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.
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.
Cash flow statements, on the other hand, provide a more straightforward report of the cash available. In other words, a company can appear profitable “on paper” but not have enough actual cash to replenish its inventory or pay its immediate operating expenses such as lease and utilities.
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.
Accounting items like depreciation, capitalized costs, or one-time charges can result in a negative net income even if cash flows were net positive for that period.
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.
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.
In working capital management we find that profitability varies inversely with liquidity.
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.
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.
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.
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.
The price-to-earnings (P/E) ratio is used by investors to determine a stock's potential for growth. It reflects how much they would pay to receive $1 of earnings. It's often used to compare the potential value of a selection of stocks.
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).
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.
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.
Once a debt is paid, or the business sees an influx in revenue, it starts to see positive cash flow again. In this example, cash flow is more important because it keeps the business running while still maintaining a profit.
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization and is a metric used to evaluate a company's operating performance. It can be seen as a loose proxy for cash flow from the entire company's operations.
For example, it's possible for a company to be both profitable and have a negative cash flow hindering its ability to pay its expenses, expand, and grow. Similarly, it's possible for a company with positive cash flow and increasing sales to fail to make a profit—as is the case with many startups and scaling businesses.