Profitability vs Liquidity | Top 6 Differences To Learn (With Infographics) (2024)

FAQs

What is the difference between profitability and liquidity? ›

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.

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. Profitability is more important in long-term. Liquidity is less important in short-term.

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.

The dilemma arises because while being the most profitable loans and advances are the most illiquid of bank assets and while being the most liquid, cash is barren of yield and indeed expensive to maintain.

Having adequate or high liquidity does not mean a business is profitable – it simply means there are enough assets to sufficiently cover immediate and short-term expenses. And even if your business is profitable, that does not necessarily mean you are adequately managing your current financial obligations.

Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational efficiency, and profitability by studying its financial statements such as the balance sheet and income statement. Ratio analysis is a cornerstone of fundamental equity analysis.

Working capital of a business refers to the excess of current assets (such as cash in hand, debtors, stock, etc.) over current liabilities. Working capital affects both the liquidity as well as profitability of a business. As the amount of working capital increases, the liquidity of the business increases.

Profitability is a measure of an organization's profit relative to its expenses. Organizations that are more efficient will realize more profit as a percentage of its expenses than a less-efficient organization, which must spend more to generate the same profit.

Profit is the amount that the company has left over after paying the expenses. Profitability is how well the company is using the resources that it has in hand to generate revenues. It tells the shareholders how much return the company is giving them for their investment.

The risk return syndrome can be summed up as follows: When liquidity increases, the risk of insolvency is reduced but the profitability is also reduced. However, when the liquidity is reduced, the profitability increases but the risk of insolvency also increases.

Why are liquidity and profitability referred to as conflicting objectives? ›

The liquidity and profitability goals conflict in most decisions which the finance manager makes. For example, if higher inventories are kept in anticipation of the increase in prices of raw materials, profitability goal is approached, but the liquidity of the firm is endangered.

The liquidity ratio is the ratio that describes the company's ability to meet short-term liabilities, solvency ratio is the ratio that describes the company's ability to meet long-term obligations and the profitability ratio is the ratio that measures the company's ability to generate profits.

A liquidity crisis occurs when a company can no longer finance its current liabilities from its available cash. For example, it is no longer able to pay its bills on time and therefore defaults on payments. In order to avoid insolvency, it must be able to obtain cash as quickly as possible in such a case.

Liquidity definition

Liquidity is a company's ability to convert assets to cash or acquire cash—through a loan or money in the bank—to pay its short-term obligations or liabilities.

Liquidity and profitability are competing goals for the Finance manager. Under liquidity management, the Finance manager is expected to manage all its current assets including near cash assets in such a way as to ensure its effectivity with a view to minimize costs.