCL has significant effect on EPS

RELATIONSHIP OF LIQUIDITY AND PERFORMANCE 10

H1 c: There exists significant relationship between NLTA and ROE

H1 d: There is a significant relationship between NLTA and EPS

H1 e: Liquidity has significant relationship with profitability

Data Analysis

Table 1 : Descriptive Statistics

N Minimum Maximum Mean Std. Deviation

ROE 5 15.40600 17.82600 16.6256000 .87496217

EPS 5 4.66400 5.76800 5.0516000 .45547865

CCL 5 7.30800 10.94800 8.9552000 1.45022591

NLTA 5 36.30400 43.96200 41.5808000 3.03098486

Valid N (listwise) 5

Table 2 : Correlations
ROE CCL EPS NLTA

Pearson Correlation 1 .053 -.133 .048

ROE Sig. (2-tailed) .933 .831 .939

N 5 5 5 5
CCL Pearson Correlation .053 1 -.765 .536
Sig. (2-tailed) .933 .132 .352
N 5 5 5 5
EPS Pearson Correlation -.133 -.765 1 -.948*
Sig. (2-tailed) .831 .132 .014
N 5 5 5 5
NLTA Pearson Correlation .048 .536 -.948* 1

Sig. (2-tailed) .939 .352 .014

N 5 5 5 5

*. Correlation is significant at the 0.05 level (2-tailed).

Table 3: Hypotheses Testing

RELATIONSHIP OF LIQUIDITY AND PERFORMANCE 11

No. HYPOTHESIS RESULTS TOOL

H1 There is significant relationship between CCL and Accepted CORRELATION
ROE
H1 There is significant relationship between CCL and EPS Rejected CORRELATION

H1 There is significant relationship between NLTA and Accepted CORRELATION

ROE

H1 There is significant relationship between NLTA and Rejected CORRELATION

EPS

Discussion

There existed a strong positive relation in between the cash and cash equivalent to

liabilities and EPS as the value of R is -0.7653. Means when the EPS of the banks increases the

CCL decreases and when the EPS decreases the CCL increases. The value of R2 is 0.5857.

As the conclusion of the second result of the ROE and CCL revealed as weak positive

relationship between the ROE and CCL and R-value is 0.0529 as the value of R is nearer to zero

the weaker the relationship is. It explains that when the ROE increases the CCL also increases

but not with the same ratio and vice versa. The value of R2 is 0.0028.

The results of the ratio of EPS with the relation with NLTA explains the strong negative

relationship as the value of R is -0.9483 indicates that relationship between these two variables is

in opposite direction means that when the value of NLTA increases the value of other variable

EPS decreases and when the value of NLTA decreases the value of EPS increases. The value of

R2 is 0.899. The results of the fourth correlation test with the R-value is 0.0481 shows that there

is a weak positive relationship in between the NLTA and ROE as the value of R is 0.0481 shows

that the relationship is positive but weak means when the NLTA increases the value of ROE also

increases but not with the same proportion and when the value of NLTA decreases the ROE also

decreases but not with the same proportion. The value of R2 is 0.0023.
 Panel ADF-Statistic 1.033036 0.8492 -0.642572 0.2603

Alternative hypothesis: individual AR coefs. (between-dimension)

RELATIONSHIP OF LIQUIDITY
Pedroni AND Statistic
PERFORMANCE
Residual Cointegration Test
Prob.
12
Series: CCETLL EPS
Group rho-Statistic 1.321931 0.9069
Date: 01/27/17
Group Time: 11:27
PP-Statistic -0.707313 0.2397
Unit Root Test Sample:
Group 2011 2015
ADF-Statistic -0.665168 0.2530
Included observations: 25
Cross-sections
Tableincluded:
4: Cross 5 section result of NLTA ROE
Null Hypothesis:
Cross No cointegration
section specific results
Trend assumption: No deterministic trend
Automatic lag results
Phillips-Peron length selection based on SIC with a max lag of 0
(non-parametric)
Newey-West automatic bandwidth selection and Bartlett kernel
Cross ID AR(1) Variance HAC Bandwidth Obs
1 hypothesis:
Alternative 0.007 10.11501
common AR coefs.8.351771
(within-dimension)1.00 4
2 -0.032 3.490414 3.490414 Weighted 0.00 4
3 -0.031 Statistic
214.1473 214.1473
Prob. 0.00
Statistic Prob. 4
4
Panel v-Statistic -0.177 75.95825
-0.245883 75.95825
0.5971 -0.2010780.00 0.5797 4
5 -0.335 1.492429 1.492429 0.00 4
Panel rho-Statistic 0.382443 0.6489 -0.003678 0.4985
Panel PP-Statistic -1.257493 0.1043 -2.238375 0.0126
Augmented Dickey-Fuller results (parametric)
Panel ADF-Statistic -1.257253 0.1043 -2.217849 0.0133
Cross ID AR(1) Variance Lag Max lag Obs
Alternative
1 hypothesis:
0.007individual AR coefs. (between-dimension)
10.11501 0 0 4
2 -0.032 3.490414 0 0 4
3 -0.031 Statistic
214.1473 Prob. 0 0 4
Group4rho-Statistic
-0.177 1.136623
75.95825 0.8722 0 0 4
Group5PP-Statistic-0.335 -1.728912
1.492429 0.0419 0 0 4
Group ADF-Statistic -1.660611 0.0484

Table 5: Cross section results of CCL EPS

Cross section specific results

Phillips-Peron results (non-parametric)

Cross ID AR(1) Variance HAC Bandwidth Obs

1 -0.242 0.456443 0.456443 0.00 4
2 -0.137 0.209457 0.209457 0.00 4
3 0.193 7.925203 7.925203 0.00 4
4 -0.303 5.090130 5.090130 0.00 4
5 -0.583 0.482857 0.411534 1.00 4

Augmented Dickey-Fuller results (parametric)

Cross ID AR(1) Variance Lag Max lag Obs

1 -0.242 0.456443 0 0 4
2 -0.137 0.209457 0 0 4
3 0.193 7.925203 0 0 4
4 -0.303 5.090130 0 0 4
5 -0.583 0.482857 0 0 4

Johansen Co Integration Test

Table 6: Co-integration results of NLTA ROE

 Included observations: 25
Cross-sections included: 5
Null Hypothesis: No cointegration
Trend assumption: No deterministic trend
RELATIONSHIPAutomatic
OF LIQUIDITY AND PERFORMANCE 13
lag length selection based on SIC with a max lag of 0
Newey-West automatic bandwidth selection and Bartlett kernel

Alternative hypothesis: common AR coefs. (within-dimension)

Weighted
Statistic Prob. Statistic Prob.
Panel v-Statistic 2.973738 0.0015 0.906268 0.1824
Panel rho-Statistic 0.265352 0.6046 0.240058 0.5949
Panel PP-Statistic 1.052675 0.8538 -0.617507 0.2685
Panel ADF-Statistic 1.033036 0.8492 -0.642572 0.2603
Pedroni Residual Cointegration Test
Series: CCETLL
Alternative EPS individual AR coefs. (between-dimension)
hypothesis:
Date: 01/27/17 Time: 11:27
Sample: 2011 2015 Statistic Prob.
Group rho-Statistic
Included observations: 25 1.321931 0.9069
Group PP-Statistic
Cross-sections included: 5-0.707313 0.2397
Group ADF-Statistic -0.665168
Null Hypothesis: No cointegration 0.2530
Trend assumption: No deterministic trend
Automatic lag length
Table 7:selection based onresults
Co-integration SIC withofa max
CCLlagEPS
of 0
Cross sectionautomatic
Newey-West specific results
bandwidth selection and Bartlett kernel
Phillips-Peron results (non-parametric)
Alternative hypothesis: common AR coefs. (within-dimension)
Weighted
Cross ID AR(1) Variance HAC Bandwidth Obs
1 0.007 10.11501 8.351771 Statistic
Statistic Prob. 1.00 Prob. 4
Panel 2v-Statistic -0.032 -0.245883 0.5971
3.490414 3.490414 -0.201078
0.00 0.5797 4
Panel 3rho-Statistic-0.031 0.382443 0.6489 -0.003678
214.1473 214.1473 0.00 0.4985 4
Panel 4PP-Statistic-0.177 -1.257493 0.1043 -2.238375
75.95825 75.95825 0.00 0.0126 4
Panel 5ADF-Statistic-0.335 -1.257253 0.1043 -2.217849
1.492429 1.492429 0.00 0.0133 4

Alternative hypothesis:
Augmented individual
Dickey-Fuller results AR coefs. (between-dimension)
(parametric)

Cross ID AR(1) Statistic

Variance Prob.Lag Max lag Obs
Group1rho-Statistic0.007 1.136623
10.11501 0.8722 0 0 4
2
Group PP-Statistic-0.032 3.490414
-1.728912 0.0419 0 0 4
3 -0.031
Group ADF-Statistic 214.1473
-1.660611 0.0484 0 0 4
4 -0.177 75.95825 0 0 4
5 -0.335 1.492429 0 0 4
Table 8.: Hypotheses Testing
Cross section specific results
No. HYPOTHESIS RESULTS TOOL
Phillips-Peron results (non-parametric)
HI a There is a long-term relationship between CCL Rejected Johansen co-
and EPS Cross ID AR(1) Variance HAC Bandwidth Obs
integration test
HI b 1
There is a long-term -0.242 0.456443
relationship between 0.456443
NLTA 0.00
Accepted 4
Johansen co-
and ROE 2 -0.137 0.209457 0.209457 0.00 4
integration test
3 0.193 7.925203 7.925203 0.00 4
4 -0.303 5.090130 5.090130 0.00 4
5 -0.583 0.482857 0.411534 1.00 4

Augmented Dickey-Fuller results (parametric)

Cross ID AR(1) Variance Lag Max lag Obs

1 -0.242 0.456443 0 0 4
2 -0.137 0.209457 0 0 4
3 0.193 7.925203 0 0 4
RELATIONSHIP OF LIQUIDITY AND PERFORMANCE 14

Conclusion

As concluded from the above calculations, working and discussion by analyzing the data

collected of the listed private banks and tested by Pearson correlation coefficient and concluded

that there is insignificant relationship between CCL and EPS and NLTA and EPS. And there is

significant relationship between CCL and NLTA with ROE. According to Johansen co-

integration test There is no long-term relationship between CCL and EPS and there is a long-

term relationship between NLTA and ROE.

Limitations

This research has been conducted by taking 5-year data of 5 private banks that are listed

in Pakistan stock exchange. Hence, it cannot be generalized to other categories and countries as

well. Sample and number of year can be increased for future research. More banks and models

can be applied for future researches, only correlation and Johansen co-integration been used in

this paper by researchers.

RELATIONSHIP OF LIQUIDITY AND PERFORMANCE 15

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