Page 292 - Cambridge IGCSE Business Studies

Cambridge IGCSE Business Studies Section 5 Financial information and decisions

Profitability versus liquidity

Profitability and liquidity are essential for the long-term survival of any business, large
or small. A business needs sufficient liquidity to be able to pay its debts. However, it

must not keep large amounts of cash which could have been used more profi tably. For
example, the cash could be used to invest in non-current assets or developing new

products, both of which should increase the future profitability of the business.
From this we can see that those assets which increase a business’s profi tability –
non-current assets – do not improve liquidity. Whereas current assets, which
increase a business’s liquidity, do not improve profi tability. Therefore it is important

for a business to maintain a balance between the need for profitability and the need
for liquidity if it is to ensure its long-term survival.
Benefits and limitations of ratio analysis
Ratio analysis is not perfect so care must be taken not to rely too heavily on the results.

Table 23.5 summarises the main benefits and limitations for users of fi nancial
statements and accounting ratios.

Benefits Limitations

Users can compare ratios over time and identify trends. Ratios compare past data. Users of accounts – stakeholders – are
much more interested in what the future holds for the business.
Users can compare results with similar businesses to Financial statements do not include all the strengths and weaknesses
see how well a business is doing against competitors. of a business, for example the quality and skills of employees. These

factors are also likely to affect business performance, especially
290 profitability.
Users can easily identify important information, such Income statements and balance sheets are not always prepared in

as profitability and liquidity, without having to look at the same way by different businesses. Therefore, the ratios do not
all of the financial statements. compare like with like.
Businesses are affected by external factors – such as legislation,

exchange rates and economic factors – but these will not be shown in
the financial statements.
Table 23.5 Benefits and limitations of financial statements and accounting ratios

ACTIVITY 23.6

Southern Gas Company (SGC) is a distributor of natural gas. The following information has been extracted from the
company’s accounts for 2011 and 2012.

2011 2012

$ $
Capital employed 533,670 590,000
Revenue 1,162,340 1,328,300

Gross profit 114,217 117,998
Profit 56,002 41,458
Current assets 805,394 1,087,365

Current liabilities 784,856 1,066,017