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The IUP Journal of Accounting Research and Audit Practices:
The Impact of Liquidity and Leverage on Profitability: Evidence from India
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The combination of liquidity variables and capital structure variables has been always a major concern for the financial managers in different companies. The present study attempts to analyze the relationship between liquidity and profitability and investigate the impact of financial leverage and liquidity on the financial performance of select pharmaceutical companies for the period from 2006-07 to 2015-16. The results of the study show that the liquidity of the companies which is reflected in the ongoing ability to pay financial obligations, affects the firm’s capital structure. The increase in liquidity of the firm leads to decrease in the leverage and vice versa. However, no significant impact of leverage on profitability and capital structure is evidenced in the present study.

 
 
 

Liquidity plays a key role in the upliftment of a company. Liquidity is the ability of a company to meet the short-term obligations, and convert its assets into cash. Short-term liquidity generally signifies obligations which mature within one accounting year. It also reflects the operating cycle: buying, selling manufacturing, and collecting. A company that cannot pay its creditors on time and continues not to honor its obligations to the suppliers of credit, services, and goods can be declared a sick company or bankrupt company. Inability to meet the short-term liabilities may affect the company’s operations and in many cases it may affect its reputation too. Lack of cash or liquid assets on hand may force a company to miss the incentives given by the suppliers of credit, services and goods. Loss of such incentives may result in higher cost of goods which in turn affect the profitability of the business. So, there is no standard norm for liquidity. It depends on the nature of the business, scale of operations, location of the business and many other factors. Every stakeholder has interest in the liquidity position of a company. Supplier of goods will check the liquidity of the company before selling goods on credit. Employees also have interest in the liquidity, as they wish to know whether the company can meet its employees-related obligations, including salary, pension, provident fund, etc. Shareholders are interested in understanding the liquidity due to its huge impact on the profitability. Shareholders may not like high liquidity, as liquidity and profitability are inversely related. However, shareholders are also aware that non-liquidity will prevent the company from getting incentives from the suppliers, creditors, and bankers.

Capital structure is a mix of long-term sources of funds used by a firm. It is made up of debt and equity securities and refers to permanent financing of a firm. It is composed of long-term debt, preference share capital and shareholders’ funds. Decisions relating to financing of assets of a firm are crucial in every business and the finance manager is often caught in the dilemma over the optimum proportion of debt and equity capital in financing the firm’s assets. Capital structure is usually designed to serve the interest of the equity shareholders. Capital structure simply reflects the efficiency of a firm in term of its assets in use, financed through different options. Generally speaking, a company with a high level of debt as compared to equity is thought to carry higher risk, though some analysts do not believe that capital structure matters with regard to risk or profitability. Investment returns help to generate earnings through assets, which can be obtained by dividing the firm’s annual earnings by its total assets and it is shown as a percentage. Most often, it is considered as a ‘return on investment’. The capital of the firm represents the amount of fund which is used for the firm’s fixed assets, accounts receivable, marketable securities and inventories. Any business firm needs to be very selective in establishing the capital structure for the firm to achieve its objectives.

 
 
 

Leverage on Profitability ,Evidence from India,The Impact of Liquidity ,Combination of liquidity variables.