Analyze the situation and determine who is correct and support your position.Raphael Ochoa is puzzled. His company had a profit margin of 10% in 2008. He feels that this is an indication that the...
Analyze the situation and determine who is correct and support your position.
Raphael Ochoa is puzzled. His company had a profit margin of 10% in 2008. He feels that this is an indication that the company is doing well. Cindy Lore, his accountant, says that more information is needed to determine the firm’s financial well being. Analyze the situation and determine who is correct and support your position.
The accountant, Cindy, definitely has the stronger case. There are many factors which determine the financial health of a company; profitability is only one of them. The first issue is business trends.
Imagine that you ran a profitable horse and buggy company in 1890 or a typewriter company in 1970. No matter how profitable these companies, both were due to become technologically obsolete in a few years. Companies are vulnerable to many externalities, including war, civic unrest, natural disasters, increases in costs of fuel and other inputs, changes in markets and technology, etc. Thus all businesses need contingency and strategic planning.
Next, profitability is not the only measure of financial health. A profitable firm, and especially one that is expanding rapidly, can encounter cash flow problems. This is especially true in times of tight credit.
Another issue is reserve funds for future expenses. Does the company have sufficient cash reserves to handle a six month downturn? Future expenses? e.g. if you are a profitable trucking firm with an aging fleet, does your "profitability" include annualized costs for future replacements and repairs?
Finally, do you have sufficient liquidity?