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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. rofitability goal, on. the other hand, requires that the funds of the firm are so used so as to yield !lt highest return. "iquidity and profitability are very closely related. #hen one increases the other decreases. $pparently liquidity and profitability goals conflict in most of the decisions which the finance manager makes. %or 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. &imilarly, 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. $ 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. %orecasting 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. $n efficient finance manager fixes that level of operations where both profit and risk are optimised

Profits, Profitability And Liquidity - LD04

1. Introduction and Definitions $mongst 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. )arious profit figures *gross, net, pre-tax etc.+ for the period can be read from the rofit and loss $ccount *,& term (-ncome &tatement(+. Profitability is the relationship between profits and capital *the (static( resources set aside to earn those profits+. .easuring profitability means that you have to relate a profit figure *from the rofit and "oss $ccount+ to a resources figure *from the /alance &heet+. -n short, profit is the measure of gain, and profitability the relation of this gain to the firm0s assets. -f profitability exceeds the cost of the firm0s capital, that is the interest rate at which it can borrow money, it can call itself successful. -t 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. %or this to hold true, private and public profit must be equivalent1 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 "213, $ccounting Theory and the urpose of $ccounting+. 2. Objecti es, Profitability and Liquidity rofit may be seen as an end in itself *i.e. the (mission( - see "234+ but it is better viewed as a necessary means to an end, namely the survival and growth of the organisation. 5apanese companies and some others are reported as seeing profits as a cost of staying in business, which is an echo of the economists0 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. "ikewise, 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. -f 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(.

; !. "easurin# $rofitability and liquidity #hereas 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. "arge 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. &uch expressions and such measurement require care, routine and administration as well as an understanding of the principles involved. $ll the levels of profit *gross, operating, net and retained+ are expressed in the various sections of the rofit and "oss $ccount *my definition being (a structured statement of income and expenses(+. The measurement of profit is, in fact, very difficult and it is to cut through the problems of principle that accountants adopt a number of (rules of thumb(, such as depreciation in equal instalments over the estimated useful life of the pro6ect *see also "217, 2epreciation+. 4. %oo&-&ee$in# 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 firm0s business *i.e. the payment of bills and the receipt of money owing+ and secondly to classify the firm0s transactions. #hen sorted into liabilities, assets, income and expenses, these transactions, drawn up into (accounts(, and with appropriate ad6ustments to bridge the gaps between the transactions and economic reality, provide the (%inal $ccounts( which provide the expression of profit and liquidity that are the sub6ect of this digest *see also "211, $ccounting &tatements and "243 /ook-keeping+. )iewed as a whole, these activities give rise to a ( magic pool of information( from which all can make extractions without diminishing the pool. '. Liquidity "iquidity, which is much easier to measure than profit, is shown in the /alance &heet, which can be seen *8hart 4, $ppendix 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. -f you hold cash or readily realisable assets such as shares, your liquidity is soundly based. -f it consists of debtors, it is dependent on their ability and willingness to pay. -f it consists of goods, liquidity is a function of the saleability of those goods and may be low if they are not in demand. %or the 8hristmas season of 19:7, $corn and &inclair 8omputers, both over-estimated sales so badly that they were left with large stocks of home computers. -n each case this was a ma6or factor causing the company *and the /ritish position in micro-computers+ to collapse.

7 $ firm needs to balance its position for each (slice of time(. 8ertain businesses, such as banks, manage this function in a most developed fashion because it is very important to them. ension funds have to balance assets and liabilities over time-scales measurable in decades. .ulti-national companies have, in addition to the time problem, the problem of balancing assets and liabilities in multiple currencies, which currencies are sub6ect to fluctuating exchange rates. %or most businesses, liquidity is conventionally and satisfactorily measured by two ratios, the current and liquid ratios. The current ratio takes the 6oint value of total current assets, i.e. stocks *,& term (inventories(+ see "23< debtors *if money is due within 14 months+, easily realised investments, *e.g. gilts+ cash and expresses it as a multiple of current liabilities *that is all monies payable within 14 months+. The 14-month limit is arbitrary but realistic as most activities are seasonal. 8urrent 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. =ents, 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. -t is a stronger form of comparison and more pessimistic in that it assumes that the stock cannot be sold *see also "214, =atio $nalysis and the ,se of $ccounting &tatements+. (. )ar#ets for Liquidity and Profitability $ worthwhile target for the liquid ratio is 1>1. 8ompanies 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 ?@8 in 19:; and 19:7, a company sees liquid investments as a sound home for its resources. The current ratio cannot be 6udged except in relation to the needs of a particular commercial situation. $nything between 1>1 and 7>1 could be acceptable. 8omparison must be made with industry norms and those competitors whom one respects. -n the absence of other data, 4>1 is not unreasonable. %or profitability there is no sense of a target - the higher the better. rofitability is normally unstable from year to year, so 6udgement 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.(

A 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 sub6ect to great uncertainty, the values for (equity interest( in the /alance &heets being merely opening bids. #here 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. 8onversely 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. 5udgements based on accounts are necessarily backward-looking, and even when you use pro6ected accounts, their simplicity does not 6ustify the loss in quality offered by cash flow methods. 2etailed discussion is outside the scope of this digest. *. Ac+ie in# 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. -n my opinion there are two distinct requirements for liquidity, firstly, profitability and secondly, care and thoroughness in administration. -t 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. -f such a firm makes losses it is paying out in cash more than it coming in from sales. -t can only sustain its cash balances by in6ections of capital or by selling off its assets, processes which cannot be continued indefinitely. rofitability may be necessary but it is not sufficient. $ 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 "211+. @very 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. #hatever 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 "231, $ &trategist0s Toolkit+. ,. "atters arisin# fro- a .ir-/s Liquidity and Profitability Position

< Though the financial tail should not be allowed to wag the company dog, the pattern of profitability and liquidity does favour particular strategies. $ simple 4 x 4 grid gives four cells and action implications as set out in 8hart 1, $ppendix 1, attached. 0eferences The substance of this digest can be found in so many books that - refer to none. Taking some points further, other "20s aim to provide access to the literature through their references. "2Bs 13, 11 and 17 are not available as at 43-13-9:

A$$endi1 1
2+art 1 - )+e Profitability 3 Liquidity 4rid P0O.I)A%ILI)5 High A - HH - Co problems. 8hoices not financially constrained. High /e vigilant take-overs, marketing. ossible strategies include H"1, H"4 and "H;. 4+ =epay capital *loan or equity+. LI67IDI)5 Low 1+ =aise capital *loan or equity+. 4+ #ait ;+ 2ivest - then H"1 or H"4. C - LH - 8hoices> inverse of H" D - LL - .any problems. Co easy answers. Cew team at the topD Eou need H"1 but money only comes from "H; Floss-makers out firstG and "H1 when confidence is restored. Low B - HL - 8hoices> inverse of "H 1+ -nvest - *e.g. cost reductions, *new+ product development,+

J 2+art 2 - )+e %alance 8+eet considered as an Accu-ulation of )i-in# Differences "eads are cash movements before the "ags are cash movements after the rofitI"oss 8ategory 8ash movement Transaction and "eadI"ag /alance &heet 8ategory -ncome "ag -ncome "ead 8ost "ead 8ost "ead 8ost "ead 8ost "ag 8ost "ag 8ost "ag 2ebtor 2eposit %ixed $sset &tock repayment 8reditor, $ccrual, rovision -ncome -n H " impact, H " impact. @xpenditure !ut

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@ffects of rofitability and "iquidity on =H2 -ntensity> 5apanese and ,.&. 8ompanies 8ompared ?reg Hundley, 8arol M. 5acobson and &eung Ho ark The Academy of Management Journal, )ol. ;9, Co. < *2ec., 199<+, pp. 1<A91<J7 *article consists of 1< pages+ ublished by> $cademy of .anagement &table ,="> http>IIwww.6stor.orgIstableI4AJ3J;

@ffects of rofitability and "iquidity on =H2 -ntensity> 5apanese and ,.&. 8ompanies 8ompared, by ?reg Hundley, 8arol M. 5acobson and &eung Ho ark N 199< $cademy of .anagement.

Abstract
This study investigates the proposition that 5apanese companies have a greater propensity than ,.&. companies to sustain commitment to =H2 in the face of fluctuating profits and liquidity. The analysis showed that profitability declines led to increased =H2 intensity in 5apan. These effects were not confined to members of 5apanese financial keiretsu, or industrial groups. The =H2 intensity of ,.&. 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 Li ui!it" vs# Pr$fitabilit" Tra!e$ff

%LOSSARY The Li ui!it" &ersus Pr$fitabilit" Princi'le( There is a trade-off between liquidity and profitability; gaining more of one ordinarily means giving up some of the other. Li ui!it"( Having enough money in the form of cash, or near-cash assets, to meet your financial obligations. Alternatively, the ease with which assets can be converted into cash. Pr$fitabilit"( A measure of the amount by which a company's revenues e ceed its relevant e penses.

!icture "Liquidity" as being on one end of a straight line and "Profitability" on the other end of the line. #f you are on the line and move toward one, you automatically move away from the other. #n other words, there is the trade-off between liquidity and profitability. This is easy to illustrate with a simple e ample. 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. #n order, the most important of these assets are$

%ash &ar'etable (ecurities Accounts )eceivable #nventory *i ed Assets

+otice 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. #n other words, the most profitable investment for company is normally in its fi ed assets; the least profitable investment is cash. Ban)ru'tc" Ris) #s it possible for a company to go ban'rupt if it has a lot of cash but is not profitable, (ure it is- #t may ta'e a while, but if it remains unprofitable, it will

14 eventually go ban'rupt. #ts available cash will be used to finance the losses, but when the cash runs out, the assets of the company will have to shrin' because there will be insufficient funds to replace them as they wear out. The company will become smaller and smaller and will eventually fail. #s it possible for a company to go ban'rupt if it is very, very profitable but is not very liquid .i.e., does not have much cash/, %ertainly- *or e ample, if a company e pands 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 lac' of cash. #n other words, the company is spending money much faster than it is ma'ing it, even though it is ma'ing a lot. 0ventually, 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 ta'e the company to court. A 1udge 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 pro1ects 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 ban'ruptcy. (o, you can see that it's dangerous to be on either e treme of the line$ .2/ highly liquid but not very profitable, and .3/ highly profitable but not very liquid. There's a broad middle ground between the two e tremes where the company wants to reside. *ortunately, 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. 4e 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, ma'e corrections.

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#hat is liquidity and profitabilityD rofit 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. F@quation goes here - download the original pdf to see it.G "iquidity 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. "-Q,-2-TE .@$C& @C!,?H 8$&H $C2 @C!,?H #!=M-C? 8$ -T$" T! @C&,=@ TH@ 2$E-T!-2$E =,CC-C? !% TH@ /,&-C@&&.