Trade-off between Profitability, Risk and Liquidity

Principle & Practice of Management

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Trade-off between Profitability, Risk and Liquidity

Liquidity versus Profitability Principle

There is a trade-off between liquidity and profitability; gaining more of one ordinarily means giving up some of the other.

Liquidity

Having enough money in the form of cash, or near-cash assets, to meet your financial obligations. Alternatively, the ease with which assets can be converted into cash.

Profitability

A measure of the amount by which a company’s revenues exceed its relevant expenses.
‘Liquidity’ as being on one end of a straight line and ‘Profitability’ on the other end of the line. If you are on the line and move towards one, you automatically move away from the other. In other words, there is the trade-off between liquidity and profitability.
This is easy to illustrate with a simple example. The items on the asset side of a company’s balance sheet are listed in order of liquidity, i.e., the ease with which they can be converted into cash. In order, the most important of these assets are:
1. Cash
2. Marketable Securities
3. Accounts Receivable
4. Inventory
5. Fixed Assets
Notice that as we go from the top of the list to the bottom, the liquidity decreases. However, as we go from top to bottom, the profitability increases. In other words, the most profitable investment for the company is normally in its fixed assets; the least profitable investment is cash.

Bankruptcy Risk

Is it possible for a company to go bankrupt if it has a lot of cash but is not profitable? Sure it is! It may take a while, but if it remains unprofitable, it will eventually go bankrupt. Its available cash will be used to finance the losses, but when the cash runs out, the assets of the company will have to shrink because there will be insufficient funds to replace them as they wear out. The company will become smaller and smaller and will eventually fail.
Is it possible for a company to go bankrupt if it is very, very profitable but is not very liquid (i.e., does not have much cash)? Certainly! For example, if a company expands so rapidly that it is constantly building new buildings and buying new equipment, it may very well get behind on its payments to the contractors and vendors due to the lack of cash. In other words, the company is spending money much faster than it is making it, even though it is making a lot. Eventually, the creditors (i.e., contractors and vendors) will demand their money and, if the company does not have enough cash to pay up, the creditors will take the company to court. A judge may very well decide that the creditors are entitled to their money and will start selling off the assets of the company in order to raise cash to pay them. (Half-finished construction projects don’t bring in much cash at a sheriff’s auction). At that point, the owners of the company have lost control and may very well be forced into bankruptcy. So, you can see that it’s dangerous to be on either extreme of the line: (1) highly liquid but not very profitable, and (2) highly profitable but not very liquid. There’s a broad middle ground between the two extremes where the company wants to reside.

Risk

Managing Current Assets and Liabilities

1. The greater the firm’s investment in current assets,
(a) the greater its liquidity, the lower the illiquidity risk
2. However, current assets (cash, marketable securities) earn very low or no income,
(a) Trade-off between low income and low illiquidity risk

Working capital Management and the Risk-return Trade-off

1. Working Capital = the firm’s total investment in current assets or assets which is
(a) expects to be converted into cash within a year or less.
2. Risk-Return Trade-off in managing working capital is
(a) Trade-off between the firm’s liquidity and its profitability

Large Investment in Current Assets (Cash, Inventories)

1. reduces the chance of production stoppages, lost sales, and inability to pay bills on time
2. no corresponding increase in profits
3. return on investments drops (asset increases, profit is the same)
Larger the firm’s reliance on short-term debt or current liabilities in financing its asset investments,
1. the greater the risk of illiquidity
2. but short-term is less costly and more flexible than long-term

Working Capital

The firm’s total investment in current assets or assets that it expects to be converted into cash within a years or less.

Net Working Capital

The difference between the firm’s current assets and its current liabilities. Frequently when the term working capital is used, it is actually intended to mean net working capital.