Note that a company may be profitable but not liquid, and a company can also be highly liquid but not profitable.
As liquidity and profitability are inversely related to each other, hence increasing profitability would tend to reduce firms' liquidity and too much attention on liquidity would tend to affect the profitability.
Still, a high liquidity ratio is not necessarily a good thing. A high value resulting from the liquidity ratio may be a sign the company is overly focused on liquidity, which can be detrimental to the effective use of capital and business expansion.
The business will either need to sell other assets to generate cash, known as liquidating assets, or face default. When the company faces a shortage of liquidity, and if the liquidity problem cannot be solved by liquidating sufficient assets to meet its obligations, the company must declare bankruptcy.
By analysing your cash flow, reducing costs, improving your accounts receivable management, increasing revenues, reviewing payment plans and seeking external funding if necessary, you can strengthen your liquidity position and get back on the road to financial stability.
The current ratio (also known as working capital ratio) measures the liquidity of a company and is calculated by dividing its current assets by its current liabilities. The term current refers to short-term assets or liabilities that are consumed (assets) and paid off (liabilities) is less than one year.
In summary, it is absolutely possible for a company can be profitable but not liquid. This situation can arise due to several factors, such as significant investments in long-term assets, high levels of short-term debt, or a high level of inventory that cannot be sold quickly.
Cash on hand is the most liquid type of asset, followed by funds you can withdraw from your bank accounts. No conversion is necessary — if your business needs a cash infusion, you can access your funds right away.
Liquid assets are less profitable as compared to long term assets. The dilemma to a finance manager is whether to invest in more profitable long term assets and risk low liquidity or invest in short term assets which are less profitable and therefore reduce return on investment made.
Working capital affects both the liquidity as well as the profitability of a business. As the amount of working capital increases the liquidity of the business increases. However, since current assets offer low returns with the increase in working capital the profitability of the business falls.
A stock's liquidity generally refers to how rapidly shares of a stock can be bought or sold without substantially impacting the stock price. Stocks with low liquidity may be difficult to sell and may cause you to take a bigger loss if you cannot sell the shares when you want to.
Yes, even a profitable business can have cash flow problems. If your sales are strong, but you're not being paid, or you're spending too much, you might not have the cash flow to keep operating efficiently.
Generally, a good Liquidity Ratio should be above 1.0. This indicates the company has enough current assets to cover its short-term liabilities. A higher Liquidity Ratio (above 2.0) shows the company is in a stronger financial position and may have spare cash available for investments or other opportunities.
Everyone knows that starting a business requires cash, and growing a business requires even more—for working capital, facilities and equipment, and operating expenses. But few people understand that a profitable company that tries to grow too fast can run out of cash—even if its products are great successes.
Ways in which a company can increase its liquidity ratios include paying off liabilities, using long-term financing, optimally managing receivables and payables, and cutting back on certain costs.
A business can have too much working capital, which would indicate an inefficient use of resources. Having too much cash sitting idle can mean that the business isn't investing enough in growth opportunities.
While profitability shows that a company can make money from its operations, liquidity ensures it can pay bills and access enough cash when needed. Strong liquidity and profitability together contribute to long-term viability. Companies need profits to sustain operations and grow.
Cash is the most liquid asset possible as it is already in the form of money. This includes physical cash, savings account balances, and checking account balances. It also includes cash from foreign countries, though some foreign currency may be difficult to convert to a more local currency.
Current Ratio
The current ratio is the simplest liquidity ratio to calculate and interpret. Anyone can easily find the current assets and current liabilities line items on a company's balance sheet. Divide current assets by current liabilities, and you will arrive at the current ratio.
Additionally, liquidity also depends on many macroeconomic and market fundamentals. These include a country's fiscal policy, exchange rate regime as well the overall regulatory environment. Market sentiment and investor confidence are also key to improving liquidity conditions.