A liquidity ratio measures how well a company can pay its bills while a profitability ratio examines how much profit a company has earned versus the expenses it has incurred. Both ratios allow a business’s management, as well as its creditors and investors, to examine a company’s financial health and profitability potential.
Liquidity ratio is a formula that measures a company’s ability to pay bills or make payroll by comparing a company’s liabilities, expenses, outstanding debts, or debts that will be incurred in the near future, to a company’s assets. A liquidity ratio is intended to measure a company’s cash on hand so assets should be measured in cash or in a form that can be easily converted into cash. In fact, liquidity ratio is sometimes referred to as cash ratio, measuring a company’s cash or cash equivalent against its liabilities. This ratio measures just how much cash will likely be on hand at a given point in time.
Types of Liquidity Ratios
Liquidity ratios, according to financial-accounting.us, are commonly split into two types. Current ratio is considered the most common and is calculated by dividing all assets into all liabilities. A good indicator of a company’s financial health, the current ratio of assets to liabilities should be between 1.3 and 1.5. While a balanced current ratio is a measure of good financial health, a declining current ratio, where liabilities are greater than assets, is a cause for concern among accountants. A quick ratio, also termed an “acid test,” measures a company’s assets and also accounts receivable against current liabilities. The quick ratio’s purpose is to identify resources that will be available quickly and can be useful in determining how a company could handle a disaster situation where it would need cash on hand.
A profitability ratio reflects a company’s ability to generate revenue and earnings as compared to incurring costs or losses over a period of time. Since profitability ratios measure profit, these reports are used by investors and creditors to decide on whether to invest in or whether to provide credit to a particular company. Stockholders also have an interest in profitability ratios since dividends produce revenue and changes in profit affect those bottom lines.
Types of Profitability Ratios
According to a St. Francis University article, common types of profitability ratios include net profit margin and return on assets. Net profit margin measures net income dollars per sale. The higher the ratio the better the profits realized so this is a margin that is watched closely by businesses and investors alike. A return on assets measurement examines how companies are able to use their assets to create profits. The inventory of a retail business, for example, is an asset that is used to create profit as is equipment in a manufacturing plant, or even land or holdings that a company sells for profit.