A company may maintain high liquidity ratios by holding excess cash or highly liquid assets, which could be more effectively deployed elsewhere to generate returns for shareholders. In addition, a company could have a great liquidity ratio but be unprofitable and lose money each year.
As a financial analyst or investor, it's important to pay more attention to a company's solvency ratio. While a company may improve its liquidity ratio when it increases profitability, a low solvency ratio may have long-term effects on it and its ability to pay back investors.
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.
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.
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.
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.
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.
In other words, a company need not forego liquidity to earn profit. The key aspect is to draw a balance in terms of the extent to which a company can forego liquidity to earn the desired profit, which is the ultimate trade-off between liquidity and profitability.
Profitability is a measure of how efficiently a business converts its expenses into profits for its owners.
Liquidity Preference Theory and Investing
Holding highly liquid assets provides protection and the flexibility to shift into other investments when the market changes. You might take on more risk and illiquidity through investments like stocks, real estate, or high-yield bonds when that occurs.
The profitability ratios often considered most important for a business are gross margin, operating margin, and net profit margin.
There is no ideal figure, but a cash ratio is considered good if it is between 0.5 and 1. For example, a company with $200,000 in cash and cash equivalents, and $150,000 in liabilities, will have a 1.33 cash ratio.
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.
Without sufficient capital or the financial resources used to sustain and run a company, business failure is imminent. No business can survive for a significant amount of time without making a profit, though measuring a company's profitability, both current and future, is critical in evaluating the company.
Practical Example. Important to note is that a company is considered financially strong if it achieves a solvency ratio exceeding 20%.
Further, a company may have tremendous potential for profitability in the long-run, but may languish due to inadequate liquidity. It is, therefore, short-term liquidity that has been considered crucial to the very existence of an enterprise.
Too much attention on liquidity would tend to affect the profitability if banks are keeping much of cash reserves greater than that amount required. Bank will miss opportunities of providing the finance, lending and investment which is generating revenue.
According to the Trade-Off Theory, the most profitable firms have capacity for a higher level of debt, taking advantage of debt tax shields (Mackie-Mason 1990; Fama, French 2002).
The Liquidity Rule expressly prohibits a fund from acquiring any illiquid investment if, immediately after the acquisition, the fund would have invested more than 15% of its net assets in illiquid investments that are assets.
How Much Should You Have In Your Business Savings Account? Aim to save at least 10% of your monthly profits, with 3-6 months' operating expenses in reserve. This is especially true if your business is seasonal and receives most of its profits over a few months.
The current ratio is a liquidity ratio that measures a company's ability to pay short-term obligations. It is calculated as a company's Total Current Assets divides by its Total Current Liabilities. Coca-Cola Co's current ratio for the quarter that ended in Sep. 2024 was 1.06.
A profitable company can still face a liquidity problem. Profitability and liquidity are two separate aspects of a company's financial health. Profitability measures a company's ability to generate profits from its operations.
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.
As institutions quickly try to sell assets or secure additional financing, liquidity becomes scarce, driving up interest rates and spreading financial instability. This event can spread through the economy, affecting businesses, employees, and overall financial stability.