The financial manager is always faced problems with liquidity vs. profitability. He has to strike a balance between the two.
- The firm has adequate cash to pay for its bills.
- The firm has sufficient cash to make unexpected large purchases and, above all.
- The firm has cash reserved to meet emergencies, at all times
Profitability goal, on the other hand requires that the funds of the firm are so used so as to yield the highest return.
Liquidity and profitability are very closely related. When one increases the other decreases. Apparently liquidity and profitability goals conflict in most of the decisions which theFINANCE manager makes. For example, it 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 illiquidity decrease
There is also a direct relationship between higher risk and higher return. Higher risk on the one hand endangers the liquidity of the firm; higher return on the other hand increases its profitability. A company may increase its profitability by having a very high debt equity ratio. However, when the company raises funds from outside sources, it is committed to make the payment of interest, etc. at fixed times and in fixed amounts and hence to that extent of its liquidity is reduced.
Thus, in every area of financial management, the financial manager has to choose between risk and profit and generally he chooses in between the two. He should forecast cash flows and analyses the various sources of funds. Forecasting of cash flow and managing the flow of internal funds are the functions which lead to liquidity, cost control and forecasting future profits are the functions of FINANCE manager which lead to profitability. An efficient finance manager fixes that level of operations where both profit and risk are optimized.