Final Version_Management Acctng

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An empirical study on the relationship between

Profitability Ratio

&

Liquidity Ratio

Sheikh Nasir Uddin

H. M. T. Tarikul Kamrul

Sadia


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Abstract

Financial ratios often act as a yardstick for the board of directors or shareholders (presentand would-be as well) to measure a companys performance. These ratios also serve as a

means to examine and establish new propositions and hypotheses. These ratios can be

obtained or derived from the corresponding organizations financial statements. Likewise,to find out a relationship (or no-relationship, at all) between two important ratios, namely,

profitability and liquidity ratio, we used and dissected financial statements of three

organizations. We focused on a particular industry to avoid confusion and interruption oftoo many unaccounted factors. We took data of three financial institutions to judge the

hypothesis that profitability and liquidity ratios indeed do have a relationship.

Objective

The main objective of this paper is to examine and observe the relationship between two

important types of financial ratios, liquidity and profitability ratios in context of financial

organizations. A trend analysis has also been done of these two through this process.


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Introduction

Financial statement analysis is a technique that is used frequently to analyze accountingand other data. Financial ratios represent short-term measures of operating performance

rather than the more relevant long-term performance. Profitability and liquidity ratios are

twp such measures that help provide an overview of a companys operation andperformance. Profitability ratios measure the firm's use of its assets and control of its

expenses to generate an acceptable rate of return where as Liquidity ratios measure the

availability of cash to pay debt. Theoretically these two have no certain intersecting pointas both are calculated considering different factors related. Moreover, conventional

financial statement analysis alone is not sufficient to serve as a basis to judgment and

come upon a decision. But as per the requirements of the course we proceed with the

financial data available and tried to come to a conclusion.


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Methodology

The information required to prepare the report was obtained from the annual reports ofthe three financial institutes, Delta Brac Housing Finance Corporation Ltd., Premier Bank

and Union Capital Limited. Since we cannot avail more, we took 5 years data from each

of these companies. Among various methods of profitability ratios we chose 5, Operating Income Ratio, Net Income Ratio, Return on Asset Ratio, Return on Equity Ratio and

Earning per Share (EPS). And we compare each of these ratios with 3 types of liquidity

ratio, Current Ratio, Quick Ratio and Debt-Equity Ratio.

We used the Spearman's Rank Correlation* to establish whether there is any relationship

between Profitability ratio and Liquidity ratio.

* Spearman's Rank Correlation is a technique used to test the direction and strength of the relationship

between two variables. In other words, its a device to show whether any one set of numbers has an effect

on another set of numbers. It uses the statistic Rs which falls between -1 and +1.


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Brief descriptions of the samples consideredA. Delta Brac Housing Finance Corporation Limited (DBH):

(DBH) is the pioneer, the largest and the specialist Housing Finance Institution in the

private sector of the country. After commencing operation in the early 1997, the companyhas registered commendable growth in creating home ownership among more than 7,500

families in Dhaka and other major cities of the country. At the same time, the companyhas been playing an active role in promoting the real estate sector to the large cross

sections of prospective clients who had but yet unfulfilled dream of owning a sweet

home.

Among all Banks and Financial Institutions of Bangladesh only DBH has been rated thehighest 'AAA' credit rating. The level of credit rating provides a very important indication

of the financial safety, security and strength of the concerned Bank or Financial

Institution and is particularly relevant to its depositors and other investors such as

shareholders and lenders.

DBH is an international joint venture organization promoted by five institutions: three

local shareholder organizations and two international partners.

Local Promoters

Delta Life Insurance Company Limited-The leading life insurance company in theprivate sector of the country.

BRAC- The largest national NGO of the world, having deep presence in the country and

contributing in the socio-economic development of the country.

Green Delta Insurance Company- The leading and pioneer general insurance companyin the private sector of the country

International partners

HDFC: A pioneer in the area of private sector housing finance in India and the most

successful housing finance institution in the South Asia bring to DBH technological andbusiness expertise making the proper recommendations in relation to products, policies,

systems and proceduresIFC: The private sector arm of the World Bank Group. Both local and foreign

shareholders come together with an objective to channel resources into providing financefor the people basic need for shelter, enhance housing stock of the country and promote

affordable home ownership.

B. Premiere Bank Limited

The Premier Bank Limited is incorporated in Bangladesh as banking company on June

10, 1999 under Companies Act.1994. Bangladesh Bank, the central bank of Bangladesh,issued banking license on June 17, 1999 under Banking Companies Act.1991. The Head


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Office of The Premier Bank Limited is located at Banani, one of the fast growing

commercial and business areas of Dhaka city. At present there are 27 branches and 8

proposed branches.

C.Union Capital LimitedUnion Capital Limited is one of the largest investment banks and fastest growing

financial institutions in Bangladesh. Previously, it was known as Peregrine Bangladesh

which had its origins and businesses rooted in Hong Kong. Out of the local office of theerstwhile Peregrine Capital Limited of Hong Kong, Union Capital Limited, Dhaka

emerged in early 1998 as a Bangladesh-based company led by a group of the foremost

entrepreneurs of the country. Union Capital, within a short span of time, has proved its

worth as a most forward-working vigorous organization achieving success with its wideinternational network and strong local base.

Union Capital is an entrepreneurial company that prides itself on its speed of through and

action. Its ability to make decisions quickly and efficiently and to generate value as anagent and executor sets it apart from all other investment banks and financial institutionsin Bangladesh. The company's strategy is to focus on Bangladesh and to develop a truly

global distribution network through the major investment institutions abroad. SES

Company Limited, which is wholly owned by Union Capital, has seats in both the Dhakaand Chittagong stock exchanges. This provides Union Capital with unmatched local

distribution capabilities to retail and institutional investors throughout the world in

relation to securities originating in Bangladesh.

Union Capital is dedicated to provide a high level of professional and personalizedservice to its domestic and international clients. Preferential treatment and superior

service to clients is what the company believes to be its ultimate goal.

As a full-service investment bank, Union Capital offers public issue management,

portfolio management, merger & acquisition, joint venture, corporate finance advice,securities dealing, research and underwriting capabilities in the financial markets of

Bangladesh. Union Capital also offers capital market fund-raising expertise which is

supported by a global distribution network. The company's strong business contactsprovide it with unrivalled access to investment opportunities for multi-national and local

companies seeking sound and properly financed business projects in Bangladesh.

Union Capital is the only institution having three unique advantages in common, which

no other institutions can match in the capital market of Bangladesh. Union Capital is

>> SEC approved Merchant Banker (Investment Banking concern),

>> Central Bank (the Bangladesh Bank) licensed Financial Institution, and


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>> On-the-ground access to the Stock Exchanges through wholly owned

subsidiary company, which has Corporate Memberships both at Dhaka and

Chittagong stock exchanges.

Union Capital is a public limited company having a profitable and dividend payment

track record.


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Theories behind the Analysis at a glance

Liquidity Ratios

Liquidity Ratios are used to indicate a companys short-term debt-paying ability.

1. Current Ratio: Current Assets

Current Liabilities

A companys current assets divided by its current liabilities is known as current ratio andtests the short-term debt paying ability of a firm.

2. Quick Ratio: Quick Assets

Current LiabilitiesThe quick or act ratio tests a companys ability to meet short-term obligations without

having to rely on inventory. It determines the immediate debt paying ability of a firm.

3. Debt-to-Equity ratio: Total LiabilitiesStockholders' equity

The debt to equity ratio indicates the relative proportion of debt and equity on thecompany's balance sheet.

Profitability Ratios

Operating Income Ratio, Net Income Ratio, Return on Asset Ratio,Return on Equity

Ratio andEarning per Share (EPS)

Return on Equity (ROE)

Net IncomeAverage stockholders equity

From the stockholders point of view, an important measure of the income producingability of a company is the relationship of net income to average common stockholders

equity also called the return on equity (ROE).

Earnings per Share (EPS): Earnings available to common shareholdersNo. of shares outstanding

The earning per share is the most widely used measure of a companys operationalsuccess. It is very important to the investors since it indicates how much they can earn on

each share. The EPS usually plays a major role in determining the market price of a

share.


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Procedure for using Spearman's Rank Correlation

1. State the null hypothesis i.e. "There is no relationship between the two sets of

data."2. Rank both sets of data from the highest to the lowest. Make sure to check for tied

ranks.3. Subtract the two sets of ranks to get the difference d.

4. Square the values of d.5. Add the squared values of d to get Sigma d2.

6. Use the formula Rs = 1-(6Sigma d2/n3-n) where n is the number of ranks you have.

7. If the Rs value...... is -1, there is a perfect negative correlation.

...falls between -1 and -0.5, there is a strong negative correlation.

...falls between -0.5 and 0, there is a weak negative correlation.

... is 0, there is no correlation

...falls between 0 and 0.5, there is a weak positive correlation.

...falls between 0.5 and 1, there is a strong positive correlation...is 1, there is a perfect positive correlationbetween the 2 sets of data.

8. If the Rs value is 0, state that null hypothesis is accepted. Otherwise, say it is

rejected.

The following hypotheses have been tested while we applied the Spearmans Rank

Correlation.

H0: There is no significant relationship between the Profitability and the Liquidity.

H1: There is a significant relationship between the Profitability and the Liquidity.


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Interpretation of the Financial Ratios

A. DBH:

(i) Liquidity Ratio:

Companys current ratio is in increasing trend. It implies that the company is managing

its assets efficiently. Quick ratio of the company is also in rapid growing trend. It showsthat the companys liquidity situation is very good. But still the point is below 2 for both

current and quick ratio. The company still has more potential improve the liquidity

situation. Debt to equity ratio of the company is in a steady situation. It shows that the

investors can continue to invest in this company.

(ii) Profitability Ratio:

Operating ratios and Net income ratios are in decreasing trend for the company. The

company needs to continue its current profitability growth in the future to retain the

investors confidence on the company.

Current Ratio

0.9

11.1

1.2

1.3

2002-

2003

2003-

2004

2004-

2005

2005-

2006

2006-

2007

year

Quick Ratio:

00.5

11.5

2

2002-

2003

2003-

2004

2004-

2005

2005-

2006

2006-

2007

year

Debt-Equity Ratio

0

5

10

15

2002-

2003

2003-

2004

2004-

2005

2005-

2006

2006-

2007

year


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Return on equity and asset both are in growing situation. It shows the company

management is managing the company asset effectively and efficiently to have morereturn on investment of the stakeholders. Also EPS for the stakeholders are growing

rapidly for the company.

RETURN ON ASSET RATIO: DBH

2.4

2.6

2.8

3

3.2

3.4

2002-

2003

2003-

2004

2004-

2005

2005-

2006

2006-

2007

Year

RETURN ON ASSET RATIO: DBH

0

10

20

30

40

50

2002-

2003

2003-

2004

2004-

2005

2005-

2006

2006-

2007

Year

EPS: DBH

0

10

20

30

40

50

60

2002-

2003

2003-

2004

2004-

2005

2005-

2006

2006-

2007

Year

B. Premiere Bank:

(i) Liquidity Ratio:

Current and quick ratio is in decreasing trend for the company. It shows that company isnot in a good condition to re-pay its debt in the short term. Also the debt to equity ratio is

in increasing trend, which shows the debt situation is worsening for the company.

Operating Income Ratio

0

10

20

30

40

2002-

2003

2003-

2004

2004-

2005

2005-

2006

2006-

2007

Year

Net Income Ratio

0

510

15

20

2002-

2003

2003-

2004

2004-

2005

2005-

2006

2006-

2007

Year


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Quick Ratio: Prem iere

0

0.5

1

1.5

2

2.5

2001 2002 2003 2004 2005 2006

Year

Debt to Equity: Premiere

0

5

10

15

20

25

2001 2002 2003 2004 2005 2006

Year


Companys net income and operating income ratio both are in decreasing trend. Also the

Return on Asset and Return on Equity of the company is not in a good trend. EPS is alsodecreased in the recent years for the company. It shows that companys profitabilitysituation is not in a very good shape. Company needs turn around the current profitability

situation immediately to regain and sustain the investors confidence and reliability on the

company.

Current Ratio

0

0.5

1

1.5

2

2.5

2001 2002 2003 2004 2005 2006

Year


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Operating Ratio

0

20

40

60

80

100

120

2001 2002 2003 2004 2005 2006

Year

Net Income Ratio

0

10

20

30

40

2001 2002 2003 2004 2005 2006

Year

ROA

0

1

2

3

4

5

6

2001 2002 2003 2004 2005 2006

Year


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C. Union Capital Limited:

(i) Liquidity Ratio:Current and quick ratio (both are same) of the company is in slight decreasing trend in the

recent year. Also the debt to equity ratio is in decreasing trend. It implies that companys

strong debt paying ability is deteriorating in the recent time, which needs s to control bythe management.

ROE

0

5

10

15

20

25

30

35

2001 2002 2003 2004 2005 2006

Year

EPS

0

20

40

60

80

100

2001 2002 2003 2004 2005 2006

Year

Current/Quick Ratio

0

0.5

1

1.5

2

2.5

3

2001 2002 2003 2004 2005 2006

Year

Debt to Equity Ratio

0

2

4

6

8

10

2001 2002 2003 2004 2005 2006

Year


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Companys net income and operating income scenario at its peak in 2005, but the

company lose its growing trend in 2006. Also Return on Asset and Return on equity are

not stable for the company. EPS is in decreasing trend for the company for last 6 years. Itshows, the company is heavily investing in the company.

Operating Ratio: Union

0

5

10

15

20

25

30

35

2001 2002 2003 2004 2005 2006

Year

Net Income Ratio: Union

0

5

10

15

20

25

30

35

2001 2002 2003 2004 2005 2006

Year

ROA: Union

0

1

2

3

4

5

6

2001 2002 2003 2004 2005 2006

Year

ROE: Union

0

5

10

15

20

25

2001 2002 2003 2004 2005 2006

Year

EPS: Union

0

1

2

3

4

5

6

7

2001 2002 2003 2004 2005 2006

Year

Analysis Based on Spearmans Rank Correlation

A. DBH:

(i) Current Ratio and Operating Income Ratio:


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Calculating the last 5 years ratio, rank correlation coefficient of the above two ratio is

-0.4. It shows a weak negative correlation between the two.

(ii) Current Ratio and Net Income Ratio:

Calculating the last 5 years ratio, rank correlation coefficient of the above two ratio is 0.5.

It shows a weak positive correlation between the two.

(iii) Current Ratio and Return on Asset:

Calculating the last 5 years ratio, rank correlation coefficient of the above two ratio is 0.5.It shows a weak positive correlation between the two.

(iv) Current Ratio and Return on Equity:



(v) Current Ratio and EPS:Calculating the last 5 years ratio, rank correlation coefficient of the above two ratio is 0.8.

It shows a strong positive correlation between the two.

(vi) Quick Ratio and Operating Income Ratio:


-0.7. It shows a Strong negative correlation between the two.

(vii) Quick Ratio and Net Income Ratio:

Calculating the last 5 years ratio, rank correlation coefficient of the above two ratio is 0.3.It shows a weak positive correlation between the two.

(viii) Quick Ratio and Return on Asset :Calculating the last 5 years ratio, rank correlation coefficient of the above two ratio is 0.3.


(ix) Quick Ratio and Return on Equity:


It shows a Strong positive correlation between the two.

(x) Quick Ratio and EPS:

Calculating the last 5 years ratio, rank correlation coefficient of the above two ratio is 1.

It shows a perfect positive correlation between the two.

(xi) Debt to equity Ratio and Operating Income Ratio:

Calculating the last 5 years ratio, rank correlation coefficient of the above two ratio is-0.7. It shows a Strong negative correlation between the two.

(xii) Debt to equity Ratio and Net Income Ratio:


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It shows no correlation between the two.

(xiii) Debt to equity Ratio and Return on Asset:


It shows no correlation between the two.

(xiv) Debt to equity Ratio and Return on Equity:

Calculating the last 5 years ratio, rank correlation coefficient of the above two ratio is 1.It shows a Perfect Positive correlation between the two.

(xv) Debt to equity Ratio and EPS:

Calculating the last 5 years ratio, rank correlation coefficient of the above two ratio is 0.9.It shows a Very Strong Positive correlation between the two.

From the rank correlation findings, we can see that Current ratio and Quick ratio are

correlated with the companys operating and net income and also with the Return on assetand Return on Equity. The ratios are highly correlated with EPS of the company.

Moreover companys operating income is negatively correlated with the current andquick ratio. The fact shows that when you better manage or pay your interest and debts to

the creditors, your operating profit goes down. It implies that the firms asset

management system will highly impact on its profitability. Companys debt-equity ratio

highly correlated with net income, return on equity and EPS. On the other hand debt-equity ratio has no correlation with net income and return on asset. It shows that

companys debt paying status is highly correlated with its net income and shareholders

earnings.

B. Premiere Bank:

(i) Current Ratio and Operating Income Ratio:Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is

0.54. It shows a Strong positive correlation between the two.



0.42. It shows a weak positive correlation between the two.

(iii) Current Ratio and Return on Asset:Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is


(iv) Current Ratio and Return on Equity:



(v) Current Ratio and EPS:


0.02. It shows a very weak positive correlation between the two.


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Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is0.54. It shows a Strong positive correlation between the two.

(vii) Quick Ratio and Net Income Ratio:Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is


(viii) Quick Ratio and Return on Asset :



(ix) Quick Ratio and Return on Equity:




Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is0.08. It shows a very weak positive correlation between the two.


Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is-0.77. It shows a Strong negative correlation between the two.


Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is-0.77. It shows Strong negative correlation between the two.

(xiii) Debt to equity Ratio and Return on Asset:Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is

-0.7. It shows Strong negative correlation between the two.

(xiv) Debt to equity Ratio and Return on Equity:



(xv) Debt to equity Ratio and EPS:Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is

-0.14. It shows a Very weak negative correlation between the two.

From the rank correlation findings, both Current and quick ratio are positively correlated

with the entire profitability ratio. Among the profitability ratio, the liquidity ratios has

strong correlation with the Operating income and Return on Equity of the Shareholders.On the other hand the profitability ratios have strong negative correlation with the debt-

equity ratio. It implies that as the company debt-equity ratio gone high, the companys

profitability will hamper.


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Null hypothesis is rejected. Profitability and Liquidity are closely related with one

another.

C. Union Capital Limited

(i) Current Ratio and Operating Income Ratio:


It shows a strong positive correlation between the two.



0.77. It shows a strong positive correlation between the two.

(iii) Current Ratio and Return on Asset:



(iv) Current Ratio and Return on Equity:Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is


(v) Current Ratio and EPS:Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is




It shows a Strong positive correlation between the two.

(vii) Quick Ratio and Net Income Ratio:

Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is0.77. It shows a strong positive correlation between the two.

(viii) Quick Ratio and Return on Asset:

Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is-0.03. It shows a weak negative correlation between the two.

(ix) Quick Ratio and Return on Equity:Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is






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Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is -1.

It shows a perfect negative correlation between the two.


Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is-0.94. It shows a very strong negative correlation between the two.

(xiii) Debt to equity Ratio and Return on Asset:Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is

-0.6. It shows a strong negative correlation between the two.

(xiv) Debt to equity Ratio and Return on Equity:Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is

0.09. It shows a very weak negative correlation between the two.

(xv) Debt to equity Ratio and EPS:Calculating the last 6 years ratio, rank correlation coefficient of the above two ratio is

0.08. It shows a weak Positive correlation between the two.

From the rank correlation findings, we can see that current and quick ratio both have

strong positive correlation with the companys operating income and net income and

negative correlation with companys ROA, ROE and EPS. On the other hand debt-equityratio has strong negative correlation with operating income, net income, ROA of the

company and positive correlation with Shareholders earnings.

Considering the Total Rank Correlation Coefficient Ratio

A. DBH:

Total rank correlation coefficient of Profitability Ratios and Liquidity Ratio are 0.8. Thisshows a very strong positive correlation between the two.

So, the null hypothesis is rejected.

B. Premiere Bank:

Total rank correlation coefficient of Profitability Ratios and Liquidity Ratio are 0.64. This

shows a very strong positive correlation between the two.So, the null hypothesis is rejected.

C. Union Capital Limited:


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Total rank correlation coefficient of Profitability Ratios and Liquidity Ratio are 0.51. This

shows a very strong positive correlation between the two.

So, the null hypothesis is rejected.

Profit and Liquidity Trend:

A. Union CapitalFrom the actual profit and total asset figures of the Union Capital limited, we can see that

the profit is closely correlated with the current asset or liquidity condition of the

company. In 2005 company made the highest profit, when companys current assets werealso highest and in 2006 the profit drops as a consequence of companys current asset

loss.

Profitability (Mill.)

1311

14

29

40

11

0

5

10

15

2025

30

35

40

45

2001 2002 2003 2004 2005 2006

Year

Profit

Profit (Mill)

Current Asset (Mill)

-9 -7 -7

225

267

237

-50

0

50

100

150

200

250

300

2001 2002 2003 2004 2005 2006


B. Premiere Bank

Premiere Banks profitability and current asset was correlated in last couple of years. Aswe can see, Premiere bank earn the highest profit in 2004 when companys current asset

increase by huge margin. We can see negative correlation between profitability andcurrent asset of the company in last two years. Though companys current asset increase,

but profit falls in back to back two years. It is due to failure of efficient banking operation

of the bank managements, as they are unable to give required loans and creditors to thecustomer.


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Profitability (Mill)

0

100

200

300

400

500

2001 2002 2003 2004 2005 2006

Year

Profit

Profit (Mill)


0

5000

10000

15000

20000

25000

30000

2001 2002 2003 2004 2005 2006

Year

AssetValue

Current Ass et (Mill)

C. DBH:

DBHs profitability and liquidity situation is fully related with one another as one grows

another follows and vice versa. The company is growing in a consistent way in last fiveyears and profitability is highest in the last year when liquidity condition is also at it

peaks.


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Profitability (Mill)

0

20

40

60

80

100120

140

160

2001 2002 2003 2004 2005

Year

Profit

Profit (Mill)


0

500

1000

1500

2000

2500

3000

2001 2002 2003 2004 2005

Year

Value Current Asset (Mill)

From the above analysis we can strongly say that, Profitability and liquidity of the above

company is strongly correlated with one another, which is also supported by the rank

coefficient correlation analysis earlier. So, report Null hypothesis is strongly rejected.


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Conclusion


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Bibliography

Both the Accounting books of our course.

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