Profitability & Liquidity (Cambridge International IGCSE Business)

The importance of profitability

Spec point — 5.5.1 · "• The concept and importance of profitability • The concept and importance of liquidity"

The importance of profitability

• Profit is what a firm earns once the total costs have been deducted from the total sales revenue

• Profitability is a measure of how successful a business is

• Profitability can be defined in two ways

  • A measure of how effectively a business converts sales revenue into profit - effectively, what percentage of sales revenue is profit
  • A measure of how well capital resources invested in the business generates profit

• Profitability is expressed in percentage form, which allows comparison of business performance over time and also comparisons with other businesses

• Several stakeholders are interested in profitability

  • Investors look carefully at profitability when deciding which business to invest in

    • The higher the level of profitability, the higher their rewards are likely to be

  • Directors and managers consider profitability when assessing business success and determining future objectives and strategy

  • Employees may consider profitability as justification for requesting higher wages or better working conditions

The importance of liquidity

• Liquidity is defined as the ability of a business to pay back its short-term debts, e.g. its suppliers

• A businesses that cannot pay its debts is considered illiquid

  • If a business cannot pay its suppliers, raw materials or components may not be delivered and production will be delayed
  • If it cannot repay an overdraft, banking facilities may be withdrawn, and its credit rating will suffer
  • Creditors may force it to stop trading and sell its assets so that the debts owed to them are repaid

• Stakeholders interested in liquidity include

  • Suppliers want to be reassured that a business is likely to be able to pay for them
  • Financial providers such as banks want evidence that a business is likely to be able to repay loans or overdrafts
  • Customers want to be sure that a supplier will be able to produce and deliver goods it orders