Differences Between Liquidity and Profitability
The liquidity is the ability of a firm to pay its short term obligation for the continuous operation. A firm is considered normally financially solid and low risky which has huge cash in its balance sheet. The liquidity is not only measured by the cash balance but also by all kind of assets which can be converted to cash within one year without losing their value. It has primary importance for the survival of a firm both in short term and long term whereas the profitability has secondary important. The profitability measures the economic success of the firm irrespective to cash flow in the firm. It is often observed that a firm is very profitable in its books but it does not have sufficient cash and cash equivalent to pay its daily bills and due obligations. That is an illustration of classical poor liquidity management. The empirical studies have proved it that a large number of the firms are bankrupt not because they are not profitable but they do not have sufficient liquidity.
The liquidity of a firm is measured primarily by current ratio and net working capital whereas the profitability is measured by return on assets and return on equity. The liquidity focuses on short term assets which generate low profit and contain low risk. The current ratio is considered acceptable if current assets to current liabilities are equal to 1. In this case the net working capital is zero which is current assets minus current liability. The acceptable rule of thumb of current ratio equal to 1 is dangerous to some extent. The current assets of a firm should be at least at the level which covers the current liability with some extra margin of safety of current assets. The negative working capital generally is a sign of short term financing requirement which is normally expensive and considered an extra burden to reduce the profit. It is an important determinant for corporate loan business to evaluate the working capital, current assets and current liability of borrower firm before providing any credit facility. The liquidity measures also include the quality of current assets. The assets which can be converted in cash within a year without losing their value are considered qualitative current assets.
Profitability and liquidity are the two terms which are most widely watched by both the investors and owners in order to gauge whether the business is doing good or not. Given below are the differences between profitability and liquidity –
- Profitability refers to profits which the company has made during the year which is calculated as difference between revenue and expense done by the company, whereas liquidity refers to availability of cash with the company at any point of time.
- A profitable company may not have enough liquidity because most of the funds of the company are invested into projects and a company which has lot of cash or liquidity may not be profitable because of lack of opportunities for putting idle cash.
- Gross profit, net profit, operating profit, return on capital employed are some of the ratios which are used to calculate profitability of the firm while current ratio, liquid ratio and cash debt coverage ratio are some of the ratios which are used to calculate liquidity of the firm.
- A company which is profitable can go bankrupt in the short term if it does not have liquidity whereas a company which has liquidity but is not profitable cannot go bankrupt in the short term.
Hence as one can see from the above that profitability and liquidity are not same and the company has to maintain a fine balance between the two because if company focuses on too much profitability then it runs the risk of not able to pay its creditors, employees and other parties whereas on the other hand if company focuses on liquidity and then it runs the risk of going into loss.
Trade-Off Between Liquidity and Profitability
An important aspect of a working capital policy is to maintain and provide sufficient liquidity to the firm. Like most corporate financing decisions, the decision on how much working capital should be maintained involves a trade-off. Having a large net working capital may reduce the liquidity-risk faced by the firm, but it can have a negative effect on the cash flows. Therefore, the net effect on the value of the firm should be used to determine the optimal amount of working capital. A firm must maintain enough cash balance or other liquid assets so that it never faces problems of payment to liabilities.
- Does it mean that a firm should maintain unnecessarily large liquidity to pay the creditors?
- Can a firm adopt such a policy?
Certainly not; “there is also another side for a coin”. Greater liquidity makes it easy for a firm to meet its payment commitments, but simultaneously greater liquidity involves cost also. The risk-return trade-off involved in managing the firm’s working capital is a trade-off between the firm’s liquidity and its profitability. By maintaining a large investment in current assets like cash, inventory etc., and the firm reduces the chance of (1) production stoppages and the loss from sales due to inventory shortage and (2) the inability to pay the creditors on time. However, as the firm increases its investment in working capital, there is not a corresponding increase in its expected returns. As a result the firm’s return on investment drops because the profit is unchanged while the investment in current assets increases.
In addition to the above, the firm’s use of current liability versus long-term debt also involves a risk-return trade-off. Other things being equal, the greater the firm’s reliance is on the short-term debts or current liability in financing its current investment, the greater the risk of illiquidity. On the other hand, the use of current liability can be advantageous as it is less costly and is a flexible means of financing. A firm can reduce its risk of illiquidity through the use of long-term debts at the cost of reduction in its return on investment. The risk-return trade-off thus involves an increased risk of illiquidity and profitability.
So, there exists a trade-off between profitability and liquidity or a trade-off between risk (liquidity) and return (profitability) with reference to working capital. The risk in this context is measured by the profitability that the firm will become technically insolvent by not paying current liability as they occur; and profitability here means the reduction of cost of maintaining current assets. The greater the amount of liquid assets a firm has, the less risky the firm is. In other words, the more liquid is the firm, the less likely it is to become insolvent. Conversely, lower levels of liquidity are associated with increasing levels of risk. So, the relationship of working capital, liquidity and risk of the firm is that the liquidity and risk move in opposite direction. So, every firm, in order to reduce the risk will tend to increase the liquidity. But, increased liquidity has a cost. If a firm wants to increase profit by reducing the cost of maintaining liquidity, then it must also increase the risk. If it wants to decrease risk, the profitability is also decreased. So, a trade-off between risk and return is required.
From the above discussion, it is clear that, in order to increase the profitability, the firm reduces the current assets (and thereby increases fixed assets). Consequently, the profitability of the firm will increase but the liquidity will be reduced. The firm is now exposed to a greater risk of insolvency. The risk return syndrome can be summed up as follows: when liquidity increases, the risk of insolvency is reduced. However, when the liquidity is reduced, the profitability increases but the risks of insolvency also increase. So, profitability and risk move in the same direction. What is required on the part of the financial manager is to maintain a balance between risk and profitability. Neither too much of risk nor too much of profitability is good.
There has been an attempt made to highlight the nexus between liquidity, profitability and working capital. A further examination can be thought of with the following indicators.
- Net Working Capital : As a general rule, current obligations or current liabilities are paid off by reducing current assets, which are assets that can be converted into cash on short notice. The arithmetic difference between current assets and current liabilities is called net working capital and it represents a cushion for creditors. Although this measure is not a ratio, it is commonly included in the liquidity ratios while analyzing companies. It is widely used by creditors and credit rating agencies as a measure of liquidity. More working capital is preferred to less. In other words, creditors like a ‘big’ cushion to protect their interest. However, too much working capital can act to the detriment of the company because they may not be utilizing the funds effectively.
- Working Capital Turnover : The turnover of working capital, which indicates the frequency at which they were rotating, is another measure of the efficiency of working capital management. Like any other turnover or activity ratio, a low ratio reflects a slow movement of the current assets, thereby implying a sub-optimum utilization of working capital.
- Rate of Return on Current Assets : The return on current assets is yet another useful economic indicator of the profitability of the enterprises and thus indicates the efficiency or otherwise with which the current assets are put to use. The rate of net profit to current assets is calculated to underline the efficiency. In case where current assets form more than half, this ratio becomes significant.
- PAT as Percentage of Sales : One of the important profitability ratios calculated for the purpose of measuring management’s efficiency is the profits after tax as percentage of sales. This is the overall measure of firm’s ability to turn each rupee of sales into profit. If the net margin is inadequate, the firm will fail to achieve satisfactory return on owners’ equity. This ratio also indicates the firm’s capacity to withstand adverse economic conditions. A firm with a high net margin ratio would be in an advantageous position to survive in the face of falling sales, prices, rising cost of production, or declining demand for the product. It would really be difficult for a low net margin firm to withstand these adversities.
- Assets Turnover : Usually the turnover ratios are employed to determine the efficiency with which a particular asset is managed and also to consider the relationship between sales and various items of assets for this purpose. These ratios which are called activity ratios indicate the speed with which the investment in the assets is getting rotated or converted into sales. A proper balance between sales and assets generally reflects that assets are managed well. Although fixed assets may not maintain close relation with sales, they are taken as important because of their contribution to production. Hence total assets turnover is taken as an indicator to measure the extent of sales generated for one rupee investment in assets.
- Collection Period: Another indicator which is considered to be important in judging the working capital efficiency is the collection period. This ratio indicates the total number of days that was taken by the firms in collecting their debts. A comparison of the norms fixed with the results obtained would show the positive or negative tendencies.
- Interest as Percentage of Profits before Interest and Tax: One of the ratios that are used to determine the debt capacity of a firm is this coverage ratio. This ratio reveals the ability of the company in servicing the debt undertaken. A high ratio speaks about the interest burden of the company and consequently the adverse impact of the same on profitability. In the same way, a high ratio enhances the financial risk of the firm.