The concepts of liquidity and profitability are often misunderstood in the world of business and finance. You might find it counterintuitive to think that a profitable business can be illiquid, while an unprofitable one can remain liquid.

In this article, we'll unravel this paradox and help business owners and bankers better understand the key metrics to assess a company's financial health. 

Understanding Liquidity

Liquidity refers to a company's ability to meet its short-term financial obligations. To better grasp this concept, we'll examine the balance sheet, focusing on the asset and liability sides.

The assets are divided into current assets and long-term assets.
Current assets are the assets that a company expects to convert into cash within one year or less.

The liabilities are also divided into current liabilities and long-term liabilities.
If a company has more current assets than current liabilities, it is considered liquid.
A popular metric to gauge liquidity is the current ratio (current assets divided by current liabilities). 
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Empty space, drag to resize
If the current ratio is above one, it means that the company should meet its short term financial obligations during the year.
Empty space, drag to resize

Understanding Profitability

Profitability is the ability of a company to generate more revenue than its expenses. A business is considered profitable if it creates value, meaning that revenues exceed expenses during a specific period.

However, it is crucial to remember that net profit does not always equate to immediate cash inflow due to the nature of accrual accounting. Some revenues might be on credit, and not all expenses are recorded on the income statement instantly. 
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The Cash Flow Statement

The cash flow statement is the key to understanding the relationship between a company's balance sheet and income statement. It is divided into three sections: operating activities, investment activities, and financing activities.

To calculate the cash flows from operating activities we start with the net profit to which we add or subtract the non-cash items. The non-cash items are income statement items which don’t have a real cash inflow or outflow.

Few examples can be:  

Amortization and depreciation

Unrealized FX losses

Unrealized interest swap gains or losses

Gain or loss on
disposal of assets

After this operation, we add or subtract the net change in working capital. This is the part where we consider the receivables which have not been collected, the inventory purchased by not accounted for in the cost of goods sold, and the inventory that has been purchased on credit (the increase in payables).

One thing to keep in mind is that a sustainable business should generate positive operating cash flow over the long run. 
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Unprofitable but Liquid

A business can be unprofitable but liquid if its liquidity is not derived from operating activities.
Instead, it comes from financing or investment activities.

Examples of these activities include

Selling long-term assets

Raising capital

Receiving a shareholder loan

Getting repaid for a loan to a subsidiary

Receiving dividends from an investment

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Profitable but Not Liquid

The scenario of a profitable business being illiquid can be a bit tricker.

A company's net profit is only a part of the cash flow equation. Factors such as uncollected accounts receivable, increased inventory levels, or unpaid accounts payable can tie up cash in working capital, making the business cash position tight. 
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Current Ratio vs Quick Ratio

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To assess a company's liquidity accurately, consider both the current ratio and the quick ratio.

The quick ratio subtracts inventory from current assets before dividing by current liabilities, providing a more accurate picture of a company's liquidity position.

This ratio is particularly useful when a business's ability to convert inventory into cash slows down. 
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Investing and Financing Impacts

Other elements affecting a company's liquidity include investments in subsidiaries, capital expenditures (CAPEX), and financing activities.
Understanding these aspects is crucial for accurately assessing a business liquidity. 
Empty space, drag to resize

Conclusion

Liquidity and profitability are distinct yet intertwined concepts in the world of business and finance. By closely monitoring financial performance and implementing sound financial management practices, businesses can work towards achieving both profitability and liquidity, ensuring the sustainability of the company.

For bankers, understanding these concepts is essential to better assess their clients' businesses and manage risks effectively.  

By focusing on the right metrics and considering the various factors that impact liquidity and profitability, businesses and bankers can make more informed decisions and contribute to the financial success of a company and reduce risks for the bank. 

The concepts of liquidity and profitability are often misunderstood in the world of business and finance. You might find it counterintuitive to think that a profitable business can be illiquid, while an unprofitable one can remain liquid.

In this article, we'll unravel this paradox and help business owners and bankers better understand the key metrics to assess a company's financial health. 

Understanding Liquidity

Liquidity refers to a company's ability to meet its short-term financial obligations. To better grasp this concept, we'll examine the balance sheet, focusing on the asset and liability sides.

The assets are divided into current assets and long-term assets.
Current assets are the assets that a company expects to convert into cash within one year or less.

The liabilities are also divided into current liabilities and long-term liabilities.
If a company has more current assets than current liabilities, it is considered liquid.
A popular metric to gauge liquidity is the current ratio (current assets divided by current liabilities). 
Empty space, drag to resize
Empty space, drag to resize
If the current ratio is above one, it means that the company should meet its short term financial obligations during the year.
Empty space, drag to resize

Understanding Profitability

Profitability is the ability of a company to generate more revenue than its expenses. A business is considered profitable if it creates value, meaning that revenues exceed expenses during a specific period.

However, it is crucial to remember that net profit does not always equate to immediate cash inflow due to the nature of accrual accounting. Some revenues might be on credit, and not all expenses are recorded on the income statement instantly. 
Empty space, drag to resize

The Cash Flow Statement

The cash flow statement is the key to understanding the relationship between a company's balance sheet and income statement. It is divided into three sections: operating activities, investment activities, and financing activities.

To calculate the cash flows from operating activities we start with the net profit to which we add or subtract the non-cash items. The non-cash items are income statement items which don’t have a real cash inflow or outflow.

Few examples can be:  

Amortization and depreciation

Unrealized FX losses

Unrealized interest swap gains or losses

Gain or loss on
disposal of assets

After this operation, we add or subtract the net change in working capital. This is the part where we consider the receivables which have not been collected, the inventory purchased by not accounted for in the cost of goods sold, and the inventory that has been purchased on credit (the increase in payables).

One thing to keep in mind is that a sustainable business should generate positive operating cash flow over the long run. 
Empty space, drag to resize

Unprofitable but Liquid

A business can be unprofitable but liquid if its liquidity is not derived from operating activities.
Instead, it comes from financing or investment activities.

Examples of these activities include

Selling long-term assets

Raising capital

Receiving a shareholder loan

Getting repaid for a loan to a subsidiary

Receiving dividends from an investment

Empty space, drag to resize

Profitable but Not Liquid

The scenario of a profitable business being illiquid can be a bit tricker.

A company's net profit is only a part of the cash flow equation. Factors such as uncollected accounts receivable, increased inventory levels, or unpaid accounts payable can tie up cash in working capital, making the business cash position tight. 
Empty space, drag to resize

Current Ratio vs Quick Ratio

Empty space, drag to resize

To assess a company's liquidity accurately, consider both the current ratio and the quick ratio.

The quick ratio subtracts inventory from current assets before dividing by current liabilities, providing a more accurate picture of a company's liquidity position.

This ratio is particularly useful when a business's ability to convert inventory into cash slows down. 
Empty space, drag to resize

Investing and Financing Impacts

Other elements affecting a company's liquidity include investments in subsidiaries, capital expenditures (CAPEX), and financing activities.
Understanding these aspects is crucial for accurately assessing a business liquidity. 
Empty space, drag to resize

Conclusion

Liquidity and profitability are distinct yet intertwined concepts in the world of business and finance. By closely monitoring financial performance and implementing sound financial management practices, businesses can work towards achieving both profitability and liquidity, ensuring the sustainability of the company.

For bankers, understanding these concepts is essential to better assess their clients' businesses and manage risks effectively.  

By focusing on the right metrics and considering the various factors that impact liquidity and profitability, businesses and bankers can make more informed decisions and contribute to the financial success of a company and reduce risks for the bank. 
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