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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 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 the expression of profit and liquidity that are the subject of this digest (see also LD11, Accounting Statements and LD20 Book-keeping). Viewed as a whole, these activities give rise to a " magic pool of information" from which all can make extractions without diminishing the pool. 5. Liquidity Liquidity, which is much easier to measure than profit, is shown in the Balance Sheet, which can be seen (Chart 2, Appendix 1) as simply an accumulation of timing differences. There is a quantity dimension and a time dimension to liquidity - it is no good having money coming in tomorrow if you need it now - that is unless you can persuade your creditor to wait. If you hold cash or readily realisable assets such as shares, your liquidity is soundly based. If it consists of debtors, it is dependent on their ability and willingness to pay. If it consists of goods, liquidity is a function of the saleability of those goods and may be low if they are not in demand. For the Christmas season of 1984, Acorn and Sinclair Computers, both over-estimated sales so badly that they were left with large stocks of home computers. In each case this was a major factor causing the company (and the British position in micro-computers) to collapse.
4 A firm needs to balance its position for each "slice of time". Certain businesses, such as banks, manage this function in a most developed fashion because it is very important to them. Pension funds have to balance assets and liabilities over time-scales measurable in decades. Multi-national companies have, in addition to the time problem, the problem of balancing assets and liabilities in multiple currencies, which currencies are subject to fluctuating exchange rates. For most businesses, liquidity is conventionally and satisfactorily measured by two ratios, the current and liquid ratios. The current ratio takes the joint value of total current assets, i.e. stocks (US term "inventories") see LD06 debtors (if money is due within 12 months), easily realised investments, (e.g. gilts) cash and expresses it as a multiple of current liabilities (that is all monies payable within 12 months). The 12-month limit is arbitrary but realistic as most activities are seasonal. Current liabilities include proposed dividends and taxes due, whilst strictly speaking, current assets will not include pre-payments unless they can be turned back into cash. Rents, insurance and rates typically give rise to pre-payments. The liquid ratio excludes inventories from the asset side of the ratio but is in other ways identical. It is a stronger form of comparison and more pessimistic in that it assumes that the stock cannot be sold (see also LD12, Ratio Analysis and the Use of Accounting Statements). 6. Targets for Liquidity and Profitability A worthwhile target for the liquid ratio is 1:1. Companies with inventories which are easily realised, such as food retailers, can manage with significantly lower ratios, but there is no excuse of going much above unless, like GEC in 1983 and 1984, a company sees liquid investments as a sound home for its resources. The current ratio cannot be judged except in relation to the needs of a particular commercial situation. Anything between 1:1 and 4:1 could be acceptable. Comparison must be made with industry norms and those competitors whom one respects. In the absence of other data, 2:1 is not unreasonable. For profitability there is no sense of a target - the higher the better. Profitability is normally unstable from year to year, so judgement is problematic. This instability is one reason why accounting practices which smooth reported results are so appealing to company executives that we have seen the rise and rise of "creative accounting" and "opinion-shopping."
5 The minimum acceptable is the cost of capital, as below this level, the owners of these funds could have done better elsewhere. The measurement of "capital" is problematic and subject to great uncertainty, the values for "equity interest" in the Balance Sheets being merely opening bids. Where the assets are highly specialised and the industry has poor prospects, such as in respect of a steelworks, the balance sheet values will generally exceed the cash realisable. Conversely inflation may mean that the values of land and buildings are grossly under-stated. These problems mean that bases of valuation based on actual and estimated cash flows are to be preferred. Judgements based on accounts are necessarily backward-looking, and even when you use projected accounts, their simplicity does not justify the loss in quality offered by cash flow methods. Detailed discussion is outside the scope of this digest. 7. Achieving Adequate Profitability and Liquidity The achievement of adequate profitability is specific to each situation and outside the scope of this digest. The problem of liquidity is less dependent on particular circumstance and it is easier to make useful generalisations. In my opinion there are two distinct requirements for liquidity, firstly, profitability and secondly, care and thoroughness in administration. It is only if a firm is profitable that in the long run it will receive in cash more than it pays out. This is most clearly imaginable in the case of a trading business which buys and sells exclusively on a cash basis. If such a firm makes losses it is paying out in cash more than it coming in from sales. It can only sustain its cash balances by injections of capital or by selling off its assets, processes which cannot be continued indefinitely. Profitability may be necessary but it is not sufficient. A firm must be careful to ensure that it does not commit itself to payments that it cannot cover. Thus detailed records require to be kept, ideally on a "real time" basis, of cash in hand and expected and cash to be paid. The accounting statement showing this detail is the cash budget (see LD11). Every item will be tracked in terms of the time of flow, and the whole managed so that there is never a time when payments cannot be made when due. This requires the steady exercise of the bureaucratic virtues of thoroughness, reliability and accuracy, together with contingency planning to cope with uncertainties. Whatever the immediate situation, profitability and liquidity also need to be seen in their strategic context i.e. in the light of market growth, market share and progress through the product and industry life cycles (see also LD01, A Strategist's Toolkit). 8. Matters arising from a Firm's Liquidity and Profitability Position
6 Though the financial tail should not be allowed to wag the company dog, the pattern of profitability and liquidity does favour particular strategies. A simple 2 x 2 grid gives four cells and action implications as set out in Chart 1, Appendix 1, attached. References The substance of this digest can be found in so many books that I refer to none. Taking some points further, other LD's aim to provide access to the literature through their references. LD’s 10, 11 and 14 are not available as at 20-10-98
Chart 1 - The Profitability / Liquidity Grid PROFITABILITY High A - HH - No problems. Choices not financially constrained. High Be vigilant take-overs, marketing. Possible strategies include HL1, HL2 and LH3. 2) Repay capital (loan or equity). LIQUIDITY Low 1) Raise capital (loan or equity). 2) Wait 3) Divest - then HL1 or HL2. C - LH - Choices: inverse of HL D - LL - Many problems. No easy answers. New team at the top? You need HL1 but money only comes from LH3 [loss-makers out first] and LH1 when confidence is restored. Low B - HL - Choices: inverse of LH 1) Invest - (e.g. cost reductions, (new) product development,)
7 Chart 2 - The Balance Sheet considered as an Accumulation of Timing Differences Leads are cash movements before the P & L impact, Lags are cash movements after the P & L impact. Profit/Loss Category Cash movement Transaction and Lead/Lag Balance Sheet Category Income Lag Income Lead Cost Lead Cost Lead Cost Lead Cost Lag Cost Lag Cost Lag Debtor Deposit Fixed Asset Stock Prepayment Creditor, Accrual, Provision Income In Expenditure Out
BS Entry Type
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Effects of Profitability and Liquidity on R&D Intensity: Japanese and U.S. Companies Compared Greg Hundley, Carol K. Jacobson and Seung Ho Park The Academy of Management Journal, Vol. 39, No. 6 (Dec., 1996), pp. 16591674 (article consists of 16 pages) Published by: Academy of Management Stable URL: http://www.jstor.org/stable/257073
Effects of Profitability and Liquidity on R&D Intensity: Japanese and U.S. Companies Compared, by Greg Hundley, Carol K. Jacobson and Seung Ho Park © 1996 Academy of Management.
This study investigates the proposition that Japanese companies have a greater propensity than U.S. companies to sustain commitment to R&D in the face of fluctuating profits and liquidity. The analysis showed that profitability declines led to increased R&D intensity in Japan. These effects were not confined to members of Japanese financial keiretsu, or industrial groups. The R&D intensity of U.S. companies fluctuated directly with two-year lagged profitability and liquidity variables, but these relationships might have been confined to more research-intensive companies.
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The Liquidity vs. Profitability Tradeoff
GLOSSARY The Liquidity Versus Profitability Principle: There is a trade-off between liquidity and profitability; gaining more of one ordinarily means giving up some of the other. Liquidity: Having enough money in the form of cash, or near-cash assets, to meet your financial obligations. Alternatively, the ease with which assets can be converted into cash. Profitability: A measure of the amount by which a company's revenues exceed its relevant expenses.
Picture "Liquidity" as being on one end of a straight line and "Profitability" on the other end of the line. If you are on the line and move toward one, you automatically move away from the other. In other words, there is the trade-off between liquidity and profitability. This is easy to illustrate with a simple example. The items on the asset side of a company's balance sheet are listed in order of liquidity, i.e., the ease with which they can be converted into cash. In order, the most important of these assets are:
• • • • •
Cash Marketable Securities Accounts Receivable Inventory Fixed Assets
Notice that as we go from the top of the list to the bottom, the liquidity decreases. However, as we go from top to bottom, the profitability increases. In other words, the most profitable investment for company is normally in its fixed assets; the least profitable investment is cash. Bankruptcy Risk Is it possible for a company to go bankrupt if it has a lot of cash but is not profitable? Sure it is! It may take a while, but if it remains unprofitable, it will
12 eventually go bankrupt. Its available cash will be used to finance the losses, but when the cash runs out, the assets of the company will have to shrink because there will be insufficient funds to replace them as they wear out. The company will become smaller and smaller and will eventually fail. Is it possible for a company to go bankrupt if it is very, very profitable but is not very liquid (i.e., does not have much cash)? Certainly! For example, if a company expands so rapidly that it is constantly building new buildings and buying new equipment, it may very well get behind on its payments to the contractors and vendors due to the lack of cash. In other words, the company is spending money much faster than it is making it, even though it is making a lot. Eventually, the creditors (i.e., contractors and vendors) will demand their money and, if the company does not have enough cash to pay up, the creditors will take the company to court. A judge may very well decide that the creditors are entitled to their money and will start selling off the assets of the company in order to raise cash to pay them. (Half-finished construction projects don't bring in much cash at a sheriff's auction.) At that point, the owners of the company have lost control and may very well be forced into bankruptcy. So, you can see that it's dangerous to be on either extreme of the line: (1) highly liquid but not very profitable, and (2) highly profitable but not very liquid. There's a broad middle ground between the two extremes where the company wants to reside. Fortunately, we have tools at our disposal that will allow us to measure where we are on the line. These tools are primarily financial ratios, which measure the company's liquidity and profitability. We can compare the company's liquidity and profitability ratios to those of other companies (particularly, to the industry average) to see where we are on the line, and can, if necessary, make corrections.
What is liquidity and profitability? Profit is what accrues (is added to) capital at the end of an period of activity as a result of a difference between the value of sales and the cost of raw materials, labour and capital that went into the production of the goods sold. [Equation goes here - download the original pdf to see it.] Liquidity is the availability of capital at each and every point of the working capital cycle to ensure the smooth flow of production through the business. LIQUIDITY MEANS ENOUGH CASH AND ENOUGH WORKING CAPITAL TO ENSURE THE DAY-TO-DAY RUNNING OF THE BUSINESS.
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