Liquidity
Liquidity refers to an organization’s ability to meet its obligations and pay its debts when 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 liquidity the company has, the better its financial position.
Liquidity can be measured through the following ratios: (Current Ratio), (Quick Ratio), and (Cash ratio).
Profitability
As for profitability, it refers to the excess of revenues over expenses, so that profitability is represented in the rate of return on the capital used by the company. In order to increase revenues, the company must use the funds in a way that guarantees 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, including manpower, materials, money, and machines, efficiently and effectively.
Thus, the 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; 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 much, it will weaken the profitability of the company.
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 liquidity management framework, the company will manage all its current assets, including near-cash assets, in a way that minimizes costs. Sometimes, even if the profit from the operations is high, the company may face a liquidity problem because the amount representing 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, accounts receivable, etc.
When the company faces liquidity problems, this will hinder the company’s work, which will lead to a decline in the company’s profitability. Also, a lack of liquidity may lead to a lower rate of return, the loss of trading opportunities, etc. Therefore, the company must maintain a trade-off state, in which the company maintains the optimal liquidity to achieve more profitability, so that the company must achieve a balance between these two conflicting goals.
On the one hand, profitability and liquidity are opposing goals, while on the other, they are concomitant. On the one hand, the bank must manage its financial portfolio in a way that achieves the maximum return and guarantees an appropriate amount of liquidity, and 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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