International Journal of Empirical Finance Vol. 2, No. 4, 2014, 143-151

Liquidity-Profitability Relationship in Bangladesh Banking Industry Afia Akter1, Khaled Mahmud2 Abstract This study explored the relationship between liquidity (measured as current ratio) and profitability (measured as return on assets) in the banking industry in Bangladesh. We have considered twelve banks in four different sectors (Government banks, Islami banks, multinational banks and private commercial banks). We tried to figure out how much liquidity of a bank can explain its profitability. We ran linear regression to find out the extent of relationship between bank’s liquidity and profitability (significance level was 10%). Individually all the sectors show no significant relationship between liquidity and profitability. Even the overall banking industry shows the same result. We considers year just before recession (2006) to post-recession (2011). We showed graphically how liquidity and profitability of these sectors varied over last couple of years. Government banks showed variable liquidity, while other sectors were steady. But, there were much fluctuations in profitability in between these times in all the sectors. Finally, we concluded that based on our sample and category, there is no significant relationship between liquidity and profitability in banks of different sectors in Bangladesh. Keyword: Liquidity, Profitability, Relationship, Bangladesh, Banks. 1. Introduction Banking is one of the most sensitive businesses all over the world and they are playing very important role in economy. They do influence and facilitate to integrate the economic activities like resources mobilization, production activities, distribution of public finance, and often social wellbeing. Banking Sector of Bangladesh consists of private commercial Banks, islami banks, multinational bank, government banks, and the Central Bank of Bangladesh. Liquidity and profitability are two very crucial issues that organization’s management always considers evaluating the financial health of the company. There is an extensive body of literature that seeks to identify the determinants of financial performance of banks. Hultman and McGee (1989), and Peek et al. (1999) focus on the understanding of foreign bank’s performance in a particular country. In contrast, John (2004), and Khalid (2006) report the determinants of growth and bank’s profitability. It is widely acknowledged that liquidity is one of the driving factors affecting the likelihood of a bank failure (Arena 2008). Liquidity is a measure of the availability of cash for use in the day to day business. A liquid asset is one that is cash or can easily be turned into cash. Liquidity plays a crucial role to both the internal and external analysts because of its close relationship with day-to-day operations of a business (Bhunia, 2010). Weaker liquidity position poses a threat to the solvency as well as profitability of a firm and makes it unstable (Niresh, 2012). 'Current ratio' and the 'quick ratio' are two common measures of the liquidity of a company. Usually a high current ratio is considered to be an indicator of the firm's ability to promptly meet its shortterm liabilities. Profitability is a measure of the amount by which a firm’s revenues exceeds its relevant expenses (Niresh, 2012). It is the potential of making profits that encourage entrepreneurs to take risks to invest in a 1 2

Assistant Professor Department of Business Administration Northern University Bangladesh Assistant Professor Institute of Business Administration University of Dhaka Bangladesh

© 2014 Research Academy of Social Sciences http://www.rassweb.com

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A. Akter & K. Mahmud business, so the first role of profits is to reward owners for risks taken when investing in a business. Profitability is a measure of the amount by which a company's revenues exceeds its relevant expenses (Owolabi et al, 2011). A low profit margin would suggest ineffective management and investors would be hesitant to invest in the company. (Niresh, 2012). Gross profit margin is an indicator of the profit a business after cost of goods sold. This profit is earned before any administration, selling and so on. Net profit margin is an indicator of the amount of net profit after taking account of the cost of sales, the administration costs, the selling and distributions costs and all other relevant costs. Profitability ratios are used to evaluate the management's ability to create earnings from revenue-generating bases within the organization. Excessive liquidity indicates idle funds that don’t fetch any profits for the firm (Smith, 1980). On the other hand, insufficient liquidity might deteriorate firm’s credit standings and that might lead to forced liquidation of firm’s assets (Ajanth, 2013). Hence, the present study is an initiative to identify the relationship between liquidity and profitability of listed banks in Bangladesh. This study analyses the liquidity and profitability ratios of different sectors’ commercial banks in Bangladesh over a six-year period. The study has five sections. After this introduction, the net section is a review of related studies done previously. Section three discusses the methodology of the study. Section four focuses on results and analysis while fifth section concludes the study. Research Question The following questions are addressed to identify the relationship (if any) between liquidity and profitability:  Is there any relationship between liquidity and profitability in banks of Bangladesh?  What is the nature and extent of the relationship between liquidity and profitability in these banks? Objectives of the Study  To identify the relationship between liquidity and profitability in banking sector of Bangladesh.  To find the nature and extent of the relationship between liquidity and profitability. 2. Empirical Studies There have been a large number of empirical studies on liquidity profitability analysis of firms around the world (Ajanthan, 2012; Patel, 2013; Aminu, 2013; Nirish 2012). While a very limited number of studies emerge to include liquidity as an explanatory variable for bank profitability or vis-veras (Bordeleau, 2010). Moreover, there is not much study on Bangladesh. However, with the deteriorating health of the banking institutions and the recent surge of bank failures as a result of the current global financial crisis, it is justified that bank liquidity and profitability investigation started to increase from both scholars and industry specialists. To our knowledge, there is no existing empirical work directly focusing on the specific question considered in the current paper. However, we are able to draw on relevant concepts in some related literature dealing with relationship between liquidity and profitability of different sectors. Berger (1995) analyses the statistical relationships between bank earnings and capital for US banks over the period of 1983-1989. Berger applies the concept of the “Expected Bankruptcy Cost Hypothesis” in the realm of capital. It is also conceptually applicable to the impact of liquid assets on profitability. Lepetit et al. (2008) investigate the relationship between bank risk and profit structure. The study represents that banks expanding into non-interest income activities present higher insolvency risk than banks, which mainly supply loans. Demirgüç-Kunt and Huizinga (2010) support this finding of increased bank fragility associated with a high proportion of non-interest income and non-deposit funding. Bordeleau and Graham (2010) in their study found that the impact on profitability of a bank’s holdings of liquid assets (i.e., reserves) depends on the amount of funding that comes due in the short-term and on the 144

International Journal of Empirical Finance general state of the economic cycle. All else equal, if a bank is more reliant on short-term funding, it may need to hold more liquid assets in order to maximize profits and continue its operation. To find out the relationship between profitability and liquidity Raheman and Nasr (2007) conducted a study on several Pakistani firms listed on Karachi Stock Exchange and found that there is a strong negative relationship between liquidity and profitability. Eljelly (2004) in his paper found a significant negative relationship between the firm’s profitability and liquidity levels. The study also found that at industry level, however, the cash conversion cycle is of more importance as a measure of liquidity than current ratio. Similarly, Jose et al (1996) showed that day-to-day management of a firm’s short term assets and liabilities plays an important role in the success of the firm. The research conducted by Walt (2009) emphasizes more importance on profitability because profit can usually be turned into a liquid asset. Don (2009) expresses that liquidity is more important as immediate survival of the company depends on it. Lanberg and Valming (2009) conducted a study on companies listed on Shochholm Stock Exchange to find out the impact of liquidity on profitability. Their findings suggested that liquidity strategies do not have significant impact on Return On Assets (ROA). Owolabi et al (2011) express in their paper that the survival of a business depends on its liquidity. Its long-term survival, growth and expansion depend on profitability. Therefore both are important for any company. They investigate liquidity-profitability relationship in three different business sectors like banking, processing and manufacturing companies in Nigeria. The study results show that liquidity and profitability are negatively correlated in a banking organization while they are positively correlated in a manufacturing and processing organization. The study proofs that there is a trade-off between liquidity and profitability in the banking business and these two reinforce each other in the manufacturing and processing businesses. For the banking sector, more liquidity implies less profitability, and vice versa. The study shows the cause as a bank maintains liquidity as regulatory requirement. In conclusion, authors suggest banks should strike a balance between liquidity and profitability to meet regulatory requirement as well as shareholders’ wealth aspirations, where as Manufacturing firms should pursue profit maximization since so doing simultaneously enhances liquidity and Processing firms should always ensure adequate liquidity, especially raw material inputs, since it is necessary to remain in operation. 3. Methodology of the Study In this study, we tried to find out the relationship between liquidity and profitability in the selected banks in Bangladesh. The study used secondary data for these analyses. The bank-specific data being examined in this study are derived from both the income statements and balance sheets of commercial banks published in the website. In addition to this, scholarly articles from academic journals and relevant textbooks were also used. The sample of this study is confined to banking area consists of 12 banks. Since our study focuses on the relationship between liquidity and profitability relationship between domestic and foreign banks, we split the sample into four sub-samples according to their ownership namely; Multinational, Islamic, Public and Private sector. For liquidity measure we considered current assets-liabilities ratio, while profitability measure was considered Return on Asset (ROA) ratio. However, this study is based on time series data extracted from annual reports for the relevant six years period (from the 2006 to 2011). To determine the nature and extent of the relationship, collected data were analyzed by employing Correlation technique; regressions & descriptive statistics. A well-known statistical package like ‘Statistical Package for Social Sciences’ (SPSS) 16.0 Version was used in order to examine the data. Correlation analysis technique is used to determine the nature and extent of the relationship, while regression analysis technique is used to determine whether cause-and-effect relationship exists between liquidity and profitability. Correlation coefficient is computed from liquidity and profitability ratios derived from six-year financial statements of the selected banks. 145

A. Akter & K. Mahmud Simple linear regression model is used for empirical investigation and analysis of the relationship between liquidity and profitability. The model has designed based on assumed dual functional relationship of liquidity and profitability. The respective model’s theoretical version is profitability (PFTY) depends on liquidity (LQTY). Functionally, PFTY = f(LQTY) ………………………. I From these functional relationship, the simple linear regression model below is specified. PFTY = λ0 + λ1LQTY + µ ……………… II Where λ0 is the intercept of the regression lines and λ1 is the slope coefficient to capture the nature and effect of the relationship between the variables. µ is the stochastic term depicting influence of other factors that affect liquidity and profitability but which is not included in the model. 4. Results and Discussion We have run the regression for different categories of bank. Then we also have run the regression for the total banking industry of Bangladesh. So, results are presented into five categories. Regression Analysis Government Banks Source | SS df MS -------------+-----------------------------Model | 6.9715e-06 1 6.9715e-06 Residual | .000295723 14 .000021123 -------------+-----------------------------Total | .000302694 15 .00002018

Number of obs F (1, 14) Prob > F R-squared Adj R-squared Root MSE

= = = = = =

16 0.33 0.5747 0.0230 -0.0468 .0046

-----------------------------------------------------------------------------roa | Coef. Std. Err. t P>|t| [90% Conf. Interval] -------------+---------------------------------------------------------------cr | -.0021932 .0038177 -0.57 0.575 -.0089173 .0045309 _cons | .0106247 .0043217 2.46 0.028 .0030129 .0182364 ------------------------------------------------------------------------------

R-square is 2.30%. P-value is 0.575 > 0.10, which means at 90% level of significance there is no significant relationship between current ratio (CR) and return on asset (ROA). Private Commercial Banks Source | SS df MS -------------+-----------------------------Model | 2.7477e-06 1 2.7477e-06 Residual | .000365857 16 .000022866 -------------+-----------------------------Total | .000368604 17 .000021683

Number of obs F (1, 16) Prob > F R-squared Adj R-squared Root MSE

= = = = = =

18

0.12 0.7334 0.0075 -0.0546 .00478

-----------------------------------------------------------------------------roa | Coef. Std. Err. t P>|t| [90% Conf. Interval] -------------+---------------------------------------------------------------cr | -.0017218 .0049669 -0.35 0.733 -.0103934 .0069499 _cons | .0156689 .0051008 3.07 0.007 .0067635 .0245744 ------------------------------------------------------------------------------

R-square is 0.75%. P-value is 0.733 > 0.10, which means at 90% level of significance there is no significant relationship between current ratio (CR) and return on asset (ROA). Islamic Banks Source |

SS

df

MS

Number of obs

= 16

146

International Journal of Empirical Finance -------------+-----------------------------Model | .000034757 1 .000034757 Residual | .000627563 14 .000044826 -------------+-----------------------------Total | .000662319 15 .000044155

F (1,

14) = 0.78 Prob > F = 0.3934 R-squared = 0.0525 Adj R-squared = -0.0152 Root MSE = .0067

-----------------------------------------------------------------------------roa | Coef. Std. Err. t P>|t| [90% Conf. Interval] -------------+---------------------------------------------------------------cr | .061054 .0693363 0.88 0.393 -.0610688 .1831768 _cons | -.0488129 .0755046 -0.65 0.528 -.1817999 .0841741 ------------------------------------------------------------------------------

R-square value is 5.25%. P-value is 0.393 > 0.10, which means at 90% level of significance there is no significant relationship between current ratio (CR) and return on asset (ROA). Multinational Banks Source | SS df MS -------------+-----------------------------Model | .000159264 1 .000159264 Residual | .002839976 16 .000177498 -------------+-----------------------------Total | .00299924 17 .000176426

Number of obs F (1, 16) Prob > F R-squared Adj R-squared Root MSE

= = = = = =

18 0.90 0.3576 0.0531 -0.0061 .01332

-----------------------------------------------------------------------------roa | Coef. Std. Err. t P>|t| [90% Conf. Interval] -------------+---------------------------------------------------------------cr | .0206745 .0218259 0.95 0.358 -.0174311 .05878 _cons | -.0050405 .0222591 -0.23 0.824 -.0439023 .0338212 ------------------------------------------------------------------------------

R-square is 5.31%. P-value is 0.358 > 0.10, which means at 90% level of significance there is no significant relationship between current ratio (CR) and return on asset (ROA). Overall Banking Industry Source | SS df MS -------------+-----------------------------Model | 1.5144e-07 1 1.5144e-07 Residual | .005139561 66 .000077872 -------------+-----------------------------Total | .005139712 67 .000076712

Number of obs F (1, 66) Prob > F R-squared Adj R-squared Root MSE

= = = = = =

68 0.00 0.9650 0.0000 -0.0151 .00882

-----------------------------------------------------------------------------roa | Coef. Std. Err. t P>|t| [90% Conf. Interval] -------------+---------------------------------------------------------------cr | .0002293 .0052005 0.04 0.965 -.0084465 .0089051 _cons | .0137338 .0055405 2.48 0.016 .0044908 .0229768 ------------------------------------------------------------------------------

R-square is 0.00%. P-value is 0.965 > 0.10, which means at 90% level of significance there is no significant relationship between current ratio (CR) and return on asset (ROA). From all the regressions, we can see that there is no significant relationship between liquidity (CR) and profitability (ROA) in all types of banks and even in the overall banking industry in Bangladesh. Correlation Analysis We also tried to look at the correlation coefficient between liquidity (CR) and profitability (ROA). Correlation between these factors to look at the direction of relationship, if there is any. Government Banks

| roa cr -------------+------------------

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A. Akter & K. Mahmud roa | cr |

1.0000 -0.1518

1.0000

Correlation coefficient between return on asset and current ratio for government banks is negative and very weak. Private Commercial Banks

| roa cr -------------+-----------------roa | 1.0000 cr | -0.0863 1.0000

Correlation coefficient between return on asset and current ratio for private commercial banks is also negative and the strength of association is weaker than government banks. Islamic Banks

| roa cr -------------+-----------------roa | 1.0000 cr | 0.2291 1.0000

Correlation coefficient between return on asset and current ratio for islami banks show positive relationship and in this case the relationship is also weak but moderately better than the other two types of banks. Multinational Banks

| roa cr -------------+-----------------roa | 1.0000 cr | 0.2304 1.0000

Correlation coefficient between return on asset and current ratio for multinational banks show positive relationship and in this case the relationship is almost same as islami banks. Overall Banking Industry

| roa cr -------------+-----------------roa | 1.0000 cr | 0.0054 1.0000

For overall banking industry, correlation coefficient between return on asset and current ratio shows almost no relationship. Although multinational and islami banks show positive correlation coefficient, there are no significant relationships between liquidity and profitability. 5. Discussion of Results These results reveal that there is no significant relationship exists between liquidity and profitability in all the categories on banks in Bangladesh. Even as a total industry there is no significant relationship between liquidity and profitability. Definitely liquidity has impact on short-term operations of any firm. But for banking industry in Bangladesh, it shows there is no significant impact of liquidity on profitability. All our analyses show that all the models can explain very small amount of dependency with no significance at 10% level of significance.

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International Journal of Empirical Finance 1.6 1.4

Government Bank

1.2 1

Islami Bank

0.8 Pvt Commercial Bank

0.6 0.4

Multinational

0.2 0 2006

2007

2008

2009

2010

2011

Figure 1: Current ratio of different types of banks in Bangladesh from 2006 to 2011 We also plotted the data of current ratio of different bank categories of Bangladesh from 2006 to 2011. Figure 1 shows the pattern. Islami banks show a steady current ratio over the years. Multinational banks and Private commercial banks also show steady current ratio. On the other hand, government banks show more variability in current ratios over that period of time. But profitability tells us a different story (fig. 2). Return on Asset of all these categories of banks show similar amount of variability over the same time period. This also explains no significant relationships between liquidity and profitability in banking industry of Bangladesh. 2.50% 2.00% Government Bank

1.50%

Islami Bank

1.00%

Pvt Commercial Bank

0.50%

Multinational

0.00% 2006 2007 2008 2009 2010 2011

Figure 2: Return on Asset of different types of banks in Bangladesh from 2006 to 2011 6. Conclusion Our analysis has shown the degree of relative relevance of liquidity and profitability in the four sectors of banks in Bangladesh. From the analysis, we can say that there is no significant relationship between liquidity (measured as current ratio) and profitability (measured as return on asset) in these banks. Still, liquidity is very important for any institutions and profitability shows the financial strength of that institution. Liquidity shows the strength of the banks in terms of their operations and profitability shows their effective and efficient value maximization over the period of time. In our future work, we will look into other variables to look at how they can explain profitability more. We also will expand our study horizon to different industry and will try to show a comparative analysis.

References 149

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