Liquidity and Profitablity

LIQUIDITY vs PROFITABILITY

The financial manager is always faced with the dil -1ntrat of liquidity vs. profitability. He has to strike a balance between the two.

a. The firm has adequate cash to pay for its bills.

b. The firm has sufficient cash to make unexpected large purchases and, above all.

c. The firm has cash reserve 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 Olt 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 the finance 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--a" 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 is to choose between risk and profit and generally he chooses in between the two. He should forecast cash flows and analyse 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 optimised

Profits, Profitability And Liquidity - LD04

1. Introduction and Definitions

Amongst many criteria of business success, there are two which are expressed in financial terms, namely profitability and liquidity.

Profit is the excess of resources earned over resources expended or income less costs. Various profit figures (gross, net, pre-tax etc.) for the period can be read from the Profit and loss Account (US term "Income Statement").

Profitability is the relationship between profits and capital (the "static" resources set aside to earn those profits). Measuring profitability means that you have to relate a profit figure (from the Profit and Loss Account) to a resources figure (from the Balance Sheet).

In short, profit is the measure of gain, and profitability the relation of this gain to the firm's assets. If profitability exceeds the cost of the firm's capital, that is the interest rate at which it can borrow money, it can call itself successful.

It is beneficial to society as a whole if less profitable businesses give up their resources to more profitable, because the total profit earned will rise, other things being equal. For this to hold true, private and public profit must be equivalent; this is not the case where, for example, profit earners cause there to be social costs, such as atmospheric pollution or noise.

Liquidity may be defined as the ability of a firm to meet its financial obligations as they fall due. The balance sheet (defined as "a structured statement of assets and liabilities") measures these resources and claims, and describes the liquidity of the firm i.e. the relationship between assets and liabilities see also LD10, Accounting Theory and the Purpose of Accounting).

2. Objectives, Profitability and Liquidity

Profit may be seen as an end in itself (i.e. the "mission" - see LD02) but it is better viewed as a necessary means to an end, namely the survival and growth of the organisation. Japanese companies and some others are reported as seeing profits as a cost of staying in business, which is an echo of the economists' view of normal profits as a cost of capital, with any excess or deficit being cleared over time as new firms move into, or out of, the industry.

Likewise, liquidity is a constraint which must be satisfied both directly, in that firms must settle their debts, and indirectly, in that they must also report an ability to continue to do so. If in the annual accounts, a firm reports poor liquidity, this may cause such a fall in confidence that its state becomes a self-fulfilling prophecy, as creditors demand immediate payment, the classic example being "a run on the bank".

3. Measuring profitability and liquidity

Whereas definition and discussion of the concepts are activities beloved by academics, their practical day to day expression and measurement is a matter for business personnel and accountants. Large organisations may employ accountants or, like smaller firms, hire the services from independent professionals. There is an associated profession whose skills overlap, namely of auditing, whose function is to validate the work of the accountant through an independent evaluation of the accounts.

Such expressions and such measurement require care, routine and administration as well as an understanding of the principles involved. All the levels of profit (gross, operating, net and retained) are expressed in the various sections of the Profit and Loss Account (my definition being "a structured statement of income and expenses"). The measurement of profit is, in fact, very difficult and it is to cut through the problems of principle that accountants adopt a number of "rules of thumb", such as depreciation in equal instalments over the estimated useful life of the project (see also LD14, Depreciation).

4. Book-keeping

The book-keeping activities of the firm begin with data capture and then serve two main purposes, firstly as part of the day to day administration of the firm's business (i.e. the payment of bills and the receipt of money owing) and secondly to classify the firm's transactions. When sorted into liabilities, assets, income and expenses, these transactions, drawn up into "accounts", and with appropriate adjustments to bridge the gaps between the transactions and economic reality, provide the "Final Accounts" which provide