Liquidity and Profitability Trade-Off in Banks: A Case Study of Commonwealth Bank of Australia

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Liquidity and Profitability Trade-Off
Liquidity and profitability are important indicators of a bank’s financial risks and
performance. Liquidity refers to a bank’s ability to settle its short term obligations that enhances
it continuous operations (Bordeleau & Graham, 2010). On the other side, profitability refers to a
bank’s ability to generate returns (revenue) in excess of the cost incurred (Tran, Lin, & Nguyen,
2016). The following essay is an argument agreeing that there is a tradeoff between liquidity and
profitability. The essay uses Commonwealth Bank of Australia data and literature to support the
argument.
Liquidity and profitability are determined using financial ratios. Liquidity is measured by
a bank’s current ratio and quick current ratio. These financial ratios show the ability of a bank to
settle it current liabilities by cash or having assets that can be turned into cash within a period of
one year. Liquidity settles obligations as they fall due enabling a bank survival by financing
expenses that are required for day to day running of the bank (Horvath, Seidler, & Weill, 2016).
Profitability of a bank is measured by return on assets (ROA) or return on equity (ROE).
Profitability shows the ability for a bank to convert assets to profits and indicate financial
performance. The Commonwealth Bank of Australia uses liquidity Coverage Ratio to monitor it
liquidity and ability to meet obligations as they fall due and return on average shareholder’s
equity to measure profitability. The Commonwealth Bank returns on average shareholder’s
equity were 16.1%, 16.2%, and 18.2% for 2017, 2016 and 2015 financial years (FY)
respectively. The liquidity coverage ratio was 128.6% for 2017 financial year and 120% for both
2016 and 2015 financial years. These financial data shows that the bank having 120% liquidity in
2015 had the highest profitability of 18.2% compared to having the highest liquidity of 128% in
2017 FY which led to the lowest profitability ratio of 16.1% for the three financial years
analyzed. These financial data show that increasing liquidity reduces the bank’s profitability.
Liquidity is correlated to profitability. Holding a high liquid assets or cash reduces the
amount that can be used to earn revenues for a bank. Firstly, a high liquidity means that the bank
will lower its lending. According to Tran et al.,(2016) lowering lending amount lowers a bank’s
operations profits. Banks earn significant profits from lending loans to customers and lowering
the amount leads to reduce amount earnings. Secondly, liquid assets that can be converted to