Liquidity Compared to Profitability

Profitability boosts a company’s equity reserves and growth potential. Liquidity, on the other hand, refers to a company’s ability to meet short- and long-term obligations, including the current portion of liabilities in the long run and the long-term portion of liabilities in the short run.

Profitability relates to a company’s improved margins; margins refer to revenue – cost; the higher the margins, the better the company’s profitability for that financial year. Profitability improves a company’s equity reserves and growth possibilities. Liquidity, on the other hand, refers to a company’s ability to meet short- and long-term obligations, as well as the current component of liabilities in the short term.

• One of the fundamental contrasts is that a profitable company does not always have to be liquid in nature since it has spent extensively. In the company’s future projects, where receivables are due over a long period of time. This is a crucial distinction to recognize when preparing financial projections for any business. A firm that is not liquid in nature can become bankrupt in the near term due to a lack of liquidity, which is why the company need working capital to meet short-term obligations.

• Profitability is a metric of a company’s success, indicating how well it performs over time rather than how cash-rich it is. It is unable to inform the analyst on the company’s cash position. Liquidity, on the other hand, informs us about the company’s financial situation; too much cash on the balance sheet might also suggest bad working capital management.

Profitability is a measure of a company’s financial success that appears in the income statement and is presented as Net profit in the profit and loss account. If the net profit is negative, the company has lost money over that time period. Apart from cash, liquidity can be found on a company’s balance sheet in the current assets column, which includes marketable securities, prepaid costs, and inventories.

Gross Profit Margin, Net Profit Margin, EBIDTA Margin, EBIT Margin, and CAGR are the key ratios used to calculate a company’s profitability.

Current Ratio, Acid Test/Quick Ratio, are all important liquidity ratios to understand a company’s liquidity position. If the company does not have enough cash on hand, working capital management will be thrown out the window, and the company will be forced to seek a working capital loan, which will raise the company’s interest rate. Profitability is also important because the company must determine why profits are low and focus on cost cutting.

• The current ratio measures the ratio of total current asset to total current liabilities.
• The Acid test/Quick ratio measures the ratio of total current Asset minus Inventory to the total Current Liabilities.

A company may be profitable but not liquid. The cash could by tied up in inventory. Therefore, it is necessary for the quick ratio to be conducted as it helps to remove the inventory from the total Current Asset compared to the current liabilities so as to know the weight of the cash and cash equivalence to the total current liabilities. The essence is to ascertain the actual liquidity position of the company.

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