Impact of liquidity and leverage

Topics: Regression analysis, Automotive industry, Operating leverage Pages: 18 (2971 words) Published: January 7, 2014


The net profit of any business entity for a particular time period can be conceptualized as the final outcome of its investing, financing and operating activities. These activities are influenced by Management’s decisions and several internal and external environmental factors. This paper investigates how profitability of firms, in the automobile sector of India, is influenced by Leverage and liquidity of firms. The current ratio was taken as representative of the liquidity and financial leverage and operating leverage are taken to represent the leverage . The aim of the research was to examine empirically, using multiple regression analysis, whether profitability of automobile firms is related to selected indicators in accordance with the generally accepted finance theory. This study investigates the effect of both leverage and liquidity on the profitability of some listed automobile companies from Indian stock exchanges. Hence the scope of the study is limited only in the automobile companies in India. Thus for analyzing the impact of leverage and liquidity on the profitability, EBIT is taken as the dependent variable and Operating leverage, financial leverage and Current ratio are taken as the independent variable. The study investigates the relationship by analyzing the values of independent variables and dependent variables from four automobile companies in India by taking forty observations from 2004 to 2013. Result reveals that operating leverage has a negative impact whereas financial leverage has a positive impact on the profitability of automobile firms.


For managing liquidity efficiently, a company’s management has to decide on the optimum level of current assets and current liabilities that it should carry. A comprehensive ratio which captures the relationship between the level of current assets and current liabilities is the current ratio, calculated as (current assets / current liabilities). In this study, current ratio has been used as the indicator for firm liquidity.

Operating leverage measures the degree to which a business organization relies on fixed operating costs in its pursuit for maximizing its operating profit. Increase in profits results from spreading a given level of fixed operating costs over a larger number of units of the product. Thus, the degree of operating leverage is higher in those companies whose operating costs include a higher percentage of fixed operating costs. On the other hand companies whose operating costs comprise a relatively high percentage of variable costs have a low operating leverage.

The operating breakeven point is higher for companies with a larger proportion of fixed operating costs. This makes such companies more risky because if the level of sales is not sufficiently high, the fixed operating costs may not be adequately covered, thereby resulting in an operating loss or a low operating profit. Thus, while a high degree of operating leverage will increase operating profit in times of rising sales; operating profits will reduce rapidly when sales are showing a declining trend. A similar impact can be visualized on the bottom line or net profit for a company with a high degree of financial leverage. For the foregoing reasons, a company having high operating cost as percentage of its total costs and also having a high financial leverage, will expose investors to a high risk. It is therefore important to realistically forecast future sales, if risk is to be contained. If sales are not sufficiently high to adequately cover fixed costs, operating profit may be so low that fixed interest charges are not covered. This would result in a net loss or a negative return on equity.

Financial leverage is similar in nature to operating leverage except for the fact that the fixed cost in this case is the interest or...

References: 3. Brigham, E. F. (1995), “Fundamentals of Financial Management”.
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