Question

Describe and discuss the importance of profitability, solvency and liquidity for the financial analysis of a business.

Answer 1

A business need to be analyzed on three aspects, namely:

Profitability,

Liquidity, and

Solvency.

Profitability:

Profitability is key to the continued survival of any business. It is the amount of net income that the business would generate in future based on past experience and future changes. A firm that does not expect to earn sufficient profits in future cannot stay in business for long as sufficient profits are required to pay off the liabilities and also to invest in assets in order to retain or increase the earning capacity.

It is measured as a % of sales and as a return on the investment.

The return % on sales is measured at various stages to indicate Gross profit, Operating profit and Net profit. Accordingly we have gross profit ratio, operating profit ratio and net profit ratio. These indicate the profit generated per dollar of sale.

When measured as a return on investment, the return is calculated as Net income/Total Assets. The resulting % gives the return earned on the assets.

These profitability ratios have to be compared with industry standards to judge relative efficiency and can also be used to create trend ratios for a firm.

Liquidity:

Liquidity refers to a firm's ability to meet the current liabilities as and when they arise from out of cash realized from the current assets. It is significant, as a firm that is not able to meet its current liabilities will find it difficult to carry out its regular operations.

The ratios used are the current ratio (current assets/current liabilities) and quick ratio [(cash+marketable securities+receivables)/Current liabilities). The former ought to be 2 and the latter 1 for the firm to be in a comfort zone as regards ability to meet current liabilities.

Solvency:

Solvency refers to a firm's ability to redeem its long term liabilities. It is significant in that it determines the long term survival of the firm.

The proportion of debt to total assets is to be appropriate enough for a firm to be able to repay the debts as and when they become due for payment. Too much of debt can put strain on the cash flows. Too little of debt will prevent taking advantage of financial leverage. One has to strike a balance for the firm depending on its cash flows.

The solvency ratios used are the Total debt/Total assets ratio, Debt/Equity ratio, Times interest earned ratio and so on.

To sum up, a financial analysis of a business should dwell deeply into the profitability, liquidity and solvency of the firm to make the analysis and conclusions comprehensive and complete.