Profitability and liquidity are two very important financial metrics to all businesses and should be given increased emphasis to maintain them at desirable levels. Liquidity can be seen as a major contributor to long-term profitability. The key difference between profitability and liquidity is that while profitability is the degree to which the company earns a profit, liquidity is the ability to swiftly convert assets into cash.
CONTENTS
1. Overview and Key Difference
2. What is Profitability
3. What is Liquidity
4. Side by Side Comparison – Profitability vs Liquidity
5. Summary
What is Profitability?
Profit can be simply referred to as the difference between total incomes less total expenses for business. Profit maximisation is among the top priorities of any company. Profit is categorized into various groups according to the components considered to arrive at each profit amount. A number of ratios are calculated using the respective profit figures to allow comparisons with prior periods and other similar companies and to facilitate financial decision-making.
| Ratio | Managerial implications |
| Gross Profit | |
| GP Margin = Revenue / Gross profit*100 | This calculates the amount of revenue left after covering the costs of goods sold. This is a measure of how profitable and cost effective the main business activity is. |
| Operating Profit | |
| OP Margin = Revenue / Operating profit*100 | OP margin measures how much revenue is left after allowing for other costs relating to the core business activity. This measures how efficiently the main business activity can be conducted. |
| Net Profit | |
| NP Margin = Revenue / Net profit*100 | NP margin is a measure of the overall profitability, and this is the final profit figure in the income statement. This takes into account all the operating and non-operating incomes and expenses. |
| Return on Capital Employed | |
| ROCE = Earnings before interest and tax / Capital employed*100 | ROCE is the measure that calculates how much profit the company generates with its capital employed, including both debt and equity. This ratio can be used to evaluate how efficiently the capital base is utilized. |
| Return on Equity | |
| ROE = Net income/ Average shareholder equity*100 | This assesses how much profit is generated through the funds contributed by equity shareholders, thus calculates the amount of value created through equity capital. |
| Return on Assets | |
| ROA = Net income / Average total assets*100 | ROA demonstrates how profitable the company is relative to its total assets; therefore it provides an indication of how effectively the assets are being utilised to generate income. |
| Earnings per Share | |
| EPS = Net income / Average number of shares outstanding | This calculates how much profit is generated per share. This directly affects the market price of the shares. Thus, highly profitable companies have higher market prices. |
What is Liquidity?
Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price. This is also the availability of cash and cash equivalents in a company. Cash equivalents include treasury bills, commercial paper and other short-term marketable securities. Liquidity is just as important as profitability, sometimes even more important in the short-term. This is because the company needs cash to run day to day business operations. This includes,
- Manufacturing and selling costs
- Payment of salaries to employees
- Payments to creditors, tax authorities and interest on borrowed funds
Without completing regular activities mentioned above, the business cannot survive to make a profit. Additional funding sources such as acquiring more debt can be considered; however, that comes with higher risks and more costs. Thus, it is important to be vigilant regarding cash flow situation and manage effectively. The following ratios are calculated to assess the liquidity position.
| Ratio | Managerial Implications |
| Current Ratio = Current Assets / Current Liabilities | This calculates the company’s ability to pay off its short-term liabilities with its current assets. The ideal current ratio is considered to be 2:1, meaning there are 2 assets to cover each liability. However, this can vary depending on the industry standards and company operations. |
| Quick Ratio = (Current Assets-inventory) /current Liabilities | This is quite similar to the Current Ratio. However, it excludes inventory in its calculation of liquidity since inventory is generally a less liquid current asset compared to others. the ideal ratio is said to be 1:1; however, it depends on industry standards just as with current ratio |
Cash flow statement provides the amount of cash reserve at the end of the financial year. If the cash balance is positive there is a ‘cash surplus’. If the cash balance is negative (), this is not a healthy situation. This means that the company does not have sufficient cash at hand to operate routine business activities; thus, there is a need to consider borrowing funds in order to continue operations in a smooth manner.
Figure_1: Availability of sufficient cash is vital for the survival of the business
What is the difference between Profitability and Liquidity?
Profitability vs Liquidity |
|
| Profitability is the ability of a company to generate profits. | Liquidity is the ability of a company to convert assets into cash. |
| Time | |
| Profitability is more important in long-term. | Liquidity is less important in short-term. |
| Ratios | |
| Key ratios include GP margin, OP margin, NP margin and ROCE. | Key ratios are current ratio and quick ratio. |
Summary – Profitability vs Liquidity
The difference between profitability and liquidity is simply the availability of profits vs availability of cash. Profit is the principle measure to assess the stability of a company and is the priority interest of shareholders. While profit is the most important, this does not necessarily mean that the business operation is sustainable. Further, a profitable company may not have enough liquidity because most of the funds in the company are invested into projects, and a company which has a lot of cash or liquidity may not be profitable because it has not utilized excess funds effectively. Thus, the success depends on the better management of both profit and cash.
Reference:
1. Parikh, Vinish. “Difference between Profitability and Liquidity.” LetsLearnFinance. N.p., 07 Jan. 2014. Web. 15 Feb. 2017.
2. “Cash Equivalents.” Investopedia. N.p., 18 Feb. 2016. Web. 15 Feb. 2017.
3. “Profitability Ratios | Example.” My Accounting Course. N.p., n.d. Web. 16 Feb. 2017.
4. “Liquidity Ratios | Example.” My Accounting Course. N.p., n.d. Web. 16 Feb. 2017.
Image Courtesy:
1. “1428594” (Public Domain) via Pixabay