Liquidity Vs. Profitability

Liquidity is a measure of the availability of cash and cash equivalent funds while profitability is a measure of the profit a company can earn by selling its goods or services. In simple terms, liquidity measures the time and ability to convert its  assets into cash to manage immediate and short-term financial obligations, while profitability is how well the business is generating financial revenue relative to the size of the business.

Both liquidity and profitability are two of the most important performance indicators of a business. They demonstrate whether the business is currently successful or has the potential to be successful. They also indicate the potential for growth and sustainability.

Having high liquidity does not necessarily mean that a company is profitable. It only means, that you have enough assets to cover immediate and short term expenses. In the same vain, a profitable business does not necessarily mean that the business is adequately meeting financial obligations.

An organization’s liquidity and profitability can be measured using ratios. There are two basic measures of liquidity, which are the current ratio, and the quick ration. While there are various measures of profitability such as gross profit margin, net profit margin, operating profit margin, earnings per share, return on equity, return on asset etc.

The short-term prospect of a company is judged by it’s liquidity. The more liquid an organization is, the lower the chances of it being unable to pay its short-term debts. Where there is poor management of the working capital, the company’s funds can be tied up in idle assets which will reduce its liquidity. This may make the company unable to invest in productive assets, which will in turn reduce the profitability of the organization. Studies have shown that there is a significant relationship between liquidity and profitability. When liquidity increases, the risk of insolvency is reduced but profitability is also reduced. However, when liquidity is reduced, the profitability increases but the risk of insolvency also increases.

Finance  managers should endeavor to strike a balance between liquidity and profitability to give optimum returns to the shareholders.

Liquidity is important to a business for the following reasons:

• It is an indicator of the financial health of a business.
• A profitable organization might find itself in a position of bankruptcy if it fails to meet its short term financial obligations.
• An organization that is not liquid, might not be able to direct funds into an investment opportunity that comes its way.
• Having a strong liquidity position allows an organization to run with minimal interruption when there is an economic downturn.
• Liquidity ratios help banks and investors determine how much cash the company has to pay its debts.

In order to maintain and improve liquidity of a business, the following steps should be considered:

• Negotiate extended payment terms with suppliers.
•  Consider selling off   assets that are expensive to maintain, but not generating any profit.
• Maintain a budget system and track monthly expenses.
• Consider taking up loans.
• Aggressively follow up on unpaid invoices

It is important to note that profitability is more important in the long term. Without profitability, the business will not survive in the long run.