Profitability vs.

Liquidity
In any company analysis, the two major parameters for analysis are profitability and
liquidity which are the two important criteria for a company to have creditworthiness and
have an increasing market capital and market share. Profitability vs Liquidity needs to be
analyzed in detail. In this Profitability vs Liquidity article, we will try and understand the
difference and the characteristics of the two in detail and why these two parameters
are important for a financial analyst..

Profitability and liquidity are the two terms which are most widely watched by both the
investors and owners in order to gauge whether the business is doing good or not. Given
below are the differences between profitability and liquidity –

 Profitability refers to profits which the company has made during the year which is
calculated as difference between revenue and expense done by the company,
whereas liquidity refers to availability of cash with the company at any point of
time.
 A profitable company may not have enough liquidity because most of the funds of
the company are invested into projects and a company which has lot of cash or
liquidity may not be profitable because of lack of opportunities for putting idle
cash.
 Gross profit, net profit, operating profit, return on capital employed are some of the
ratios which are used to calculate profitability of the firm while current ratio, liquid
ratio and cash debt coverage ratio are some of the ratios which are used to calculate
liquidity of the firm.
 A company which is profitable can go bankrupt in the short term if it does not have
liquidity whereas a company which has liquidity but is not profitable cannot go
bankrupt in the short term.

Hence as one can see from the above that profitability and liquidity are not same and the
company has to maintain a fine balance between the two because if company focuses on
too much profitability then it runs the risk of not able to pay its creditors, employees and
other parties whereas on the other hand if company focuses on liquidity and then it runs the
risk of going into loss.

Let us discuss some of the major Difference between Profitability vs Liquidity:

 Profitability refers to the company improvement in margins, margins refer to

revenue – cost the more the margins are increasing it reflects enhanced profitability
in the company for that financial year. Profitability enhances the equity reserves
and growth prospects of the company. On the other hand, liquidity refers to the
ability of the firm to meet short-term and long-term obligations which the business
needs to pay in the long-run and in the short-run the current portion of liabilities
 One of the key differences is that it is not necessary always that the company who
is profitable is also liquid in nature that is because the company has invested
heavily In the future projects of the company from which the receivables are due
after a considerable period of time. This is a major difference which needs to be
 understood when doing financial projections for any company. A company who is
not liquid in nature can also go bankrupt in the short-run because it does not have
enough liquidity in its hands that is why the company needs working capital in
order to meet short-term obligations
 Profitability is a measure of business success that is how well the company is
performing over a period of time it is not an indication of how cash-rich the
company is and it cannot tell the analyst the cash position of the company.
Liquidity, on the other hand, tells us the cash position of the company, too much
cash on the balance sheet also indicates poor working capital management of the
company as the company is bearing the opportunity cost of cash which is lying idle
on the balance sheet
 Profitability is the financial performance measure of the company which is
indicated in the income statement and is reported as Net profit in the profit and loss
account. If the number of net profit is negative it indicates that the company is
bearing losses in that period. Liquidity is present in the balance sheet on the current
assets section of any balance sheet of the company which includes marketable
securities, prepaid expenses, and inventories apart from cash.

Profitability vs Liquidity Comparison

Profitability Liquidity

Profitability is for a period and it not a position for a Liquidity is for a particular time and it is as on date position and not
particular time for a particular time period

Profitability is an income statement item and not a Profitability is a balance sheet item and not an income statement
balance sheet item item

The Key ratios to determine the profitability of the The Key ratios to determine the Liquidity of the company is:-
company is:-
Current Ratio
Gross Profit Margin
Acid Test Ratio
Net Profit Margin
Quick Ratio
EBIDTA Margin
Interest Coverage Ratio
EBIT Margin
Fixed Coverage Ratio
CAGR

Profitability is more important in the long run of the Liquidity is more important in the short-run of the business
business
Profitability is a measure of financial performance Liquidity is a measure of cash position in the company and how
liquid is the company is to meet its short-term obligations

Profitability is also a  degree of how well the company is Liquidity is a degree of how well the company is able to convert its
generating margins from its business sales into cash

onclusion – Profitability vs Liquidity

Both Profitability vs Liquidity are important for a business as it is a vital aspect for a

company. If the company does not have enough cash on its hands the working capital
management will go for a toss and the company needs to look for a working capital loan
which in turn will increase the interest cost of any business. Profitability is also a vital
aspect as the company needs to analyze the reason for low-profit growth and also focus on
cost reduction.

Profitability VS Liquidity

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.

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

This calculates the amount of revenue left after covering the costs of goods sold.
GP Margin = Revenue / Gross
This is a measure of how profitable and cost effective the main business activity
profit*100
is.

 Operating Profit

OP margin measures how much revenue is left after allowing for other costs
OP Margin = Revenue / Operating
relating to the core business activity. This measures how efficiently the main
profit*100
business activity can be conducted.
 Net Profit

NP margin is a measure of the overall profitability, and this is the final profit
NP Margin = Revenue / Net
figure in the income statement. This takes into account all the operating and
profit*100
non-operating incomes and expenses.

 Return on Capital Employed

ROCE is the measure that calculates how much profit the company generates
ROCE = Earnings before interest
with its capital employed, including both debt and equity. This ratio can be used
and tax / Capital employed*100
to evaluate how efficiently the capital base is utilized.

 Return on Equity

ROE = Net income/
shareholder equity*100
This assesses how much profit is generated through the funds contributed by
Average
equity shareholders, thus calculates the amount of value created through equity
capital.

Return on Assets

ROA demonstrates how profitable the company is relative to its total assets;
ROA = Net income / Average total            
therefore it provides an indication of how effectively the assets are being
assets*100
utilised to generate income.

 Earnings per Share

This calculates how much profit is generated per share. This directly affects the
EPS = Net income / Average number
market price of the shares. Thus, highly profitable companies have higher
of shares outstanding
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

This calculates the company’s ability to pay off its short-term liabilities with its current
Current Ratio = Current
assets. The ideal current ratio is considered to be 2:1, meaning there are 2 assets to cover
Assets / Current
each liability. However, this can vary depending on the industry standards and company
Liabilities
operations.

Quick Ratio = (Current This is quite similar to the Current Ratio. However, it excludes inventory in its calculation of
Assets-inventory) liquidity since inventory is generally a less liquid current asset compared to others. the ideal
/current Liabilities 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.

What is the difference between Profitability and Liquidity?

Profitability vs Liquidity

Profitability is the ability of a company to generate Liquidity is the ability of a company to convert assets
profits. 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 Key ratios are current ratio and quick ratio.
ROCE.

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.