CHAPTER TWO

LITERATURE REVIEW

2.1 Introduction

Microfinance is a financial service designed to provide small-scale financial

assistance to individuals and small businesses that lack access to traditional
banking services. It aims to empower low-income individuals, particularly in
developing countries, by offering them the means to invest in income-generating
activities, improve their living standards, and ultimately lift themselves out of
poverty (Ledgerwood, 1999). The concept of microfinance can be traced back to
the late 1970s, with the pioneering work of Dr. Muhammad Yunus in
Bangladesh. He initiated the Grameen Bank in 1983, which offered small loans
to impoverished women to enable them to start their own businesses. This model
demonstrated that low-income individuals could repay loans and manage
financial services effectively, challenging the traditional perception that the poor
were not creditworthy. Microfinance typically involves providing small loans
(microloans) that can range from a few dollars to several thousand, depending
on the local economy and the borrower’s needs (Armendariz and Morduch
2010). Unlike traditional banks, microfinance institutions often require little to
no collateral, making it accessible for individuals without significant assets.
Many microfinance programs utilize group lending models, where borrowers
form groups and guarantee each other’s loans (Morduch, 1999). This approach
fosters accountability and social cohesion among members. A significant portion
of microfinance initiatives targets women, recognizing their role in family and
community development (Yunus, 1999). Empowering women through financial
services has been shown to have a multiplier effect on improving health,
education, and economic outcomes for families.
Microfinance encompasses a variety of financial products, including microloans;
small loans for starting or expanding a business, micro-savings; low-barrier
savings accounts that encourage individuals to save money securely, micro-
insurance; insurance products tailored for low-income individuals, covering
health, life, property, and crop insurance, remittances; services that facilitate
money transfers, especially for migrant workers sending money back to their
families (Cull, Demirguc-Kunt & Morduch, 2009).

Microfinance has shown potential in alleviating poverty by providing financial

resources that empower individuals to start and grow businesses, generating
income and employment, improve their household’s living conditions through
better housing, education, and healthcare, increase their savings and invest in
future opportunities, leading to greater financial stability (Armendariz &
Morduch, 2010). However, the impact of microfinance is a subject of debate.
Studies have shown mixed results, with some indicating that while microfinance
can improve individual financial conditions, it may not lead to substantial
community-level economic development. Critics also highlight concerns
regarding over-indebtedness among borrowers, especially when interest rates are
high or when borrowers take multiple loans from different sources (Kipesha &
Zhang, 2013).

Despite its potential, the microfinance sector faces several challenges;

sustainability; many MFIs struggle to balance social goals with financial
sustainability, leading to questions about their long-term viability. Regulatory
issues; lack of regulation can lead to predatory lending practices and high
interest rates, undermining the benefits of microfinance. Market saturation, in
some areas, the proliferation of MFIs has led to increased competition and
borrower over-indebtedness. Measuring impact, quantifying the social impact of
microfinance remains complex, making it difficult to assess its effectiveness
conclusively (Naser et al, 2013).
Money is the most important invention of modern times. It has undergone a long
process of historical evolution. Human beings passed through a stage when
money was not in use and goods were exchanged directly for one another. Such
exchange of goods for goods was called Barter Exchange (Smith, 1776). The
inconveniences and drawbacks of barter led to the gradual use of a medium of
exchange. If we study history of money, we shall find that all sorts of
commodities like pearls, precious stones, tea, tobacco, salt, wine have been used
as a medium of exchange that is money (Friedman, 1969). It is called
commodity money. Inadequacy of commodity money led to the evolution of
metallic money (gold and silver). The problem of uniformity of weight and
purity of precious metals led to private and public coinage (Fisher, 1911). This
process was finally taken over by the state as one of its essential features and
ultimately commodity money gave way to paper money which means currency
notes. Nowadays, use of paper money has almost become universal along with
coins made of copper, bronze or nickel. The process of evolution of some better
medium of exchange still continues (Keynes, 1930). As the volume of
transactions increased, even paper money started becoming inconvenient
because of time involved in its counting and space required for its safe keeping.
This led to the introduction of bank money (or credit money) in the form of
cheques, drafts, bills of exchange, credit cards. These days, plastic money in the
form of debit cards is becoming popular (Mishkin, 2015). Thus, bank money has
become the most important form of money in modern times because it is not
only a very convenient form of money for large payments, but also eliminates
risks and is durable.

Lending is the principal business activity for most banks. The loan portfolio is
typically the largest asset and the predominate source of revenue. As such, it is
one of the greatest sources of risk to a bank’s safety and soundness. Loan
portfolio problems have historically been the major cause of bank losses and
failures (Menger, 1892). Effective management of the loan portfolio and the
credit function is fundamental to a bank’s safety. Loan portfolio management is
the process by which risks that are inherent in the credit process are managed
and controlled. Assessing loan portfolio management involves evaluating the
steps bank management takes to identify and control risk throughout the credit
process (Baur, Hong & Lee, 2018). This booklet is written for the benefit of
both examiners and bankers and discusses the elements of an effective liquidity
management process.

Liquidity management is an important tool for the management of MFIs; it

reflects the organization’s ability to repay short-term liabilities. Amengor (2010)
defines liquidity MFIs as its ability to fund all contractual obligations as they
fall due. These obligations may include lending and investment commitments
and deposit withdrawals and liability maturates, in the normal course of
business. The main objective for any MFIs is to reduce poverty and in order to
do so, they need to be financially sustainable (Mishkin, 2015).

MFIs generally try to keep or maintain sufficient funds to meet unexpected

demands from depositors, given they primarily deal with poor and low-income
earners. Possible fallout of the crisis is an increase in the volume of
nonperforming loans of financial institutions, as businesses have gone bankrupt,
farmers have been unable to cultivate effectively due to difficulty in accessing
farm lands, and the region’s population and number of small business owners
has reduced greatly (Jensen & Meckling, 1976). MFIs have struggled to survive,
and some MFI branches have even shutdown in many areas due to the ongoing
Anglophone. MFIs’ profits have dropped in many cases. Nonetheless, there still
exist lots of profitable investment opportunities in the region and beyond. While
some MFIs have struggled to cope, others have opened new branches and
recorded huge successes. One of the factors which may account for the
sustainability of MFIs as seen in past research is proper liquidity management
(Putman, 1993). In Cameroon in general and northwest and southwest in
particular in the midst of the ongoing Anglophone crisis, whether or not
liquidity management contributes to the profitability of MFIs remains largely
unproven.

2.2 Overview of Liquidity Management

Liquidity is important in financial services as it has an effect on the service

provider’s ability to meet daily withdrawals by clients (Francis, 2016). MFIs for
example should have sufficient number of profitable assets in order to pay
dividends to their shareholders and still be able to transfer to reserve. Liquid
assets are important to have in times of crisis or emergency because they can be
readily converted into cash. Without liquidity, money can become tied up in
systems that are difficult to cash out of and even more difficult to assess for
actual cash value (Chaplin et al., 2000).

Liquidity is the term mostly used to illustrate how easy it is to change both fixed
and current assets to cash. The most liquid short term asset and what everything
else is compared to is cash. This is can be explained by the fact that it can be
used easily and immediately. Assets that can be converted to cash quickly are
important to have in times of crisis or emergency especially in the ongoing
Anglophone crisis in the Northwest and South west regions of Cameroon
because they are readily converted into cash. During times of financial needs,
large financial institutions close down due to lockdowns, ghost town, etc making
it difficult for their customers to access the cash they need to buy basic needs
like food, gasoline and other emergency supplies (Chaplin, Emblow & Michael,
2000).

No universally accepted definition has been fronted on liquidity; some scholars

have defined it as the ability of a firm to ensure the availability of funds to meet
its short term obligations. In the business of financial institutions, it can also be
defined as its capacity to fund an increase in assets and meet both expected and
unexpected cash and collateral obligations at a reasonable cost and without
incurring unacceptable losses.

According to Choudhry (2011), liquidity management refers to the funding of

deficits and investment of surpluses, managing and growing the balance sheet,
as well as ensuring that the bank operates within regulatory and stipulated limits.
Ideal bank management is an uninterrupted endeavour of assuring that a balance
exists between liquidity, profitability, and risk (Banks, 2014). MFIs indeed
require liquidity since such a large proportion of their liabilities are payable on
demand (deposits) but typically the more liquid an asset is, the less it yields.

Liquidity management is inversely related to the performance of banks (Bassey,

2015). A liquidity management crisis was evident in the global financial crisis of
2007–08 (Dullien, 2010). This was the worst financial crisis raising fundamental
questions about liquidity management (Basel Committee on Banking
Supervision, 2013). During the crisis, banks were hit hardest by liquidity
management pressures cutting back sharply (Basel Committee on banking
supervision, 2013). Major commercial banks like Lehman Brothers collapsed.
Other banks were bailed out by the governments. The impact on the stock
market was very severe as stocks shed prices (Basel Committee on Banking
Supervision, 2013). In many areas the economy faced a huge financial blow,
resulting in house evictions, foreclosures and prolonged unemployment (Basel
Committee on Banking Supervision, 2013). The crisis underscored the role of
liquidity management in commercial banks (Basel Committee on Banking
Supervision, 2013).

Liquidity management is important for all firms in all situations. Eljelly (2004)
argued that liquidity management is important when firms are in a good
situation, but is most important during troubled times (Gryglewicz, 2011). When
a firm is unable to pay its obligations, it is illiquid. Liquidity is measured in
terms of the ratio of liquid assets to deposits and short term liabilities. Liquidity
is the ability of an organisation to have funds to meet their current liabilities as
they fall due and the ability to meet increasing loan demands. Liquidity is the
ability of a bank to fund increases in assets and meet obligations as they fall due
without incurring unacceptable losses (Basel Committee on Banking
Supervision, 2008).. Liquidity is also stated by, (Amadeo, 2013) to be the
amount of capital that is available for meeting short-term obligations. Liquidity
is positively related with bank profitability (Dang 2011). The most common
financial ratios that reflect the liquidity position of a bank according to the
above author are customer deposit to total asset and total loan to customer
deposits.

Ahmed & Javad (2009) in their study concluded that firms which are more
liquid are likely to realize better financial performance than firms with liquidity
problems hence liquidity is an important determinant of financial performance.
A study conducted in China and Malaysia found that liquidity level of banks has
no relationship with the performances of banks (Said & Tumin, 2011). On the
other hand, Anupam (2012) in his study stated that firm liquidity is not
significant in influencing firm performance.

Liquidity management is the capacity of banks to meet its short-term financial

obligations (Saunders & Cornett, 2005). Liquidity mis-management is mainly
caused by a mismatch between assets and liabilities of commercial banks. This
arises from maturity mismatch or refinancing risk (Saunders & Cornett, 2005).

The indicators of poor liquidity management are a fall in asset prices, inadequate
debt, low marketability of assets (Saunders & Cornett, 2005). Many commercial
banks as a result face the challenge of reduced profitability (Molefe and
Muzindutsi, 2016).
It is against this background that liquidity management is regarded as the life
blood of the economy and in its absence financial markets cease to function
efficiently profitability (Molefe and Muzindutsi, 2016). Persistent liquidity
management constraints in the Kenyan economy have resulted in reduced public
confidence in the banking sector as well as increased financial disintermediation
(Alemayehu & Ndung’u, 2012).

2.3 Financial Performance Metrics in MFIs

Financial performance is the measure of organizations achievement on the goals,

policies and operations stipulated in monetary terms. It involves the financial
health and can be compared between similar firms in the same industry (Agola,
2014). Financial performance of a company, being one of the major
characteristics, defines competitiveness, potentials of the business and economic
interests of the company’s management and reliability of present or future
contractors (Dufera, 2010). In the MFI context, financial performance is the
ability of a MFI to keep on going towards microfinance objective without donor
support (Thapa, 2008). The main aim of every micro-finance institution is to
have operations that are profitable in order to maintain stability and improve on
sustainability and growth (Agola, 2014). Thus, Microfinance Institutions (MFIs)
should seek to maximize performance in many areas, whether it is social or
economical (Jørgensen, 2011).

Financial performance analysis is an appraisal of the feasibility, solidity and

fertility of a business, sub- business or mission (Bhunia, Mukhuti & Gautam,
2011). Good financial performance rewards the shareholders for their
investment (Ongore & Gemechu, 2013). A firm’s financial performance, in the
view of the shareholder, is measured by how better off the shareholder is at the
end of a period, than he was at the beginning and this can be determined using
ratios derived from financial statements; mainly the balance sheet and income
statement, or using data on stock market prices (Baraza, 2014). Financial
performance can be measured through various financial measures such as profit
after tax, return on assets (ROA), return on equity (ROE), earnings per share and
any market value ration that is generally accepted (Yenesew, 2014). The return
on assets ratio (ROA) is an important financial performance ratio because it
measures the efficiency with which the company is managing its investment in
assets and using them to generate profit (Jørgensen, 2011).

A good performing microfinance industry is vital in sustaining the stability of

the micro banking system. Poor financial performance deteriorates the capacity
of MFIs to absorb negative shocks, which subsequently affect solvency
(Yenesew, 2014). Better financial performance leads the lenders to recover full
cost or make profit, and building institutions that can sustain themselves for a
considerable period without continued reliance on government subsidies or
donor funds. MFIs financial performance is based on the extent to which service
users directly pay the full cost of providing services (Adhikary, 2014). As such
operational efficiency, capital levels, liquidity risk, credit risk and size are some
of the major factors that influence financial performance of microfinance banks.

Operational efficiency refers to the ability of a microfinance program to deliver

a specific service with minimum costs (Adhikary, 2014). Operational efficiency
is performance measure that shows how well MFIs is streamlining its operations
and takes in to account the cost of the input and/or the price of output (Ongore &
Gemechu, 2013). Efficiency in expense management should ensure a more
effective use of MFIs loanable resources, which may enhance MFIs profitability.
Inefficiency is one of the significant risk factors for sustainable microfinance as
large numbers of institutions are still far from minimal scale or the efficiency
required to cover costs. Operational efficiency is usually measured using
operating efficiency ratio (OER) where lower OER is preferred over higher
OER as lower OER indicates that operating expenses are lower than operating
revenues (Dufera, 2010).
Capital is the amount of own fund available to support the bank's business and
act as a buffer in case of adverse situation. Capital creates liquidity for a
financial institution since deposits are essentially other people’s money, which
can be recalled at any time (Dang, 2011). In the event of loss of assets, higher
capital level relative to its assets ensures the institutions would have sufficient
funds of its own to cover the loss or there is sufficient level of capital required to
absorb potential losses while providing financial sustainability (Adhikary,
2014). As such, in the presence of asymmetric information, a well-capitalized
bank could provide a signal to the market that a better-than-average performance
should be expected (Kahiga, 2014). Capital level/adequacy is normally proxied
using proportion of MFI equity to total assets.

Liquidity refers to the ability of institutions to meet demands for funds.

Liquidity risk arises when a microfinance bank is unable to meet its cash
requirements or payment obligations timely and in a cost-efficient manner
(Idama et al., 2014).MFI with inadequate liquidity might be less immune
towards future uncertainty, timely delay of refinancing, disruption in meeting
growth projections and increased portfolio at risk (Brom, 2009). To reduce
liquidity risk, each microfinance bank branch needs to prepare a daily fund plan
that guides the matching of cash inflows from loan repayment and saving
deposits with cash outflows for the branch on a daily basis (Idama et al., 2014).
Loan to total assets ratio (LAR) is normally used to measure the liquidity
position of MFI that indicates the percentage of total assets used to provide the
loan (Adhikary, 2014).

Credit risk is the financial loss that a lender will suffer because of a borrower’s
failure to perform according to the terms and conditions of the credit or loan
agreement. Effective management of credit risk through proper management
results in the improvement of earnings and reduces insolvency (Sule, 2012).
Credit risk is not confined to a microfinance banks’ loan portfolio alone, but can
also exist in its other assets and activities. Credit risk affects the profitability and
the general performance of any financial institution and is one of the major risks
to microfinance banks sustainability. Thus, managing credit risk is an integral
part of microfinance bank operating techniques, with reducing the risks
requiring a major operational effort (Idama et al., 2014).

The size of an institution plays an important role in determining the kind of

relationship the firm enjoys within and outside its operating environment and
hence profitability. The modern intermediation theory predicts efficiency gains
related to size of a financial institution, owing to economies of scale (Kahiga,
2014). Smaller MFIs in particular are at a disadvantage, struggling to cover the
industry’s high operational costs and diversify their products in order to compete
with larger microfinance providers (Muriu, 2011). In addition, large firms are
more diversified than small ones and have greater market power and during
good times may have relatively more organizational slack (Addisalem, 2015).
Size captures the economies or diseconomies of scale of an institution and
normally the natural logarithm of total asset of MFIs is used as a proxy of size
(Cull et al., 2007).

2.4 Literature Review Sources on Financial Performance

A study by Arthur et al. (2013) examined the degree of financial performance in

selected Microfinance institutions in central region, Uganda. The study
employed the ex-post facto or retrospective, prospective designs and descriptive
survey design, and specifically descriptive comparative and descriptive
correlation strategies. The findings of the study revealed that the degree of
financial performance in the microfinance institutions in central region Uganda
was high. Mwizarubi, Singh and Mnzava (2015) also examined the impact of
modern Microfinance Institutions (MFIs) capital structure variables on MFI’s
financial sustainability. The study found that deposit mobilization is the most
crucial determinant of financial sustainability amongst other MFI capital
structure variables, followed by shareholders’ equity, debt (commercial
borrowing) and lastly going public.

In their study, Tilahun and Dereje (2012) assessed the financial performance of
Ethiopian MFIs using a descriptive research design. The findings of the study
revealed that there was a negative shift in the performance indicators with the
decline of the gross loan portfolio. The study also found that the portfolio at risk
rose during 2008 and 2009 indicating deterioration of portfolio quality while the
number of active borrowers (outreach) declined though there was an increase in
number of staff members in the MFI. Muriu (2011) explored the impact of
financing choice on microfinance profitability using an unbalanced panel dataset
comprising of 210 MFIs across 31 countries operating from 1997 to 2008. The
study found a proportionally higher deposit as a ratio of total assets was
associated with improved profitability. Further, the study revealed that MFIs
with a higher portfolio-assets ratio are more profitable but the impact depends
on MFI age.

A study by Jørgensen (2011) examined the factors that determine profitability of

microfinance institutions using a sample of 879 MFIs. The study findings
established that the factors that statistically influenced profitability positively
were the capital asset ratio, age (new) and the gross loan portfolio. The study
also found that operating expense over loan portfolio had a positive influence
but the number of active borrowers had a negative influence. Assefa, Hermes
and Meesters (2010) investigated the relationship between competition and the
performance of microfinance institutions (MFIs). The findings of the study
revealed that competition among MFIs was negatively associated with various
measures of performance.

Cull, Demirgüç-Kunt and Morduch (2009) examined the implications of

regulation and supervision on MFIs profitability and their outreach to small-
scale borrowers and women. The study findings established that supervision is
negatively associated with profitability. In addition, the study revealed that
supervision is associated with substantially larger average loan sizes and less
lending to women although it is not significantly associated with profitability.
Narwal, Pathneja and Yadav (2014) studied the performance variables of
banking sector and microfinance institutions in India over a study period of six
years 2006 to 2012. The findings of the study established that performance of
microfinance institutions mainly rotate around two variables, which include size
and spread to total assets.

In Kenya, Njenje and Bengi (2016) assessed the financial factors that affect the
growth of microfinance institutions (MFIs) in Bahati Sub-county. The study
findings established that there exists a strong, positive and statistically
significant relationship between financial literacy and growth of MFIs; whereas
relationship between interest rates and growth of MFIs was not statistically
significant. Njeru et al. (2015) explored the effect of loan repayment on financial
performance of deposit taking SACCOs in Mount Kenya Region. The study
findings established that there was positive relationship between loan repayment
and financial performance of deposit taking SACCOs in Mount Kenya Region.

Okombo (2014) examined the impact of low transactional costs on the financial
performance of deposit taking MFIs. The study findings established that there
was positive and statistically significant relationship between the low transaction
costs and financial performance. Agola (2014) explored the relationship between
credit policy and financial performance of microfinance institutions in Kenya.
The findings of the study revealed a positive relationship between financial
performance, credit policy, credit risk controls, credit appraisal and collection
policy. Ongaki (2012) examined the determinants of profitability of deposit-
taking microfinance institutions and co-operative societies. The study findings
established that there was a positive relationship between profit ratio and interest
income ratio and non-interest income ratio. The study also found that there was
negative relationship between profit ratio and noninterest expense ratio and
liquidity ratio.

A study by Gisbson (2012) explored the factors that determine the operational
sustainability of micro finance institutions in Kenya. The findings of the study
established that the factors affecting operations and financial sustainability are
capital/ asset ratio and operating expenses/loan portfolio. Baraza (2014) also
investigated the relationship between funding structure and financial
performance of Microfinance institutions in Kenya. The study found that debt to
equity ratio had a negative correlation with financial performance meaning the
more debt a firm employ in financing its operations the inferior financial
performance it registers. The study also found that deposits to assets ratio had a
positive correlation with financial performance implying that the more deposits
a microfinance institution accepts the higher the financial performance.

2.5 Overview on Liquidity

Liquidity is the potential of the financial service companies to fulfill the

client’s cash requirements and make available advances in the forms of
overdrafts and financial loans. Liquidity risk arises from maturity mismatches
where liabilities have a shorter tenure than assets. A sudden rise in the
demand of borrowers above the expected level can lead to a shortage of
cash or liquid marketable assets (Oldfield & Santomero, 1995). The liquidity
crisis in a banking institution could lead to insolvency and bank runs.
Consequently, minimizing the liquidity risk is one of the most important aspects
of asset and liability management of banks. Liquidity risk has received
substantial attention of risk specialists and regulatory bodies in recent years. It
has a devastating effect on financial institutions’ profitability (Diamond &
Rajan, 2005). It also adversely affects the overall earnings, capital adequacy,
and assets base of the financial institutions. Therefore, it becomes Empirical
study of the impact of liquidity risk on the financial performance: A study of
selected commercial banks in Bangladesh Journal of Financial Markets and
Governance of the top priority of a bank’s management to ensure the availability
of sufficient funds to meet future demands of providers and borrowers, at
reasonable costs. Muranaga and Ohsawa (2005) suggested that there are two key
dimensions of liquidity risk: liquidating the assets as and when required; and
liquidating these at a fair market value. Banks face liquidity risk if they are
not liquidating their assets at a reasonable price. The price fetching remains
precarious due to frazzled sales conditions while liquidating any of the
bank’s assets urgently. This may result in losses and a significant reduction in
earnings. According to Edem (2017), when cash sources surpass cash
consumption, it results in excess liquidity and when the cash consumption
surpass money sources, it leads to liquidity shortage. This could create a bank
incapable to diminish the debts or to gather reserves to expand the resources.
The recent economic quandary is that there is a common knowledge that banks
have not completely acknowledged the significance of liquidity threat
management despite having the indication of this threat applicable to them and
have there-fore not taken more extensive financial practices. As such,
policymakers have recommended that bank ought to keep more liquid
resources than they did in the past which will help them self-insure against
manageable liquidity or financing challenges (Chege, 2017). Bank liquidity
risk and financial performance Liquidity versus profitability is a common
topic in the finance literature. Some researchers find negative, and some
researchers find positive relationships, while others find mixed relationship
between the liquidity risk and financial performance of commercial banks.
There-fore, it is very important to identify the e ffects of liquidity risk on
different types of performance indicators of the banks when taking decisions to
minimize the banks’ risk and maximize their profitability. There are numerous
studies on the impact of liquidity risk on financial performance of banks
(Bourke, 1989; Eichengreen & Gibson, 2001; Kosmidou et al., 2008;
Olagunju et al., 2011) which have explained that liquidity risk has a positive
impact on bank performance. However, other studies argued that there is a
negative impact between liquidity risk with bank performance and did not
support this concept. In line with their results Guru et al. (2002) and Goddard et
al. (2004) also found evidence of a negative liquidity-profitability relation-ship
for European banks in the late 1980s and mid-1990s, respectively. Chen et al.
(2021) investigated that a depositor would withdraw from banks in
financial crises if the health of the banking industry becomes a concern to
them. Facing such withdrawal pressure, banks that take on greater liquidity
risk must make more costly adjustments to their assets and liabilities to
mitigate the possible damage caused by liquidity shocks and may even fail if
they cannot satisfy the needs of their depositors and borrowers. Athanasoglou
et al. (2006) discovered that liquidity risk, measured by the proportion of loans
to total assets, has no impact on return on asset and return on equity by
analyzing an unbalanced panel dataset of Southeastern European credit
institutions

European credit institutions over the period 1998–2002. Bordeleau et al.

(2010) employed quantitative measures to assess the impact of liquidity on
bank profitability. The study suggested that a nonlinear relationship exists,
whereby profitability is improved for banks that hold some liquid assets,
however, there is a point beyond which holding further liquid assets
diminishes banks’ profitability, holding all else equal. Hossain Mohammad
Yeasin Journal of Financial Markets and Governance Chen et al. (2021) argued
that liquidity risk may affect bank performance in financial crises. Greater
liquidity (cash in their case) increases banks’ incentive to reduce credit risk.
This factor should become important during financial crises, when the credit
quality of bank loans may substantially deteriorate. Banks with more
liquidity buffers (and therefore lower liquidity risk) should also have more
incentive to control credit risk, so they should su ffer fewer loan losses in
financial crises, and thus have better performance than their peers. Shahchera
(2012) established that the relationship between profitability of the banks
and loans to asset ratio was non-linear. This implied that profitability of the
banks increased up to certain levels of loans-to-asset ratio after which it started
decreasing with increased values of the ratio beyond that level. The
relationship exhibited an inverted U-shape. Ahmed et al. (2011) examined that
liquidity risk affects bank profitability very significantly. Here, non-performing
loans is the factor that enhances the liquidity risk as it has a negative relationship
with profitability. Olangunji et al. (2011), in their study of bank liquidity risk
with profitability, found that there is a significant positive relationship
between bank liquidity and bank performance. They argued that there is a two-
way relationship, especially for commercial banks, where banks’ accelerating
performance and profitability is significantly influenced by high levels of
liquidity and vice-versa. Lartey et al. (2013) studied the relationship between the
liquidity and the profitability of banks and revealed that there was a very weak
positive relationship between these two variables. The study made by Siaw
(2013) concluded that bank profitability, which is measured by return on asset
and return on equity, is positively affected by liquidity risk that is, banks with
high exposure to liquidity risk made higher profits, resulting from higher net
interest margins as compared with banks with low liquidity risk exposure. The
researchers recommended that banks should reduce the percentage of liquid
assets held rather than raising the percentage of illiquid assets (loans
disbursed) to maximize the profit through high interest income. This will be
achieved by collecting huge amounts of deposit by making the saving more
attractive and consider those as the major source of funding. Chen et al.
(2021) showed that investors moved their funds from capital markets to the
banking system during market crises. Because of the deposit inflows, taking
high liquidity risk would not cause a problem for banks in market crises. The
nature of a financial crisis may affect the relationship between liquidity risk
and bank performance in the crisis. Maaka (2013) used non-performing loans as
a variable to measure the impact of liquidity risk on financial performance.
As per the above researchers and analysis, the expected result is a negative
relationship between non-performing loan and financial performance of
commercial banks, indicating a negative relationship between liquidity risk and
financial performance of commercial banks, as measured by return on asset.
Abdullah and Jahan (2014) examined the impact of liquidity on commercial
banks in Bangladesh. The sample included five commercial banks and
information was analyzed using panel data over a five-year period from 2009-
2013 where return on assets and return on equity were used to measure bank
profitability and loan deposit ratio, deposit asset ratio, and cash deposit ratio
were used to measure liquidity. The Empirical study of the impact of liquidity
risk on the financial performance: A study of selected commercial banks in
Bangladesh Journal of Financial Markets and Governance results of the study
showed that there is no significant relationship between liquidity and
profitability of listed commercial banks in Bangladesh. Said (2014) analyzed
the impact of liquidity risk on bank performance, by using Net Stable
Funding Ratio (NSFR) as a proxy for the former and return on asset and
return on equity as a proxy for the latter. The study employed Pooled
Ordinary Least Squares (POLS) and Fixed Effect estimations. They showed
a positive relationship between NSFR with return on equity and return on
assets. Thus, there is a positive relationship between liquidity risk and bank’s
performance. Nyabate (2015) sought to seek the optimum liquidity level
that would positively influence the performance of financial institutions by
balancing the risk and returns of holding liquid assets. The study findings
revealed that there was a positive association between liquidity of the
financial institutions and their financial performance. Murithi and Waweru
(2017) investigated the effect of liquidity risk on financial performance of
commercial banks. Liquidity risk was measured by liquidity coverage ratio
(LCR) and net stable funding ratio (NSFR) while financial performance
was measured by return on equity (ROE). The result revealed that net stable
funding ratio inversely affects the return on equity while liquidity coverage
ratio does not significantly influence the financial performance of
commercial banks. Akinwumi et al. (2017) studied the e ffect of liquidity
management on financial performance of listed deposit money banks. The
result revealed that liquidity management has significant positive
relationship with profitability when measured by return on equity and no
significant relationship with profitability when measured by return on
[Link] impact of liquidity risk on bank performance may di ffer across
banks in financial crises. According to Chen et al. (2021), depositors have
stronger incentives to withdraw from financially weaker banks. Several
empirical papers also find evidence showing that liquidity problems are
more serious for weak financial institutions. Bank capital can increase the
survival probability of banks and improve bank performance during crises.
Banks bearing more credit risk are also likely to su ffer more serious non-
performing loan problems during crises (Chen et al., 2021) also found that
during financial crises, depositors should be more worried if their banks have
lower capital ratios or higher credit risk as liquidity risk will lead to higher costs
for these banks.

2.6 Theoritical Review

Ridley (2012) defines a theoretical review as a critical analysis of theories

relevant to the research question, helping to establish a conceptual framework
and guide hypothesis formulation. Hart (1998) explains that a theoretical review
surveys and evaluates theories to understand the intellectual landscape of a
topic, facilitating the development of new ideas or models.
2.6.1 Theories of Liquidity Management

Theories of liquidity management refer to various frameworks and concepts that

explain how organizations can effectively manage their liquid assets to meet
short-term obligations while optimizing returns. These theories provide insights
into the behavior of firms regarding cash and liquid asset holdings, guiding
financial managers in making strategic decisions about liquidity. Here’s an
overview of different theories of liquidity management.

[Link] Transaction Theory

The transaction theory of cash management focuses on the role of cash as a

medium for conducting transactions. It explains how firms manage cash
balances to facilitate day-to-day operations while minimizing related costs.
Baumol (1952) is credited with developing the foundational model of the
transaction demand for cash. He likened cash management to inventory
management suggesting firms hold cash to meet transactional needs but seek to
minimize the total cost of holding and converting cash. Miller and Orr (1966)
extended Baumol’s work by incorporating uncertainty, allowing firms to set
upper and lower cash balance limits to control their cash holdings more flexibly.

Firms hold cash primarily to meet operational expenses and day-to-day

transactions (Keynes, 1936). Cash is necessary to pay suppliers, employees, and
other obligations smoothly, preventing disruptions.

According to Baumol (1952), firms balance two types of costs; opportunity cost,
the return lost by holding cash instead of investing in interest-bearing assets.
Transaction cost, the cost incurred to convert securities into cash. Firms seek to
minimize the sum of these costs by determining an optimal cash balance.

Baumol model provides a formula to calculate the ideal cash level to minimize
total costs, assumes predictable cash outflows and inflows. Miller-Orr Model
recognizes that cash flows are often unpredictable, introduces control limits
(upper and lower bounds) that trigger cash transfers to maintain balances within
desired ranges.

Gitman (2009) highlights that transaction theory underpins many practical cash
management policies by explaining why firms hold cash beyond immediate
transactional needs. Lazaridis and Tryfonidis (2006) emphasize that
understanding transaction costs and opportunity costs helps firms optimize cash
holdings to improve profitability. In microfinance institutions, efficient
application of transaction theory ensures liquidity to meet clients’ demands
while minimizing idle cash (Kipesha & Zhang, 2013).

Key Components:

1. Transaction Motive for Holding Cash:

Firms hold cash primarily to facilitate daily business transactions such as paying
suppliers, employees, and other operational expenses. Keynes (1936) introduces
this motive in his liquidity preference theory, emphasizing the need for cash to
carry out routine transactions. The component highlights that cash is essential
for operational continuity.

2. Opportunity Cost of Holding Cash:

Holding cash involves an opportunity costs because cash typically earns little or
no interest compared to other investments. Baumol (1952) stressed that firms
must weigh the lost potential earnings from holding cash instead of investing in
marketable securities. Firms aim to minimize this cost by not holding excessive
cash.

3. Optimal Cash Balance:

Firms seek an optimal cash balance that minimizes the total cost; the sum of
transaction costs and opportunity costs. Baumol (1952) developed a model to
calculate this optimal cash level under the assumption of predictable cash flows.
The optimal balance maximizes efficiency in cash management.

4. Cash Flow Forecasting:

In reality, cash flows are uncertain and fluctuate. Miller and Orr (1966) expected
on Baumol’s model by introducing upper and lower control limits for cash
balances. When cash reaches the upper limit, excess cash is invested when it hits
the lower limit, securities are converted to cash. This component adds flexibility
in managing cash under uncertainty.

[Link] Cash Conversion Cycle (CCC) Theory

Gitman (2009) defines CCC as the length of time a firm’s cash is tied up in the
production and sales process before it is converted back into cash through
account receivable collection. The Cash Conversion Cycle is a financial metric
that measures how efficiently a company converts its investments in inventory
and accounts receivable into cash. It assesses the time taken to convert resource
inputs into cash flows from sales. A shorter CCC indicates better liquidity
management and operational efficiency. The Cash Conversion Cycle is a metric
that measures how efficiently a company converts its investments in inventory
and accounts receivable into cash. It encompasses three components: Days
Inventory Outstanding (DIO), Days Sales Outstanding (DSO), and Days Payable
Outstanding (DPO). A shorter CCC indicates effective liquidity management, as
it reflects quicker cash conversion.

Components of CCC:

The CCC consists of three key components:

1. Days Inventory Outstanding (DIO):

• This metric measures the average number of days a company holds inventory
before selling it. It is calculated as:
DIO = ( Average Inventory / Cost of Goods Sold ) × 365

• A lower DIO indicates that inventory is being sold quickly, which improves
liquidity.

2. Days Sales Outstanding (DSO):

• DSO measures the average number of days it takes for a company to collect
payment after a sale has been made. It is calculated as:

DSO = (Accounts Receivable / Total Credit Sale ) × 365

• A lower DSO indicates faster collection of receivables, contributing positively

to cash flow.

3. Days Payable Outstanding (DPO):

• DPO measures the average number of days a company takes to pay its
suppliers. It is calculated as:

DPO = ( Accounts Payable / Cost of Goods Sold) × 365

• A higher DPO means that a company is taking longer to pay its suppliers,
which can enhance liquidity by allowing more time to use cash before it is paid
out.

Calculation of CCC:

The Cash Conversion Cycle is calculated as follows:

CCC = DIO + DSO - DPO

A shorter CCC indicates that a company can convert its investments into cash
more quickly, leading to improved liquidity.

Implications:
A shorter CCC means that a company can reinvest cash into operations or pay
down debt more quickly.

Companies with efficient inventory management and collections processes tend

to have better liquidity positions.

[Link] Baumol Model

Lazaridis and Tryfonidis (2006) highlight that the Baumol Model offers a
practical tool for firms with predictable cash flows to optimize liquidity. Gitman
(2009) notes that while the model is useful, its assumptions limit applicability in
environments with uncertain cash flows. The Baumol Model is a cash
management framework that helps firms determine the optimal cash balance to
minimize costs associated with holding and converting liquid assets. It likens
cash management to inventory management, where firms aim to balance
transaction costs (costs incurred when converting securities to cash) against
opportunity costs (lost interest from holding cash). The model provides a
formula to calculate the ideal cash reserve. The Baumol Model, developed by
William J. Baumol in 1952, is often referred to as the "inventory model of cash
management." It draws parallels between cash management and inventory
management, suggesting that firms should maintain an optimal cash balance to
minimize the total costs associated with holding cash and transaction costs
incurred when converting securities into cash.

Key Components:

1. Cash Flow Needs: Firms have predictable cash outflows (e.g., payments for
expenses) that require them to hold cash.

2. Transaction Costs: When firms need cash, they often sell securities or
liquidate investments which incurs transaction costs.
3. Holding Costs: These are the opportunity costs of holding cash instead of
investing it in interest-bearing securities.

Assumptions:

• Cash inflows and outflows are predictable and occur at regular intervals.

• The firm can convert securities to cash at a constant transaction cost.

• The interest rate on securities is constant.

Formula:

The optimal cash balance (C*) can be calculated using the following formula:

C^* = √(2T/)i}

Where:

• T = Total cash needs over a specific period (total transaction amount)

• D = Transaction cost per conversion (cost to convert securities into cash)

• i = Interest rate on marketable securities

2.6.2 Financial Performance Theories

Financial Performance Theory encompasses various frameworks and models

that assess how well a firm utilizes its resources to generate profits and create
value for shareholders. It focuses on measuring and analyzing financial
outcomes to evaluate a company's performance.

[Link] Stakeholder Theory

Stakeholder Theory, primarily developed by R. Edward Freeman in the 1980s,

posits that businesses should create value for all stakeholders, not just
shareholders. Stakeholders include anyone who has an interest in or is affected
by the company’s activities, such as employees, customers, suppliers, investors,
communities, and the environment. The theory argues that firms should create
value for all stakeholders, including employees, customers, suppliers,
communities, and shareholders.

Donaldson and Preston (1995) elaborate that stakeholder theory encompasses

descriptive, instrumental and normative dimensions: descriptive describes how
organizations actually behave regarding stakeholders, instrumental explores the
relationship between managing stakeholders and achieving organizational goals,
normative addresses the moral and ethical obligations firms have toward
stakeholders.

Jensen (2002) emphasizes the practical application of the theory, suggesting that
managing stakeholder relationships strategically can enhance firm performance
and sustainability.

Stakeholder theory broadens corporate responsibility beyond profit

maximization to include social and environmental concerns (Freeman, 1984). It
informs corporate governance, ethical business practices, and sustainability
reporting (Savage et al, 1991). The theory supports the idea that satisfying
stakeholder interests leads to long-term organizational success (Clarkson, 1995).

Some critics argue that managing diverse stakeholder interests can lead to
conflicting objectives (Jensen, 2002). Others have extended the theory to
emphasize stakeholder engagement and dialogue for mutual benefit (Freeman et
al, 2010).

Key Components

Stakeholder identification. Recognizing all groups or individuals who are

affected by or can affect the organization’s activities. Freeman (1984) defines
stakeholders broadly to include employees, customers, suppliers, communities,
shareholders, and even governments. Mitchell, Agle, and Wood (1997) propose
a framework identifying stakeholders based on their power, legitimacy, and
urgency.

Stakeholder interests and expectations. Understanding and addressing the

diverse interests, needs, and expectations of different stakeholders. Donaldson
and Preston (1995) emphasize that organizations must manage stakeholder
interests to maintain legitimacy and support. Clarkson (1995) highlights the
importance of balancing competing stakeholder claims.

Stakeholder engagement and communication. Establishing ongoing dialogue and

interaction with stakeholders to build trust and cooperation. Freeman et al
(2010) stress active stakeholder engagement as essential for effective
management and conflict resolution.

Mutual influence and interdependence. Recognizing the reciprocal relationship

between the organization and its stakeholders. Freeman (1984) notes that
organizations depend on stakeholders for resources, legitimacy, and survival,
while stakeholders rely on organizations for value.

Ethical and normative considerations. Incorporating moral obligations towards

stakeholders in decision making. Donaldson and Preston (1995) describe the
normative aspect, asserting that firms have ethical duties to consider stakeholder
welfare beyond legal requirements.

Stakeholder management and strategy. Developing strategies to align

stakeholder interests with organizational goals, Jensen (2002) argues that
strategic stakeholder management enhances organizational performance and
sustainability.

Implications

Broadening the scope of corporate responsibility. Freeman (1984) argues that

organizations should go beyond shareholder interests and consider the needs and
rights of all stakeholders. The broadening leads to corporate social responsibility
practices that address social, environmental and ethical concerns (Carroll, 1991).

Enhancing organizational legitimacy and reputation. Engaging stakeholders and

addressing their concerns helps firms gain legitimacy and build reputational
capital (Suchman, 1995). Clarkson (1995) notes that managing stakeholder
relationships reduces risks associated with conflicts and enhances long-term
viability.

Improved decision-making and strategic management. Considering diverse

stakeholder perspectives leads to more informed and balanced decisions
(Donaldson and Preston, 1995). Jensen (2002) suggests that strategic
stakeholder management aligns organizational goals with stakeholder
expectations, improving performance.

Facilitating stakeholder engagement and dialogue. Active communication and

participation foster trust, reduce conflicts and promote cooperation (Freeman et
al, 2010). This participatory approach supports more sustainable and socially
responsible business practices.

Ethical and normative business practices. Stakeholder theory embeds ethical

considerations into corporate governance, emphasizing fairness and respect for
stakeholder rights (Donaldson & Preston, 1995). It challenges firms to act
responsibly beyond legal obligations.

[Link] Agency Theory

Agency Theory, developed by economists Michael C. Jensen and William H.

Meckling in the 1970s, addresses the relationship between principals (owners or
shareholders) and agents (managers or executives). It focuses on the challenges
that arise when agents do not act in the best interests of the principals.
Eisenhardt (1989) defines agency relationships as involving a contract where
one party delegates work to another who performs that work.

Key Components

Principal-Agent Relationship: the core of the agency theory is the relationship

where the principal delegates authority to the agent to perform tasks on their
behalf. Jensen and Meckling (1976) highlight that this relationship is
characterized by differing goals and risk tolerances between principal and
agents.

Information Asymmetry: Agency Theory highlights the problem of information

asymmetry, where agents have more information about their actions and the
organization's operations than principals do. This can lead to mistrust and
inefficiencies. Eisenhardt (1989) notes that this asymmetry can cause principals
to distrust agents, increasing monitoring costs.

Agency Costs: These are costs incurred by principals to monitor and incentivize
agents to align their interests with those of the principals. Agency costs can
include monitoring expenses, performance-based compensation, and potential
losses from poor decision-making. It includes monitoring costs, bonding costs,
and residual loss (Jensen and Meckling, 1976).

Incentive Structures: To mitigate agency problems, organizations often

implement incentive structures, such as performance-based pay or stock options,
to align the interests of agents with those of principals. Eisenhardt (1989)
emphasizes the role of contracts and governance structures in managing agency
relationships.

Implications

Corporate Governance: Jensen and Meckling (1976) stress that organizations

must establish governance mechanisms, such as boards of directors and audit
committees, to monitor management and protect shareholder interests. Agency
Theory has significant implications for corporate governance practices. It
emphasizes the need for effective oversight mechanisms to ensure that managers
act in shareholders' best interests. Good governance reduces agency problems by
overseeing managerial actions and ensuring accountability.

Design of incentive systems. Agency theory implies that incentive contracts,

including performance-based pay, stock options, and bonuses, are essential to
align managers’ objectives with those of shareholders (Eisenhardt, 1989).
Properly designed incentives motivate agents to act in principals’ best interests.

Monitoring and reporting. To mitigate information asymmetry, firms need

transparent reporting, audits, and disclosure practices (Fama, 1980). Monitoring
increases costs but is crucial for reducing managerial opportunism.

Costs of agency relationships. Agency costs, compromising monitoring costs,

bonding costs, and residual loss, impact firm value (Jensen and Meckling,
1976). Firms must balance the costs of controlling agents against the benefits of
reduces agency conflicts.

2.7 Conceptual Review

Webster and Watson (2002) define a conceptual review as a critical review as a

critical evaluation of existing theories and concepts that helps to identify gaps
and develop a framework for further research. Jabareen (2009) describes
conceptual review as the process of analyzing various concepts and theories to
build a coherent conceptual framework that guides research inquiry.

2.7.1 Definitions and Key Concepts

According to Merriam-Webster Dictionary (2014), a definition is a statement of

the exact meaning of a word or the nature or scope of something. Neuman
(2014) states that defining concepts is essential in research to ensure that all
readers share a common understanding of the terms used.

[Link] Liquidity Management

According to Choudhry (2011), liquidity management refers to the funding of

deficits and investment of surpluses, managing and growing the balance sheet,
as well as ensuring that the bank operates within regulatory and stipulated limits.
Ideal bank management is an uninterrupted endeavour of assuring that a balance
exists between liquidity, profitability, and risk (Banks, 2014). MFIs indeed
require liquidity since such a large proportion of their liabilities are payable on
demand (deposits) but typically the more liquid an asset is, the less it yields.

Liquidity management is inversely related to the performance of banks (Bassey,

2015). A liquidity management crisis was evident in the global financial crisis of
2007–08 (Dullien, 2010). This was the worst financial crisis raising fundamental
questions about liquidity management (Basel Committee on Banking
Supervision, 2013). During the crisis, banks were hit hardest by liquidity
management.

[Link] Profitability in MFIs

Profitability is the ability to make surplus from all activities of an institution. It

measures management efficiency in the use of organizational resources in
adding value to the institution. Profitability may be regarded as a relative term
measurable in terms of profit (surplus) and its relation with other elements that
can directly influence the profit. Profitability is the relationship of income to
some balance sheet measure which indicates the relative ability to earn income
on assets.

The issue of institution’s profitability and performance efficiency has been

considered in a number of theoretical and empirical researches of different
kinds. However, return on assets (ROA) and return on equity (ROE) have
always been mentioned among the main indicators characterizing organisation’s
profitability.

Return on Assets (ROA) is the ratio of net income to total assets (Khrawish,
2011). It measures the ability of the MFI’s management to generate income by
utilizing MFIs’ asset at their disposal. In other words, it shows how efficiently
the resources of the MFIs are used to generate the income.

Return on Equity (ROE) is a financial ratio that refers to how much profit a
company earned compared to the total amount of equity invested or found on the
balance sheet. Thus, the higher the ROE the better the MFIs is in terms of profit
generation.

[Link] Financial Performance

Richard A. Brealey and Stewart C. Myers in Principles of Corporate Finance,

defined financial performance in terms of the profitability and sustainability of a
business, emphasizing the importance of metrics like return on equity and return
on assets.

Robert C. Higgins in Analysis for Financial Management discusses financial

performance as a measure of how effectively a company’s financial resources
are employed. He focuses on financial ratios and performance indicators to
assess health and viability.

Peter F. Drucker in his work on management highlights financial performance as

a reflection of the effectiveness of a company’s strategy and operations,
suggesting that it encompasses both financial outcomes and the efficiency of
resource allocation.

Robert E. Hoskisson in his research on strategic management, views financial

performance as a crucial indicator of competitive advantage, linking it to market
position and strategic initiatives. Overall, while the definitions may vary
slightly, common themes include assessment of profitability, effective resource
utilization, and comparison against benchmarks or industry standards. Financial
performance serves as a critical measure of a company’s overall health and long-
term viability.

[Link] Liquidity

Benjamin Graham referred to as the father of value investing described liquidity

as an asset to be sold quickly without a substantial loss in value. He emphasized
the importance of liquidity for investors, particularly during times of market
volatility.

Aswath Damodaran, a well-known finance professor defines liquidity in terms

of the ease of buying or selling an asset without causing a significant impact on
its price. He highlights that liquidity is not just about cash but also involves the
market’s depth and breath for various assets.

Robert Kiyosaki in his personal finance books discusses liquidity in terms of

cash flow and assets. He emphasizes the importance of having liquid assets like
cash or easily sellable investments to take advantage of opportunities and
manage financial emergencies.

Brigham and Ehrhardt (2013) describe liquidity as the firm’s capacity to convert
assets into cash quickly without significant loss in value to satisfy immediate
obligations. Gitman (2009) describes liquidity as the availability of cash or
assets that can be quickly converted into cash to meet short term needs. Shin and
Soenen (1998) emphasize that liquidity is essential for maintaining smooth
operations and avoiding financial distress. Miller and Modigliani (1961)
highlight liquidity as a critical factor influencing firm value and financial
stability.
[Link] Asset Management

John C. Bogle the founder of Vanguard Group and a pioneer of index investing
emphasized that asset management involves not just managing investments but
also understanding the importance of low costs and long-term investment
strategies. He advocated for a focus on board market exposure rather than trying
to beat the market through active management.

William F. Sharpe, a noble laureate in economics defined asset management in

terms of portfolio theory. He discussed the importance of diversification and the
risk-return trade-off in constructing an investment portfolio. Sharpe’s work laid
the groundwork for modern portfolio theory, which is a cornerstone of asset
management practices.

Brigham and Ehrhardt (2013) describe asset management as the planning and
controlling of resources to optimize their utilization and enhance profitability.
Gitman (2009) defines asset management as managing tangible and intangible
assets to ensure efficient operation and financial performance. Jensen and
Meckling (1976) through agency theory, highlight the importance of aligning
asset management with shareholder interests to maximize firm value.

[Link] Capital Adequacy

The functions of capital in banks include incentives function and risk sharing
function. Capital adequacy is the ability of a commercial bank to withstand
abnormal losses (Saunders and Cornett, 2005). Due to the debt-like nature of
liabilities in financial institutions, they tend to shifting risk or substitution of
assets. To avoid this, regulators require them to hold a minimum capital to assets
to reduce their sensitivity to risk (Kongiro, 2012; Saunders and Cornett, 2005).
Rose and Hudgins (2013) describe capital adequacy as the financial cushion that
banks maintain to absorb unexpected losses, supporting confidence and
soundness in the banking system. Pandey (2010) views capital adequacy as an
indicator of a bank’s financial strength, reflecting its ability to meet obligations
and continue operations during adverse conditions.

The importance of capital adequacy is that it ensures financial stability by

mitigating the risk of insolvency, it protects depositors and creditors by
providing a loss-absorbing buffer, it supports regulatory compliance, as capital
adequacy ratios are mandated by financial authorities (Basel Accords)., it
promotes market confidence and the institution’s reputation.

2.7.2 Liquidity Management Strategies

Managing liquidity is essential for maintaining the financial health and

operational stability of your business. Below are strategies to help with
corporate liquidity management:

1. Establish cash reserves

Create a financial buffer by setting aside funds for unexpected situations. This
ensures you have the liquidity to cushion against unforeseen expenses or
revenue shortfalls. Brigham and Ehrhardt (2013) state that firms balance
between holding too much cash, which incurs opportunity costs, and too little
which risks liquidity crises. Opler et al (1999) also highlight the precautionary
motive for maintaining cash reserves to safeguard against uncertainties

How Much Should Go into a Cash Reserve?

The amount that a company puts into a cash reserve account depends entirely on
its needs. Financial experts generally say that a solid reserve is one that can take
care of anywhere from three to six months of the company’s ordinary expenses.

Deciding on a reserve amount is an important financial decision for a company.

Failure to set aside enough cash makes a company financially vulnerable – but
holding too much in reserve means the company is not taking full advantage of
the opportunity to invest more funds in growing its business.
It’s important for a business to review its financial statements to help determine
how much should be placed in a cash reserve. Focusing on business expenses
and earnings, as well as the company’s cash flow statement, is the standard way
to determine how large a reserve should be. In most cases, it’s best to use the
previous year’s cash flow statement to identify how much revenue the company
earned and how much money it spent.

Subtracting expenses from total revenue reveals the total amount of money that
went toward business expenses. That figure can then be divided by the number
of months in the accounting period to determine the monthly cash burn rate.

For startups that don’t have financial statements yet, the cash reserve amount
can be established by using the company’s projected cash flow and business
budget. Subtracting the projected monthly expenses from projected monthly
revenue gives the company a number that they can then multiply by the number
of months the cash reserve should cover.

2. Utilize credit lines wisely

Maintain access to credit facilities for added financial flexibility. Use these lines
of credit judiciously to manage short-term liquidity needs without overextending
your company's debt. Pandey (2010) suggests that maintaining good
relationships with lenders and creditworthiness facilitates access to such funds.
Gitman (2009) views this as a flexible liquidity backup strategy.

A line of credit is a flexible loan from a bank or financial institution. Similar to a

credit card with a set credit limit, a line of credit is a defined amount of money
that you can access as needed and use as you wish. Then, you can repay what
you used immediately or over time.

As with a loan, you will pay interest using a line of credit. Borrowers must be
approved by the bank, which considers credit rating and/or your relationship
with the bank, among other factors. Lines of credit tend to be lower-risk than
using a credit card, but they are not as common.

A line of credit can be secured or unsecured. If you offer an asset you own as
collateral for the line of credit, you'll pay a lower rate than if you were to offer
the lender nothing they can potentially take from you in the case of default.

Unlike with personal loans, the interest rate on a line of credit is generally
variable, meaning it could change as broader interest rates change. This can
make it difficult to predict what the money you borrow will end up costing you.

Lines of credit are not intended to be used to fund one-time purchases such as
houses or cars, though they can be used to acquire items for which a bank might
not normally underwrite a loan. Most commonly, individual lines of credit are
intended for unexpected expenses or to finance projects that have unclear costs.

When you need money, you may consider getting a personal loan, which
provides a lump-sum amount. However, if you don’t know exactly how much
money you may need, you may want to consider a line of credit.

A line of credit is a revolving loan that allows you to access money as you need
it up to a certain limit. You can borrow up to that limit again as the money is
repaid. Learn more about what a line of credit is, about the different types, when
to avoid them, and how to use them to your advantage.

As with a loan, you will pay interest using a line of credit. Borrowers must be
approved by the bank, which considers credit rating and/or your relationship
with the bank, among other factors. Lines of credit tend to be lower-risk than
using a credit card, but they are not as common.

Lines of credit are not intended to be used to fund one-time purchases such as
houses or cars, though they can be used to acquire items for which a bank might
not normally underwrite a loan. Most commonly, individual lines of credit are
intended for unexpected expenses or to finance projects that have unclear costs.

Problems with Lines of Credit

Like other loan products, lines of credit have benefits and risks to consider.
Firstly, if you have poor credit, you may not even get approved for this product.
And, if you do, you'll have to pay the money back and make sure you can afford
to make those repayments.

Some banks will charge a maintenance fee (either monthly or annually), even if
you don't use the line of credit, and a transaction fee every time you draw
money. And interest starts accumulating as soon as money is borrowed. Because
lines of credit can be drawn on and repaid on an unscheduled basis, some
borrowers may find the interest calculations for lines of credit more
complicated. You could be surprised at what you end up paying in interest.

3. Balanced investment strategies

Align your investment decisions with your liquidity requirements. One of the
best ways to do this is to choose the right mix of liquid assets and longer-term
investments to optimize returns while maintaining cash availability. Brigham
and Ehrhardt (2013) recommend this to earn returns while keeping funds
accessible. Lazaridis and Tryfonidis (2006) highlight this as a strategy to
balance liquidity and profitability.

A balanced investment strategy combines asset classes in a portfolio in an

attempt to balance risk and return. Typically, balanced portfolios are divided
between stocks and bonds, either equally or with a slight tilt, such as 60% in
stocks and 40% in bonds. Balanced portfolios may also maintain a small cash or
money market component for liquidity purposes.
Understanding a Balanced Investment Strategy

There are many different ways to put together a portfolio, depending on the
preferences and risk tolerance of the investor.

On one end of the spectrum are strategies aimed at capital preservation and
current income. These generally consist of safe but low-yielding investments,
such as certificates of deposit, investment-grade bonds, money market
instruments, and some blue-chip stocks that pay dividends. Such strategies are
appropriate for investors concerned with preserving the capital they already have
and less concerned with growing that capital.

On the other end of the spectrum are strategies aimed at growth. These more
aggressive strategies generally involve a higher weighting of stocks, including
small-cap companies. If fixed income instruments are included, they might have
lower credit ratings or less security but offer a higher yield, such as in the case
of debentures, preferred shares, or higher-yielding corporate bonds. Growth
strategies are suitable for younger investors with a high-risk tolerance, who are
comfortable accepting greater short-term volatility in exchange for better
expected long-term returns.

4. Accelerate receivables

Implement policies that encourage early payments, such as offering discounts

for prompt payments, and make sure to follow up on overdue accounts. Deloof
(2003) finds that firms optimizing working capital components improve
liquidity and profitability. Shin and Soenen (1998) discuss shortening the cash
conversion cycle to enhance liquidity.

Accelerate Collection of Receivables: Strategies to Streamline Invoice to Cash

Your business may be seeing peak sales, but still struggling to have enough
cash on hand to maintain comfortable business operations. If this sounds like
your company, then the best solution is to accelerate your accounts receivable
collection so you can turn sales into capital you can actually use to maintain
your business.

There are many strategies to streamline invoice collection to get the money
owed to your company quicker. We even list several popular strategies below,
along with a few recommended services to consider. However, getting paid
ahead of or at the point of sale is always the best way to streamline your cash
inflow. But we don’t live in an ideal world and for many companies, upfront or
immediate payments aren’t an option. As such, here are seven ideas to help you
improve your accounts receivable collection strategies so you can turn your
unpaid invoices into cash more quickly:

Strategy 1: Be prepared to turn down a sale if you don’t expect rapid

payment

Some collection challenges can be avoided by choosing who you do business

with wisely. You should carefully consider who you are providing goods or
services to before you enter into a relationship with a customer. While it is
tempting to try and make as many sales as fast as possible when operating a
business, the resources and time required to collect certain payments can lead to
significant operational waste. If the potential customer has poor credit or gives
off any sort of indication that they will not be able to make payments on time,
you may want to consider not doing business with them. This is especially true
for potentially negative interactions that will stress out your employees or lead
to a bad business review or reputation hit. Even an accelerated receivables cash
flow won’t sustain your business if you constantly have to resolve issues arising
from bad customer interactions.
Strategy 2: Send reminders more frequently

Some companies make the mistake of only sending out reminders on certain
days of the month, or waiting until a certain amount of time that an invoice is
overdue before sending a reminder to pay. While this may minimize the number
of emails you have to write, fewer reminders means that your customers are
more likely to forget to pay you. Good customers usually welcome friendly
reminders that help them remember their payment obligations.

What is a good best practice? Send invoices as soon as you have fulfilled your
obligations and send a reminder about a week before the invoice is due. Don’t
wait until the start of the following month, or until the end of the week. If an
invoice goes unpaid, send an overdue invoice reminder sooner rather than later.

Strategy 3: Make sure invoices are easy to pay

In connection to the previous strategy, it doesn’t matter how many invoice

reminders you send if the process of paying invoices is difficult. However your
collection of receivables is set up at your company, you should make it very
easy for those who need to pay off their invoices to understand how much is
owed and how to pay you when they’re ready to do so.

Strategy 4: Be flexible in your payment methods

One difficulty that often leads to delayed or missed invoice payments is when a
customer is unable to pay via the requested method. Ideally, customers should
know ahead of time what is expected of them, but people make purchases all the
time without being aware of how they are supposed to pay.

If possible, offer multiple payment options to make it easier on your customer.

This may include direct deposits, credit card payments, sending in a paper
check, or some other alternative. A few of these methods may result in
transaction costs, which may be why you don’t offer them regularly to
customers. Be sure to carefully explore different payment facilitators and
processors with your company when considering alternative payment methods
for customers.

Strategy 5: Work out a credit or finance payment plan

Contact the customer, discuss their situation, and consider restructuring their
credit plan. If no plan exists, offer to finance the purchase and give them the
opportunity to pay it off in smaller chunks over time. While this isn’t a perfect
solution, it often allows companies to collect payments without having to resort
to third parties. This can also help your company save money, since many third
parties charge fees or buy consumer credit at a lower price than the value of the
goods or services you are trying to collect on. It also reduces risk; it is better to
collect a fraction of your client’s receivables owed than to collect no receivables
at all.

5. Extend payables

Negotiate longer payment terms with suppliers without compromising

relationships or incurring late fees. Focus on leveraging payment terms
effectively to maintain a healthy cash flow.

Accounts payable (AP) is the money a business owes its suppliers for goods and
services purchased on credit. It is a current liability in the balance sheet,
representing the total of approved and unpaid invoices from the suppliers.
Companies must pay these unpaid invoices on time to avoid defaults.

The accounts payable of a company display its short-term debt obligations and
impact on cash flow. When a business purchases goods on credit but this needs
to be paid back in a short time period. This is known as Accounts Payable. If the
payables increase over time, it indicates that the company buys more products
on credit. If the payables decrease, it could imply that the company is paying off
its obligations faster than they purchase new goods or services on credit.

Why are Accounts Payable and its management important?

Accounts payable and its management is vital for the smooth functioning
process of any business entity. It is important for any business because:

It primarily takes charge of paying the entity’s bills on a timely basis. This is
important so that strong credit and long-term relationships with the vendors can
be maintained. Only when invoices are paid on time, vendors will ensure an
uninterrupted flow of supplies and services; which in turn will help in the
systematic flow of business.

A good accounts payable process ensures there are no overdue charges, penalty
or late fees to be paid for the dues.

The organized accounts payable process ensures all that the invoices due are
tracked and paid properly. This will help avoid missing payments and making a
payment twice.

It also enables business entities to manage better cash flows (i.e. making
payments only when due, using the credit facility provided by the vendor, etc.)

Frauds and thefts can be avoided to a greater extent by following a stringent

accounts payable process.

6. Consider purchasing liquidity

Think about acquiring liquidity through external sources like short-term loans or
lines of credit. This can provide immediate cash flow when needed, but it's
crucial to weigh the costs and benefits carefully. Gitman (2009) emphasizes
forecasting as a proactive strategy that helps firms anticipate cash shortages or
surpluses and take corrective actions timely. Pandey (2010) supports detailed
cash budgeting as essential for managing liquidity efficiently.

In a business context, liquidity refers to the availability of means of payment,

such as cash and bank balances, and the ability to mobilize these funds in a
timely manner. A high level of liquidity means that a company is able to meet its
ongoing obligations, such as paying salaries, servicing suppliers and covering
unexpected expenses, without having to resort to external sources of funding.

In the financial world, liquidity is also a measure of the ease with which
securities or other assets can be bought or sold on the market. A liquid market is
characterized by high trading activity and low price volatility, which allows
participants to execute transactions quickly and without high costs.

There are various forms of liquidity:

Company liquidity: Refers to the ability of a company to pay its current bills and
debts.

Market liquidity: Describes how easily assets can be bought or sold on the
market without major price changes.

Bank liquidity: Includes the availability of liquid funds at banks to meet their
daily financial requirements.

Liquidity is a key indicator of financial health and stability and plays an

important role in decision-making in the financial and corporate world.

In summary, liquidity is a key element in the financial stability and flexibility of

both companies and individuals. It significantly influences the ability to
overcome financial challenges and take advantage of economic opportunities.
Importance of Liquidity: Why is Liquidity so important?

Liquidity is crucial in the financial world and for companies and individuals for
several important reasons:

Meeting short-term liabilities: Liquidity enables companies and individuals to

pay their short-term debts and current expenses such as salaries, rent, utilities
and supplier bills on time. Without sufficient liquidity, financial bottlenecks and
payment defaults can occur.

Financial stability and confidence: Companies with high liquidity are

considered more financially stable and less risky. Investors, lenders and business
partners prefer such companies as they are less susceptible to payment defaults.
This strengthens confidence in the company and facilitates access to financing
and better conditions.

Crisis management: In times of economic uncertainty or unexpected events,

such as market crises or natural disasters, liquidity is crucial. It enables
companies to absorb financial shocks without jeopardizing their long-term goals
and investments.

Flexibility and ability to act: Liquidity provides the necessary flexibility to react
quickly to market opportunities. Companies can make investments, start new
projects or make acquisitions when attractive opportunities arise without having
to rely on external sources of financing.

7. Centralize all financial data

An effective technique for managing liquidity is centralizing all financial data. If

you want to enjoy easier tracking, analysis, and decision-making, ensuring you
have a comprehensive view of your company's financial health is the way to go.
2.7.3 Factors Influencing Liquidity in MFIs

Liquidity in microfinance refers to the ability of microfinance institutions

(MFIs) to meet their short-term financial obligations and provide timely access
to funds for their clients. Several factors can influence liquidity in microfinance,
including:

1. Funding Sources: The availability and diversity of funding sources, such as

loans from commercial banks, grants, equity investments, and deposits from
clients, significantly impact liquidity. MFIs that rely heavily on a single source
of funding may face liquidity challenges if that source becomes unavailable.

Costs incurred in descendant projects will be associated back to their funding

source, enabling the tracking of funds across your organization. Funding sources
are created with a fixed amount as well as a start date and end date for when
funds can be used.

Depending on what system settings are on or off, funding sources can be used in
more or less restrictive ways. Funding sources can be available to all projects in
the organization. They also may or may not require allocations.

2. Client Repayment Behavior: The repayment rates of clients influence

liquidity. High repayment rates enhance liquidity by ensuring a steady flow of
cash into the MFI. Conversely, high default rates can strain liquidity as the
institution may struggle to cover its obligations.

Some of the factors that influence repayment behavior are:

Personal factors: These include the borrower's income, expenses, savings, assets,
liabilities, financial goals, and personal values. For example, a borrower who
has a stable income, low expenses, and high savings may be more likely to pay
their debts on time and in full than a borrower who has a variable income, high
expenses, and low savings. Similarly, a borrower who values financial security
and freedom may be more motivated to repay their debts than a borrower who is
indifferent or reckless about their finances.

Behavioral factors: These include the borrower's habits, attitudes, beliefs,

emotions, and biases that affect their decision-making and actions regarding
their debts. For example, a borrower who has a habit of paying their bills on the
due date may be more likely to pay their debts on time than a borrower who
procrastinates or forgets to pay their bills. Likewise, a borrower who has a
positive attitude and belief in their ability to repay their debts may be more
likely to pay their debts in full than a borrower who has a negative attitude and
belief in their ability to repay their debts.

Environmental factors: These include the external factors that affect the
borrower's financial situation and opportunities, such as the economy, the
market, the interest rates, the inflation, the regulations, the social norms, and the
peer pressure. For example, a borrower who faces a recession, a market
downturn, a high interest rate, or a high inflation may be more likely to default
on their debts than a borrower who faces a boom, a market upturn, a low interest
rate, or a low inflation. Similarly, a borrower who faces a strict regulation, a
social norm, or a peer pressure to repay their debts may be more likely to repay
their debts than a borrower who faces a lax regulation, a social norm, or a peer
pressure to default on their debts.

Repayment behavior can be changed by using various strategies, such as:

Education: Educating the borrower about the benefits and consequences of

repaying or defaulting on their debts, such as improving or damaging their credit
score, saving or paying more interest, avoiding or facing legal actions, and
achieving or missing their financial goals.
 Incentives: Offering the borrower incentives to repay their debts, such as
rewards, discounts, bonuses, or recognition for timely and full payments, or
penalties, fees, charges, or sanctions for late or partial payments.

Nudges: Nudging the borrower to repay their debts, such as reminders, prompts,
notifications, or messages that encourage, persuade, or urge the borrower to pay
their debts on time and in full.

Support: Providing the borrower support to repay their debts, such as

counseling, coaching, mentoring, or guidance that help the borrower plan,
budget, manage, or resolve their debts.

Restructuring: Restructuring the borrower's debts, such as modifying,

refinancing, consolidating, or settling their debts to make them more affordable,
manageable, or favorable for the borrower.

Payment history: The borrower's record of paying their debts on time and in full,
such as the number, frequency, amount, and duration of their payments, and the
number, frequency, amount, and duration of their delinquencies, defaults, or
bankruptcies.

Debt-to-income ratio: The borrower's ratio of their total debt to their total
income, which indicates their ability to cover their debt obligations with their
income.

Credit utilization ratio: The borrower's ratio of their total credit balance to their
total credit limit, which indicates their level of reliance on their credit.

Credit mix: The borrower's mix of different types of credit, such as revolving
credit (such as credit cards) and installment credit (such as loans), which
indicates their diversity and experience in handling different kinds of debt.

Repayment behavior can improve or worsen the borrower's repayment ability

rating, depending on whether they pay their debts on time and in full or not. A
higher repayment ability rating means a lower risk for the lender and a higher
chance for the borrower to get approved for more credit, lower interest rates, and
better terms and conditions. A lower repayment ability rating means a higher
risk for the lender and a lower chance for the borrower to get approved for more
credit, higher interest rates, and worse terms and conditions. Therefore,
repayment behavior is a crucial factor that affects the borrower's financial well-
being and opportunities.

3. Loan Portfolio Quality: The quality of the loan portfolio, including the level
of non-performing loans (NPLs), directly affects liquidity. A high level of NPLs
can reduce cash inflows and create liquidity problems for the institution.

Here are some in-depth insights into loan portfolio quality:

Loan documentation: The quality of a loan portfolio is influenced by the quality

of the loan documentation. If the loan documentation is incomplete or
inaccurate, it increases the risk of default and negatively impacts the net charge-
off rate. For example, if the borrower's income and employment information is
not verified, it can lead to loans being granted to unqualified borrowers.

Underwriting standards: Underwriting standards are crucial in determining the

quality of a loan portfolio. Lax underwriting standards can lead to higher default
rates and negatively impact the net charge-off rate. For example, if a financial
institution approves loans without verifying the borrower's ability to repay the
loan, it increases the risk of default.

Credit risk policies: Credit risk policies are essential in managing the quality of
a loan portfolio. If the credit risk policies are not well-defined or not followed, it
can lead to higher default rates and negatively impact the net charge-off rate. For
example, if a financial institution does not have policies in place to monitor the
borrower's creditworthiness, it increases the risk of default.
Economic conditions: Economic conditions also play a vital role in determining
the quality of a loan portfolio. A recession or economic downturn can lead to
higher default rates and negatively impact the net charge-off rate. For example,
during the 2008 financial crisis, many financial institutions experienced higher
net charge-off rates due to the economic conditions.

Assessing loan portfolio quality is critical in managing credit risk. The net
charge-off rate is a fundamental indicator of the loan portfolio's quality, and it
provides insight into the institution's credit risk management practices. By
evaluating the loan documentation, underwriting standards, credit risk policies,
and economic conditions, financial institutions can effectively manage their loan
portfolio quality and maintain a low net charge-off rate.

4. Operational Efficiency: The efficiency of an MFI's operations, including its

cost structure and management practices, can impact liquidity. Efficient
operations can lead to lower costs and better cash flow management, enhancing
liquidity.

Factors influencing operational efficiency

Operational efficiency requires a company to cost-effectively streamline its base

operations while eliminating redundant processes and waste. Most organizations
do this by focusing on resource utilization, production, inventory management
and distribution.

Resource utilization aims to minimize waste in production and operations. In the

digital and service-oriented economy, minimizing waste extends to optimizing
software efficiency, data utilization and virtual services.

Production focuses on making the production environment as organized as

possible. Employees and equipment should work as well as they can to increase
production efficiency.
5. Regulatory Environment: Regulations governing microfinance institutions,
including capital requirements and reserve ratios, can influence liquidity.
Stricter regulations may require MFIs to maintain higher liquidity reserves,
impacting their ability to lend.

6. Market Conditions: Economic and market conditions, such as inflation rates,

interest rates, and overall economic stability, can affect liquidity. For instance,
high inflation may increase operational costs and reduce the purchasing power
of clients, impacting their ability to repay loans.

7. Seasonality of Demand: The demand for microfinance services can be

seasonal, depending on agricultural cycles or local economic activities. MFIs
must manage their liquidity to accommodate fluctuations in demand throughout
the year.

8. Risk Management Practices: Effective risk management strategies,

including credit risk assessment and cash flow forecasting, can help MFIs
anticipate liquidity needs and mitigate potential shortfalls.

9. Investment Policies: The investment strategies adopted by MFIs can also

influence liquidity. Investments in illiquid assets can tie up funds that could
otherwise be used for lending or meeting short-term obligations.

10. Technology and Innovation: The adoption of technology in microfinance

operations can enhance efficiency and improve liquidity management. Digital
platforms can streamline processes, reduce transaction times, and improve client
engagement, leading to better cash flow.

2.7.4 The Relationship Between Liquidity and Financial Performance

Liquidity and financial performance are closely linked in financial management.

Liquidity refers to an institution’s ability to meet its short-term obligations,
while financial performance measures how well the institution utilizes its
resources to generate profits.

Shin and Soenen (1998) found a positive relationship between liquidity and
profitability, arguing that firms with adequate liquidity are better positioned to
meet obligations and avoid financial distress, which supports stable operations
and profitability. Deloof (2003) suggested that firms that manage liquidity
effectively by optimizing working capital components tend to have better
financial performance due to efficient use of resources.

Raheman and Naser (2007) argue that while liquidity is necessary, holding
excessive liquid assets can reduce profitability because such assets typically
yield lower returns, indicating a trade-off between liquidity and financial
performance. Lazaridis and Tryfonidis (2006) emphasized that maintaining an
optimal level of liquidity is crucial, as both insufficient and excessive liquidity
can adversely affect profitability.

Kipesha and Zhang (2013) highlighted that liquidity management significantly

affects the financial performance of microfinance institutions by ensuring they
can meet client demands while maintaining profitability. Naser et al (2013)
found that poor liquidity management in MFIs leads to financial distress and
reduced profitability.

Impact of Liquidity on Financial Performance

Deloof (2003) found that efficient liquidity management, through the

optimization of working capital components, positively impacts profitability by
reducing costs and improving operational efficiency. Shin and Soenen (1998)
demonstrated that firms with better liquidity positions tend to achieve higher
profitability because they avoid financial distress and maintain uninterrupted
operations. Gitman (2009) supports that view that liquidity ensures firms can
meet their obligations timely, which sustains investor confidence and enhances
overall financial performance.

Raheman and Naser (2007) argue that while liquidity positively influences
financial performance, excessive liquidity can adversely affect profitability due
to the opportunity cost of holding non-earning assets. Lazaridis and Tryfonidis
(2006) emphasize the importance of maintaining an optimal liquidity level, as
both liquidity shortages and surpluses can negatively impact financial outcomes.

In microfinance institutions, Kipesha and Zhang (2013) highlight that liquidity

management directly affects financial sustainability, enabling MFIs to serve
clients effectively while maintaining profitability. According to Naser et al,
(2013), liquidity constraints in MFIs can lead to reduces lending capacity and
lower financial returns, demonstrating liquidity’s pivotal role in their
performance.

Impact of Financial Performance on Liquidity

Gitman (2009) explains that strong financial performance reflected in higher

profitability and cash flows, improves a firm’s liquidity by increasing internal
funds available to meet short-term obligations. Brigham and Ehrhardt (2013)
argue that profitable firms generate sufficient operating cash flow, which
directly contributes to better liquidity management and reduces reliance on
external financing.

According to Deloof (2003), firms with better financial performance can convert
earnings into cash more efficiently, enhancing liquidity and enabling smoother
operations. Pandey (2010) emphasizes that improves profitability and retained
earnings provide firms with flexibility in liquidity management, allowing them
to maintain cash reserves or invest in liquid assets.
In Microfinance institutions, Kipesha and Zhang (2013) observe that improved
financial performance strengthens liquidity by increasing operational self-
sufficiency and reducing liquidity risks.

2.7.5 Conceptual Framework

This study is based on the following conceptual model.

Working capital
management

Asset liquidity

Financial
Liquidity performance
management
Cash management

Financing liquidity
2.8 Empirical Review

Hart (1998) defines an empirical review as the process of critically analyzing

past research that involves data collection and observation to inform the current
study. Ridley (2012) describes empirical reviews as evaluations of studies that
test hypothesis through experiments, surveys, or other data-gathering methods,
providing evidence-based insights.

2.8.1 Overview of Empirical Studies on Liquidity Management

Liquidity is a measure of the ability and ease with which assets can be converted
to cash. Liquid assets are those that can be converted to cash quickly if needed
to meet financial obligations; examples of liquid assets generally include cash,
central bank reserves, and government debt.

To remain viable, a financial institution must have enough liquid assets to meet
its near- term obligations, such as withdrawals by depositors. The main
measures of liquidity current ratio, capital ratio, cash ratio, quick ratio,
investment ratio.

According to Sugar and Rajesh (2008), Success of any bank depends on level of
liquidity that is sufficient for its operation. Inefficient management of liquidity
results in serious impairment of banking functions and contagious effect on the
economy. A bank is set to be liquid if it stores sufficient liquid assets and cash
together with the ability to raise fund quickly from other sources to enable it to
meet its payment obligations and financial commitments in a timely manner.

To understand liquidity management, we need to contemplate on liquidity

creation, so let’s picture a firm in need of long-term financing in a world without
banks. In such a world, savers would directly finance the funding needs of the
firm, and they would end up with an illiquid claim against the firm. In contrast,
in a world with banks and other financial institutions, it is the institution that
provides the long-term loan to the firm, and the bank is able to offer savers
demand deposits. So it is the institution that holds the illiquid claim against the
firm and savers end up with a liquid claim against the bank. Because of this
difference in liquidity between what banks do with their money and the way
they finance their activities, banks are said to create liquidity. Inherent in the
liquidity creation in these models is maturity transformation. (Bhattacharya and
Thakor (1993) and Hellwig (1994).

Therefore, the term “Liquidity creation” refers to the fact that banks provide
illiquid loans to borrowers while giving depositors the ability to withdraw funds
at par value at a moment’s notice (e.g., Bryant, 1980; Diamond and Dybvig,
1983). According to Diamond and Dybvig (1983), this liquidity creation exposes
MFI to withdrawal risk. Fear that other depositors may rush in to withdraw their
deposits prematurely even though they may not have liquidity needs can cause
all depositors to withdraw, precipitating a Microfinance run as one of two
possible equilibrium. It is impossible for the bank to “provision” for such an
event, short of practicing 100% reserve banking, i.e., keeping all deposits as
cash in vault. But such an institution would be merely a safe-deposit box, rather
than a bank that creates liquidity.

Diamond and Dybvig (1983) argue that federal deposit insurance can eliminate
bank runs, thereby ridding banks of the prospect of the large-scale deposit
withdrawals that characterize such runs. But of course, the intent of deposit
insurance is to help banks deal with panic runs, not substitute for the liquidity
banks need to keep on hand to meet day- to-day routine deposit withdrawals.
Thus, even with deposit insurance, banks need to worry about having enough
liquidity on hand to meet the normal liquidity needs of depositors.
2.8.2 Liquidity Management

Liquidity Management is a concept broadly describing an institution’s ability to

meet financial obligations through cash flow1, funding activities and capital
management. Liquidity management can be challenging as it is impacted by
revenue and cost generating activities, capital and dividend plans and tax
strategies. (Wikipedia)

Business can only operate under the state of adequate liquidity. A bank or any
financial institution is said to be liquid, if it can convert its assets to cash with
minimum amount of delay and inconvenience. A bank or financial institution
should ensure that it does not suffer from lack of liquidity and does not also
have excess liquidity. Failure to meet obligation due to lack of sufficient
liquidity results in poor credit worthiness and loss of creditors‟ confidence.
However, a high degree of liquidity results in idle cash. Thus, liquidity
management as a concept encompasses efficient and effective planning and
organization of Bank’s assets which will enhance its liquidity and profitability at
a minimum cost possible. It is the ability of an institution to meet demands for
funds thereby ensuring that the institution maintain sufficient cash and liquid
assets to satisfy client demand for loans and savings withdrawals and then meet
its expected expenses.

Liquidity is a precondition to ensure that financial institutions are able to meet

its short- term obligations. The liquidity position in a company is measured
based on 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 (Beck &Hesse, 2006). The quick ratio establishes a
relationship between quick or liquid assets and current liabilities. An asset is
liquid if it can be converted into cash immediately or reasonably soon without a
loss of value. Low liquidity leads to the inability of a company to pay its
creditors on time or honor its maturing obligations to suppliers of credit,
services and goods. This could result in losses on account of non-availability of
supplies and lead to possible insolvency. Also, the inability to meet the short-
term liabilities could affect the company's operations and in many cases, it may
affect its reputation as well (Egesaand Abuka, 2006). Inadequate cash or liquid
assets on hand may force a company to miss the incentives given by the
suppliers of credit, services, and goods as well. Loss of such incentives may
result in higher cost of goods which in turn affects the profitability of the
business (De-Young & Rice, 2004). Every stakeholder has interest in the
liquidity position of a company. Suppliers of goods will check the liquidity of
the company before selling goods on credit. Employees should also be
concerned about the company's liquidity to know whether the company can meet
its employee related obligations, i.e., salary, pension, provident fund, etc. Thus,
a company needs to maintain adequate liquidity (Deger&Adem, 2011). In
today’s society, financial institutions hold a considerable market share, with the
IMF estimates that across all banking sector assets in developing countries, the
market share of co-operative finance was equivalent to 14 percent in 2004
(Goddard et al., 2004). Previous research on financial institutions during crisis
indicates that they tended to fare better than investor-owned savings and loans
institutions, as they pursue more conservative investment policies (Hoffmann,
2011). For instance, analysis from the IMF indicates that co-operative banks in
developed countries tend to be more stable than commercial banks, especially
during financial crisis, as their investment patterns tend to be less speculative
and returns are therefore less volatile (Iannotta et al., 2007).
2.8.3 Relationship between Liquidity management practices on
performance of Microfinance institutions

[Link] Liquidity Management Practices

The process of liquidity management begins with the stipulation of liquidity

management policies by the BOD as the ultimate guidance for all entities in the
organization. For this purpose, there are at least three requirements for BOD to
carry out; (a) the BOD has to understand the bank’s liquidity risk profile and the
internal and external business environment and stipulate the liquidity risk
tolerance; (b) the BOD has to determine and approve the strategies, policies, and
practices of liquidity risk management; (c) and the BOD has to disseminate,
communicate, and guide the senior managers to manage liquidity effectively
(BIS, 2008)

The policies must contain the specific goals and objectives of managing
liquidity, including the short-term and long-term strategies of managing
liquidity. The policies determine the roles and responsibilities of the bodies
involved in the liquidity management process, including asset and liability
management policies, and the relationship with other financial institutions and
regulators. When preparing and formulating the liquidity management policies,
BOD may consider and incorporate ideas from the bodies in charge of managing
liquidity risk such as the Chief Executive Officer (CEO) and heads of risk
management departments (divisions). In particular, input from banking
regulators and stakeholders are also very important to be taken into account in
the policies. This intensive integrative cooperation and coordination will ensure
that the board fully understands the realities of the internal and external business
environments in order to be able to formulate applicable liquidity management
policies (BIS, 2008).
Following the liquidity management policies and, the roles of the Asset liability
committee and their counterparts, the effective information system comes next
to support the liquidity management process (BIS, 2008). This system enables
banks to monitor, report, and controls the liquidity risk exposure and determines
the funding needs inside and outside the organization. In general, the effective
information system concerns two players, namely; the decision makers of
liquidity management and the decision followers on the operational level.

Practically, upon receiving the commands on managing liquidity from the

decision makers, the senior managers assign and monitor their subordinates, and
ask them to report the implementation of liquidity management. The decision
makers receive a special internal report about any liquidity risk problem, and the
internal and external liquidity management information from senior managers.
In some cases, the bank management publishes reports about the implementation
of liquidity management for public disclosure to enable market participants to
make an informed judgment about the soundness of the bank’s liquidity risk
management framework and liquidity position (BIS, 2008).

In order to maintain the soundness of the liquidity management process, the

banks should have an internal control system to comply the process conducted
by the decision followers with the one stipulated by the decision makers (BIS,
2008). This internal control system can be assigned to ALCO as a representative
of BOD to bridge the gap between decision makers and decision followers.
However, the regular functions of the internal control system are to
comprehensively audit the liquidity management process, to evaluate the
liquidity position, and, when necessary, to propose revision or enhancement of
the liquidity management process to the BOD.
[Link] Liquidity Risk Management Process

An effective liquidity risk management process should include systems to

identify, measure, monitor and control its liquidity exposures. Management
should be able to accurately identify and quantify the primary sources of a
bank’s liquidity risk in a timely manner. To properly identify the sources,
management should understand both existing as well as future risk that the bank
can be exposed to. Management should always be alert for new sources of
liquidity risk at both the transaction and portfolio levels. Key elements of an
effective risk management process include an efficient MIS to measure, monitor
and control existing as well as future liquidity risks and reporting them to senior
management and the board of directors.

[Link] Liquidity Management System (MIS)

An effective management information system (MIS) is essential for sound

liquidity management decisions. Information should be readily available for
day-to-day liquidity management and risk control, as well as during times of
stress. Data should be appropriately consolidated, comprehensive yet succinct,
focused, and available in a timely manner. Ideally, the regular reports a bank
generates will enable it to monitor liquidity during a crisis; managers would
simply have to prepare the reports more frequently. Managers should keep crisis
monitoring in mind when developing liquidity MIS. There is usually a trade-off
between managing liquidity risk accuracy and timeliness. Liquidity problems
can arise very quickly, and effective liquidity management may require daily
internal reporting. Since bank liquidity is primarily affected by large, aggregate
principal cash flows, detailed information on every transaction may not improve
analysis.

Management should develop systems that can capture significant information.

The content and format of reports depend on a bank's liquidity management
practices, risks, and other characteristics. However, certain information can be
effectively presented through standard reports such as "Funds Flow Analysis,"
and "Contingency Funding Plan Summary". These reports should be tailored to
the bank's needs. Other routine reports may include a list of large funds
providers, a cash flow or funding gap report, a funding maturity schedule, and a
limit monitoring and exception report. Day-to-day management may require
more detailed information, depending on the complexity of the bank and the
risks it undertakes. Therefore, Management should regularly consider how best
to summarize complex or detailed issues for senior management or the board.

[Link] Liquidity Management Structure

The responsibility for managing the overall liquidity of the bank should be
delegated to a specific, identified group within the bank. This may be in the
form of an Asset Liability Committee (ALCO). Since liquidity management is a
technical job requiring specialized knowledge and expertise, it is important that
responsible officers not only have relevant expertise but also have a good
understanding of the nature and level of liquidity risk assumed by the bank and
the means to manage that risk. It is critical that there can be close links between
those individuals responsible for liquidity and those monitoring market
conditions, as well as other individuals with access to critical information. This
is particularly important in developing and analyzing stress scenarios.

2.8.4 Financial Performance of Microfinance.

Ball & Shivakumar (2004, describes financial performance as a comparison of

companies across the same industry or sectors in aggregation over a given
period of time. It measures the financial soundness over a given time period. It is
a measure of financial institution’s policies and operations in monetary terms.
Bank’s financial performance is measured in different ways, reflected in the
firm’s value, asset return and investment return. Mishkin (2007) stated that sale
of products by financial industry is in the business of earning profits.
Development of new products is for the satisfaction of client needs and those of
the financial institution so as to maximize profits. According to McNamee and
Selim (1999), this innovation process leads to a search for profitable innovations
by financial institutions due from a change in the financial environment.

According to Apps (1996), financial performance is measured using: repayment

rate, portfolio quality ratios, arrears ratio rate portfolio rate and delinquent
borrowers. Repayment rate measures the amount of payment received with
respect to the amount due. Portfolio quality ratios; involves the arrears rate,
portfolio risk and delinquent borrowers. The amount of loans that have become
payable and have not been paid are the rate of arrears. Unpaid amount for all
loans are the rate of portfolio. Number of delinquent borrowers relative to
volume of delinquent loans is determined by delinquent borrowers.

Ball & Shivakumar (2004) in their study described that majority of financial
intermediaries were unable to obtain funding which could soon make them out
of business because they only had instruments of finance which were traditional.
Research and development of new products and services to profit the company
and meet customer needs for financial institutions ensures sustainability in a
changing economic environment. These are the basic types of financial
innovation: regulations avoidance, supply conditions changes responses and
demand conditions supply changes responses.

Firm’s investment return, assets return, added value, among others is subjective
measures on how a firm can use assets from its primary operations in business
and it generates revenue. These are some of the different ways to measure a
MFI’s financial performance. Financial performance of MFIs can be evaluated
using many financial indicators such as liquidity ratios, profitability ratios and
others for example (Saleh & d Zeitun, 2007). However, in this paper will use
three major profitability indicators to evaluate the financial performance of
MFIs, namely ROA as a stable measure of financial performance.

2.8.5 Assessment Of Bank’s Performance:

Berger and Humphrey (1997) describe bank performance assessment as

analyzing efficiency, profitability, and risk management using financial ratios
and advanced econometric methods. Athanasoglou et al (2008) emphasize that
bank performance is influenced by internal factors such as market conditions
and regulatory environment. In order to determine the extent of the bankability
to make profits from its invested money, there are different financial ratios
related to both the owners and depositors. The following two ratios are the most
important earnings ratios used in assessing the bank profitability:

Return on assets (ROA), this ratio measures the efficiency of a firm at

generating profits from each unit of shareholder equity, also known as net assets
or assets minus liabilities. ROE shows how well a company uses investments to
generate earnings growth (Athanasoglou et al, 2008).

Return on Equity (ROE), this ratio measures the efficiency of a firm at

generating profits from each unit of shareholder equity, also known as net assets
or assets minus liabilities. ROE shows how well a company uses investments to
generate earnings growth (Kosmidou, 2008).

2.8.6 Relationship between Liquidity Management and Performance of

Microfinance institutions

Sufian (2010), asserts that the objective of liquidity management is to gear

banks towards a financial position that enables them meet their financial
obligations as they arise. Lack of adequate liquidity in a bank is often
characterized by the inability to meet daily financial obligations. At time it may
have the risk of losing deposits which erodes its supply of cash and thus forces
the institution into disposal of its more liquid assets.

As opined by (Stiroh & Rumbie, 2006), managing monies of a firm in order to

maximize cash availability and interest income on any idle cash is a function of
liquidity management. However, the problems of weak corporate governance,
poor capital base, illiquidity and insolvency, poor asset quality and low earnings
are some of the constraints faced by the banking system. According to Tianwei
and Paul (2006), deposit mobilization is one of the most important functions of
banks. This enables deposits to be mobilized which otherwise would have
remained idle and unproductive in the surplus economic unit and the need for
adequate income through interest on loan is as well as important as this will
ensure continued provision of productive resources. Therefore it is uneconomic
and financially unreasonable for institutions to allow excess idle cash in the
vault or excess liquidity. Rather, they should manage their liquidity to
maximized revenues while holding risks of insolvency at a desired level.

Liquidity management therefore refers to the planning and control of liquid

assets either as an obligation to the customers financial needs or as a measure to
adhere to the monetary policies of the Central Bank. For a commercial bank or
any financial institution to plan or manage its liquidity position, it must comply
firstly with the legal requirement concerning its cash position (Trujillo-Ponce,
2012).

However, Vander-Vennet (1996) opines that it is very essential for banks and
other financial institutions to manage and maintain adequate funds for
operations in order to avoid excesses or deficiencies of the required primary
reserves. Where there is a decline in the market price of securities or where
additional funds needed to correct the bank reserve position are for a short time,
it will be definitely expensive to secure securities than to borrow from another
bank. Moreover, it may be more desirable to borrow for bank’s liquidity needs
than to call back outstanding loan or cancel out rightly or place embargo on new
loans, a situation that will reduce the customer confidence in the bank.

Effective liquidity management therefore involves obtaining full utilization of

all reserves. The primary reserves are made of vault cash, cash balances or
excess reserves with the CBN, as well as deposits with other banks, both locally
and abroad. They are maintained to satisfy legal and operational requirements.
While the secondary reserves are those liquid assets that can be converted into
cash without impairment of the principal sum invested. Secondary reserves are
characterized by short maturity, high credit quality and high marketability. The
secondary reserves are held primarily to meet both anticipated and unanticipated
short-term and seasonal cash needs from depositors. They contribute to that
attainment of both profitability and liquidity objective of financial institution
(Wanjohi, 2013).