Introduction

Repeatedly, we see small businesses with high profitability. One would think that higher profitability means higher cash flow. However, we would be gravely mistaken if we believed this equated to having healthy liquidity. Profitability does not equate to a business’s ability to pay its debts and maintain a sufficient cash reserve for future business expenses.

Profitable businesses can earn a positive return on their invested capital. Profitability is not always a reflection of good liquidity. Liquidity is defined as the efficient conversion of assets into cash or cash equivalents. Numerous factors contribute to high-profitability businesses’ inability to convert profits to cash, resulting in low liquidity.

Profitability and liquidity are two things that small businesses should be paying attention to. There is often a trade-off between the two. This article will look at what profitability and liquidity really mean and how they can be applied to the daily management of your business.

At the conclusion of this article, small business owners should be able to answer the following frequently asked questions based on Google searches regarding profitability and liquidity:

• What is the difference between liquidity and profitability?

• What is the relationship between liquidity and profitability?

• Does liquidity affect profitability?

• Which is more important: liquidity or profitability?

Background

As a business owner, you may be wondering where all the profit that your accountant declares year after year has gone, especially when the company is perpetually broke and barely surviving.

Theoretically, the reason for this is an accounting principle called “the accrual concept” that, in simple terms, adds non-cash elements to the recording of transactions.

However, let’s be realistic; you expect to see evidence of all these profits in your bank account.

Profits have been known to conceal a plethora of issues within a business, particularly when they are undeserved, and losses do not always indicate that all is not well with a business, particularly if they are not sustained.

Profitability

When you’re running a small business, profitability is the name of the game. Many small businesses fail in their first year or two because they don’t understand how to get there.

Profitability, simply put, is a measure of how much revenue your business brings in compared to the cost of operating it. If you’re a brick-and-mortar store, that means you need to be able to pay rent and other expenses (such as utilities and employees’ wages) out of the money that comes from selling inventory. If you run an online business, this means that the revenue generated by your products must cover your hosting costs and other overhead.

When most people think about how to make money in their business, they think about sales. But if you’re bringing in money without paying attention to the costs associated with doing so, then you won’t have any leftover at the end of the month. So, you need to do more than just focus on making sales—you also need to focus on minimizing expenses wherever possible!

You must be profitable to keep your business running—it’s as simple as that.

Profitability is about more than just your bottom line. In fact, it’s about much more than money at all. It’s about finding a way to make your product or service better, so you can attract and retain customers who will pay you for it.

For example, let’s say you run an ice cream shop. Profitability can be increased by adding new flavors, such as pumpkin spice and gingerbread ice cream. Or you could add toppings like candy cane bits or peppermint patties for a seasonal twist on your treats!

Liquidity

Liquidity is a term that refers to how easily an asset or security can be converted into cash. Liquidity is a critical indicator of a small business’s health because it indicates how much money they have on hand and which assets can be used to pay the bills.

There are two main types of liquidity: market liquidity and accounting liquidity. Market liquidity refers to the ease with which an asset can be bought or sold on the open market without affecting its price. Accounting liquidity refers to the ease with which an asset can be converted to cash without causing the holder to lose value.

There are two basic ways to measure liquidity: using the current ratio or using the quick ratio (also known as the acid-test ratio). The current ratio considers all assets that can be converted into cash quickly (like inventory) or within 90 days (like accounts receivable), while the quick ratio only measures cash and assets that can be turned into cash in a brief period.

The differences between profitability and liquidity

Simply put, profitability is about how much you make, while liquidity is about how much money you have on hand at any given time. Profitability looks at your bottom line over a period (like a quarter or a year). Liquidity, on the other hand, is about how much cash you have right now.

Profitability is all about revenue minus expenses, so it tells you whether your business is making money (or losing it). Liquidity is all about how much cash you have coming in versus how much you have going out.

While profitability provides insight into your business’s long-term health, liquidity provides insight into the current situation.

Profitability and liquidity are two key concepts that are important for the success of your business, but it’s important to know how they differ.

Profitability is typically determined by the income statement, whereas liquidity is determined by the balance sheet and cash flow statement.

Profitability is about how much money you are making—or losing—in total. It’s the bottom line. Liquidity refers to the amount of money available to pay current bills, as not all your assets will be liquidated immediately.

To help make this a little clearer, let’s look at an example: You buy a car for N2m. Next week, you sell that car for N2.5m. Your profitability has increased by N500k. But if the buyer pays you in instalments over the course of six months, your liquidity will be lower until they pay off the full amount.

It’s also important to remember that profitability and liquidity don’t always mean cash flow: profitability can refer to accounts receivable or inventory (anything with value), while liquidity can refer to accounts payable (any debt).

Measuring profitability and liquidity

While it would be simple to examine the income statement for a single figure indicating profitability (profit or loss), or the balance sheet for the cash figure, it is far more efficient to use ratios to determine profitability and liquidity levels.

A- Profitability ratios

Gross Profit Margin

In its most basic terms, the gross profit margin is the difference between your revenue and the cost of goods sold, divided by your overall revenue. This means that if you purchase inventory worth N100,000 and sell it for N200,000, your gross profit margin is 50%. This number tells you how much of your sales are pure profit.

As a small business owner, knowing what your gross profit margin is can help you make better decisions because it can help determine where you should focus your resources. For instance, if you have a high gross profit margin but low sales volume, this might suggest that you should be investing in marketing so that more people know about you. Alternatively, if the problem is that your costs are too high relative to your sales volume, then it might be time to renegotiate with your suppliers or find a new supplier.

Net Profit Margin

The term “net profit margin” refers to the amount of money earned by a business. It is calculated by dividing the company’s net income by its revenue.

This ratio tells you how many cents of profit you’re making for every dollar of sales. It’s a valuable metric because it helps you identify how efficiently your company is generating profit. For example, if your net profit margin is 10%, then for every N100,000 in sales, your business only keeps N10,000 as profit.

This number can be useful to CEOs and other leaders in comparing their business performance to others in the same industry. Industry standards are not set in stone and will vary depending on the market, but on average, a business that makes at least 20% net profit margin is doing well, while one that has less than 10% is struggling financially (though this varies depending on the industry).

EBITDA Margin

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s a business term that is used to assess the profitability of a company.

EBITDA margin is a profitability ratio. It is used to determine the percentage of revenue that a business retains after deducting earnings before interest, taxes, depreciation, and amortization (EBITDA). The EBITDA margin is expressed as follows:

EBITDA Margin = EBITDA/Total Revenue

The EBITDA margin ratio allows you to see the operating efficiency of your business over time or in comparison to other businesses in your industry. This ratio can be used to help you determine whether costs are too high or if savings are possible.

Importantly, one of the benefits of calculating this ratio is that it excludes non-cash expenses such as depreciation and amortization. These expenses do not require any cash payments from the company, so they are not relevant when comparing two companies in different industries that have vastly different capital expenditures.

EBIT Margin

EBIT stands for “earnings before interest and taxes,” and it refers to your business’s total revenue less all expenses and direct costs, but before interest and taxes.

The formula for calculating EBIT margin is EBIT/Net Sales.

An EBIT margin, also known as the operating margin, is the ratio of earnings before interest and taxes (EBIT) to revenue. This ratio shows the profit you have left after covering all expenses that are related to making your product or delivering your service. It can be an important indicator of health for small businesses because it measures how much money a company has left to cover other expenses, such as interest on loans and income taxes.

While this number may not sound important, it’s important for small businesses because they tend to be less able to cover additional expenses than larger businesses. For example, a large business may be able to afford an advertising campaign that costs significantly more than its expected return on investment; whereas a small business might lose money if it tried such an undertaking. A larger sum of leftover money means that the company will have more flexibility and options when it comes to spending.

B – Liquidity ratios

Current Ratio

The current ratio (also known as the working capital ratio) is a measure of liquidity that helps small businesses assess the health of their organization. It’s also an important metric for investors to consider when deciding whether to take a risk on a new or growing company.

This metric is calculated by dividing current assets by current liabilities. In other words, how much cash do you have on hand to pay your bills?

For instance, suppose your coffee shop has N1 million in cash and N500,000 in inventory, totaling N1.5 million in current assets. You also owe N1.2m in short-term debt, so your current liability total is N1.2m.

When current assets are divided by current liabilities, the result is 1.25, which means that each naira of debt is backed by N1.25 of available funds.

If this number is lower than one (say, 0.5), it means that you don’t have enough money on hand to cover all your short-term financial obligations, which could make it difficult for you to pay back debts on time and make lenders wary of giving you more money in the future.

Acid Test Ratio

The acid test ratio is a way of measuring how well your business can pay its bills on short notice. In other words, it’s a way of measuring how liquid your assets are—and the higher the number, the better. The acid test ratio is calculated by taking the value of your current assets and subtracting inventory. Then, you take that resulting number and divide it by your total current liabilities.

What does this mean for your small business?

If you have a high acid test (above 1), you can pay off your bills easily. This means that you’ve got enough cash or assets that can be turned into cash quickly to pay off all your short-term obligations. This is great news! Having a low acid test (below 1) means that you might not have enough liquid assets to cover all your obligations—so you’ll either need to cut back on expenses or try to bring in more income.

Interest Coverage Ratio

The interest coverage ratio is a measure of a company’s ability to pay the interest on its outstanding debt. This can be useful to know because if you’re thinking about taking out a loan or line of credit, the interest coverage ratio will tell you how much of that loan you can expect to pay back.

The formula for ICR looks like this: EBIT/Interest Expense = ICR.

The interest coverage ratio is a quick and straightforward way to tell whether you’re paying too much in interest on your loans and credit cards. You can calculate it by dividing your EBITDA (earnings before interest, taxes, depreciation, and amortization) by the total amount of interest payments. If you’re paying too much in interest on a regular basis, your ratio will be low—below one—which indicates that you have a problem. If this is the case, you should investigate refinancing your debts or lowering the rates on your existing loans and credit cards.

Fixed coverage ratio

This metric will tell you how your business’s debt is performing, and it can also give you an idea of how lenders will perceive your company.

The fixed coverage ratio (FCR) is found by dividing your cash flow from operations by your total interest expense. You’ll want to calculate this ratio for the past 12 months, or for each month in the past year, to see how it changes over time.

If you have any outstanding debt, lenders will look at this ratio to determine how well your company is managing its debt payments. If the number is low, below 1x or 0.5x, it means that you aren’t earning enough money to pay all your debts; if this happens, lenders might be reluctant to lend more money to your company.

If the FCR is high, above 2x or 3x, it means that you are earning much more than you need to pay off your debts each month. If this happens, lenders might be willing to lend extra money so that you can invest in new opportunities and grow your business.

Reasons why high profitability will not necessarily lead to high liquidity

Understanding a few practical reasons why accounting profits might not be so clear in the bank balances might be a step in ensuring that it does.

1. A sizeable portion of sales are made on credit and remain unpaid.

This one is self-explanatory because if one does not get paid, one’s liquidity balance does not grow. The sale is recorded and reflected in the profits once the items are transferred to the buyer, but not in the cash book until payment is received.

It is important to note that while selling on credit is not a terrible thing, problems arise when receivables become past due and go bad. Be wary of large receivables and/or long outstanding balances.

2. A large part of the purchases is in cash.

For some businesses, there is no choice but to pay for everything in cash, but most sustainable balances have mastered the art of using credit to manage their exposure. Again, paying cash for everything is not always a problem; however, when combined with a situation like the one described above, it results in a rapid drain of cash flow despite the company earning profits.

3. A lot of funds are tied down in slow-moving inventory.

While it is possible to profit from inventory sales, if there is significantly more inventory than is required and it remains idle, liquidity will suffer. The associated costs of carrying and holding inventory are usually added to the inventory.

4. Significant loan repayments.

Loan repayments have a greater impact on the cash flow of a business than most owners realize. While only the interest component, which is typically a fraction of the total, affects profit calculations, the impact on profit may be minimal, but the total repayment (principal plus interest) will influence the bank balance.

There is an argument that principal repayment is simply a return of the money that increased the bank balance in the first place, but this is rarely the case, especially if the activities for which funds were borrowed did not materialize as planned.

5. Purchasing non-yielding non-current assets.

In theory, assets should generate revenue or at the very least reduce expenses, but there are plenty of assets that look nice but generate nothing.

Another variation on this theme is to buy an unnecessarily expensive type of asset when a less expensive type can perform equally well or better.

6. Diverting company cash

Naturally, continuously diverting company cash for non-business purposes, most likely to benefit the business owner, is a recipe for declining liquidity.

Accountants, auditors, and tax authorities are wary of “director’s current account” and “intercompany receivables” with large balances owed to the company. Often, it is just a sign of funds moving out with no valid business purpose. These diverted funds have no effect on profit calculations, but they do ensure that a business lacks enough liquidity.

7. Fraud

Of course, there is the age-old practice of fraudulently recording sales that never occurred. This clearly increases revenue and profit margins while having no effect on liquidity.

Indeed, the company will have to pay income tax on profits that it did not earn, as well as dividends in some cases.

8. Understating Expenses and Liabilities

While understating or simply concealing expenses in the profit calculation increases reported profit, if they must be paid, the bank balance reflects the outflows.

In fact, when it comes to recognizing expenses and liabilities, accountants tend to conveniently “forget” the accrual concept referenced earlier.

9. Errors

Beyond fraud, the accountant might make significant errors that will overstate profit. A common mistake that comes across is the recording of contracts before any work has been done. Typically, when these types of errors occur, the costs are unknown and thus omitted, increasing profits while having no effect on liquidity.

10. Timing Difference

Finally, it could be a matter of timing. For example, a substantial increase in valid credit sales just before the year-end accounts are prepared will result in an increase in profits without an increase in cash. In some cases, the timing of the outflows and the inflows never align and may cause such issues.

Conclusion

This article helps you ‘differentiate’ between liquidity and profitability so that you can focus on the former.

The underlying principle is that if a business is truly profitable, it is likely to have a healthy liquidity position.

While sound business management should strike a balance between profitability and liquidity, if forced to choose, liquidity should take precedence over profitability, as cash is king.

If you are genuinely concerned that the “wonderful” profit figures do not tell a story of healthy liquidity, take the steps above or talk to us to help you understand why.