Liquidity Ratio, Profitability and Correlation

Introduction

Liquidity refers to the ease with which a firm can sell its assets for cash to meet its obligations. Eljelly (48) has clearly defined liquidity as the capability of a business enterprise or a firm to meet its financial obligations when required. Liquidity acts as a measure of individuals’ or firms‘ability to convert its assets into cash and at the same time minimize the loss. It entails a relationship between a firm’s assets and liability. Firms embrace effective control of their current assets and current liability to avoid the risk of making excessive investments on the assets in the verge of maintaining liquidity position.

Current assets include debtors, money in current bank account and items regularly used or replaced such as stocks whereas current liabilities include amounts owed due to be repaid within a year, creditors and short term loans. A firm is responsible for the timely payment of the current liabilities. Working capital is the most popular tool for liquidity management by the firms (Shin and Soenen 40).

Accountants define profits as income over expenses of a firm over a specified period of time. Economists on the other hand define it as a residual which a firm gets after deducting expenses from its gross return. Eljelly (56) defines profitability as the relationship that exists between profits of a firm and its capital. To measure actual profits firms compares profit figures as stated in their profit and loss account with the capital figure affirmed in the balance sheet. Therefore, profitability can simply be defined as the relationship connecting a firm’s earnings and its assets. A firm is said to be efficient when profitability surpasses the cost of soliciting its capital, that is, the rate of interest of borrowing capital from financial institutions (Modigliani and Miller 281).

Correlation between liquidity and profitability

There exist profound correlation between liquidity and profitability. Firm’s finance managers usually face major challenges while trying to strike a balance between the two concepts. For instance, they have to ensure that the firm has adequate cash to pay for the expenditures, pay the amount they owe others, and other emergencies a firm may be faced with. On the other hand, they have to ensure that they achieve profitability goals. They have to use the funds in order to realize high yields of that firm (Chamberlain Trevor and Gordon Myron 599).

Profitability and liquidity are in a major ways correlated. For instance, if liquidity increases, profitability decreases and vice versa. Striking a balance between liquidity goal and profitability goal remains one of the major challenges that face finance managers in many firms. If we take for instance a firm that embrace a noninterventionist credit policy, it put itself in a position whereby it would boost its sales volumes, however, that firm’s liquidity position declines (Eljelly 56).

This is a form or an inverse correlation between the two concepts. When firms tie too much funds in current assets, they enjoy greater liquidity. This means that it is in a better position to pay its debts. However, theories construe that such funds do not earn anything. It is worth to note that funds have economic costs. Higher liquidity in this respect would mean that it is at a cost of profitability since the money is left idle. Too much Investment in the current assets lowers a firm’s level of profitability and liquidity as well (Harris 1573).

There prevails a direct relationship between profitability and liquidity when we look at high risk and higher return. When a firm experience higher return, it means that its profitability significantly increases. However, if that firm experience high risk, then its liquidity position is endangered. Firms sometimes ensure that their debt equity ratios are high with intentions of increasing their profitability. However, if a firm sources its fund from outside, it commits itself to pay back with interest at stipulated intervals and in fixed amount. This may significantly reduce its liquidity (Eljelly 58).

Chart: The Profitability / Liquidity framework.

Conclusion

Liquidity and profitability are two common concepts that are commonly used in business. There is a great correlation between these two concepts. Every firm aims at attaining profitability goals as well as enhancing its liquidity position which is very important in business environment. Firm’s finance managers face major challenges in maintaining equilibrium between the two. In enhancing profitability, a firm needs also to be careful not take up liabilities which it cannot cover.

Works cited

Chamberlain, Trevor and Gordon, Myron. Liquidity, Profitability, and Long-Run Survival: Theory and Evidence on Business Investment, Vol. 11, No. 4 (1989): 589-610.

Eljelly, A. “Liquidity-Profitability Tradeoff: An empirical Investigation in an Emerging Market”, International Journal of Commerce & Management, Vol. 14 No 2 (2004). 48– 61.

Harris, L.E, “Liquidity, trading rules, and electronic trading systems,” Monograph Series in Finance and Economics, New York University, Salomon Brothers Center, (1990): 1565-1593.

Shin, H. H, and Soenen, L. Efficiency of working capital management and corporate profitability. Financial Practice and Education, Vol 8 No 2 (1998): 37–45.

Soenen, L. A. “Cash conversion cycle and corporate profitability”, Journal of Cash Management, Vol 13 No 4 (1993): 53-58.