1.1 BACKGROUND OF THE STUDY
Liquidity management is a concept that is receiving serious attention all over the world especially with the current financial situations and the state of the world economy. Some of the striking corporate goals include the need to maximize profit, maintain high level of liquidity in order to guarantee safety, attain the highest level of owner’s networth coupled with the attainment of other corporate objectives. The importance of liquidity management as it affects corporate profitability in today’s business cannot be over emphasised. The crucial part in managing working capital is required maintenance of its liquidity in day-to-day operation to ensure its smooth running and meets its obligation (Eljelly, 2004). Liquidity plays a significant role in the successful functioning of a business firm.
Liquidity entails meeting obligations as they fall due and striking a balance between the current assets and current liabilities. Jensen (1986) observes that companies are strained when their level of liquidity is low and have negative working capital. This is because either inadequate liquidity or excess liquidity may be injurious to the smooth operations of the organization (Janglani and Sandhar, 2013). Almeida et al (2002) proposed a theory of corporate liquidity demand that is based on the assumption that choices regarding liquidity will depend on firms’ access to capital markets and the importance of future investment to the firms. The model predicts that financially constrained firms will save a positive fraction of incremental cash flows, while unconstrained ones will not. The cost incurred in a cash shortage is higher for firms with a larger investment opportunity set due to the expected losses that result from giving up valuable investment opportunities. A liquid company takes advantage of available investments, cash discounts and lower interest charges on borrowings. Hence there is a relationship between cash holdings and investment opportunity and thus financial performance.
The difficulties experienced by some banks and other financial institutions during the financial crisis were due to lapses in basic principles of liquidity management. In response, as the foundation of its liquidity framework, the Committee in 2008 published Principles for Sound Liquidity Risk Management and Supervision (“Sound Principles”). Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses (Basel Committee on Banking Supervision, 2013). The liquidity of an asset depends on the underlying stress scenario, the volume to be monetized and the timeframe considered. Therefore, efficient and effective liquidity management is crucial if the survival and prosperity of firms is to be assured. According to the Banking Act (2014) and CBK Prudential Guideline (2013), an institution shall maintain such minimum holding of liquid assets as the Central Bank may from time to time determine. Kenyan banks are required to maintain a statutory minimum of twenty per cent (20%) of all its deposit liabilities, matured and short term liabilities in liquid assets. Liquidity Ratio is determined by net liquid assets and total short term liabilities.