Liquidity Vs Profitability

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What is liquidity?
Liquidity refers to the ability of the business to pay off its SHORT TERM DEBT.

What is Profitability ?
Profitability refers to the ability to generate profit after taking into account the sales revenue , other income and expenses of the business.

Liquidity -- to check on the ability to pay, so we look at the statement of financial position.
Profitability- to check on how well the business perform, we look at the statement of financial performance.


There are a few formula that we need to look at for liquidity

Working capital ratio = Current Assets - Current Liabilities
Current ratio = Current assets/ Current liabilities
Quick ratio/Acid test ratio =( Current Assets- prepayment-inventory)/Current liabilities

If working capital ratio is positive, means that the business has more Current assets to pay off its current liabilities.
If current ratio is 2 or above, means that the business has the ability to pay off its current/ short term debts.
If current ratio go below 2, ,means the business may face some financial difficulty in servicing its short term debts.

If Quick ratio is 1 or above, means the business is able to pay off its short term debts , if it goes below 1, then the business may face some financial difficulty in paying off its short term debts.

Since Quick ratio has taken away inventory, prepayment, it is a better indicator of liquidity as compare to current ratio.  So as long as Quick ratio goes below 1, then the business really face financial problem.
Ilustration for Liquidity:-


    The following information is extracted from the balance sheet of Sweet Beverages Trading for the year

   ended 31 August 2024.

 

$

Bank Overdraft

1800

Inventory

30000

Cash in hand

300

Trade receivables

10000

Loan from OCBC

50000

Trade payables

22000

Prepaid salaries

1500

Accrued advertising

1700

Fixtures and fittings at net book value

48000

 

Additional information:

Sweet Beverages Trading produced the following figures for the year ended

31 August 2023:

 

Working capital

$11600

Current ratio

3.32 : 1

Quick ratio

1.87 : 1

REQUIRED

(a)       Calculate the following ratios for Sweet Beverages Trading as at 31 August 2024, rounding off to 2 decimal places. .                                                                                        

(i) Working capital                
(ii) Current ratio
(iii) Quick ratio

(b) Compare and comment on the change in Sweet Beverages’ liquidity over the year.
(c) Suggest two ways to improve the liquidity of Sweet Beverages
                                                                                                                     
Answer:








There are a few formula for profitability

Inventory turnover rate = Cost of sales/average inventory   

Average inventory = (opening inventory + closing inventory)/2

Days sales in inventory = Average inventory/cost of sales x365

Trade receivable turnover = Net credit sales revenue /average trade receivable
Trade receivable collection period = Average trade receivable/net credit sales revenue x 365

Gross profit mark  up = Gross Profit/Cost of sales x100
Gross profit margin = Gross Profit/Net sales revenue   x100
Profit margin = Profit for the year / Net sales revenue x100

Net sales revenue = sales revenue - sales returns


Returns on Equity = Profit for the year / Average equity 

Average equity = (beginning of year equity + ending year equity )/2

Whether business is profitable or not, you need to compare it with
(1) the industry profitability
(2) the previous years profitability
(3) other competitors profitability

Illustration for profitability:-

   Shine Designers own a retail business online. The following balances were extracted from the business’ books for the year ended 31 March 2024.

 

      $

Net sales revenue

186 000

Cost of sales

96 500

Gross profit

89 500

Total operating expenses

10 760

Average equity

130 000

Average inventory

6 600

REQUIRED

 

(a)  Calculate the following for the year ended 31 March 2024. Show your answers to two decimal places.

             (i)    Gross profit margin                                                                                                      [1]

             (ii)   Profit margin                                                                                                                [1]

             (iii)  Return on equity                                                                                                          [1]

             (iv) Rate of inventory turnover                                                                                           [1]

        (b)  Suggest two ways in which inventory rate can be improved.                                           [2]

Answer : - 

(i) GP margin = GP/Net sales revenue

                        =$89 500/ $186 000x 100 

                        = 48.12% 

 

(ii) Profit Margin = Profit for the year / Net sales revenue

                           = ($89 500- $10 760)/186000 x100

                           = 42.33% 

 

(iii) Return on equity = Profit for the year / average equity

                                  = $78 740/ $130 000*x100

                                  = 60.57% 

 

iv) Rate of inventory turnover = Cost of sales/average inventory

                                                    = $96 500/ $6 600

                                                     =14.62 times 

 

(b)

·          Sell inventory faster such as reduce selling price for slow-moving goods. 

·         Provide trade discounts to encourage customers to buy in bulk and regularly. 

·         Attract more customers through marketing campaigns. 

·         Keep sufficient inventory on hand with the help of technological tools to improve the accuracy of predictions about customer demands. 


The question continue into comparing with the competitor:-

Mark & Sally is a direct competitor of Shine Designers. Bill is a potential investor, who is interested in investing in Shine Designers or Mark & Sally.

 

Mark & Sally’s financial information for the year ended 31 March 2024 as follows:

 

Gross profit margin

45.23 %

Profit margin

38.15 %

Return on equity

55.30 %

 

(a)  Compare and comment on the profitability of both businesses and suggest to Bill which business he should invest in.                                                                                              

 

(b)  Bill should also compare the liquidity of both businesses. Explain what is meant by the liquidity of a business.                                                                                                        


To compare, we put two businesses profitability margin side by side so we can see better.

 

Shine Designers

M&S

Gross profit margin

48.12%

45.23 %

Profit margin

42.33%

38.15 %

Return on equity

60.57%

55.30 %


Then we comment


(a)The gross profit margin of Shine Designers which is 48.12% is better/higher than Mark& Sally’s of 45.23%.  This could be due to Shine Designers selling the goods at a higher selling price, or buying the goods at a lower cost price. 

 

The profit margin of Shine Designers is 42.33% which is better/higher than Mark & Sally’s of 38.15%. This can mean that Shine Designers is efficient in managing its expenses as compared to Mark & Sally. This also implies that the business is better at managing and controlling its operating expenses. 

 

The return on equity for Shine Designers is 60.57% which is higher than Mark & Sally’s 55.30%.  This suggests that Shine Designers is more efficient at generating profits for shareholders. 

 

In conclusion, Bill should invest in Shine Designers as it is more profitable than Mark & Sally


(b) Liquidity refers to the ability to pay off the current/ short term debts when they fall due

Illustration 2 for Profitability 

    So Yummy Kitchen provided the following financial information for the years ended 31 December 2023 and 2024.

         2023                          2024

                                                                 $                                  $

Net sales revenue                           150 000                      225 000

Cost of sales                                       90 000                      180 000

Gross profit                                          60 000                        45 000

Profit for the year                               22 500                        22 500

 

Equity                                                   65 000                      64 000

 

REQUIRED

(a) Define profitability.                                                                                                         

(b)Calculate the following profitability ratios for the two years ended 31 December 2023 and 2024, rounding off to 2 decimal places.

(i)    Mark-up on cost                                                                                         

(ii)   Gross profit margin                                                                                    

(iii)  Profit margin                                                                                               

             (c) Comment on the profitability of So Yummy Kitchen for the year ended 31 Dec 2024                   

A                Answer:-                         

           (a)  Profitability measures the ability of the business to generate enough income to cover its                         expenses.                                                                                                                                           

            (b)  

 

 

 

2023 ($)

2024($)

(i)

Mark-up on cost =

(gross profit / cost of sales) x100%

60000 / 90000 x 100%

= 66.67% 

45000 / 180000 x 100%

= 25.00% 

(ii)

Gross profit margin =

(gross profit / net sales revenue) x 100%

60000 / 150000 x 100%

= 40.00%  

45000 / 225000 x 100%

= 20.00%  

(iii)

Profit margin =

(profit for the year / net sales revenue) x 100%

22500 / 150000 x 100%

= 15.00%  

22500 / 225000 x 100%

= 10.00%  

 

 

(c)   

The mark-up on cost of 25% in 2024 is worse than the 66.67% in 2023.                             

This may be due to the business being unable to obtain the same quality goods at a cheaper rate from the supplier in 2023.                                                                                                           

The gross profit margin of 20% in 2024 is worse than the 40% in 2023.                              

This may be due to the business being unable to sell more or sell its goods at a higher price, or both in 2024.                                                                                                                       

More sales in 2023 could have been achieved by marketing, advertising, promotion etc.            

The profit margin of 10% in 2023 is worse than the 15% in 2024.                                        


The question continue to check which business is doing better and worth invest in by looking at the return on equity.

A competitor, Mummy Cooking has a return on equity ratio of 30.55% for the year ended 31 December 2023

REQUIRED

(d)  Calculate the return on equity for So Yummy Kitchen for the year ended 31 Dec 2024.                                                                                                   

(f)   State which business is a better investment and explain why. State one non-accounting information that an investor may need to consider as well.     

(   (d)Return on equity = (profit for the year / average equity) x 100%

                            = (22500 / [(65000 + 64000)/2]) x 100%

                            = 34.88%                  

 So Yummy Kitchen is a better investment.                                                                                 

Because its return on equity 34.88% is better than Mummy Cooking  30.55%                                      


Any relevant economic news or development that will have an impact to the industry in the near future?

What kind of trend are the businesses currently on? Upward, downward or fluctuating?

Any important success factors that will not be available in the near future. Such as retirement of key management personnel, accessibility of key resources or funds?

Any government policy that may affect business in the near future?                                               

 


     


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