Liquidity and Profitability are firmly related. First of all, let us understand what is Liquidity and Profitability.
Liquidity portrays how much and how easily the assets or stocks or securities can be converted into cash.
Profitability is the capacity of an organization to utilize its assets to create incomes in an overabundance of its costs. As such, this is an organization’s ability to produce benefits from its operations.
Which one is more important?
Liquidity is the capacity of a firm to pay its obligations that are of short term for their ongoing operations. A firm is viewed as financially strong and low risky which has tremendous cash or cash equivalents in its accounting report. Liquidity isn’t just estimated by the cash balance ,but in addition by all sorts of assets which can be changed over to cash within one year without losing their worth.
Profitability estimates the financial achievement of the firm regardless of cash flow in the firm. It is frequently seen that a firm is entirely profitable in its books however it doesn’t have adequate cash and cash equivalent to pay its day by day obligations.
The empirical studies have proved that the reason behind businesses which go bankrupt is not that they are not profitable, it’s because they don’t have adequate liquidity.
- A Business which is exceedingly liquid has significantly more current assets than obligations (for example creditor liabilities). Consequently, it has a more noteworthy capacity to pay its suppliers on time, as these assets are either cash or can be converted into cash within 1 year.
- Worldwide money visibility has been a mantra for organizations for many years. As the most recent couple of years have demonstrated liquidity is as significant as profitability; low profitability hurts, however absence of liquidity kills.
- Over the years of working with entrepreneurs , we have seen that some companies keep on supplying products or services to their customers though they don’t get paid for it , and the reason they give for such continued supply is that, they are worried, if they stop the supplies they may not recover their dues. Sometimes this goes on for more than a year or two before they realise that they can no longer afford to manufacture or supply the products, since they themselves have turned cash deficient.
As a new entrant into the market, it is imperative that you are in business to sell your goods or services and at the same time make some profits over your investments done. While profits rate can be relooked at – but Liquidity is something that cannot be compromised on. You need to have a cash float to be in business.
First time entrepreneurs get carried away when they bag big orders or big names which adds to their profile, however the terms of trade may not be in the interest of the business. The credit terms may not be in the best interests , still to get the first order going, it is important to take such steps. However, it is important to understand and analyse the impact on your cash flows.
It also happens that the business borrows money from banks, financial institutions or lenders to use it in their business and this may also lead them to have cash in bank in their accounts. Hence they could have liquidity in the system, but this liquidity is a liability which needs to be repaid.
With the help of the liquidity raised by borrowings, it is important to generate additional revenue or sales and thereby profits associated with the same.
Always remember – You can be in business only if you make profits and those profits get converted into Stock or Cash . There is no other way you can remain in business for a long time without converting your profits into cash.
If you are one of those entrepreneurs who has been in business by extending long periods of credit, having a lot of receivables , where clients are not paying you on time and this becomes a habit; you have been borrowing money from external sources to fund your business – its high time you press the pause button and think over. Assessing your Financial Health and clearly understanding where you stand vis a vis Profits and Liquidity will surely help you see better the way forward for you as an entrepreneur. At Centurion, we can assist you with this aspect of your business and help you redraft your financial plans.
Both Profitability and Liquidity are significant for a business It is important to realise the Profits shown into cash or stock within acceptable timelines for you to be a Cash sufficient at all times to fund your needs and plan the growth of your business. While borrowed funds also assist in growth, at the end of the day – the funds borrowed and invested should yield cash profits to repay the borrowings and further grow the business..
Be Cash Wise and profitable at all times. Good Luck