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Liquidity and profitability indicators are the main indicators of the company’s financial condition. However, the main thing when conducting financial analysis is not the calculation of indicators, but the ability to interpret the results obtained and use them to optimize economic and financial processes.
Liquidity (current solvency) is one of the most important characteristics of the financial condition of the company’s all around the world, expressed in the degree of coverage of the company’s obligations by its assets, the period of conversion of which into money corresponds to the maturity of the debt. In other words, liquidity is the ability to pay obligations in full and on time.
Low liquidity
Low solvency (liquidity) is manifested in the fact that the company is experiencing problems with paying bills (short-term obligations) due to a lack of money. Also, indicators of the problem are excess debts to the budget, personnel, creditors, the threatening growth of attracted loans, as well as a decrease in net working capital and, of course, the negative value of net working capital.
The most common liquidity indicator is the current liquidity ratio, which is defined as the ratio of current assets and short-term liabilities.
In order to understand the ways of optimization, you need to understand the factors that determine liquidity. To do this, it will be more convenient to rewrite the classic formula for the liquidity indicator as follows:
Current assets = Balance sheet currency – Non-current assets = (Equity + Long-term liabilities + Short-term liabilities) – Non-current assets
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Factors that determine the company’s liquidity:
1) the profitability of the activity (the amount of equity capital)
2) number of investments (amount of non-current assets)
3) financial policy (short-term liabilities)
4) efficiency of working capital management (current assets / short-term liabilities)
5) accounts receivable (a large number of debtors).
1. Optimisation of current liquidity is possible by increasing the profitability of activities and increasing the share of profits remaining at the disposal of the enterprise (reducing the share of profits allocated for non-production purposes, payment of dividends).
2. Number of investments (construction, reconstruction, purchase of equipment) exceeding the financial capabilities of the company, namely the amount of its own funds and attracted long-term loans. In this case, the task of increasing the current solvency comes down to reducing investment projects financed by borrowed capital, especially short-term ones.
3. The most typical reason for the decrease in liquidity is the financing of investment programs through short-term loans, which leads to an additional burden on debt servicing. When attracting a short-term loan, the company implies that within the current year there will be an opportunity to repay this loan, and this is often not typical for large-scale investments, the payback period of which exceeds a year.
Consequently, one of the methods of maintaining current solvency is compliance with the condition: long-term liabilities are attracted to finance non-current assets, short-term loans – for the needs for working capital. If the company has already received short-term loans for investment purposes, and it is experiencing financial difficulties with debt repayment, it is necessary to try to replace the short-term loan with a long-term one with a deferred repayment of the debt, this will increase the company’s liquidity.
4. Principles of working capital management affect the decrease in liquidity when the growth of current assets is fully funded by short-term liabilities. Improving the efficiency of working capital management leads to improved liquidity.
5. Accounts receivable are debts of legal entities and individuals to the enterprise. The faster they can be repaid, the more liquid it is. Usually, buyers and suppliers are obliged, less often – employees who received money from the company’s budget, or government agencies (for example, tax).
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For the growth of current liquidity, it is necessary to:
-to make sure that your business has steady profits, and it is growing;
-have a financial rule: financing the investment program (investments in non-current assets) at the expense of long-term, but not short-term loans;
-strive to minimize (reasonable) inventories of work in progress, that is, the least liquid circulating assets.
-think about debt collection. Debt collection professionals from Brisbane will help you with this.
Profitability indicators allow you to assess the effectiveness of the company.
Return on equity characterizes the return on funds invested in assets, return on sales (profitability) – on funds invested in current activities. Having high rates of profitability, the company can be characterized by low rates of return on equity. That is, the profit received may be acceptable in relation to the cost of production, but small in relation to the scale of the company.
Conclusion
Business liquidity is very important. Analyze and rank debtors on a regular basis, work with debt registries, look for the causes of delinquencies, signs of bona fide and unscrupulous counterparties.
Promptly change the terms of work with counterparties, depending on how they are followed by the payment terms: stop lending to debtors or switch to promissory notes with them, increase the size of the loan to conscientious payers.