Liquidity was found to be one of the most important unresolved problems in the field of corporate finance (Brealy and Myers, 1996). In addition, the same studies found that the liquidity management was the pinpoint of determining both future investment opportunities and future capacity of external borrowing.

Firms, in general, invested in the liquid assets. Liquid assets made up a substantial division of total capital or assets and had the more important implications for the risk and profitability of firms (John, 1993). For instance, according to Kim, David, and Ann (1998), the average ratio of cash plus marketable securities to total assets (Liquidity) was 8.1% during the period of 1975 to 1994 of a sample of 915 industrial firms of the United States of America. Kim et al. (1998) analyzed both the costs and benefits of holding the liquid assets and concluded that the investment in liquid assets (e.g., Treasury Securities) was more costly because by investing in liquid assets, the firms accepted opportunity cost of investing in less liquid and more rewarding assets; furthermore, the firms also bear transaction costs of trading financial securities. However, firms managed significant and predictable amounts of excess liquid asset holdings because of the capital market imperfections provided a strong logic to maintain some excess liquidity to tackle some emergencies. Huberman (1984), Ang (1991), and Myers and Rajan (1995) had noted that liquid assets might prompt more severe agency problems than less liquid assets.

Specifically, if and only if the external financing was costly then the investment in liquid assets was the most advantageous reply to having to seek costly external financing to fund future production needs or investment opportunities and the costs of external financing included the direct expense to issue securities, the costs arising from potential agency conflicts, and costs arising from the adverse selection problems attributable to asymmetric information (Smith, 1986). Thus, investment in surplus liquidity could be viewed as a cost-effectively rational way to reduce the firm’s reliance on costly external financing. Obviously, any such remuneration must be balanced against the holding costs that liquid assets force on the firm. Liquid assets earned a low rate of return as compared to the less liquid assets. However, the firms despite decided to hold a positive amount of liquid assets provided undecided future in-house funds and costly external financing. Hence, it was concluded that there was a tradeoff between the holding cost of liquid assets (a low rate of return) and the benefit of minimizing the need to seek costly external financing if internally generated funds were insufficient to finance future investment opportunities.

According to Horne and David (1968), liquidity could be expressed as the ability to realize value in an accepted means of exchange. Being the acceptable means of exchange, money was the most liquid asset and was also a benchmark against which the value of other type of monetary assets was compared as to its degree of replacement. In addition, liquidity had two dimensions: the one was the time required to convert the asset into money, and the other was the certainty of the price realized, i.e., the stability of the exchange ratio between the money and the asset.

In the business world, there was the high corporate demand for liquidity and firms in the real, financial and industrial sectors managed its liquidity needs in the numerous ways in order to carry out further production and investment plans efficiently without being stopped by impermanent liquidity deficiencies. The firms’ decisions regarding the future ability to avail financial funds was affected by several key factors such as the capital structure set deadlines for settling the amounts to investors, corporations did not invest all of its resources in the most profitable, long term projects and in fact firms also invested funds in less profitable liquid assets, the corporations engaged in the risk management and derivatives were used to evade the particular risks (such as rate risk, exchange rate risk, etc.), and lastly, international risk burden was also measured by the companies. (Holmstrom and Jean, 2000)

1.2 Problem Statement

In the corporate finance, the liquidity was considered to be one of the most important issues. The main objective behind the study of the corporate liquidity was that this was the most important issue for the present firms either to invest in the more liquid assets or to invest in the less liquid assets. Furthermore, investment in liquid assets was prompted by several other factors such as the future investment opportunities and future uncertain cash flows and the external costly financing. Contrastingly, the investment in less liquid assets attracted the corporations because of the high rate of return of such investments.

The purpose of the study was to notice whether the financial factors explained in detail by Kim and David and Ann (1998), and John (1993), presented the detail regarding the choice of the firm to invest in liquid or non-liquid assets in Pakistan. The scope of study was to analyze the distinctive financial factors which affected the firms’ decisions to place their funds in more liquid assets and on the basis of firms’ financial factors, the research study determined the choice of investing in liquid assets or the choice of having internal liquidity.

1.3 Hypotheses