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LIQUIDITY AND PROFITABILITY
What is Liquidity?
Liquidity refers to the efficiency or ease with which an asset or security can be converted into ready cash without affecting
its market price. The most liquid asset of all is cash itself.
Key Takeaways
• Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its
market price.
• Cash is the most liquid of assets while tangible items are less liquid. The two main types of liquidity include market
liquidity and accounting liquidity.
• Current, quick, and cash ratios are most commonly used to measure liquidity.
There are two main measures of liquidity: market liquidity and accounting liquidity.
❖ Market liquidity refers to the extent to which a market, such as a country's stock market or a city's real estate
market, allows assets to be bought and sold at stable, transparent prices. In the example above, the market for
refrigerators in exchange for rare books is so illiquid that, for all intents and purposes, it does not exist.
The stock market, on the other hand, is characterized by higher market liquidity. If an exchange has a high volume of trade
that is not dominated by selling, the price a buyer offers per share (the bid price) and the price the seller is willing to accept
(the ask price) will be fairly close to each other.
Investors, then, will not have to give up unrealized gains for a quick sale. When the spread between the bid and ask prices
grows, the market becomes more illiquid. Markets for real estate are usually far less liquid than stock markets. The liquidity
of markets for other assets, such as derivatives, contracts, currencies, or commodities, often depends on their size, and
how many open exchanges exist for them to be traded on.
❖ Accounting liquidity measures the ease with which an individual or company can meet their financial obligations
with the liquid assets available to them—the ability to pay off debts as they come due.
In the example above, the rare book collector's assets are relatively illiquid and would probably not be worth their full
value of $1,000 in a pinch. In investment terms, assessing accounting liquidity means comparing liquid assets to current
liabilities, or financial obligations that come due within one year.
There are a number of ratios that measure accounting liquidity, which differ in how strictly they define "liquid assets."
Analysts and investors use these to identify companies with strong liquidity. It is also considered a measure of depth.
Profitability:
Profitability is ability of a company to use its resources to generate revenues in excess of its expenses. In other words, this
is a company’s capability of generating profits from its operations.
What Does Profitability Mean?
Profitability is one of four building blocks for analyzing financial statements and company performance as a whole. The
other three are efficiency, solvency, and market prospects. Investors, creditors, and managers use these key concepts to
analyze how well a company is doing and the future potential it could have if operations were managed properly.
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The two key aspects of profitability are revenues and expenses. Revenues are the business income. This is the amount of
money earned from customers by selling products or providing services. Generating income isn’t free, however.
Businesses must use their resources in order to produce these products and provide these services.
Resources, like cash, are used to pay for expenses like employee payroll, rent, utilities, and other necessities in the
production process. Profitability looks at the relationship between the revenues and expenses to see how well a company
is performing and the future potential growth a company might have.
What is the difference between Profitability and Liquidity
The major differences between profitability and liquidity are as follows −
Profitability:
• Profit made by the company in a period/during a year.
• May not have enough liquidity.
• A company which is profitable can go for bankrupt if it does not have liquidity in short term.
• Present in income statement.
• Determines Gross profit margin, net profit margin, EBIDTA margin, EBIT margin, CAGR.
• Measures financial performances.
• Tells about how good is company is able to generate margins form its business.
