Question

What is the profitability–solvency dilemma? How do you think this is managed in practice?

Answer 1

Context:
There are two aspects of profit that we should be cognizant of : Accounting profit and Cash profit
Accounting profit can be ascertained by analysing the P&L statement from the Annual report of companies. This amount includes both realised gain/losses that may not necessarily result in cash profit/loss. Hence while accounting profit is very important to know the well-being of the company, it is of paramount importance that we also look into the cash flow statement of the company to know about its operating solvency. A company may be showing profit in the P&L statement but it could be possible that it is unable to meet the obligations of its creditors. This is not a desirable scenario for any company.

It is regarded by many that solvency versus profitability is a false dilemma. It may be argued that both are important and that companies need to monitor both closely. On the other hand, others may argue that a company cannot realise its potential profit if it can't remain solvent along the way. They argue that the relative importance of solvency versus profitability depends on the time horizon that is being used. So if we are looking at the short term, solvency is important because if the company isn't solvent, then being profitable in the long run won't be of any use. On the other hand, it may be solvent in the short-run but not being profitable in the long run would hinder it's chances of long term survival and the company's responsibility to its stakeholders.

In practice, company's look very carefully at both solvency and profitability because it cannot survive. The company's age and maturity plays a very important role in deciding which of the above two is a priority. Monitoring the cash flow position and the operating margins/operating cash flow is the best way to ensure that the company is meeting its obligations on both fronts. Ratio analysis like the current assets ratio, quick ratio, debt equity ratio and operating margin ratios are being used by companies.