Relationship Between Profitability and Liquidity

Relationship Between Profitability and Liquidity CHAPTER 1: INTRODUCTION This study empirically examines the relationship between profitability and liquidity, of insurance companies in Mauritius by using regression models and correlation analysis. The goal of any business is to make profits. If it does not make profit, it will soon go out of existence. Business need to ensure that it has enough money not only to cover expenses, but ensures that something is left over. Profitability of a company can be affected by many factors, among which there is liquidity. Every stakeholder has an interest in the liquidity position of his related company. Employees are also having interest in the liquidity of their company in order to know whether the company can meet its employees related obligations that are salary, pension, and provident fund. Shareholders are interested in understanding the liquidity due to its huge impact on the profitability. One can understand the liquidity position by analyzing the financial statements of a company. Liquidity position of a company can examined through financing decisions or investment decisions. 1.1 Definition of Liquidity Liquidity is defined as the ability of a company to meet its short term obligations. It is also the ability of the company to convert its assets into cash. It is more explicitly the ability of a company to meet the cash demands of its policy and contract holders with no or negligible loss (Claire et al., 2000). The assets and liabilities of a company reflect its liquidity profile. Since liquidity risk is inherent in the financial institutions, one must be able to understand measure, monitor and manage this risk (Douglas and Raghuram, 2001). Liquidity Risk According to Claire et al., (2000), liquidity is the ability to meet expected and unexpected demands for cash through ongoing cash flow or the sale of an asset at fair market value. Liquidity risk is the risk that, at a point in time, an entity will be in short of cash or liquid assets to attain its cash obligations (Darling, 1999). This may result in a run-on-the-company event, which is an example of loss due to this risk which causes the collapse of an institution. This type of event can occur during a depression whereby most customers ask to have their cash paid immediately and that demand exceeded cash reserves. Other less dramatic losses can occur when a company needs to borrow unexpectedly or sell assets at an unanticipated low price (Stewart and Raghuram, 1998) 1.2 Profitability Profitability is defined as the ability of a company to generate income which surpasses its liabilities. Profitability is measured by different ratios such as, Return on Equity (ROE), Price to Earnings Ratio (PER) and Return on Assets (ROA) amongst others. The measurement of profitability is essential to every company (Eljelly, 2004). Insurance regulators either encourage profitability, when concerned with solvency, or seek to limit it, when regulating rates. To investors and insurers, profitability plays an essential role. To policyholders of a stock insurer, it sounds like markup, while to those insured by a mutual company, it has no impact (McClenahan, 1999). Enz and Karl (2001), state that profitability is subject to consistent and accurate determination under a given set of conventions and accounting rules. Profits are important to investors and management as sources of dividends and growth. Profits provide better security against insolvency to insurers and regulators. 1.3 Background on Insurance Sectors in Mauritius The first two insurance companies (Phoenix Assurance Company and the Commercial Union) were set up in 1835 by the British. In 1845, the Mauritius Marine Insurance was formed by Mauritian shareholders. A second Mauritian company was set up called the Mauritius Fire Insurance company in 1854. From that time till date, new companies have emerged. Presently there are 16 insurance companies operating in Mauritius. All these companies are engaged in Life business, General business or both. INSURANCE COMPANY LINE OF OPERATION Anglo Mauritius Assurance Co Ltd Life Insurance Albatross Insurance Co Ltd Life General Insurance British American Insurance Co Ltd Life General Insurance Island Life Assurance Co Ltd Life Insurance Indian Ocean General Assurance Co Ltd Life General Insurance Jubilee Insurance Mauritius Ltd Life General Insurance Llyods Mauritius Co Ltd Life General Insurance La Prudence Mauricienne Assurance Ltd Life General Insurance Lamco International Insurance Ltd Life General Insurance Life Insurance Corporation of India Life Insurance Mauritian Eagle Co Ltd Life General Insurance Mauritius Union Assurance Co Ltd Life General Insurance New India Assurance Company ltd General Insurance Swan Insurance Co Ltd General Insurance State Insurance Company of Mauritius Ltd Life General Insurance Sun Insurance Company Ltd Life General Insurance Table 1.1: List of Insurance Companies and their respective lines of operation 1.3.1 Liquidity issues in Mauritius Each insurance company has their own structures and policies to manage all the risks in their operations including liquidity. In addition, they have to abide by the guidelines on liquidity provided by the Financial Services Commission and Section 23 of the Insurance Act 2005. Insurance companies have also to develop a contingency plan which should help them manage their liquidity on a global consolidated basis. Recent technological and financial innovations have provided insurance companies new means to finance their activities and to manage their liquidity (Vittas, 2003). The liquidity of insurance companies should usually be well planned since the frequency, timing and severity of insurance claims and benefits are quite uncertain (Levene, 2003). Insurance companies obtain their liquidity through (i) Underwriting: Underwriting is calculated as premium revenues subtract payments and operating expenditures; (ii) Investment Income: Investment income consists of dividends, realized capital gains on stocks and coupon payments and principal payments on bonds and (iii) Asset Liquidation: Assets liquidation is primarily concerned with stock sales and bonds on the financial markets (Holden and Ellis, 1993). 1.4 Problem Statement The eventual measure of efficiency of the liquidity planning and control is the effect it has on profitability. The companies preference of high return on assets to increase their profitability affects their liquidity positions. As a result, a study in the insurance sector in Mauritius is carried out to confirm this statement. 1.4.1 Research Objectives The research objectives of the study are as follows: i. To assess the impact of liquidity on profitability of Mauritian insurance companies ii. To determine the relationship between liquidity and profitability iii. To evaluate the impact and significance of the different liquidity ratios on profitability 1.4.2 Aim and Objectives of the Dissertation The aim of this dissertation is to investigate the relation between profitability and liquidity within the Mauritian context, in particular in the insurance sector. An econometric model would be used for this research study. The same model will be used to test the impact of liquidity on profitability of thirteen insurance companies, namely Anglo Mauritius Assurance Co Ltd, Albatross Insurance Co Ltd, British American Insurance Co Ltd, Island Life Assurance Co Ltd, Indian Ocean General Assurance Co Ltd, Jubilee Insurance Mauritius Ltd, Llyods Mauritius Co Ltd, Lamco International Insurance Ltd, Mauritian Eagle Co Ltd, Mauritius Union Assurance Co Ltd, Swan Insurance Co Ltd, State Insurance Company of Mauritius Ltd and Sun Insurance Company Ltd. 1.5 Outline of the Dissertation 1.5.1 Chapter 1: Introduction The introduction gives an overview on liquidity risk and explains why it is an important area for research, in particular in the insurance sector in Mauritius. It gives a clear and concise statement of the aim and objectives of this dissertation. 1.5.2 Chapter 2: Literature Review This chapter is wholly a review of existing literature on liquidity and any relevant articles related to liquidity issue have been considered. This will help to put the proposed research in a relevant context and ensure that up-to-date techniques are used for the analysis in this research study. 1.5.3 Chapter 3: Methodology This chapter describes the methods and estimation techniques used to compute estimates of the parameters in the econometric model and explain the equations being used. It also outlines the sources of data collection. Finally, the limitations of the study are outlined in this chapter. 1.5.4 Chapter 4: Results and Findings Chapter 4 presents the Analysis of data and findings. Tables, graphs and figures are usually used in this chapter to better illustrate graphically the results of this research study. The data was analysed using EViews 7 and the findings will be discussed. The latter will enable comparison that will either confirm or contradict expectations. 1.5.5 Chapter 5: Conclusions and Recommendations This final chapter presents the conclusions reached based on the findings of the previous chapter. Finally, some suggestions for further research in liquidity will also be presented.