topic 18 liquidity vs profitability

• Profit on its own does not show the profitability of a business. To measure profitability, profit must be compared to something else. Profitability is measured by using profitability ratios
• Gross profit markup = GP/CoS x 100%
• Liquidity means how easily a firm can turn its assets into cash without a loss and refers to a firm's ability to pay day to day expenses and short term debts. A firm may be profitable but have cash flow problems, for example if receivables take too long too pay. A shortage of working capital is the main cause of business failure so management of working capital is important for the short term survival of a business
• Liquidity ratios measure a firm's ability to pay short term debts and expenses
• Inventory turnover:

  • Cos/Avg inv = Times per annum
  • Avg inv/Cos x 365 = Days
• Current ratio = CA/CL
• Liquid capital ratio CA-Closing inv/CL
• Receivable days = Receivables/Credit sales x 365
• Payables days = Payables/Credit purchases x 365
• Credit control is an important role of bookkeeping and involves monitoring the sales ledger and purchases ledger accounts to make sure that customers are paying on time in order for the business to pay its suppliers in good time
• A company must weigh the potential drawbacks of delaying payment to suppliers:

  • eg. loss of discount for early settlement of an invoice
  • refusal to supply any more goods on credit
  • possible court action
• Commenting on ratios:

  • ratios are calculated to provide comparisons
  • comments should be clear eg. is ratio better or worse or how great is the difference
• How to improve gross profit margin:

  • increase revenue
  • offer sales promotions
  • offer longer periods of credit
  • advertise more
  • reduce cost of sales
• How to improve gross profit markup:

  • increase selling price
  • reduce cost of sales
• How to improve profit in relation to revenue:

  • increase gross profit
  • reduce expenses
• How to improve rate of inv turnover:

  • reduce selling price
  • special offers to increase sales
• How to improve current ratio:

  • increase current assets
  • reduce current liabilities
• How to improve liquid capital ratio:

  • increase liquid assets
  • reduce current liabilities
• How to improve receivable days:

  • offer cash discount
  • chase up slow paying customers
• How to improve payable days:

  • negotiate longer credit periods
  • find alternative suppliers
• Explain the difference between profit and profitability:

  • profits refer to the amount of surplus money a business has once costs have been paid
  • profitability refers to the percentage of revenue which the business makes as profit, included a calculation for gross profit margin and profit for the year margin
• How may liquidity lead to cash flow issues:

  • liquidity means how easily a firm can turns its assets into cash and refers to a firm's ability to pay day to day expenses and short term debts
  • a firm may be profitable but have cash flow problems eg. if trade receivables take too long to pay
  • a shortage of working capital is the main cause of business failure so management of working capital is important for the short term survival of a business
• How may high levels of inventory negatively impact a firm's ability to make payments - High levels of inventory could mean that cash and cash equivalents are tied up in stock which means that they may not have sufficient cash to support the day to day running of the business. Therefore this could lead to difficulties in paying expenses eg. wages impacting the relationship/agreement with employees resulting in employee demotivation
• Explain how awareness of credit control may have a positive impact on a firm's liquidity - Credit control is an important role of bookkeeping and involves monitoring the sales ledger and purchases ledger accounts to make sure that customers are paying on time. In order for the business to pay its suppliers in good time. The business should ideally have shorter receivables days and longer payables days