We
all from our studies understand profits, whether Gross Profit, Net Profit or
the ways of measuring profit margins (GPM and NPM), But what is liquidity and
how can we compare profits and liquidity?
Liquidity
is a measure of the availability of money for use in the day to day running of
a business. A liquid asset is one that is cash or can easily be turned into
cash, for example a debtor, someone who owes a business money, is likely to pay
soon, so this is a liquid asset. Stocks that will be sold in the near
future—another liquid asset.
Working
Capital-
Working
Capital is a measure of liquidity. If a firm has large amounts of working
capital, it can be described as having good levels of liquidity. Low or even
negative working capital = low levels of liquidity. Working capital is
calculated by using figures on a firms balance sheet, Current Assets take away
Current Liabilities gives us Working Capital.
Profits
and Liquidity Compared-
There
does seems to be a clear relationship between profits and liquidity, after all
profits are calculated by taking costs from sales revenue, and liquidity is
measured by taking current liabilities which include creditors (created by
purchases) from Current Assets (which includes cash and bank balance, the money
that comes from selling goods and services).
But
there are important differences between the two. These differences include;
Capital
Inflows- If a
business receives an injection of capital that has not arisen from its trading
activities (sales) then this improves availability of cash. So if a firm
borrows money for investment, this increases the amount of working capital
available —liquidity is improved. But this borrowing is obviously not an
increase in profits, and repayments on the loan will be shown as a business
expense, reducing profitability.
Depreciation- As depreciation is
a paper accounting transaction, not involving actual spending of money, this
loss in value of assets does not affect liquidity. But depreciation is shown as
a business expense, reducing profits.
Sales
or revenue- How
sales and revenue is shown on accounts also causes differences between
measurement of profits and liquidity. Sales are applied to the accounting
period in which the sale occurs. So if a good sold in one period on credit, is
entered as a sale for that period and adds to the profit in that period, The
payment may not be due or received until the next accounting period (maybe 60
days later), so liquidity does not benefit until maybe 60 days after the sale.
Even though the sales has created a debtor (which is a current as-set) it is
not the same as having cash, and will not become cash until the debtor pays .
In fact the sale may have for a short period made liquidity worse, as the costs
of sales will have to be paid before the money is received from the buyer of
the goods.
This
problem of costs and payments being incurred well before money received from
the buyer is a real problem for small firms, and is one of the main causes of
lack of liquidity.
The
Importance of Profits and Liquidity-
Liquidity-
If
managers of a business say they have a liquidity or working capital problem,
this means that they will have a problem meeting all their immediate or near
future expenditure demands. That is they do not have enough cash in hand, or do
not expect enough cash to be flowing into the business and cannot convert
enough assets into cash in the short term to be able to pay all their bills,
wages, debts etc..
Without liquidity firms can go bust very
quickly. Cash is needed to keep the wheels of business turning, to pay bills,
wages, suppliers etc. In the short run liquidity is more important than profit,
but in the longer term, there is no point in having available cash, if this
cash has not come from profits made.
Profits-
Profits
are the reason why businesses exist, it is the potential of making profits that
en-courage entrepreneurs to take risks to invest in a business, so the first
role of profits is to reward owners for risks taken when investing in a
business. Apart from rewarding enter-prise / risk taking, profits have other
uses.
·
Providing
money for investment. Profits kept within the firm and reinvested, help firms
grow.
·
Profits
attract new investors, therefore making raising capital easier.
·
Growing
profits increase the value of a business, giving the owners ‘capital gain’.
·
Profits
allow the repayment of loans made to a firm, reducing gearing and reliance on
lenders.
