Liquidity versus Profitability: The Dilemma of the Finance Manager

LIQUIDITY VERSUS PROFITABILITY: THE DILEMMA OF THE FINANCE MANAGER

Written By: Shafii Ndanusa FCCA, Abuja - Nigeria.

The global economic crisis left in its wake a string of corporate failures across the different economies of the world, regardless of the stage of economic and political developments that different nations are faced with. One of the worst industries hit is the financial industry which has led to a plethora of different reform initiatives designed to reduce the undesirable impacts of the crises. From the Americas to Europe, Africa and Asia, the ripple effects are still being felt by individuals, enterprises, industries and nations. This scenario provided an excellent opportunity for most business and corporate analysts to conclude that the business failures were more as a result of the global economic crisis rather than the conventional management mistakes that has often been adduced as the chief reason for corporate failure.

Since the dawn of civilization when businesses became more organized and strategic, when detailed records of financial transactions began to emerge, specifically with the advent of what is known today as the Balance Sheet, finance managers had come face to face with a dilemma. It did not matter whether there was a general economic downturn, each business enterprise needed to survive, grow and prosper well into the future. Each time a major investment decision had to be made, technically there is always a dilemma in choosing between keeping more or less liquidity or desiring less or more profitability.

For organizations that are purely profit-oriented, it is easier to see the interplay of conflicting preferences. While for organizations that are non-profit, the desire for profitability can be equated to the desire for value-for-money in service delivery. The metrics for measuring value-for-money are as varied as their objectives hence a bit more difficult to fully appreciate. However, for all enterprises that wish to operate in perpetuity, such enterprises must manage their financial resources in a way and manner that ensures that they do not go under or become extinct.

The business environment around the world has become increasingly competitive. Just like in any venture, to succeed you have to find a way to have the best of resources in people, strategy, finance, products and market niche. With respect to the management of financial resources, a challenge usually arises in deciding whether to favor liquidity or profitability. It is not possible to favor both in one single decision. The more liquidity you keep, the less profitability you achieve. Likewise, the less liquidity you decide to keep, the more financial resources you are able to channel to fixed capital investments which eventually leads to more profitability. More of both choices are thus desirable, but mutually excluding.

Once a major asset allocation decision is to be made, there is need for the finance manager to strike a balance between liquidity and profitability. Striking this balance is instinctively one of the major roles of the finance manager in any organization. Good practice takes cognizance of the context in which the decision is to be made in addition to the peculiar circumstances of the enterprise as well as the short, medium and long-term objectives of the enterprises' management.The pattern of investments in fixed assets and current assets is usually a reflection of management's preference for either profitability or liquidity. 

Overall, some of the factors affecting managers' preference for either liquidity or profitability include the individual managers' attitude to risk, the industry peculiarities, the general investment climate, cost of borrowing both long and short-tem funds and the current levels of return on the various classes of fixed capital investment in the firms' portfolio, amongst others.

It is obvious that excessively high levels of liquidity will not do any organization any good, particularly in the long run as such an organization may be losing out on worthwhile investment opportunities. Low liquidity levels may limit an organizations' ability to respond to business emergencies. Low profitability levels may lead to slow speed of corporate growth and may even affect a firms' market rating. One of the probable dangers of high profitability levels is that it can create a false impression that an organization has fully matured and reached a comfort zone. The resultant effect is that the management of such enterprises ends up becoming less strategic, less proactive and thus prone to corporate drift.  Corporate drift itself may end up leading to corporate failure.

In summary, a proactive, vigilant and purposeful approach to the management of enterprises' financial resources is the key to corporate survival, growth and prosperity in the long run.