Liquidity
Liquidity refers to an organization’s ability to meet its obligations and pay its debts as they fall due. Liquidity measures the company’s ability to meet expected and unexpected cash requirements, expand its assets, reduce its liabilities, or cover any operating losses. The more the company has sufficient liquidity, the better its financial position will be.
Liquidity can be measured through the following ratios: the current ratio, quick ratio, and cash ratio.
Profitability
As for profitability, it refers to the excess of revenues over expenses, so that profitability is the rate of return on the capital employed by the company. To increase revenue, the company has to use the funds in a way that ensures the highest possible return. The concept of profitability refers to the operational efficiency of the organization, which can be achieved by adding value by using the resources available to the company in terms of labor, materials, money, and machinery efficiently and effectively.
Therefore, a company that seeks to increase the rate of return on investment to the maximum extent possible must first seek to ensure the most appropriate level of investment for it. This means that its investment in working capital must be ideal.
After determining the most appropriate level of investment in working capital, the company must focus on the optimal use of its working capital investment. If the investment in working capital is too high, this will lead to a weakening of the company’s profitability.
The relationship between profitability and liquidity
The relationship between profitability and liquidity is inverse. The higher the liquidity, the lower the profitability, and vice versa. Within the framework of liquidity management, the company will manage all of its current assets, including near-cash assets, in a manner that minimizes costs. Sometimes, even if the profit from operations is high, the company may face a liquidity problem because the amount that represents the profit may be in the form of fixed assets such as factories, buildings, etc. or in the form of current assets such as inventory, debtors, etc.
And when the company faces liquidity problems, this will hinder the company’s work, which will lead to a decrease in the company’s profitability. Lack of liquidity may also result in a lower rate of return, the loss of trading opportunities, etc.
Therefore, the company has to maintain a trade-off situation in which it maintains optimum liquidity to achieve greater profitability, so it must strike a balance between these two opposing goals.
Profitability and liquidity are two opposing and mutually exclusive goals on the one hand. On the one hand, the bank must manage its financial portfolio in a way that achieves the maximum return and ensures an adequate amount of liquidity. On the other hand, investing in the available financial resources means that there is no shortage of liquid funds.
Therefore, in order for the bank to follow an appropriate investment policy, it must be exposed to profitability and liquidity requirements that differ from one bank to another.
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