Abstract

The aim of this research is to examine the relationship between liquidity and profitability of three selected commercial banks in Cameroon. The main objective of this research is to verify if there is any relationship between liquidity and profitability in some commercial banks in Cameroon: that is, looking at the tradeoff between liquidity and profitability.

Liquidity indicators used were net working capital current ratio and cash ratio, which measure the company’s ability to meet its short-term obligations, while profitability is measured by return on asset (ROA) and return on equity (ROE). Data were collected from the websites of Afriland First Bank, Ecobank and BICEC, with emphasis on their respective financial reports for the period 2010 to 2015.

Different tests were applied to analyze the relationship between liquidity and profitability: that is, the descriptive analysis, the correlation and the regression analysis. The study revealed that there is significant relationship between the independent variables cash ratio, current ratio and net working capital on dependent variables return on asset (ROA) and return on equity (ROE). This means profitability through ROA and return on equity ROE is significantly influenced by liquidity through net working capital and cash ratio.

CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

Banking industry is one of the significant sectors of the financial system in most countries (San & Heng, 2013). Banks play a crucial role in promoting the growth of the economy by mobilizing savings and using the mobilized savings in  financing the most productive sectors of economics (Alkhazaleh & Almsafir, 2014).

As such, commercial banks are important to the financial segment, particularly in developing economies where capital markets are not well developed and strong. In economies where the capital markets are still developing, banking institutions serve as a vital source of finances for enterprises (Ntow & Laryea, 2012). Therefore, good performance of the bank is usually measured as per its profitability and liquidity levels, and has been essential to shareholders, customers as well as for banks’ continued survival and expansion (Nkegbe & Yazidu, 2015).

It is obvious that a good banking system, everything being equal, is a panacea for economic growth and development of a nation. According to Aurangzeb (2012), it is crystal clear that nations that have good banking system have a tendency to develop their economic growth more quickly. The sector plays fundamental role in the economy through development activities, and gives resources in form of loans and advances to the general public, as well as to other development organizations (government, firms    and      households).    This            forms   an        integral            part      ofthe intermediation role of banks in an economy. The intermediary functions of banks cannot be attained in the absence of liquidity and profitability.

The ability of a bank to meet demand, deposit, withdrawals and other cash flow is a visible indicator of its liquidity. If a bank cannot meet depositors’ withdrawal requirements, or is forced to dishonor new lending obligations, a lack of confidence ensues. The level of liquidity maintained by banks must meet minimum regulatory requirements and other routine financial obligations.

Liquidity position and/or crisis does not do banks any good, if not well managed. Its management should be commensurate with banking operations, safety of deposits or principal, among others. This underscores the reasons why the monetary authorities do not compromise on banks’ liquidity position, as illiquidity will not only amount to a doom, but total collapse of the system, in particular, and the economy at large (Bagh et al., 2017).

Liquidity is a concept that is receiving serious attention all over the world, especially with the current financial situations and the state of the world economy. The concern of business owners and managers all over the world is to devise a strategy of managing their day-to-day operations in order to meet their obligations as they are due and increase profitability and shareholders’ wealth (Don, 2009). Liquidity management, in most cases, is considered from the perspective of working capital management, as most of the indices used for measuring corporate liquidity are a function of the components of working capital.

Liquidity is basic for efficient operations of a bank. A bank is said to be liquid when there is enough liquid assets and cash, coupled with the ability to raise funds quickly from other sources, to meet its financial obligations on daily basis (Nzotta, 2004). Management of bank liquidity is of utmost importance for survival and profitable operations of the system. It helps sustain depositors’ confidence and keeps the industry growing.

Andrew and Osuji (2013) observe that liquidity management involves the strategic supply or withdrawal from the market or circulation the amount of liquidity consistent with a desired level of short-term reserve money, without distorting the profit-making ability and operations of the bank.

A greater percentage of banks profit is generated through lending, and this is anchored on how liquid the banks are. This is why the Bank of Central African States (BEAC) mandatorily requires banks in Cameroon to meet certain reserve requirements as part of liquidity management strategies. The ability of banks to honour new financial obligations, in terms of loans and advances, instills confidence in the minds of the public and tends to show the viability state of the banks. These performance indicators are vital to the shareholders and depositors who are the banks’ major markets (Enjelly, 2004).

Profitability of banks is important since the soundness of an industry is closely connected to the soundness of the whole economy (Lipunga, 2014). The financial strength of a banking institution is unquestionably associated to its profitability; thus, the most important need of any bank’s management and leadership is to make profits on a continuous basis, since this will guarantee the bank’s continuous existence.

As such, achieving profitability goal is vital to any bank (Adeusi, Kolapo & Aluko, 2014). The banking sector profitability is also central, as the well-being of the industry is closely associated with the wellness of the whole economy in general (Alkhazaleh & Almsafir, 2014). Thus, a proficient and productive banking sector is able and better placed to endure negative economic shocks (Ally, 2014).

The trade-off between liquidity and profitability has been a burning issue in the field of banking. Theoretically, both liquidity and profitability are affected by the working capital decisions of any company. Excess of investment in working capital may result in low profitability, and lower investment may result in poor liquidity. Therefore, bank management needs to tradeoff between liquidity and profitability to maximize shareholders’ wealth.

Every organization, whether profit- oriented or not, irrespective of size and nature of business, requires necessary amount of working capital. Working capital is the most crucial factor for maintaining liquidity, survival, solvency and profitability of business (Mukhopadhyay, 2004). It is observed that, if a firm wants to take a bigger risk for mammoth profits, it minimizes the dimension of its working capital in relation to the revenues it generates. If it intends to improve its liquidity, that in turn raises the level of its working capital.

Nonetheless, this technique might tend to reduce the sales volume, and, consequently, it would affect the profitability. Thus, a company needs to have a striking balance between liquidity and profitability. In order to maintain high profitability levels, companies might need to forfeit their solvency by maintaining relatively low levels of current assets.

As soon as the companies start doing so, their profitability would improve, as less amount of money is fastened up to the idle current assets and their solvency would be in danger. Therefore, excessive levels of current assets may have a negative effect on the firm’s profitability, whereas a low level of current assets may lead to lower level of liquidity and stock outs, resulting in difficulties in maintaining smooth operations. (Van and Wachowicz, 2004). A bank should ensure that it does not suffer from lack of, or excess, liquidity to meet its short-term compulsions.

A study of liquidity is of major importance to both the internal and the external analysts because of its close relationship with day-to-day operations of a business (Gapenski, 2010). Liquidity requirement of a firm depends on the peculiar nature of the firm, and there is no specific rule on determining the optimal level of liquidity that a firm can maintain in order to ensure positive impact on its profitability.

 

According to Greuning and Bratanovic, (2004), banking liquidity represents the capacity of a bank to finance itself and its transactions efficiently. The liquidity of a bank is an expression of the probability of losing in the capacity of financing its transactions: the probability that the bank cannot honour its obligations to its clients (withdrawal of deposits, maturity of other debts, and cover additional funding requirements for the loan portfolio and investment).

The sophistication of liquidity management and liquidity risk depends on the size and characteristics of each bank, as do the nature and complexity of activities held by it. The management of liquidity policies of a bank has to include a decisional structure for risk management, a pattern (a strategy) for approaching operations and funding, a set of exposure limits to liquidity risk and a set of procedures for planning liquidities after alternative scenarios, including crisis situation.

Bhunia (2010) refers to liquidity as the ability of a firm to meet its short-term obligations. Liquidity plays a crucial role in the successful functioning of a business firm. Weak liquidity position poses a threat to the solvency as well as profitability of a firm, and makes it unsafe and unsound.

Two common ways to measure accounting liquidity are the current ratio and the quick ratio. The current ratio establishes the relationship between current assets and current liabilities. Normally, a high current ratio is considered to be an indicator of the firm’s ability to promptly meet its short-term liabilities. The quick ratio establishes a relationship between quick or liquid assets and current liabilities.

Despite continued improvement in economic conditions within the Central African Economic and Monetary Community (CEMAC) region, the banking system remains vulnerable with pronounced variation among countries. Large and long currency positions protect banks against a depreciation of the currency.

Eleven banks have net position that exceed twice their regulatory capital, with the positions of Gabonese and Congolese banks being the largest, and those of domestic banks larger than those of foreign banks. In the event of an appreciation of the currency against the Euro (and to a lesser extent against the US Dollar), the capital adequacy ratio and banks in Cameroon can grow and some other domestic banks and local groups would fall short of the regulatory minimum. Gabonese banks would be less affected due to a high capital adequacy ratio, and local groups would suffer more than foreign ones.

In 2005, 7 of 11 banks in Cameroon were found to be in good and solid standing; furthermore, the liquidity ratio of the whole financial system in Cameroon was 2% in 2004 and 0.58% in 2005 (CEMAC, surveillance report 2005), with an increase in the amount from 2004 to 2005. Furthermore, the amount of bad or non- performing loans was 13.1 Billion in 2004; it increased in 2005 by 0.8 billion (COBAC, 2005). Thus, a financial manager has to ensure, on the one hand, that the firm has adequate cash to pay its bills, has sufficient cash to make unexpected large purchases and cash reserve to meet emergencies, while on the other hand, he/she has to ensure that the funds of the firm are used to yield the highest return.

This poses a dilemma of maintaining liquidity or profitability. The liquidity and profitability goals conflict in most decisions which finance managers make. For example, if higher inventories are kept in anticipation of increase in prices of raw materials, profitability goal is approached, but the liquidity of the firm is endangered. Similarly, if a firm focuses more on profitability, then the bank’s liquidity will decrease.

Likewise, there is a direct relationship between higher risk and higher return. A company taking higher risk could endanger its liquidity position. However, if a company has a higher return, it will increase its profitability.

Consequently, a firm is required to maintain a balance between liquidity and profitability in the conduct of its day-to-day operations. Investments in current assets are inevitable to ensure delivery of goods or services to the ultimate customers. A proper management of the same could result in the desired impact on either profitability or liquidity.

1.2. Statement of the Problem

The Cameroon banking industry has continued to grow in terms of new local and foreign entrants, customer and deposit base, regionalization and increased scrutiny from the regulators, specifically the Bank of Central African States (BEAC). This new shift in the Cameroon banking industry can be attributed to the liberalization of the sector, increased adoption of information technology and improved business environment due to reforms being undertaken in the political, economic, social and cultural field (IMF country report, 2009).

With these changes, the level of competition in the banking industry has reached an all-level high, coupled with enlightened customers and increased scrutiny from the regulators, which has prompted local banks to introduce effective management of liquidity and profitability.

Adoption of such practices has been found to be a source of sustainability – more-so in such an environment characterized by stiff competition and enlightened customers (Chao et al, 2010). Competitiveness of an organization will lead to sustainability, which refers to the development that meets the needs of the present generation without compromising the ability of the future generation to meet their needs.

The varied nature of the functions performed by banks exposes them to liquidity risk – the risk that a bank may not meet its obligation (Jenkinson, 2008), as the depositors may call their funds at an inconvenient time, causing fire sale of assets, negatively affecting profitability of the bank (Chaplin et al., 2000). It is important for a bank to understand the effect of the liquidity components on its profitability, and to also undertake deliberate measures to optimize its liquidity level.

Liquidity issues may arise due to the breakdown of delays in the cash flow from the borrowers or early termination of projects for which funds were borrowed (Diamond and Rajan, 2005). Moreover, liquidity issues may also originate from  the very nature of banking: macro factors that are exogenous, and financing and operation policies that are endogenous (Ali, 2004).

 

The problem then becomes to determine how to select or identify the optimum point or the level at which a commercial bank can maintain its assets in order to optimize these two objectives, since each of the liquidity has a different effect on the level of profitability. This problem becomes more pronounced as a good number of commercial banks are engrossed with profit maximization and, as such, tend to neglect the importance of liquidity.

As a result of this gap, it is imperative to examine the relationship between liquidity and profitability of commercial banks in Cameroon, in order to determine how best to strike a balance between the two variables in Cameroon’s banking sector.

1.3. Research Questions

Considering the above problem, the principal research question is: Is there actually a dilemma between liquidity and profitability of commercial banks in Cameroon? The problem as stated can be carefully developed using the following research questions:

1. Is there any relationship between liquidity and profitability in commercial banks in Cameroon?
2. Is there any relationship between profitability and liquidity in commercial banks in Cameroon?

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