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What is the Difference between Liquidity and Profitability?
Liquidity
The liquidity and profitability of a company are directly related to the working capital. When a company maintains high temporary working capital in current assets, it is known to be more liquid. The companies that maintain a lower level of working capital are known as less liquid.
Companies that maintain higher liquidity and considered to be at lower risk. They are able to meet the needs of the company and their reservoir of current assets lets them have the freedom to stay solvent.
However, more liquid companies have lower profitability because their funds are tied up in operations and these funds cannot be used for the production and expansion of the company.
In general, there are two main aims of working capital management. They are −
- Solvency and
- Profitability.
Solvency
Solvency is the capability of a company to meet its maturing obligations.
These obligations may be met with current assets or temporary working capital. To be solvent, a company should be very liquid in nature. Being liquid means having enough cash or cash equivalent funds to meet the general, day-to-day business needs.
When a company maintains enough current assets, it won’t have to have any difficulty in meeting the claims of the creditors when the payment is due. The creditors, therefore, prefer companies that have high liquidity.
A company with high liquidity and less risk is, however, less profitable too. As the business operations and production funds are used as current assets, the companies that are very liquid become less profitable. It is a direct outcome of the risk-return trade-off as well.
Profitability
Profitability is different from liquidity. In fact, the terms profitability and liquidity are opposite in sense when they are used for a company’s operations. Profitability is the amount of profit the company earns from the sales of its products.
Some of the outcomes of profitability are related to liquidity as well. For example, when a company uses its current assets for liquidity, it is going in the direction of less profitability. Doing so will make the company more liquid but as the return from the activity leads to less income, the activity will generate less profit.
Profitability is the ultimate aim of all companies. In order to earn profits, the companies should manage their working capital in the best way possible.
For example, the company utilizing its temporary working capital more efficiently will be able to use its current assets more favorably. Therefore, it will earn more profit than its competitors that do not follow an efficient working capital management policy.
When a company is highly liquid and solvent, it will become less profitable. As the funds needed for growth and profitability or the current assets of the company are tied up and idle, it cannot be profitable. Therefore, a company aiming to be profitable must take some risks and be less liquid in nature.
Conclusion
Although financial professionals sometimes assume liquidity and profitability to be the same, there are many differences between the two. Liquidity is a measure of the availability of cash and cash equivalent funds while profitability is the measure of profit a company can earn by selling its products or services.
Both liquidity and profitability are related to the current assets and working capital of a company. When a company uses a more temporary working capital to meet the needs of the operations, it is usually highly liquid but not profitable. When the company takes enough risk and invests its funds in high-return funds, it is looking for more profitability.
Therefore, using the two terms interchangeably is wrong technically.
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