How liquidity management and financial leverage improve the financial performance of firms

Document Type:Research Paper

Subject Area:Finance

Document 1

Working capital management is a broad component of liquidity management is seen as a safe cushion in provision of short-term funds for current liabilities and short term operations in companies. As such, working capital and especially liquidity of assets has contributed greatly in capital restrains of the company as per its financial performance (Sanger, 2001). Liquidity management also takes good times during trouble moments of the firm. Other than liquidity, financial leverage, overtrading, solvency and other management risks have a positive or negative correlation with the company performance including profitability and the entire management. Financial leverage is the extent to which a firm uses debt financing and equity financing in carrying out its daily operations. Overtrading is performing large volume of work at a short time using the available limited capital. Profitability is a margin that arises between the company revenues and expenses. It is when revenues than flows into a company supersedes the level of expenses flowing out of the company during sales and business operations. Theoretical review Several research and articles came have up with various methodologies of how to address the great concept about liquidity management techniques and financial leverage of firms along with solvency and other related knowledge of improving the overall financial performance of small and medium enterprise. After critically analyzing the past research and relating the findings with the current business dynamic environment in terms of financial liquidity, some of the areas to be covered in this research will include; the extent to which high liquid assets can affect the general performance of firms, liquidity techniques to be used to effectively manage cash cycle of business, the role of the management in determining the right amount of working capital and the impact of overtrading with long-term financial leverage in firms.

Sign up to view the full document!

This theory majorly can be applicable to companies because most follow strict laws that are laid or amended either by the state or strict rules by the financial institutions offering the loans Shift-ability Theory Unlike anticipated income which has dwelled so much on firms ensuring proper phasing and structuring of loan commitments, , the theory asserts that, the ability of the private company to hold assets could be shifted or sold to lenders or shareholders for cash to boost the cash cycle in the business. The theory recognizes and satisfies the fact that shift-ability, transferability and marketability of company assets is the main base for ensuring liquidity management in private firms. In addition, the theory supports the idea that, highly marketable securities held by private firms are clear indicators for managing liquidity.

Sign up to view the full document!

Sharma & Kumar (2011) narrated that, liquidity management consists of activities involved in obtaining cash resources while determining the appropriate capital structure mix for funds to flow into the company while shifting assets with ease into cash. Empirical review This section will try as much as possible to draw a vivid comparison on studies done while majorly analyzing various research articles and journal books written by qualified researchers who strived to provide a great scope of knowledge on liquidity management, its impact on financial performance and other concepts related to the research topics. Finally, the dishonored risks which arises from calls from the company management to honor maturity obligations. If a firm has enough of liquid assets, they are high chances of the firm to benefit from cash discounts on purchases and this feature is crucial since it will result in increased return on investment.

Sign up to view the full document!

If the company is not in any financial capacity to pay creditors within the specified time given, they will be required to pay interest on the amount of purchases. This means, shortage in liquid assets or resources will lead to low cash discount and additional cost incurred in payment of the interest expense, (Narware, 2004). Low cash discount and incremental cost of interest payment will certainly decrease the company profits thus affecting the company state of financial performance in the long run. It is determined using the formula cost of goods sold/average inventory. Other ratios include working capital ratio which is also called the current ratio. It measures the ability of the company to pay off its short-term obligations. It is determined using the formula Current assets/ current liabilities. Quick ratio and collection ratio are other ratios that are helpful to the management of a firm in determining the working capital management requirement (Mathuva, 2015).

Sign up to view the full document!

Notional pooling This liquidity management technique does not allow movement or co-mingling of funds in the company business. The technique is also referred as interest offset pooling because the business credit balances are counterbalanced against the debit account balances and the net obtained will be used as part of the cash in liquid form. Notional Pooling improves the cash in liquid by offsetting surplus balances against the business debt of the company. Secondly, it reduces and may permanently remove short-term borrowing thus improving the cash cycle. There are more benefits of notional pooling which include the following: • Reduce costs of cash transfers • Reduce management time that could be used in converting assets to cash • Helps in improving internal control and discipline Cash concentration Occasionally, company policies, management rules and government policies may not support notional pooling and it may require that the management of the company should adopt cash concentration to manage cash cycle in the business.

Sign up to view the full document!

In their literature, investors traditionally were much restricted on trading using long-term financial leverage by being subjected to a condition of opening a margin account that would be operated as a brokerage instrument. Currently, several instruments of debt have emerged that allow leveraging to be easier. Minimal requirements are needed for an investor to get debt financing for trading in the company. Indicators of overtrading on financial leverage • Increase in the company receivables and inventory turnover • Rapid growth in the amount of current/fixed assets • Payment to lenders is pushed to increase the business volume • Too many lenders and shareholders with huge balances in the company • High debt ratio, that is, long-term liabilities much more than equity • Long-term loans exceeding limits and the firm tries to negotiate increased limits Overtrading with long-term financing according to Dann and Mikkelson is associated with serious business risks including high leverage risk, price movements and credit risks to the company.

Sign up to view the full document!

These risks pose a serious impact to the company operations that may end up causing bankruptcy and even dissolution. Financial performance as well as the progress of the firm is greatly influenced by liquidity levels and liquidity management techniques. The analysis here will be the impact of liquidity management on financial performance of the private companies. All companies are worried on uncertainties that face their operations in the market including fluctuation in prices and adverse weather conditions. With this, there is need for liquidity management that offsets the risks arising out of the fluctuations of market material prices. Liquidity management helps the commodity players to minimize business risks that face the company. It is because of this set data that the companies ended up performing very poorly in the market (Dyreng, Mayew, and Schipper, 2017).

Sign up to view the full document!

Different timeframes showed different liquidity positions according to Eljelly, (2004). Most first show a high liquidity position peak seasons of the business with high profitability levels being seen at this period too. On the other hand, the off-peak seasons gave a vice versa result in the performance of the company. Liquidity and leveraging/gearing Leveraging is any system including the utilization of obtained finances in the buy of an advantage, with the desire that the after duty pay from the benefit and resource value gratefulness will surpass the acquiring cost. Regardless of the possibility that money streams and benefits are adequate to keep up the continuous getting costs, credits might be called. This may happen precisely when there is little market liquidity and deals by others are discouraging costs. It implies that as things get terrible, use goes up, duplicating misfortunes as things keep on going down.

Sign up to view the full document!

This can prompt fast destroy, regardless of the possibility that the fundamental resource esteem decay is mellow or temporary. The hazard can be alleviated by arranging the terms of use, by keeping up unused space for extra getting, and by utilizing just liquid assets (Feng, L. Secondly, the companies should maintain the margin of leveraging and should perform business over and above the set margin to keep their financial performance at stake. Firms should hold more liquid assets and fewer capital assets for them to be more productive (Feng L. and Wang, 2017) Equally, the management of these companies should always evaluate the leverage levels in the capital structure to avoid cases of marginal calls. There is a positive relationship between liquidity management and financial performance of a firm and an inverse relationship between leveraging and liquidity management.

Sign up to view the full document!

REFERENCES Eljelly, A. Liquidity management, operating performance, and corporate value: evidence from Japan and Taiwan. Journal of multinational financial management, 12(2), 159-169 Dann, L. Mikkelson, W. Convertible debt issuance, capital structure change and financing-related information: Some new evidence. Journal of financial economics, 13(2), 157-186 Feng, Lu and Wang (2017), Productivity and liquidity management under costly financing: Journal of Corporate Finance Adediran, A. Effect of working capital management on firm profitability: Empirical evidence from India. Global Business Review, 12(1), 159-173. Ganesan, V. An analysis of working capital management efficiency in telecommunication equipment industry. Rivier academic journal, 3(2), 1-10 Deloof, M. Uyar, A. The Relationship of Cash Conversion Cycle with Firm Size and Profitability:An Empirical Investigation in Turkey. International Research Journal of Finance and Economics.

Sign up to view the full document!

From $10 to earn access

Only on Studyloop

Original template

Downloadable