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For the long-term viability of a business, both profits, as well as cash flows, are equally indispensable. Generally, profitable businesses tend to secure positive cash flows over the long run and accumulate a significant amount of cash. However, this may not always be true. There may be situations where a firm can register a hefty amount of profit but expand more cash than it takes in during the profitable accounting period. It is important to gauge the causes behind such situations.
Accountants typically use accrual cost accounting to file financial statements. With this method, expenses are reported only when goods or services are consumed in full, irrespective of when the bill is paid. Similarly, revenue is only registered when the product or service has been shipped to the consumer, and the company has received the right to collect cash payment, regardless of whether the customer pays us.
Unlike large public corporations whose shares are traded on the stock exchange, small firms are not governed by a legal obligation to prepare and publish three financial statements, including balance sheet, profit and loss statement, and cash flow statement. But it is in the interest of every business, whether small or big, to prepare these statements as they offer invaluable information. One of the main reasons why companies should prepare both an income statement and a cash flow statement is that cash and profitability may not mirror each other. If divergence is noticed and the business entity books a profit while its cash position declines, then these two statements will prove to be very beneficial to clarify why that happened.
Some examples of transactions/causes that may lead to a situation signalling a decline in cash flows while simultaneously gearing up the profits are as follows:
For example, a retailer purchases furniture worth Rs. 10,000 and sells it to a customer for Rs. 5,000 down and Rs. 10,000 due in the course of 2 months. As the cost of goods sold (COGS) is Rs. 10,000, he books a profit of Rs. 5,000. However, if we look at the cash position, the retailer took in only Rs. 5,000 in cash, for an item it had bought by paying Rs. 10,000 cash. Thus, his cash reserves decline by Rs. 5,000 with every such transaction.
Suppose a firm acquires a building for Rs. 20 lacs in cash. With this, its cash position shows a sudden decline of Rs. 20 lacs, yet net profits will remain unchanged. Acquiring something for cash does not influence the profit, because the firm trades one form of asset for another.
If one thinks about the liquidity of a company, he seeks to calculate the capacity of the company to meet planned and unforeseen cash needs, increase its assets, minimize its liabilities, or cover any operating losses. Companies’ financial status is deemed strong enough on the condition that they have sufficient liquidity.
No matter how many fixed assets, buildings, or furniture a business owns or how large its accounts receivables are, if a business does not have sufficient cash, it throws a negative impact on its liquidity. Such receivables or fixed assets cannot be utilized to pay bills on a time-to-time basis. Indeed, many profitable firms sometimes go bankrupt since they simply are unable to find the necessary cash to honor their payment obligations on time.
Liquidity or short-term solvency means the ability of the business to pay its short-term liabilities as and when they fall due. The inability to pay-off short-term liabilities affects the credibility as well as the credit rating of a business. Continuous default on the part of the business leads to commercial bankruptcy.
Furthermore, short-term lenders and creditors of a business are very much interested to know its state of liquidity because of their financial stake in the business. Both lack of sufficient liquidity and excess liquidity is bad for the organization.
The liquidity of a business should be assessed using the following parameters:
1. Current Ratio:
Current Ratio = Current Assets ÷ Current Liabilities
The current ratio is a simple measure that estimates whether the business can pay short-term debts or not. A generally acceptable current ratio is 2:1.
Current Assets may include Inventories + Sundry Debtors + Cash and Bank Balances + Receivables/ Accruals + Loans and Advances + Disposable Investments + Any other current assets.
Current Liabilities may include Creditors for goods and services + Short-term Loans + Bank Overdraft + Cash Credit + Outstanding Expenses + Provision for Taxation + Proposed Dividend + Unclaimed Dividend + Any other current liabilities.
2. Quick Ratio or Acid-test Ratio:
Quick Ratio = Quick Assets ÷ Current Liabilities
Quick Assets = Current Assets − Inventories − Prepaid expenses
It measures the ability to meet current debt immediately. It is a much more conservative measure of short-term liquidity than the Current Ratio. It answers the question as to whether a business can meet its current obligations as and when they fall due with the readily convertible quick funds on hand. A generally acceptable quick ratio is 1:1.
3. Cash Ratio or Absolute Liquidity Ratio:
Cash Ratio = (Cash and Bank balances + Marketable Securities) ÷ Current Liabilities
It measures the absolute liquidity of the business. This ratio takes into consideration only the absolute liquidity available with the business firm.
4. Net Working Capital Ratio:
Net Working Capital Ratio = Current Assets – Current Liabilities
It is a measure of cash flow to determine the ability of a business to survive a financial crisis. Bankers often look at Net Working Capital over time to determine a company’s ability to weather financial crises. Bank loans are also often tied to minimum working capital requirements.
To determine the liquidity position of a company, it is essential to monitor the current ratio regularly. A company should compare the company’s current ratio and other liquidity ratios to the industry standards to determine whether it is a higher or a lower number. Neither a higher ratio nor a lower one is preferable for a company’s financial health and short-term solvency.
1. Increase the liquidity ratios
To increase liquidity means increasing your business’s cash flow, often so that cash on hand is sufficient to pay current liabilities. When short-term solvency concerns become accentuated, the management of the company can improve its liquidity through a variety of means.
The liquidity ratios can be improved by adopting the following measures:
2. Reduce the liquidity ratios
Businesses always aim to improve liquidity ratios; however, there may be circumstances when it is imperative to reduce these ratios.
When the current ratio (liquidity ratio) is too high, it signifies that the company is keeping more margin of safety than required, and its resources are not fully utilized to the best possible extent. In addition, excess resources may be tied up in working capital and may not be put to productive and profitable avenues.
Moreover, it can mean that the business holds excess cash, and such excess cash may be decreasing the company’s profits owing to implied interest costs.
The liquidity ratios can be reduced by adopting the following measures:
In a company, liquidity signifies the ability to pay when due. Liquidity and insolvency are on the same line of numbers but on two opposite sides. Therefore, holding the Liquidity-Bankruptcy indicator on the liquidity side is in the best interests of the company. We should strike a balance because low liquidity is a risk of bankruptcy, whereas too high liquidity is an indicator of inadequate cash management.
Also, Read: Critical Financial Performance Ratios to Track a Start-up’s Liquidity, Profitability, and Solvency.
A CA together with MBA (Fin) and M Com, she relishes taking interest in insightful writing in the domain of taxation and finance. She has gained experience as a full-time author and has also served an accounting role in industry.
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