Profitability and liquidity

The fact that a firm is profitable does not guarantee that it will have enough cash to remain
trading (being 'solvent'). It may seem surprising that a firm that is making a profit or has
made profits in the past can run out of cash, but this disbelief stems from a common
misunderstanding of what the terms 'cash' and 'profit' actually mean. People often assume that
at the end of each year there is an amount of money in the firm's bank account equivalent to
its profit and that this can be withdrawn and spent by the owner(s) of the firm. However, it is
more likely that the profits will be tied up in many different areas of the firm. For example,
the profit may have been used to acquire new equipment or stock; if the goods have been sold
on credit the revenue may still be in the form of debtors. It is possible, therefore, for a firm to
be profitable but to also be short of cash because:

Differences between cash and profit

 Many sales are on credit. These sales will be counted immediately towards the profit
even though the cash from the sale may actually appear months later. Accepting and
order for sales may mean that a firm has to spend more on production without
generating the cash flow from the sale until much later. This problem is known as
overtrading - where a firm experiences cash flow by accepting extra sales without the
necessary cash flow to produce the output.

 The firm may have invested heavily in capital items such as equipment. Although this
will involve a cash outflow, the 'cost' of these assets in the profit and loss account will
be 'written off' as depreciation over the working life of the asset. This means that
capital expenditure will affect cash flow not profit.

 The firm may have invested in stocks. These will appear as an asset on the balance
sheet but will not appear as a cost until they are used up. The cash outflow will occur
when they are bought.

 If a firm has paid for something in advance but not used it up yet (e.g. it has paid for
the use of some equipment or property in advance) this will reduce cash flow but will
only be recorded as a cost when the service or good is used up next period.
Conversely, if the firm has used up something, such as electricity, this will count as a
cost even if the bill has not been paid for. This is summarised in the accruals concept.

Why is cash flow important?

Firms usually exist in order to make a profit. This may not always be their main objective. It
is also, however, important for firms to monitor their cash flow position. This is because a
firm will need cash to pay for the daily running of the business.

Cash will be needed to pay wages, to pay bills, to pay suppliers and for the general upkeep of
the firm. If a firm cannot pay one of its creditors, then the firm may ultimately face a
bankruptcy order forced on to the firm by those who it cannot pay. If it cannot pay its own
workers then industrial action is likely to occur.

Sufficient levels of cash are needed to ensure that a firm is liquid; it is important, therefore,
that managers track the cash flow position of the business. This is likely to involve drawing
up cash flow forecasts which estimate the likely amounts of cash inflows and cash outflows
over the near future. Very short-term cash flow forecasts may be particularly important for
small or newly established firms, which often have to target cash flow over a daily or weekly
period rather than on a month by month basis. This is because a new or small firm is thought
to be more likely to fail than a larger firm. As a result, the sources of cash flow available to a
larger firm (such as extended credit periods offered, or extensions to overdrafts) may not be
offered to small firms if their cash flow becomes negative.

Which is more important - cash or profit?

In the long run there is probably little point undertaking an activity if the value of the sale is
less than the value of the inputs used up (i.e. if turnover is less than costs). This means that
over time a firm will need to make a profit if it is to continue with an activity. Firms will
generally measure not just the absolute size of the profits but also their size relative to the
capital employed, to decide if an activity is worthwhile.

In the short run, however, the priority is to keep the business going; this means the firm must
be liquid and have sufficient cash flow. There is little point in getting involved in a project
that is potentially profitable if, in fact, the business will not survive long enough to be able to
sell the products it produces. Firms must pay attention to their cash flow as well as their
profit. If a bill has to be paid, cash is likely to be regarded as more important than profit;
however, when reviewing the firm's activities over a period of time it will usually be
expected to achieve a suitable rate of return in terms of profit.

A firm must be careful when engaging in activities to monitor the effect on each transaction
on both profit and cash flow. Many firms may forget that the cash flow will be, in some
cases, more important than the profits.

Limitations of ratios
It is important to realise that with ratio analysis that the question will rarely focus on the
calculation of ratios alone, most of the time the calculation of the ratio will only be the first
step on some investigation into some aspect of business performance. Therefore it is
especially important that you can interpret and analyse what the result of the ratios actually
mean,

Areas that are important in ratio analysis are as follows:

1. Analysing the ratios of a particular area of a firm (e.g.: profitability, efficiency,

liquidity, etc.)
2. Limitations of ratios
3. A basis for comparing the performance of two firms or one firm over time
4. As a tool to help decide a firm's strategy (e.g. has it a safe liquidity position for
expansion, or analysis of gearing to help decide on the best form of finance)

When answering any question on ratios you must consider the following factors:

1. What type of firm are we dealing with?

2. What is the size of the firm and should this have any effect on the ratios?
3. Will the time of year have any effect on the ratios? (see liquidity ratios section for
example)
4. Have we got enough information to make any serious conclusions?
5. What external factors are important?
6. Are the accounts supplied reliable? Ratios are only as accurate, true and fair as the
original figures from which they were calculated

Obviously, the first stage should be to calculate the ratios in the correct manner. Once you
have completed this then it is time to start to interpret the results that you have calculated.

This interpretation can be in the form of your theoretical knowledge of what the ratio tells us.
For example, the current ratio will look at the firm's ability to pay day-to-day expenditure.

Once you have interpreted the meaning of the results you can then look around to consider
wider issues, such as the context of the question. For example, it does not matter what size
the firm's profit margin is if the economy is entering a recession and a firm sells goods that
are significantly affected by changes in consumer spending. Also, you may wish to look at
other non-financial factors within the firm. A highly motivated workforce may be more
important for cash flow than an efficient debtors collection period.

It is important that you realise that although accounting ratios can be a very useful tool they
also have many serious limitations which can render the results meaningless, or worse, can
cause you to jump to incorrect conclusions.

 
Common limitations of ratios

Common limitations of ratios are as follows:

 Not having more than one years' data. Even two years may not be enough to give a
clear picture of the overall direction of the firm.
 Comparisons with other firms are only meaningful if the firm's are very similar (same
industry and similar size). Even firms that appear similar may have different
objectives, making any comparison meaningless.
 All firms will be affected by changes in the economy in different ways - this must be
taken into account when analysing firm's results.
 Firm's can window dress their accounts to make it look as if they are performing
better than they actually are. The actual accounts and the notes to the account should
be analysed to find out more about the results.
 Balance sheets are drawn up on one day. If this day is not a typical day then the ratios
may give a misleading picture.
 Concentrating on financial data means that we may ignore important non-financial
factors, such as industrial unrest, the training level of the workface and managerial
problems.

The best way to avoid falling into these traps is to spend time trying to understand what the
ratios actually mean. This is not just a question of learning what they should theoretically
show, but rather what thinking lies behind the actual calculation of the ratio. For example, we
all know that the current ratio shows us the solvency position of a firm. However, we must
look into the ratio itself for it to provide meaning. A firm may have many current assets, but
if these are stocks which are not very liquid then the firm may face problems. We also need
to know the limitations of using a single financial statement rather than the 'whole picture'.
Balance sheets are just snapshots which may have been constructed at an atypical time giving
us unusual results. It is very important that ratios should be considered with the previous
years' equivalent figures if any meaningful solution is to be offered.

Its is also important that the ratios were calculated in a similar way, i.e. you are treating 'like
with like'. If you are engaging in comparing between two firms then it is common sense to
point out that the two firms should be similar firms. In this chapter we have seen very
successful firm having radically different ratios.

If you are to perform an inter-firm comparison then it is also important that the same
formulas were used and that the data used was of equivalent meaning. It is also important that
the accounting policies are consistent across the firms being analysed. For example, has
machinery been depreciated in a more-or-less similar way such as the straight-line method?

The results that you calculate may indicate a problem which cannot be summarised through
financial figures and may actually require you looking at the other areas of the firm, such as
marketing or human resources. Remember, of course to take into account that the firms will
be affected by the economic cycle. Firms will be affected in different ways, but all will be
affected.

The best answers in ratio analysis are those that can join up the theoretical knowledge with
real world factors. It is very important that you structure your answers carefully. Try to start
off with the theory first before opening up to wider issues. A common format could be as
follows:

1. Calculation of ratios.
2. What does the ratio tell us anyway?
3. What does theory tell us about our result?
4. Can the context of the question explain the results?
5. How valid are our results anyway?
6. What other factors should we consider?

Exam tips
 There is no other way around it, you will have to learn all the formulas for the ratios -
all of them!!

 You can help yourself by practicing the ratios as much as possible - you will find it
easier if the ratios have actually been used.

 Read the question very carefully. Sometimes questions will want just a calculation
and nothing else. However, it is likely that you will have to consider the scenario of
the questions as well as any theoretical knowledge you have picked up through the
course

 The type of firm, time of year and market it operates in will all partly explain the
results of the ratio calculations.

 Make sure that you are looking at the appropriate category of ratio - each category
will cover a slightly different aspect of the firm's overall financial position.

(Source: https://www.thestudentroom.co.uk/revision/accounting/a-level/accounts-module-4-ratio-
analysis)