Liquidity and Financial Leverage On Financial Performance PDF
Liquidity and Financial Leverage On Financial Performance PDF
Liquidity and Financial Leverage On Financial Performance PDF
org
ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) DOI: 10.7176/RJFA
Vol.10, No.8, 2019
Abstract
This paper analyzes the effect of liquidity and financial leverage on firm performance of manufacturing industries
quoted on the Ghana Stock Exchange from six different sectors from 2007-2015. We choose ROA and ROE as
proxy variables for enterprise performance. We use fixed effect model and random effect model for modeling, and
choose the more appropriate model. The empirical results of the study indicated that liquidity (LIQ) measured by
current assets to current liabilities has a positive significant effect on return on equity (ROE) used as performance.
The study finds out that the effect of financial leverage has a strong positive impact on firm performance
(ROA&ROE) with 65% of debt used to finance firm assets which in some extent has a great influence on firm
performance. The study recommends management to minimize the use of debt financing and rather use more of
their retained earnings for their operations to avoid bankruptcy soon.
Keywords: liquidity; financial leverage; firm performance
DOI: 10.7176/RJFA/10-8-08
Publication date: April 30th 2019
1. Introduction
A primary concern of Liquidity and financial leverage play a significant role in the survival and success of every
business organization activities, hence to function efficiently and effectively the financial managers and owners of
the entity must show great concern on the outcomes of the firm performances. The term Liquidity commonly
referred to the ability of an entity to change their assets into cash within the shortest possible time without losing
its value. In other word, liquidity also describes the ability of an organization to strategically manage and focuses
on maintaining efficient levels of current assets and current liabilities to enable the firm to have a constant flow of
cash to meet its short-term obligations thus continue to exist in the foreseeable future. Another key aspect of
liquidity is that it performs an important role in the existence of every firm and proper management is needed to
ascertain continues cash flows for the day-to-day operation of the firms. According to Robinson et al.(2015), there
are various liquidity ratios used by organizations to manage their short terms obligations and this includes current
ratio, quick ratio, cash ratio, defensive interval ratio which can greatly affect the financial performance of
companies. Current assets include receivable, inventory, investments for trading and cash that are continuously
flowing in and out of the organizations. However current liabilities are short-term current liabilities such as
accounts of creditors, that part of long-term liability during the financial year or operating cycle. Liquidity ratios
indicate the capability of an entity's to settle its short-term obligations, however, the weakness of the ratios values
may portray that the organization is facing some challenges in meeting their short-term debt.
More so, a primary concern of financial leverage and firm's performance decisions have remained the most
crucial interesting issues among financial analysts and scholars for decades. According to Banafa et al.
(2015) ,financial leverage is one of the key components of financial structure decisions, and therefore it is
necessary for firm’s management in developing countries to examine the pros and cons before outsourcing for
their operations. Financial leverage is another sources for generating funds for financing business operations and
the decisions made by both the financial manager and management can positively have an impact on firm
performance through the acquisition of assets and expansion of their activities. Moreover, the decision on financial
leverage can principally increase the firm profit depending on the company activities or have a negative impact on
performance due to default payment of borrowed fund. Financial leverage is an external source of funds that an
entity acquired to purchase more assets and finance its project without employing too much equity to operate its
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Research Journal of Finance and Accounting www.iiste.org
ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) DOI: 10.7176/RJFA
Vol.10, No.8, 2019
activities. Furthermore, financial leverage integrates the firm's long- term liability, short term- liability,
shareholders equity and profit, which are the main sources of financing firm’s activities and growth (Hasan et
al.,2014).
In Ghana, a lot of manufacturing firms are facing some challenges surviving in the competitive environment
due to financial issues confronting management in paying their short-terms and long-terms obligations to achieve
an optimum financial structure that would minimize the firm's cost of debt and improves the firm performances.
Some of these challenges are high cost of acquiring new machinery, feeding the industry with raw materials and
funds needed to pay wages and salaries to workers and meeting other financial obligations which are persistently
reducing the number of industries in the country. However, financial leverage and liquidity are the convenience
sources of financing for manufacturing company. Meanwhile, providers of credit prefer short-term credit market
to long-term market, because of the higher inflation rate in Ghana compared to other developed or emerging
countries, which have the tendency of reducing the demand for future cash flows. In recent theory, most authors
posit that a firm can benefits from using debt because payments of interest are not taxable and that it can increase
firm performance and contrary, default payment of borrowed funds can result to bankruptcy.
Likewise, mangers are having issues on how to combine debt and equity in their operations, in order to
strategically ascertain a particular combination that will efficiently minimize cost and boost manufacturing sectors
performance. With the above circumstances coupled with financial distress due to illiquidity and insolvency, and
other sources of financing manufacturing industry are scarce, it is therefore important that industries in Ghana
have to strategically manage their capital and resources efficiently and to become profitable. The term illiquid
describe the inability of a firm to settle it short-terms obligations or current expenditure whiles insolvency also
refers to incapability of a firm to pay for long-terms liabilities. Furthermore, manufacturing firms in Ghana must
pay more attention to efficient use of debt and liquidity management which are needed to improve performance
and growth of the existing firms in solving the country's unemployment issues and ensuring economic stability.
Resulting from the above challenges facing the industries, the government of Ghana has taken several steps in
addressing and aimed to revive the country's manufacturing sectors to create employment and also boost the locally
produced products. Therefore, management and financial managers need to have a clear guideline of whom to
consult when taking decisions concerning the financial structure of the manufacturing firms. The purpose of this
paper is to investigate and empirically analyze the effects of liquidity and financial leverage on the performance
of manufacturing firms in Ghana. Although extensively research has been carried out on the association between
liquidity and profitability, however, most scholars, financial analyst, and even management have disagreed with
their findings among profit-oriented businesses.
Other schools of thought also investigated the impact of financial leverage on firm performance and
concluded that debt financing can positively or negatively influence a proportion of firm performance.
Furthermore, numerous authors also attempted to explain the effects of financial leverage on firm
performance, but the conclusions are quite different, which needs further study. Previous study conducted in the
past shows that a number of industries in Ghana utilize debt or converting their assets into near-cash to achieve
their rapid growth but the effect of liquidity and financial leverage on firm performance has not yet reached a
unified conclusion. Reviews of literature reported that the study of liquidity and financial leverage on firm's
performance has been conducted in the banking industries and small and medium enterprises than little can be said
about the manufacturing industry. Therefore, the main objective of this study is to investigate the effects of
liquidity and financial leverage on the performance of listed manufacturing firms in Ghana from 2007-2015.
Furthermore, the findings of the research will guide financial managers of manufacturing firms in Ghana to analyze
the financial decision impact that liquidity and financial leverage both have on firm profitability and thus, which
may enable them to meet short- term and long- term financing obligations and ultimately improve their
performance.
Currently, there has been just a little on the topic effect of liquidity and financial leverage on firm performance
of manufacturing industries in Ghana, therefore the researchers seek the opportunity to further examined the effect
about the said topic and it’s important for Ghana. In Ghana, most of the manufacturing firms use financial leverage
as their external source of fund for their operations but has no idea about how to use an ideal level of debt that will
not negatively influence their financial performance and hence increase shareholders return. Also, many of the
firm's assets are been held in liquid states which creates another problem for managers by not able to settle their
short- term debt when maturity is due. All these depend on managerial skills and capability to clear their debt
burden by increasing sales through exportation of locally produced goods to improve the economic conditions of
Ghana. This research will serve as a tool for financial managers to analyze their financial needs, minimizes the
level of debt for their operations hence generate more returns on shareholders’ equity and finally improve the
manufacturing performance to boost the economic growth of Ghana.
The current paper is presented as follows: section 2 presents literature reviews and hypothesis development;
Section 3 outlines the research methodology, Section 4 discusses the results, and finally, section 5 concludes the
paper.
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Moreover, most of the research conducted concluded that financial managers are confronted with one major issue
that is how to allocate borrowed funds to the right projects in order to generate more fund to maximum return.
Although numerous studies have been conducted in the past to examine whether financial leverage has a positive
or negative association between firm’s performances, but their studies have failed, and also some of their findings
produce mixed outcomes or quite different results. Furthermore, some author's believe that financial leverage has
a positive influence on a firm's performance, however, debt financing could also reduce consistent cash flow of
the firm, hence increases the firm value and performances. According to Abor (2005) research on the effect of
capital structure and profitability of a sample of 22 firms listed on the Ghana Stock Exchange from (1998-2002).
Findings of the study show that short term debt and total debt has a strong positive relationship on return on equity
whiles there is a negative relation between long term debt and ROE. The author also confirms that firm size and
sale growth has a significant effect on profitability, hence concluded that 85% of the firms in Ghana depends on
short term debt as the main source of financing its activities.
Similarly, Awunyo-Vitor and Badu (2012) conducted empirical research on the impact of capital structure
and performance of the listed bank in Ghana for 10 years period. The data for the study were retrieved from
published annual financial statement of listed banks on Ghana stock exchange where regression and panel model
was used to analysis the data. The regression analysis indicated that bank capital structure is closely related to the
firm performance (ROE & Tobin’s q) however, the study also shows a high level of financial leverage which
negatively affects banks performance and a consistent dependency can contribute high risk in the bond market.
Amidu (2007) also examine the dynamics involved in the determination of financial leverage on profitability of
19 listed banks in Ghana during the period 1993-2003. The paper found that total debt has a negative significant
relationship on the profitability of banks listed on Ghana stock exchange. Further studies reported that other
variables such as profitability, corporate tax, growth, asset structure, and bank size influence banks' financing
decision. Other studies have been done in different part of the world and came out with their own findings. In a
related study, Bui (2017) conducted a research on 18 British Gas and Oil companies and investigate the effects of
debt financing on performance by using published data from financial statements from 2009 to 2014. The result
indicated a strong negative impact of leverage on performances of ROA and ROE, of those firms. Based on the
findings, the researcher concluded that firms that rely on debt for financing its operations exhibit poorer
performances, therefore in order to maximize profit, the author advice firm’s management to carefully consider
how to use optimal level of debt to eliminate elements of bankruptcy cost and maximized profit.
According to Ibhagui and Olokoyo (2018) investigated the relationship among financial leverage, company
size and performance of 101 listed pharmaceutical firm in Nigeria covering the period of 2003-2007.Using a
threshold model the result of the of the study indicated that leverage has a negative effect on performance of small
and medium size firm but rather increases the performance of firms that grow bigger irrespective of amount of
debt used in Nigeria listed firms. A further study conducted by Raza (2013), researched on the topic effect of
financial leverage on company performance of 482 non-financial industries quoted on Karachi Stock Exchange
(KSE) from the period of 2004-2009. The author employs panel data and regression analysis for the study and
found out that the value for leverage ratios for textile industry is very high therefore have a negative effect on their
performance due to the high level of debt. The author also reported that the above result constitutes to high cost of
borrowing which has resulted in the low profitability of the textile industries. Similarly, Chadha and Sharma (2015)
conducted 10 years researched on 422 listed Indian manufacturing firms to examine the impact of leverage on
firms financial performance. The paper uses three proxy for measuring financial performance which includes
return on asset, return on equity and Tobin’s Q. The study found that leverage has no significant impact on two of
the performance ratios namely return on asset and Tobin’s Q respectively whereas it is significantly correlated to
return on equity with other variables such as firm age, firm size, sale growth, and asset turnover are a good predictor
of financial performance of Indian manufacturing sectors.
Following Shubita and Alsawalhah (2012) analyze the impact of financial leverage on the profitability of
manufacturing firms quoted on the Amman Stock Exchange for six-year (2004-2009). The study was carried out
in 39 companies using correlations and multiple regression analysis to analyze the result. The author found a
negative significant relationship between debt and profitability of the firm and concluded that profitability
increases with firm size and sales growth used as a control variable for the study. And also recommend
management to pay more attention to their financing decision to avoid high indebtedness. According to Banafa et
al. (2015) explored the impact of financial leverage on the financial performance of 42 listed non-financial firms
in Kenya covering the period of 2009-2013 from different sectors. The paper uses causal research design and panel
data model, and the empirical result shows that leverage had a negative significant impact on corporate financial
performance. Again the author reported that greatest proportions of the firm's resources or assets were financed
through long term debt.
Pouraghajan et al. (2012) reviewed the effect of financial leverage on the financial performance of 400
companies in Iran. The study was conducted on 12 different industries with data collected from the annual financial
statement of firms quoted on Tehran stock exchange covering the period of 2006-2010. The finding of the study
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Vol.10, No.8, 2019
indicated that leverage ratios have a strong negative effect on performance (ROA & ROE) of Iranian firms. They
also reported that the following variables; asset turnover ratio, firm size, assets tangibility, and growth
opportunities have a positive significant relation with measures of financial performance on companies. Through
the above empirical analysis on the effect on firm performance, we can conclude that most scholars have different
outcomes on the said topic. Furthermore, some authors also argue out that the impact of financial leverage on firms
performance can be associated with or affected by numerous factors such as firm asset tangibility, ownership
structure, and growth opportunity. Thus, in this study we predict that financial leverage will have a positive
significant effect on firm performance. So we put forward the hypothesis:
H2: Financial leverage has a positive correlation effect on firm performance (ROA & ROE) of listed
manufacturing industries in Ghana.
3. Research method
3.1. Sample and Data Collection
The sample size consists of 22 manufacturing firms quoted on the Ghana Stock Exchange covering the period
from 2007-2015. The paper examines manufacturing firms from six different sectors listed on Ghana stock
exchange including Wood and Processing, Beverage and Pharmaceutical industries, Trading and Information
Technology, Manufacturing and Paper converters, Metal and Oil, and Agriculture and Agro processing. The
purpose of the study is to empirically investigate the effects of liquidity and financial leverage on the performance
of listed manufacturing firms in Ghana. All other manufacturing firms which are not quoted are excluded from
this study, however, the data was interpreted by using matrix correlations, descriptive statistics and Fixed Effect
model with the aid of STATA 14. The study uses panel data for the research because it combines both time series
and cross sectional data hence it is expected to give unbiased estimators. Also, the panel data model gives
researchers greater flexibility to control the impact of individual-specific variables and time-specific variables
Baltagi, Egger, and Pfaffermayr (2014). The data for the study was collected and retrieved from the audited annual
financial reports, Fact Book of Ghana Stock Exchange and from the web portals of individual firms. The data were
collected from the annual financial statement of manufacturing industries quoted on Ghana Stock Exchange from
the period 2007-2015.
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Financial leverage can be computed as dividing total debt to the total asset.
Liquidity
According to pecking order theory, opinion that firms that are highly liquid are required to use their retained
earning capital other than using external financing (Khémiri & Noubbigh, 2018). However, liquidity is the ability
of an entity to meet its short-term obligation and consistently has free flows of cash. Therefore, the variable
liquidity can be calculated by dividing the ratio of current assets to current liabilities (LIQ). This ratio has been
used by a number of scholars Khan (2012).
Table1. Variable definitions and descriptions
Variables Description
Return on asset (ROA) profit after tax / total asset
Return on equity (ROE) profit after tax/shareholders’ equity
Financial leverage (FLE) total debt / total assets
Liquidity (LIQ) current asset / current liabilities
Firm size (FS) natural logarithm of total assets
Firm Age (FA) current year – the year of incorporation
Sales growth (SG) current year’s sale minus previous years divided by previous year’s sale
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having a mean value of 8.61% and with a standard deviation of 1.97%. In addition, the descriptive statistics of
sales growth (SG) has a mean value of 24.34% and a standard deviation of 5.76%. The high mean of sales growth
indicated that manufacturing companies have a higher rate of return on their sales thus increases a firm’s
performance. In, a conclusion the values of skewness show negatively skewed values of all the variables in the
table used to measured firm performance.
Table 3. The correlation coefficient of the variables
ROA ROE FLEV LIQ FS FA SG
ROA 1.0000
ROE 0.9193 1.0000
FLEV 0.9652 0.9225 1.0000
LIQ 0.8400 0.9335 0.8873 1.0000
FS 0.7924 0.8110 0.7539 0.7496 1.0000
FA 0.8574 0.9066 0.8135 0.8520 0.8426 1.0000
SG 0.9355 0.9727 0.9232 0.9044 0.8395 0.9108 1.0000
From the correlation matrix, it shows that the relation between financial leverage (FLEV) and return on asset
(ROA) has a strong positive coefficient of 97%. This implies that the company debt has contributed to a 97%
return on asset. Also, the correlation matrix of FLEV on ROE is at 92%. This result indicates, that FLEV has a
strong positive significant effect on return on shareholders’ equity. It can be observed that the liquidity (LIQ) in
term of the current asset has contributed to 84% on ROA. This result implies that in the short-term the company’s
solvency increases which cause a rise in the firm ROA. Likewise, LIQ has a great positive impact on return on
equity with a coefficient of 93%. Furthermore, the result depict a positive correlation between firm size (FS) on
the variables used to measure firm performance (ROA&ROE) with a coefficient of 79% and 81% respectively.
This result also shows that firm size has a great influence on firm performance in terms of production and benefit
from economies of scale. More so, the correlation result of firm age on firm performance (ROA&ROE) also has a
strong coefficient of 86% and 91%. This indicates that the number of years in business increases the firm reputation
and credit worthiness and profit. The high rate of sale growth on performance implies that there has been an
increase in revenue which contributed to a significant impact on firm performance.
Table 4. Hausman fixed random for ROA
(b) (B) (b-B) sqrt(diag(V_b-
Fixed model Random model Difference V_B)) S.E.
Financial Leverage 0.7982 0.7993 -0.0011 0.0117
(FLEV)
Liquidity (LIQ) -0.0435 -0.0356 -0.0079 0.0142
Firm Size (FS) 0.0280 0.0328 -0.0049 0.0068
Firm Age (FA) 0.1705 0.1740 -0.0034 0.0148
Sale Growth (SG) 0.0591 0.0576 0.0016 0.0088
From the Hausman test of both random and fixed effect, the probability chi2 which is less than 0.05, show
that the best model for estimating the main effect on firm performance is the fixed effect model. The condition for
the selection of either effect is if the prob>chi2 is less than 0.05 or equal to 0.05, hence the selection of the fixed
effect model.
Table 5. Hausman fixed random for ROE
(b) (B) (b-B) sqrt(diag(V_b-V_B)) S.E.
Fixed model Random model Difference
Financial Leverage (FLEV) 0.2371 0.2549 -0.0178 0.0131
Liquidity (LIQ) 0.3207 0.3207 1.3915 0.0000
Firm Size (FS) -0.0337 -0.337 9.7816 0.0076
Firm Age (FA) 0.1317 0.1317 -3.2815 3.4209
Sale Growth (SG) 0.3792 0.3792 -1.1116 0.0099
From the Hausman test of both random and fixed effect, the probability chi2 which is less than 0.05, show
that the best model for estimating the main effect is a fixed effect. The condition for the selection of either effect
is if the prob>chi2 is less than 0.05 or equal to 0.05, we chose the fixed effect model to run the regression but if
the prob>chis2 is more than 0.05 we chose the random effect for the estimation. The Hausman test also shows that
the right model to use is the fixed effect. This is based on the probability chi2 which is more than 0.05 for all the
22 manufacturing firms in Ghana.
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Furthermore, the analysis also indicated that the age of a firm significantly have a positive influence on firm
performance (ROA&ROE) 21% and 25% respectively at a significant level of 0.01. Similarly, Sale growth (SG)
has contributed to a 24% increase on the return on assets of the firm and 30% increment on return on equity (ROE).
From the study, the hypothesis that state that liquidity has a positive impact on a firm’s performance (ROE),
is accepted based on the profitability “F” test which is 0.000. Also, we accept the second hypothesis that state that
financial leverage has a positive effect on firm performance (ROA&ROE). We, however, reject the alternative
hypothesis which states that liquidity has a positive influence on return on asset (ROA) on a manufacturing industry
listed on the Ghana Stock Exchange.
5. Conclusion
The study on Liquidity and financial leverage in the manufacturing firms are the common issues facing the survival
and operations of firm performance with which information on them are seriously hidden. This paper investigated
the effect of liquidity and financial leverage on the performance of manufacturing firms quoted on the Ghana Stock
Exchange from six different sectors. The statistical results of the study indicated that liquidity (LIQ) measured by
current assets to current liabilities has a positive significant effect on return on equity (ROE) used as proxy firm
performance. This result means that financial managers of the manufacturing industries meet their short terms
obligation thus improved the firm's performance, while liquidity (LIQ) shows a negative insignificant impact on
return on asset. A further study reported that financial leverage ratio shows a strong positive significant influence
on firm performance (ROA&ROE) with 65% of debt used to finance asset which in some extent has a great impact
on firm performance. Although debt financing can result to a decline in firm performance, however, shareholders
of manufacturing firms must work hard to avoid the risk caused by either short terms or long terms debts thus
effectively use them to promote the growth and performance. Result of the empirical studies also shows that sales
growth significantly and positively affects firm performance, this finding implies that listed manufacturing firms
in Ghana will extremely improve their performance when they increase their sales.
Based on our empirical results, the researchers therefore suggest that management should reduce or eradicate
the problems associated with liquidity and financial leverage on firms' performance in the manufacturing sectors
in Ghana and also applicable to other countries. Managers of manufacturing firms should adopt a prudent way to
resolve their liquidity issues hence ensure that current assets and current liabilities of the firm must be maintained
at an ideal level since it can influence how short-term obligations are honored. More so they should also avoid
holding more of their assets in the liquid state for unexpected demands from suppliers and other recurrent
expenditures hence, find a better way to attend to such demands. A retained earnings and shareholders dividend
should be use to settle those obligations. In addition, financial manager should adopt an optimal capital structure
to control the scale of debt financing, so as not to increase the risk caused by excessive debt that brings adverse
effects on firm's performance but rather to maximize shareholders equity. The study recommended that
government should support local manufacturing firm by giving them subsidies for borrowing and enactments laws
to protect the local manufacturing firms and to restrict the activities of importers thus promote high demand for
locally manufactured goods to increase the economic growth in Ghana.
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