As well as measuring profitability it is also important for businesses to measure their liquidity (solvency). Liquidity is the ability of a company to convert its assets into cash. A business that cannot pay its creditors on time, cannot continue to meet its obligations to the suppliers of credit, services, and goods can go bankruptThe business could miss out the incentives given by the suppliers of credit, services, and goods if it is short of cash or liquid assets. Loss of such incentives may result in an increase in the cost of goods consequently affecting the profitability of the business.
The stake holders of a business also have an interest in the liquidity position of the business. Lenders of money will check the liquidity of the business to be assured that the loan repayments will be paid on time. Suppliers of goods will also check the liquidity of the business before selling goods on credit. Employers will also have an interest in the liquidity of the business, they will want to know If the business will be able to meet their needs e.g. salary, pension.
Assets
Assets are things that a business owns. Business assets can be divided into two categories: fixed assets and current assets.
Fixed assets are long term; they tend to have a life-span of more than one year. Examples of fixed assets include premises, machinery and equipment. They are usually shown in the top half of the balance sheet, and the current liabilities are subtracted from them to show net current assets.
Current assets are short term; less than a year. They can be quickly realised and changed frequently. The main current assets include stock, debtors and cash.
Liabilities
Liabilities are things that businesses owe. There are two types of liabilities: current liability and long term liability.
Current liabilities are short term debt for a business. They include an amount that can be paid off within a year. These liabilities may include overdraft repayments, wages, trade creditors, and expenses such as electricity/gas/water.
Long term liabilities are the items that a business intends to keep for longer than a year. These liabilities do not require interest payments during the current year. They could include bank loan or mortgage.
Expenses
Business expenses are the cost of carrying on a business. Every business incurs expenses. These expenses might include: the rent of premises, utility, advertising costs, insurance, interest on loan, motor expenses and depreciation. These expenses are usually deductable and can reduce your tax liabilities.
Cash flow Forecasts
Cash flow forecasts are statements that show the amount of money that is predicted to come into and flow out of the business over a period of time. It is therefore useful for a business to make a cash flow forecast because it aids them in making decisions. However, cash flow forecast do have some weaknesses the main one being that they are not always accurate because they are based on assumptions. As cash flow forecasts are based on predictions about whats going to happen, a false forecast can have an extremely negative effect on a business because if it runs out of money it may go bankrupt. Good cash flow forecasting needs experience and research into the market.
Break-Even
Break- even is a useful planning tool as it provides business with information on what volume of sales is needed to cover its cost. This is known as the break-even point. When sales are below the break-even point the business makes a loss. However when sales are above the break- even point, the business makes a profit.
Break- even analysis can also help to analysis the impact of a change in the environment on the business. It can also help in deciding whether or not it is feasible to accept an order for products at a different price from normal.
However break- even analysis can be a lot more complicated for business that sell a variety of different products. The analysis is based on assumptions that everything produced is sold whereas it is often the case that not all output will be sold.
Profit & loss Account
All companies are legally obliged to produce a trading profit & loss account. The profit and loss account covers all of your business trading activity over a period of time, usually twelve months. It shows how much the business has earned form selling its product or service, and how much it has paid out in costs (production costs, salaries, etc).
Profit and loss account is important to my business as it will show me the performance of my business and will indicate whether the business has made a profit or loss over the year. It will also help me to work out the amount of tax I will need to pay.
Profit and loss account is an essential financial tool for the business, as its stakeholders have an interest in the financial status of the business. For example employees would be interested in the amount of profit the business is making, as an indicator of job security and potential pay rises. Shareholders would also want to know the business’s operating profit because they would like to get as much dividend as possible.
However profit and loss account can be manipulated to paint a better picture of the business which can be misleading. The financial data included is not adjusted for price changes, impact on the business’s performance due to a change in the environment e.g. inflation.
Profit and loss will be very useful to my business as it will enable me to pay the correct amount of tax. I can also compare my Profit and loss forecast with the actual performance of other companies- preferably a competitor, to see which aspect of my business needs to be considered more seriously.
Balance Sheet
The profit and loss account only shows part of the picture. It may show an excellent profit but at the same time, the company may have burdened itself with debt. The balance sheet shows the current health of the business as measured in terms of its assets and liabilities. A balance sheet shows how solvent the business is, and how liquid its assets are. It shows whether the business has the ability to meet its short term obligations, as well as paying all current and long term debts.
