Relationship Between Profitability, Risk and Liquidity
These three concepts are characteristics of financial assets that have an established and logical relationship between them.
There is usually a positive relationship between risk and return. Since if the possibility of suffering losses is greater, the debtor will have to offer greater benefits to creditors . Otherwise, it will be very difficult to obtain financing.
That is why the debt of underdeveloped countries, for example, offers higher returns than that of developed countries. On the contrary, a debtor who offers more securities will not need to promise so many benefits to finance himself. It will be easier for you to find investors with a conservative profile who will be willing to sacrifice future profits in exchange for insuring their investments.
Profitability, risk and liquidity
When there is less liquidity in a financial asset, the expected return is higher, since it will be more difficult to sell that asset when we want to get rid of it. Let us briefly explain and clarify these concepts first:
Profitability refers to the benefit obtained by an asset in relation to its acquisition cost, (ability of the asset to produce interest or other returns to the acquirer or investor )
Profitability = Profit / Acquisition Cost
Example: we buy a bond for a value of 1,000 and at maturity we agree to receive 1,030, we would obtain a profit of 30, so the return obtained would have been 30/1000=0.03, that is, 3%.
The risk of an asset depends on the probability that, at maturity, the issuer complies with the agreed profitability and financial amortization clauses. In other words, following our previous example, it would refer to the probability that at the end of the bond contract, from which we have bought it, it will actually pay us the 1,030. The greater the probability of non-payment or non-compliance with the conditions, the greater the risk.
It is common to measure risk through mathematical variance . In addition, in the financial markets, the rating agencies usually give "notes" to the capacity of companies to default or default.
The risk depends on the solvency of the issuer and the guarantees that it incorporates into the security.
The liquidity of an asset is measured by the ease and certainty of converting it into money in the short term without suffering losses. Therefore, money is the most liquid asset that exists as opposed to the less liquid that are real assets. An example of a real asset could be a house.
Savings and term deposits in credit institutions are highly liquid financial assets .
Relationship between profitability, risk and liquidity
Once these concepts have been explained, we expose the relationship between them:
- Greater risk and greater profitability: Anyone who is going to invest in an asset will assess their probability of default or of not receiving the conditions agreed at the beginning. The more likely it is that the issuer will not be able to meet the conditions, the higher the return the investor will demand as payment for assuming a risk.
- Less liquidity and higher profitability: The more difficult it is for an investor to convert the asset he owns into money, the higher the return that the asset requires. This is justified because the investor is currently sacrificing his purchasing power. By not being able to dispose of his invested money at the time he wishes, it would be understood as a payment for the sacrifice of purchasing power made.
- Greater liquidity and less risk: The easier it is for an investor to convert an asset into money, the less risk is exposed. Let us imagine that an investor wants to convert an asset into money that does not allow it to be done in the short term. In order to sell it, he will have to sell at a price, usually below the real price. In some cases, the asset can be converted into money before its maturity, but facing a commission that will reduce its profitability.
The above are summarized in the following triangle. This triangle reflects very well the relationship between profitability, risk and liquidity:
From the triangle above, the lesson follows that we cannot have it all. In other words, there is no type of investment without risk, with high profitability and high liquidity.