Alok Patnia founded Taxmantra.com, an expert in tax advisory & compliance. He is a Chartered Accountant having prior exposure with Ernst & Young & KPMG.
Is Cash really King for Businesses ? Majority of Businesses fail due to lack of cash.
We often hear from business owners that,
my consultant says we need to pay taxes, but I don’t have money in my bank account; my business is facing liquidity problem.
Why cash is so important? What is meant by liquidity? How liquidity differs from profitability?
This article will provide you answer for the above questions. The article focuses upon why liquidity is so important for startups and small firms and what can they do to maintain their liquidity.
What is liquidity?
Liquidity refers to a company’s ability to pay its bills when they become due. It can also be defined as measure of the availability of money, for use in the day to day running/ operations of a business.
Liquidity is measured by comparing a company’s current assets to its current liabilities. A liquid asset is one that is cash or can easily be turned into cash, for example a debtor, someone who owes business money, is likely to pay soon, so this is a liquid asset. Stocks and money market instruments are another example of liquid assets.
Importance of liquidity
Liquidity/Cash is needed to keep the wheels of business running. Liquidity gives a security to the companies during uncertain times. Startups and small firms are prone to financial difficulties. They need to recoup the cost of putting up the business, complete their daily operations as well as expand further.
A company having liquidity crunch will have difficulty in meeting its immediate expenditure demands i.e. either they do not have enough cash in hand, or they do not expect enough cash to be flowing in near future into the business. They also might not convert enough assets into cash in the short term to be able to pay all their bills, wages, and debts.
What is Profitability?
Profitability is a measure of the amount by which a company’s revenues exceed its relevant expenses. Profitability is an accounting convention which indicates the value created by the business over a period of time, expressed as earnings.
Profits are the reason why businesses exist. The primary role of profits is to reward business owners for risks they have taken on investing in the business.
Relation between Liquidity and Profitability
Liquidity and profitability both are very closely related as to when one increases, the other one decreases and vice-a-versa. The finance manager of a company has to strike a balance between the two because liquidity and profitability goals conflicts in most of the cases.
For example, the finance manager may anticipate increase in prices of raw materials and might decide to keep higher inventories. In this case although the profitability goal is approached but the liquidity of the firm is endangered. Similarly, if the firm decided to follow a liberal credit policy and may be in a position to push up its sales but it will result in a decrease in its liquidity.
The difference between liquidity and profitability arise a result of accrual method of accounting. Under the accrual basis of accounting:
- Revenues are reported on the income statement when they are earned which often occurs before the cash is received from the customers.
- Expenses are reported on the income statement in the period when they occur.
The accrual basis of accounting is required because of the matching principle of accounting which requires a company to match expenses with related revenues in order to report a company’s profitability.
Let us understand this with the help of some example
The matching principle requires that an asset’s cost should be allocated to depreciation Expense over the life of the asset. In effect the cost of the asset is divided up, with a portion of the cost being reported on each of the income statements issued during the life of the asset.
This means, that the asset’s cost is being matched with the revenues earned by using the asset.
Thus Depreciation expense does not involve actual spending of money. It reduces a company’s net income (or increases its net loss) but it does not involve a payment of cash in the current period. It reduces profits but does not affect liquidity.
These types of expenses might also result in situations where a company is showing net losses but still having positive cash flows.
Let’s us take another example of sales revenue. As per the accrual method of accounting, sales revenue is reported in the accounting period in which the sale occurs and thus it adds to the profit of that period. In the case of credit sales the payment may be due in next accounting period say after 60 days of sale so there will be no improvement in liquidity until 60 days.
Although, the sale will create debtors (a current asset) but it will not be same as having cash and will not become cash until the debtor pays off. In fact this situation might have actually worsened the liquidity for that smaller period as the company has to pay the cost of sales (suppliers) before the money is received from the buyer of the goods.
This problem of payments incurred before the money is received from the buyer is a serious problem for small firms and is one of the main causes of lack of liquidity.
Possible way out and things to ponder upon
Cash has always been a challenge for smaller firms and start-ups. However, they can maintain their liquidity by following some business tricks mentioned below:
- Negotiating for longer periods for making payment to suppliers and at the same time requiring faster payment from customers.
- Refinancing or factoring of accounts receivable is another way out.
- Always pay your accounts payable on due date and not early, this way you can make the best use of your cash.
- Preparation of cash budgets/statement of cash flows is another way to manage cash flows. It showcases the timing difference between the profits shown in the income statement and the cash that is actually coming in and out of the firm. Cash budgets forecasts the cash needs of the firm in future.
- The business owners should closely observe the sources and uses of cash.
- Keep a track on your company’s Cash Conversion Cycle (length of time between paying your expenses and receiving payment from your customers) and try to minimize the length of the cycle because longer the CCC, the longer the company’s cash is tied up, and the greater will be the risk of being unable to meet other short-term obligations. Thus by following above ways startups and smaller firms can overcome cash flow problems.
- Always try to find ways of minimizing your overhead costs such as cost of your human resources and space costs.
Liquidity constraints can make the businesses prone to external shocks and therefore more likely to shut down. However, an effective and efficient policy towards cash management can greatly facilitate your ability to walk the fine line between liquidity and profitability. Always try to redesign your business model to free up more cash. The key to successful liquidity management, therefore, lies in closely monitoring collections and disbursements, establishing effective billing and collection measures, and adhering to budgetary restrictions.