Ans 1: Introduction

The relationship between liquidity and profitability has remained a source of disagreement
among experts, researchers, professional financial analysts and even managements of profit-
oriented businesses. Therefore, views on the actual relative importance of each in business
enterprises have continued to differ.

Liquidity is a basic thing 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 y
soon without a loss of value. Low liquidity leads to the inability of a company to pay its creditors
on time or honor its maturing obligations to suppliers of credit, services and goods. This could
result in losses on account of non-availability of supplies and lead to possible insolvency. Also,
the inability to meet the short term liabilities could affect the company's operations and in many
cases it may affect its reputation as well. Inadequate cash or liquid assets on hand may force a
company to miss the incentives given by the suppliers of credit, services, and goods as well. Loss
of such incentives may result in higher cost of goods which in turn affects the profitability of the
business. Every stakeholder has an interest in the liquidity position of a company. Suppliers of
goods will check the liquidity of the company before selling goods on credit. Employees should
also be concerned about the company's liquidity to know whether the company can meet its
employee related obligations, i.e.,

salary, pension, provident fund, etc. Thus, a company needs to maintain adequate liquidity.

Profitability is a measure of the amount by which a company's revenues exceed its relevant
expenses.

Profitability ratios are used to evaluate the management's ability to create earnings from revenue-
generating bases within the organization. The profitability position of a company is measured
using the Return on Assets.

There is an inverse relationship between profitability and liquidity. The higher the liquidity the
lower will be the profitability and vice versa. Liquidity and profitability are competing goals for
the Finance Manager. Under liquidity management, the Finance Manager is expected to manage
all its current assets including near cash assets in such a way as to ensure to minimize costs.

Sometimes, even if the profit from operations is higher, the firm may face liquidity problems due
to the fact that the amount representing the profit may be in the form of either in fixed assets like
plant, buildings etc. or in the form of current assets like inventory, debtors – other than in the
form of cash and bank balances. In situations where the firm faces the liquidity problems, will
hamper the working of the company which result in lower profitability of the firm.

Lack of liquidity may lead to lower rate of return, loss of business opportunities etc. Therefore, a
firm should maintain a trade-off situation where the firm maintains its optimum liquidity for
greater profitability and the Finance Manager has to strike a balance between these two
conflicting objectives. If more assets of the firm are held in the form of highly liquid assets, it
will reduce the profitability of the firm. The corporate liquidity is a vital factor in business.

Conclusion

Working capital management is an important part in firm financial management decisions. The
optimization of working capital management is could be achieved by firm that manage the
tradeoff between profitability and liquidity. The purpose of this study is to investigate the
liquidity management efficiency and liquidity profitability relationship. The results of this study
found that correlation and regression results are significantly positive associated to the firm
profitability. All of our variables i.e. Inventory Turnover, Creditors Turn over, Quick Ratio,
interest Coverage Ratio, Firm Size are contributing positively towards the profitability of the
firm which are measured by Return on Assets Ratio while the 2 Ratios i.e.

Debt to Equity and Debtors Turnover are negatively correlated to ROA because when the
element of Debt is increased in the Capital Structure of a company then the Risk of the Firm is
also increased which ultimately leads towards the increased Weighted Average Cost of the
Capital (WACC) and when DTR increases that means firm’s tight their credit policy and that
leads towards the decreased sales and ultimately decreased profitability of the firm. Thus, firm
manger should concern on inventory and receivables in the purpose of creating shareholder
wealth.

Ans2. Introduction: In simpler words, the CAMELS rating system is used by the RBI officials to
assess the strength of a bank through the six categories. These include capital adequacy, assets,
management capability, earnings, liquidity, and sensitivity.

Through the CAMELS parameters, the RBI, one of the prime Regulators of Banks and Financial
Institutions in India, rates the banks on a scale of 1 to 5. While the best rating of 1 is given to
banks that are financially stable as far as the risks are concerned, a worst rating of 5 is given in
the other case. Now let us know about each of the parameters in the acronym CAMELS to
understand the system in a much better way.

C: Capital Adequacy

A: Asset Quality
 M: Management

E: Earnings

L: Liquidity

S: Sensitivity

Capital Adequacy

Examiners assess institutions' capital adequacy through capital trend analysis. Examiners also
check if institutions comply with regulations pertaining to risk-based net worth requirements. To
get a high capital adequacy rating, institutions must also comply with interest and dividend rules
and practices. Other factors involved in rating and assessing an institution's capital adequacy are
its growth plans, economic environment, ability to control risk, and loan and investment
concentrations.

Asset Quality

Asset quality covers an institutional loan's quality, which reflects the earnings of the institution.
Assessing asset quality involves rating investment risk factors the bank may face and balance
those factors against the bank's capital earnings. This shows the stability of the bank when faced
with particular risks. Examiners also check how companies are affected by the fair market value
of investments when mirrored with the bank's book value of investments. Lastly, asset quality is
reflected by the efficiency of an institution's investment policies and practices.

Management

Management assessment determines whether an institution is able to properly react to financial

stress. This component rating is reflected by the management's capability to point out, measure,
look after and control risks of the institution's daily activities. It covers management's ability to
ensure the safe operation of the institution as they comply with the necessary and applicable
internal and external regulations.

Earnings

A bank's ability to produce earnings to be able to sustain its activities, expand, remain
competitive are a key factor in rating its continued viability. Examiners determine this by
assessing the bank's earnings, earnings' growth, stability, valuation allowances, net margins, net
worth level, and the quality of the bank's existing assets.

Liquidity
To assess a bank's liquidity, examiners look at interest rate risk sensitivity, availability of assets
that can easily be converted to cash, dependence on short-term volatile financial resources and
ALM technical competence.

Sensitivity

Sensitivity covers how particular risk exposures can affect institutions. Examiners assess an
institution's sensitivity to market risk by monitoring the management of credit concentrations. In
this way, examiners are able to see how lending to specific industries affects an institution. These
loans include agricultural lending, medical lending, credit card lending, and energy sector
lending. Exposure to foreign exchange, commodities, equities, and derivatives are also included
in rating the sensitivity of a company to market risk.

Objectives of the CAMELS Rating System

The CAMELS Rating System is considered to be highly effective in determining the risk levels
of the financial institutions. Hence, below are the main purposes for which the CAMELS Rating
System is used:

Operational Condition: The CAMELS rating system evaluates a bank's liquidity position and
manages risks to ensure a sound operational environment.
Managerial Condition: It indicates the management's efficiency to handle risks, liquidity
position, and managing sources of funds.

Financial Condition: It helps determine the financial soundness and stability of the financial
institution.

Ans 3a. Introduction

NPA expands to non-performing assets (NPA). Reserve Bank of India defines NPA as any
advance or loan that is overdue for more than 90 days. “An asset becomes non-performing when
it ceases to generate income for the bank,” said RBI in a circular form 2007. To be more attuned
to international practises, RBI implemented the 90 days overdue norm for identifying NPAs has
been made applicable from the year ended March 31, 2004. Depending on how long the assets
have been an NPA, there are different types of non-performing assets as well.

Categories of NPA

There are different types of non-performing assets depending on how long they remain in the
NPA category.

a) Sub-Standard Assets

b) Doubtful Assets

c) Loss Assets

Reasons for the rising Non-Performing Assets in the Indian banking sector

It is seen that the Indian banking sector is going through severe problems due to rising NPAs.
However, the problems related to bad loans in public sector banks are much more than in private
banks. Some important reasons are:

1. Credit boom: At the time of the credit boom in the year 2003-2004, it was seen that the
problem of rising NPA was increasing rapidly. During this period, the world economy and the
Indian economy were flourishing. Seeing this scenario, many Indian firms borrowed huge
amounts to take advantage of the opportunities and grow their businesses.

2. Tightened Monetary Policy: During that time, the Reserve Bank of India tightened the
monetary policy in the country. It increased the repo rate and reserve repo rate. Rising cases of
NPAs were still prevalent even after those steps were taken.
3. Stalled Judiciary & Legislative Procedures: The courts in India gave judgements that were
not in favour of businesses. The judgements negatively affected businesses, specifically the
mining, power and steel divisions. Furthermore, the businesses had to face problems regarding
the acquisition of land because of which many projects got stalled due to which the repayments
have been not done by many current NPA defaulters.

4. Intentional Defaults: It is also observed that many borrowers are totally competent to pay the
loan, but they are deliberately not paying. Such people must be identified, and appropriate
measures should be taken to recover the money lent to them.

5. Poor Credit Appraisal System: The lack of proper credit appraisal is another factor for the
rise in NPAs. Because of poor credit appraisal, sometimes the bank gives loans to those who
cannot pay back the loan.

6. Natural Calamities: Natural calamities are also a factor creating an alarming rise in NPAs in
public sector banks. India is hit by one or the other major natural calamity very often that causes
failure of repayment of loans by the borrowers. Generally, the farmers are dependent on rainfall
for their crops. However, the irregularity in rainfall reduces the production level of the farmer,
and as a result, he is unable to repay the loan.

Ans 3b. The SARFAESI Act full form is – “Securitization and Reconstruction of Financial
Assets and Enforcement of Security Interest Act”.

The SARFAESI Act allows banks and other financial institutions for auctioning commercial or
residential properties to recover a loan when a borrower fails to repay the loan amount.

Thus, the SARFAESI Act, 2002 enables banks to reduce their non-performing assets through
recovery methods and reconstruction.

The SARFAESI Act provides that banks can seize the property of a borrower without going to
court except for agricultural land. SARFAESI Act, 2002 is applicable only in the cases of
secured loans where banks can enforce underlying securities such as hypothecation, mortgage,
pledge etc.

An order from the court is not required unless the security is invalid or fraudulent. In the case of
unsecured assets, the bank would have to go to court and file a civil case against the defaulters.

Methods of Recovery Under SARFAESI Act, 2002

The SARFAESI Act provides the following three methods of recovery of the Non-
Performing Assets (NPAs):

 Securitisation : Securitisation is the process of issuing marketable securities backed by a

pool of existing assets such as home or auto loans. An asset can be sold after it is
 converted into a marketable security. A securitization or asset reconstruction company
can raise funds from only the Qualified Institutional Buyers (QIBs) by forming schemes
for acquiring financial assets.

 Asset Reconstruction : Asset reconstruction empowers asset reconstruction companies.

It can be done by managing the borrower’s business by selling or acquiring it or by
rescheduling payments of debt payable by the borrower as per the provisions of the Act.

 Enforcement of security without the interruption of the court. The Act empowers
banks and financial institutions to issue notices to individuals who have obtained a
secured asset from the borrower for paying the due amount and claim to a borrower’s
debtor to pay the sum due to the borrower.