Resumen
Lack of short-term liquidity often is a concern for any manufacturing company as it may disrupt the regular business operation. Excessive liquidity has its own opportunity cost creating a possibility of principal-agent conflict in a corporate setting. This paper looks at the working capital practices of the pharmaceutical sector of Bangladesh to identify how liquidity of these firms affects profitability. The paper focuses in developing three novel indices that reflect combined liquidity, activity, and gross profitability of the selected firms. Post-estimation of Pooled OLS, Random, and Fixed effect models demonstrates that these models are inefficient and inconsistent while indicating possibility of time dependency of the profitability (ROA) variable. The Instrumental Variable approach and 2 Stage Least Square (2SLS) regression model have been utilized considering the first-order lagged ROA as the endogenous variable. First stage regression shows that first-order lagged values of Liquidity and ROE have significant positive impact on the first order lagged value of ROA. The results of the IV regression using the 2SLS method show that ROE and the first-order lagged value of the ROA (IV) have positive impact on the liquidity. This result implies that the liquidity of the previous year affects earning power of that year as well as the current year. The reason for such a relationship could/might? be the high inventory turnover days as the industry average is 200 days. Policy recommendations for managers of Pharmaceutical Industries are made to revisit existing inventory management policies, carefully managing the liquidity, implementing efficient cost management and asset utilization policies as they affect current and future liquidity and profitability of the firms.Keywords: Working capital, liquidity, activity, profitability, time dependency of liquidity and profitability, IV (2SLS) regression