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Liquidity Ratio as a Determinant of Profitability

Profitability of a company is measured by analyzing its Return on Equity (ROE) and Return on Assets (ROA). Liquidity of a company is measured by analyzing its Current ratio and Quick ratio.

Current Ratio

The current ratio is an indication of a firm’s liquidity. The current ratio is a liquidity ratio that measures whether or not a firm has enough resources to meet its short-term obligations. It compares a firm’s current assets to its current liabilities, and is expressed as follows: Current Ratio = Current Assets / Current Liabilities

Quick ratio

The quick ratio is an indicator of a company’s short-term liquidity, and measures a company’s ability to meet its short-term obligations with its most liquid assets. Because we’re only concerned with the most liquid assets, the ratio excludes inventories from current assets. The quick ratio is also known as the acid-test ratio. Quick ratio is calculated as follows: Quick ratio = (current assets – inventories) / current liabilities, or Quick ratio = (cash and equivalents + marketable securities + accounts receivable) / current liabilities.

Return on assets (ROA)

It is an indicator of how profitable a company is relative to its total assets. It is the relation between net income earned by the company and the total assets held by it. It s calculated as: ROA = Net Income / Total Assets

Return on equity (ROE)

It is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested. ROE is expressed as a percentage and calculated as: Return on Equity = Net Income/Shareholder’s Equity

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