Liquidity v/s profitability - Striking the right balance
Sherin Moraes, a student at Marian Institute of Health
Sector Management, Goa writes about the implications of liquidity and profitability
in a pharmaceutical company
A firm is required to maintain a balance between liquidity and profitability
while conducting its day to day operations. Investments in current assets are
inevitable to ensure delivery of goods or services to the ultimate customers.
A proper management of the same could result in the desired impact on either
profitability or liquidity.1
Liquidity is a precondition to ensure that firms are able to meet its short-term
obligations.1 The 'liquidity position' in a company is measured based onthe
'current ratio' and the 'quick ratio'. The current ratio establishes the relationship
between current assets and current liabilities. Normally, a high current ratio
is considered to be an indicator of the firm's ability to promptly meet its
short term liabilities. 1 The quick ratio establishes a relationship between
quick or liquid assets and current liabilities. An asset is liquid if it can
be converted into cash immediately or reasonably soon without a loss of value.1
Consequences of low liquidity
a) A company that cannot pay its creditors on time and continues not to honor
its obligations to the suppliers of credit, services and goods could result
in losses on account of non-availability of supplies and lead to possible sickness
or insolvency.2 Also, the inability to meet the short term liabilities could
affect the company's operations and in many cases it may affect its reputation
as well.2 Lack of cash or liquid assets on hand may force a company to miss
the incentives given by the suppliers of credit, services, and goods as well.
Loss of such incentives may result in higher cost of goods which in turn affects
the profitability of the business.2
b) Every stakeholder has interest in the liquidity position of a company. Suppliers
of goods will check the liquidity of the company before selling goods on credit.
Employees should also be concerned about the company's liquidity to know whether
the company can meet its employee related obligations--salary, pension, provident
fund, etc. Thus, a company needs to maintain adequate liquidity.2
Profitability is a measure of the amount by which a company's revenues exceeds
its relevant expenses.4 Profitability ratios are used to evaluate the management's
ability to create earnings from revenue-generating bases within the organization.7
The 'profitability position' of a company is measured using the 'gross profit
margin' and the 'net profit margin'. The gross profit margin is an indicator
of the profit a business makes on its cost of sales, or cost of goods sold.
It is the profit earned before any administration costs; selling costs and so
on are removed.5 The net profit margin is an indicator of the amount of net
profit per rupee of turnover a business has earned. That is, after taking account
of the cost of sales, the administration costs, the selling and distributions
costs and all other costs, the net profit is the profit that is left, out of
which the company will have to pay interest, tax, dividends and so on.5
Consequences of low profitability
profit ratio indicates how effectively management can wring profits from sales.
It also indicates how much room a company has to withstand a downturn, fend
off competition and make mistakes.6 Potential investors are interested in dividends
and appreciation in market price of stock, so they focus on profitability ratios.
Managers, on the other hand, are interested in measuring the operating performance
in terms of profitability. Hence, a low profit margin would suggest ineffective
management and investors would be hesitant to invest in the company.
Thus, a financial manager has to ensure on one hand that the firm has adequate
cash to pay for its bills, has sufficient cash to make unexpected large purchases
and cash reserve to meet emergencies, while on the other hand, he has to ensure
that the funds of the firm are used so as to yield the highest return.8
This poses a dilemma of maintaining liquidity or profitability as indicated
in the figure below:
The liquidity and profitability goals conflict in most decisions which the finance
manager makes. For example, if higher inventories are kept in anticipation of
increase in prices of raw materials, profitability goal is approached, but the
liquidity of the firm is endangered. Similarly, the firm by following a liberal
credit policy, may be in a position to push up its sales, but its liquidity
Similarly, there is a direct relationship between higher risk and higher return.
A company taking higher risk could endanger its liquidity position.8 However,
if a company has a higher return it will increase its profitability.
The liquidity and profitability ratios of four pharmaceutical companies-Cipla,
Divi's Laboratories, Bafna Pharmaceuticals, and SMS Pharmaceuticals-over a four
year period were analysed to understand the relationship between liquidity and
profitability. (See Box)
The liquidity and profitability ratios of the above four pharma companies indicate
that liquidity and profitability could go hand in hand. Except the year 2008,
there is a positive correlation between the movement in the
profitability ratios and the liquidity ratios. Despite the limited scope of
this study, the observations would suggest that a company while planning working
capital need not maintain a trade off between the two as is usually felt. In
the light of the above, financial managers would need to reflect on the implications
of each decision that usually involves a trade-off between liquidity and profitability.
It would also be useful to assess the effect of one decision involving this
trade-off vis-à-vis another, so that an overall view can be taken.
The present economic scenario has its implications on liquidity and profitability.
'Recession means a general slowdown in economic activity over a period of time.
Production, employment, investment spending, capacity utilization, household
incomes, business profits and inflation fall during recessions; while bankruptcies
and the unemployment rate rise.10 Because of this, companies are reverting inwards.
In order to survive during these times, frugal measures need to be adopted.
'Frugal basically means prudent, not wasteful, wise in expenditures, and inexpensive'.
Being frugal would involve measures such as:11
1. Decreasing the size of sales force and concentrating on highly trained sales
reps that have already established relationships with physicians. This reduces
the amount of liquid cash needed to be kept to pay salaries to sales reps; thereby
increasing the liquidity position.11
2. Focusing on already established relationships rather than trying to build
new ones reduces the amount of money needed to be spent in order to acquire
3. Embracing technology,such as use of e-detailing programs,
can reduce expenses incurred by the company, and hence enhance the liquidity
position of the firm.11
|Analysis of liquidity and profitability ratios
of four pharma companies over a four year period
1)http://www.msrit.edu/dept/mba/iitpowai.pdf; Date accessed:
23rd August 2009
"Meaning and importance of liquidity"; Date accessed: 23rd August
Date accessed: 23rd August 2009
"the liquidity vs. Profitability tradeoff", date accessed: 23rd August
5)http://www.bized.co.uk/compfact/ratios/profit3.htm, Date accessed: 22nd August
6)http://www.investopedia.com/articles/fundamental/04/042804.asp - the bottom
line on margins, Date accessed: 22nd August 2009
7)http://www.exinfm.com/board/profitability_ratios.htm, Date accessed: 15th
8) http://www.my-quickloans.com/LIQUIDITY-vs-PROFITABILITY.html, Date accessed:
15th August 2009
9)http://money.rediff.com/companies/, Date accessed: 15th August 2009
10)http://en.wikipedia.org/wiki/Recession, Dt acc: 20th feb 2010
Dt acc: 20th feb 2010