Liquidity and Profitability| Working Capital

This article provides a short note on Liquidity and Profitability:- 1. Meaning of Liquidity 2. Measurement of Liquidity 3. Meaning of Profitability 4. Liquidity-Profitability Tangle.

Meaning of Liquidity:

Liquidity means one’s ability to meet claims and obligations as and when they become due. In the context of an asset, it implies convertibility of the same ultimately into Cash and it has two dimensions in it, viz., time and risk.

The time dimension of liquidity is concerned the speed with which an asset can be converted into Cash Risk dimension is concerned with the degree of certainty with which an asset can be converted into Cash without any sacrifice in its book value. Viewed from this, all assets will have a degree of liquidity and assets that comprise of cash and ‘near cash’ items are most liquid assets’.

In the context of a firm, however, liquidity means, its potential ability to meet obligations. In the opinion of Solomon, E. and Springle, J., whenever one speaks of a firm’s liquidity, he tries to measure firm’s ability to meet expected and unexpected Cash requirements, expand its assets, reduce its liabilities or cover any operating losses.

Financial position of firms is considered to be good enough provided they have adequate liquidity.

Measurement of Liquidity:

The liquidity is normally measured with the help of the following financial ratios:

(a) Current Ratio;

(b) Liquid Ratio;

(c) Absolute Liquidity Ratio;

(a) Current Ratio:

It is the relation between the amount of current assets and the amount of current liabilities. It is essentially a tool for measuring short-term liquidity and solvency position of firms. In other words, it may be stated that this ratio is taken to measure the margin of safety of current assets over current liabilities that the management of a firm maintains in obtaining business finance from short-term sources.

Generally, a 2 : 1 ratio is considered as normal (i.e., for every two rupees of current assets there is only one rupee of current liability) and it expresses the satisfactory liquidity position But current ratio alone cannot be accepted as an indicator of firm’s liquidity without qualification.

Because there are some snags in it, e.g., the components of current assets and current liabilities may be window-dressed or lack of common ‘standard’ etc. But it does not mean that it is of no use. Besides some of the limitations may be overcome by proper action.

(b) Liquid Ratio:

It is the ratio between total liquid assets to total liquid liabilities. The normal for such ratio is taken to be 1:1. As a tool for assessment of liquidity position of firms, it is considered to be much better than that of the current ratio as it eliminates the snags in the same, since it indicates the relationship between strictly liquid assets whose realizable value is almost certain on the one hand, and strictly liquid liabilities on the other.

(c) Absolute Liquidity Ratio:

Liquid ratio measures the relationship between cash and near cash items on the one hand and immediately maturing obligation on the other. But as the composition of cash and near cash items in the calculation of liquid ratio, comprises accounts receivable also, doubts have been expressed about the efficacy even of this ratio as a flawless tool for measuring liquidity position of a firm.

It is urged, that, accounts receivable included in the denominator of liquid ratio may suffer unrealizable value because of the possibility of bad debts, though compared to inventories, accounts receivable are more liquid as an item of current assets.

Therefore, a real measure of liquidity will be the ratio between cash and marketable securities to immediately maturing obligation which is known as ‘Absolute Liquidity Ratio’. A firm, judged by this ratio may be deemed sufficiently liquid and solvent if it is found to be 1:1.

Since all current assets do not have the same liquidity and all current liabilities do not mature for payment with equal quickness, therefore, weights may be assigned on each individual current asset and current liability depending upon, however, the degree of their relative current assets and relative urgency of payments in case of current liabilities in order to have a Weighted Current Ratio which is more depend­able and reliable one than the others.

Again, a problem would remain and it would arise from the fact that the sum of money received in future is less valuable than it is to-day, i.e., the problem arises from Time value of money. This problem can be tackled by the Time Adjusted Current Ratio- (through the process of discounting) which is much more dependable and representative one for the purpose of testing short-term liquidity.

Meaning of Profitability:

Profitability of a firm is represented by the rate of return on its capital employed.

This is measured as:

It is clear from the above that the ratio between Net Profit and Sales, can be increased either by reducing the Cost of Sales or by increasing the volume of sales. Reduction in cost of sales is possible only when there is an effective management of working capital.

In the second alternative, increase in sales is associated with increase in variable cost. And therefore, only an optimum use of working capital can ensure increase in profitability due to increase in sales.

Liquidity-Profitability Tangle:

From what has hitherto been stated, it becomes obvious, that, a firm in its bid to maximize the rate of return on investment has first to strive for ensuring its most appropriate level of investment for working capital purposes. That is to say, its investment in working capital must be optimum.

Neither be in excess nor be in adequate. Secondly, once the most appropriate level of investment in Working Capital has been determined, the firm has to concentrate on the optimum use of the same. Where investment in Working Capital is much in excess of requirement, no doubt, it will impair the firm’s profitability.

On the other hand, inadequate investment in Working Capital will tell upon the profitability of firms. Therefore, it may generally be assumed that there is always a negative relationship between the two. But that is, however, not true in all the cases.

It is only when the investment in Working Capital is optimum that firms can maximise their rates of return not only from the standpoint of profitability but also from the standpoint of liquidity. For existence of a linear relationship, though not continuous, between profitability and liquidity corresponding to the holding of current assets at least up to a certain level by firms, is not an impracticable proposition.