Liquidity and Profitability Relationship and Financial Fallacy

Abstract

Theoretically, a company needs to maintain a liquidity level that is not detrimental to its profitability. Empirical evidence shows a negative correlation between liquidity and profitability but a company cannot operate with zero liquidity in order to maximize its profits. Normally firms try to maximize their profitability by maintaining the desired liquidity, but increasing profitability will definitely lead to reduce firms’ liquidity and increased stress on liquidity would tend to affect the profitability adversely. In general, low or no working capital and large payables of a firm are considered as a sign of serious financial trouble and negative working capital is often viewed by rating agencies as an alarm of default risk, which may lead to the firm incurring higher interest cost on its loans. In this paper, the researcher has conducted a comparative study of the liquidity and profitability position of two Indian pharmaceutical companies i.e. Ajanta Pharma and Primal Pharma. The analysis shows that in the case of Ajanta Pharma, there is a significant positive relationship between liquidity and profitability measures. In other words, CR and QR are positively correlated with ROA, ROE, and NP, and the relationship is significant, whereas, in case of Piramal Pharma, the relationship between liquidity and profitability measures is very weak and insignificant. Although the risk and return theories of finance indicate that the relationship between liquidity and profitability should be negative; there have been studies that produced different results. These findings seem to be really interesting because they indicate that there are different kinds of relationships between liquidity and profitability in different industries, and these relationships in different industries might be different in different countries as well. This difference in the relationship between liquidity and profitability could lead to a difference in management of the liquidity. Hence the author feels that there is a fallacy in the established rule of finance that liquidity and profitability have always an inverse relationship, i.e, both are negatively related to each other. As proved in the case of Ajanta Pharma, an organization can increase its profitability even after keeping its liquidity intact.

Keywords: Liquidity, Profitability, Bankruptcy, Trade-off, Working Capital

JEL Classification: G30, G32