Liquidity solvency and profitability?
The liquidity ratio is the ratio that describes the company's ability to meet short-term liabilities, solvency ratio is the ratio that describes the company's ability to meet long-term obligations and the profitability ratio is the ratio that measures the company's ability to generate profits.
Overall impact of liquidity ratio on performance is positive but quick ratio shows the weak positive impact on the performance. Solvency ratio has negative and highly significant impact on the ROA and ROE. It means that debt to equity ratio increases then performance decreases.
In other words, solvency reflects the company's ability to repay long-term obligations including principal payments and its benefits (Robinson et al., 2015). Profitability refers to the company's ability to generate profits as a return on the funds invested.
As a financial analyst or investor, it's important to pay more attention to a company's solvency ratio. While a company may improve its liquidity ratio when it increases profitability, a low solvency ratio may have long-term effects on it and its ability to pay back investors.
- Profitability ratios.
- Liquidity ratios.
- Solvency ratios.
- Valuation ratios or multiples.
As liquidity and profitability are inversely related to each other, hence increasing profitability would tend to reduce firms' liquidity and too much attention on liquidity would tend to affect the profitability.
Important to note is that a company is considered financially strong if it achieves a solvency ratio exceeding 20%. So, from our example above, it is clear that if SalesSmarts keeps up with the trend each year, it can repay all its debts within four years (100% / 24.6% = Approximately four years).
Liquidity – the ability to meet short-term obligations, like money owed to suppliers. Solvency – the ability to meet long-term obligations, like longer-term debt payments. It's important when analysing a company to think about both. It's all well and good looking robust over the long term.
Solvency refers to an enterprise's capacity to meet its long-term financial commitments. Liquidity refers to an enterprise's ability to pay short-term obligations—the term also refers to a company's capability to sell assets quickly to raise cash.
Weak liquidity position poses a threat to the solvency as well as profitability of a firm and makes it unsafe and unsound. Two common ways to measure accounting liquidity are the current ratio and the quick ratio. The current ratio establishes the relationship between current assets and current liabilities.
What is the conflict between liquidity and profitability?
In addition to this, referring to the risk return theory there is a direct relationship between risk and return. Thus, firms with high liquidity may have low risk and then low profitability. Conversely, firm that has low liquidity may face high risk results to higher return.
In short, results suggest that a nonlinear relationship exists, whereby profitability is improved for banks that hold some liquid assets, however, there is a point beyond which holding further liquid assets diminishes a banks' profitability, all else equal.
Liquidity ratios measure a company's ability to pay off its short-term financial obligations, while profitability ratios evaluate how efficiently a company generates profits from its operations. Though distinct, both are vital for assessing financial health.
In short, a “good” liquidity ratio is anything higher than 1. Having said that, a liquidity ratio of 1 is unlikely to prove that your business is worthy of investment. Generally speaking, creditors and investors will look for an accounting liquidity ratio of around 2 or 3.
The profitability ratios often considered most important for a business are gross margin, operating margin, and net profit margin.
- Earnings per share (EPS) ...
- Price/earnings ratio (P/E) ...
- Return on equity (ROE) ...
- Debt-to-capital ratio. ...
- Interest coverage ratio (ICR) ...
- Enterprise value to EBIT. ...
- Operating margin. ...
- Quick ratio.
Another example is a prepaid expense which is an expense paid in advance. The prepaid expense is considered an asset but there is a cash outflow which will reduce the cash, hence liquidities will be reduced. So, with these examples, we can say that a company can be profitable but not liquid.
The growth of the share of current assets in total assets causes higher level of financial liquid- ity, however, it may lower profitability. The growth of short-term liabilities in total liabilities, on the other hand, causes lower level of financial liquidity, but contributes to higher profitability of assets.
In practice, all current assets take positive values because firms seek to reduce working capital risks. However, if more funds are deployed in current assets, the higher would be the cost of funds employed, and therefore, lesser the profit. If liquidity goes up, profitability goes down.
A solvency ratio indicates whether a company's cash flow is sufficient to meet its long-term liabilities and thus is a measure of its financial health. An unfavorable ratio can indicate some likelihood that a company will default on its debt obligations.
Is 2.5 solvency ratio good?
For context, a ratio of 1 to 1.5 is too low to be considered favorable. Instead, you should aim to see 2 or 2.5 for this solvency ratio. Now, keep in mind that a high debt-to-equity ratio doesn't necessarily mean that a business can't pay off debt.
As per the IRDAI's mandate, the minimum solvency ratio insurance companies must maintain is 1.5 to lower risks. In terms of solvency margin, the required value is 150%. The solvency margin is the extra capital the companies must hold over and above the claim amounts they are likely to incur.
- #1 Gross Profit Margin. Gross profit margin – compares gross profit to sales revenue. ...
- #2 EBITDA Margin. ...
- #3 Operating Profit Margin. ...
- #4 Net Profit Margin. ...
- #6 Return on Assets. ...
- #7 Return on Equity. ...
- #8 Return on Invested Capital.
If the firm has more assets and cash flow than overall debt, it is solvent. Liquidity measures how much cash a company has on hand. If the firm has enough cash and cash-like assets to pay its bills over the next 12 months, it is liquid.
The principal solvency ratios are the debt-to-assets ratio, the interest coverage ratio, the equity ratio, and the debt-to-equity (D/E) ratio. These measures can be compared with liquidity ratios, which consider a firm's capability to meet short-term obligations rather than medium- to long-term ones.