Liquidity v Profitability: sink or swim?

The difference between a company that thrives, and a company that drowns, is most commonly down to the management of the balance between the company’s liquidity and profitability. It is a delicate balance, and is individual to each company, making it of significant importance that the accounts department monitors the company’s finances with precision – this is one reason many medium-large companies employ management accountants.


Liquidity means having enough funds to be able to make payments when they fall due. Companies need cash to pay for day-to-day expenses such as paying creditors, wages etc., and also on occasion larger payments such as repaying loans. A company is deemed to be liquid if it is able to make its payments on time.

There are a number of measures of liquidity, for example, the current ratio and quick ratios. The current ratio looks at the balance between the company’s current assets and liabilities, to see how many times they would be able to pay their current liabilities. The quick ratio is a more accurate measure, as it calculates the same ratio less the inventory value from the current assets. This is because it looks at the ratio between the assets and liabilities on the basis of its most liquid assets. Inventory is capital/cash tied up in stock, and is much less capable of being turned into cash quickly.

Working capital is another indicator of liquidity. Having too much working capital ensures liquidity but reduces profitability and thus the wealth of the shareholders. However, having too little cash increases the risk of insolvency if the company is unable to pay its debts.


Profitability relates to the ability of a company to make profits from its trading activities. This involves selling products at a higher price than it costs to produce. Companies need to generate profits as those who invest in a business do so in the hope of getting a return, thus they expect the business to be profitable.

Profitability is very closely related to risk, as it is these risky investments made by the company that increase the profitability and value of the firm to a level that could not be achieved through normal business trading. However, there is a level of risk above which is not deemed acceptable by the shareholders as it may put the business in a compromising position i.e. they may not have enough cash to remain liquid.

Getting the Right Balance

It is vital that a business has a good balance of liquidity and profitability, as too much of either may be detrimental to the other. For example, if the company has large cash balances, it will be very liquid but may not be very profitable and the investors/shareholders might lose interest, as they may not receive their required return from their investment. Also the cash in the bank is earning little to no interest, which similarly is not maximising shareholder wealth.

Alternatively, if the business uses all of its available cash to invest in new projects, it may be left with too little cash to pay its debts as they fall due – meeting the definition of illiquidity.

As discussed in my article on ‘Corporate Finance and Capital Markets‘ regarding internal sources of finance, liquidity issues can largely be improved by good working capital management; cash management, credit control, stock management etc., and the way in which the company’s assets are funded. Simple cash management means planning what levels cash will be needed by the company, and when – this can be achieved through a simple budget/cash flow forecast. Credit control is reliant on the credit control department and their efficiency in following up debtors on payments, however if it is inefficient or if the company experiences rapid growth they may consider using other options such as factoring companies. Management of stock by using efficient methods such as EOQ, Just-in-time and others, not only reduces the costs associated with stock, but also the amount of working capital tied up in stock, increasing the liquidity position of the company. Finally, the way that assets are funded is an important aspect in any business; long-term assets should be financed by long-term debt, and similarly short term assets by short-term debt. If a company finances its long-term assets with short-term sources of finance, this could create significant liquidity problems.

One method used by many companies to manage the balance between profitability and liquidity is the Miller-Orr Model.


The model balances profitability and liquidity by indicating the levels at which cash should be withdrawn from the company and invested, and when cash should be put back into the company. When the cash level within the company reaches the ‘upper limit’, the model says to move as much cash into an investment account (or other short-term and easily accessible investment) as would bring the level of cash in the company back down the ‘return point’. As the cash remaining in the company is used up or falls below the return point to the ‘lower limit’, cash is then to be transferred back from the short-term investment to the company to bring it back up to the return point. The upper limit ensures profitability by minimising the amount of cash in the company and earning the maximum return, whilst the lower limit ensures liquidity. The lower limit is normally set by the company, and can be any value that the company wishes. The return point is the point at which liquidity and profitability are most suitably balanced.

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