The Liquidity of a Firm - Assignment Example

The Liquidity of a Firm Critically evaluate why the liquidity of a firm is considered crucial especially in the growth stage of a company's development. How would the strategic changes in financial statements influence the value creation process? 1. Introduction The measurement of the value of modern organizations is developed using a range of strategies; managers in these organizations have to choose that strategy which is more feasible, in terms of existing conditions in the internal and the external organizational environment. In any case, under certain terms, the assumptions developed in regard to the level of organizational performance and the prospects of organization in the future can be inaccurate, especially if the criteria, or else the drivers, used for the development of the relevant task are not carefully checked in advance as of their relevance. Current paper focuses on a particular aspect of organizational performance: liquidity, a term used in order to show the potentials of an organization to meet its liabilities. Emphasis is given on the significance of liquidity in the growth stage of the company development. At the same time, efforts are made in order to identify the terms under which the changes in the financial statement of a particular organization can influence the organization’s value creation process. The literature published in regard to these issues has been reviewed and evaluated; it is made clear that the role of liquidity in the growth stage of the company development can be differentiated. As of the changes on a firm’s financial statements, these seem as unavoidable especially under the following terms: the value creation process of each organization is based on specific organizational data; changes on the particular data could influence the validity of the assumptions made in regard to the economic status of the organization and its power within its industry. 2. Liquidity and company development - Why the liquidity of a firm is considered crucial especially in the growth stage of a company's development In order to understand the role of liquidity in the growth stage of a company development, it would be necessary to refer to the activities in which a company has to be involved during the specific phase. In accordance with Schmeisser, Clausen and Popp (2011), during its growth phase, a firm has to develop its activities covering the relevant costs; at this point, the following problem appears: the development of a company in its growth phase may be delayed due to a series of factors that cannot be easily controlled, such as the lack of capability of employees, failures in the communication of the organization with its customers or suppliers and so on (Schmeisser, Clausen and Popp, 2011). During the above period, the cash required for the completion of the firm’s projects can be increased while the profits achieved may be low, especially in the initial period of the firm’s growth. Therefore, the liquidity of the organization during the specific period may be low. In a different case, i.e. in case that the liquidity of the organization in its growth phase is high, it can be assumed that the prospects for the organization, in terms of its performance, are quite positive. Kapil (2011) notes that the level of liquidity of each organization should be periodically checked in order to ensure the status of the organization within its market. It is explained that for modern firms, liquidity reflects their ability to achieve their targets, no matter if they refer to the short or the long term. In the context of the above role, liquidity is described as an indicator of ‘the investments and assets of a firm that can be quickly converted to cash at any time or within one year’ (Kapil 2011, p.6). In the study of Arnold (2008) reference is made to the liquidity risk, which is described as the condition in which the organization is not able to retrieve the cash necessary for covering its liabilities. Moreover, Singla (2007) notes that in the growth stage of a company development, liquidity can reflect not just the cash available for covering the organization’s liabilities but also the level at which the dividends can be paid; it is also explaining that in ‘growing firms liquidity may be low’ (Singla 2007, p.271) since during its growth phase an organization needs to invest ‘more funds on its working capital’ (Singla 2007, p.271). In the context of the modern market, liquidity is a factor that highly influences the development of companies. Different approaches have been used in the literature in order to explain the value of liquidity in the growth stage of a company’s development. In order to understand the role of liquidity in the development of modern organizations it would be necessary to refer to the characteristics of liquidity, as a firm’s key performance indicator. In accordance with Gibson (2010) when having to evaluate the policies that are most appropriate for the company development, financial managers need to check the company’s financial ratios; these ratios are related to different aspects of the organizational performance. One of these ratios, the cash ratio, is used for estimating the level of liquidity of a particular organization. The cash ratio is estimated using the following equation: ‘cash ratio=(cash equivalents+marketable securities)/current liabilities’ (Gibson 2010, p.231). The cash ratio is used in order to measure the level of liquidity within modern organizations. Depending on its cash ratio, a company is considered as more or less prepared in order to meet its liabilities. More specifically, a high cash ratio means that the firm’s cash ‘is not used for supporting the organization’s operations’ (Gibson 2010, p.231). On the other hand, a low cash ratio reflects the inability of the organization to pay its debts, not necessarily the long –term ones but even those expenses related to the firm’s daily operations (Gibson 2010, p.231). In the context of the issues highlighted above, liquidity can be used in the growth stage of a company’s development in order to estimate the potentials of the organization to respond to the needs of the particular project; for example, in the case of an extremely low cash ratio, it is assumed that the growth of the organization is in risk, either in the short or the long term. Moreover, liquidity can affect the valuation of firms, which are at ‘early stage of development’ (Beaton 2010, p.65). Indeed, the valuation of such firms is usually based on the estimation of their volatility. At the next level, volatility, as an element of a firm’s valuation, is estimated using different approaches. In the context of the option-pricing model, the volatility of the organization is estimated by referring to two different time points: ‘the valuation date and the liquidity event date’ (Beaton 2010, p.65). From this point of view, liquidity can affect the assumptions on the level of an organization’s volatility; these assumptions are then used for valuating the particular organization. Thus, liquidity can indicate the value of the organization within its industry. The importance of liquidity in company valuation, which is quite common in the growth stage of the company development, is also highlighted in the study of Von Gehr (2007). The above researcher notes that when having to valuate their organization, entrepreneurs have two different choices: to cause a liquidity event when ‘the cycle of development of their organization is favourable’ (Von Gehr 2007, p.92), even if the actual performance during that period is not high; otherwise, they can wait so that the performance their firm is increased; in this case, additional cash will be required for supporting the enhance of organizational performance, even for a short period of time (Von Gehr 2007, p.92). From another point of view, Asaf (2004) notes that in its growth phase, a company needs to respond to a series of liabilities, including the payroll of its employees and other operational costs. During this phase, the liquidity of the organization may be low (Asaf 2004). Thus, when being in its growth phase an organization needs to ensure that it can retrieve the necessary funds for responding to its costs, which at the particular point of time may be increased, as already explained above. The cooperation with a bank, which helps the organization to respond to its liabilities, i.e. to secure its liquidity, is critical for the organization’s survival in its industry. If an organization cannot secure that its liquidity during its growth phase is not high, then it is expected to face severe problems in stabilizing its position in the local or the global market. In the study of Mellen and Evans (2010) emphasis is given on the importance of appropriate planning when need to promote a particular organizational project. In the context of the above planning process, the liquidity of the organization needs to be accurately estimated, as possible, since it would influence the mode of the plan chosen for addressing the organization’s needs during the particular period. On the other hand, even if the needs of the organization and its level of liquidity are measured, still, the effectiveness of the organizational plans cannot be guaranteed. In other words, the ‘stage of the development of the organization should be identified’ (Mellen and Evans 2010, p.290) before the firm’s critical strategies are designed. In accordance with the above view, the level of liquidity of an organization should be measured only after identifying the level of the organization’s development; then, the financial status of the organization and its needs could be estimated, revealing the potentials of the organization in terms of liquidity. In any case, the role of liquidity in company development, referring to the growth stage of the organization, can be differentiated in accordance with the organizational structure and aims but also with the conditions in the external organizational environment. More specifically, in case of a new venture, liquidity can increase the value of the venture (Leach and Melicher 2011, p.32). It is explained that when a venture ‘enters a rapid-development phase’ (Leach and Melicher 2011, p.153) its needs in terms of financing are likely to be significantly increased. At this point, the commercial banks and other financial institutions that are asked to cover the organization’s financing needs are likely to review the level of the organization’s liquidity in order to understand the potential of the organization to repay its debts. In other words, in its growth phase, an organization is highly based on its liquidity since it is considered as an indicator of the organization’s capability to repay its debts. 3. At what level and how strategic changes in financial statements influence the value creation process. The data included in the financial statements of each organization can be used in order to identify the organization’s value drivers, which are the features explaining the reasons for the organization’s current value creation (Pratt 2010). Value drivers can also indicate the prospects for the value creation of the organization in the future (Pratt 2010). It is at this point that a firm’s financial statements are related to the value creation process. On the other hand, the increase of derivative in the context of global market, has led ‘to misleading financial statements’ (Rezaee and Riley 2009, p.45). In this context, the changes in financial statements for reflecting more accurately the organization’s actual economic status is often necessary. The above changes can influence the value creation process at the following point: in accordance with the Statements of Financial Accounting Standards (SFASs), ‘the measurement of the organization’s fair value is based on specific fair value measures’ (Rezaee and Riley 2009, p.46). Organizations that try to meet these standards need to appropriately customize their financial statements, especially through the right of a firm to restate its financial statements (Rezaee and Riley 2009, p.45). Therefore, changing financial statements may be unavoidable for modern organizations that highly emphasize on their value creation process. On the other hand, Rezaee (2011) focuses on the following problem: financial statements, which are highly based on historical facts, may not be appropriate for supporting the value creation process of the organization involved. In fact, it is noted that such figures may be irrelevant in terms of the value creation process of the organization (Rezaee 2011). From this point of view, changes on the financial statements of an organization may be unavoidable in case that a value creation process is introduced in the particular organization. Moreover, changes in financial statements may not be clear. Under certain terms, changes in organizational operations or the performance of the organization may be implied through data presented in regard to an irrelevant organizational activity. For example, the changes in liabilities can ‘imply cash flows’ (Wahlen, Stickney, Brown and Baginski 2010, p.183), even if these cash flows are not clearly described in the financial statements of the particular organization. Moreover, Gessner, Schmidt-Gothan and Lubben (2003) refer to a particular aspect of the relationship between changes in financial statements and value creation: the importance of value creation, as a process revealing the potentials of organizational performance, can be estimated using a series of figures included in an organization’s financial statements, as for example the annual profits of the organization. At the next level, the effectiveness of organizational units, as identified through the value creation process, can be compared to ‘that of the business units of competitors’ (Gessner, Schmidt-Gothan and Lubben, 2003, p.51). The figures on which the measurement of the value of the business units of competitors will be based can be retrieved through their financial statements. If these statements incorporate changes which are not identifiable, then the assumptions made on the value of the business units of competitors will be invalid. 4. Conclusion The development of modern organizations is based on different factors. Liquidity can be used as an indicator in order to show the potentials of a specific organization to achieve a long-term growth. On the other hand, liquidity has been related to different aspects of organizational operations, as analytically explained above. The review of the forms and the role of liquidity in modern organizations has led to the following assumption: liquidity can reflect the potentials of an organization to achieve a stable growth. It is also made clear that liquidity can be used for highlighting different aspects of a firm’s operations. However, in its common use, the term liquidity shows the ability of the organization to repay its liabilities. In the growth stage of company development the achievement of the above target is critical, since the firm would not have a chance to expand its activities unless its debts are covered, at least up to a particular level. In accordance with the above, reviewing an organization’s liquidity level could be a secure method for identifying the organization’s prospects in the future. The review and the update of the organization’s financial statements could serve another need: the need for rapid organizational growth, as this growth can be achieved through a specific macro-economic policy. Changes in the organization’s financial statements may be necessary so that updates in the firm’s practices or aims are made clear. References Arnold, G. 2008. Corporate financial management. Essex: Pearson Education. Asaf, S. 2004. Executive corporate finance: the business of enhancing shareholder value. Essex: Pearson Education. Beaton, N. 2010. Valuing early stage and venture-backed companies. Hoboken: John Wiley and Sons. Gessner, K., Schmidt-Gothan, H., and Lubben, H. 2003. The House of Value Creation: How to Increase Company Value Systematically. New York: Springer. Gibson, C. 2010. Financial Reporting & Analysis: Using Financial Accounting Information. Belmont: Cengage Learning. Kapil, S. 2011. Financial Management. New Delhi: Pearson Education India. Leach, C. and Melicher, R. 2011. Entrepreneurial Finance. Belmont: Cengage Learning. Mellen, C. and Evans, F. 2010. Valuation for M&A: Building Value in Private Companies. Hoboken: John Wiley & Sons. Pratt, J. 2010. Financial Accounting in an Economic Context. Hoboken: John Wiley and Sons. Rezaee, Z. 2011. Financial Services Firms: Governance, Regulations, Valuations, Mergers, and Acquisitions. Hoboken: John Wiley & Sons. Rezaee, Z., and Riley, R. 2009. Financial Statement Fraud: Prevention and Detection. Hoboken: John Wiley and Sons. Schmeisser, W., Clausen, L. and Popp, R. 2011. Controlling and Berlin Balanced Scorecard Approach. Munchen: Oldenbourg Wissenschaftsverlag. Singla, R. 2007. Business Studies. New Delhi: FK Publications. Von Gehr, G. 2007. The Effective Entrepreneur. Lincoln: iUniverse. Wahlen, J., Stickney, C., Brown, P., and Baginski, S. 2010. Financial reporting, financial statement analysis, and valuation: a strategic perspective. Belmont: Cengage Learning. Read More