Theory: companies, objectives and liquidity

In this article we want to look a little at the theoretical background to companies, corporate objectives and conflicting objectives, above all in connection with maintaining liquidity. A crash course on companies and liquidity, if you like.

For those in a hurry: maintaining liquidity as a permanent core task

• Every entrepreneur knows it: “The enterprise is regarded as an extremely complex, open, dynamic and social system.”
• The long-term maximisation of profit can be regarded as the main objective of the enterprise.
• One of the most important secondary conditions for the continued existence of the enterprise is maintaining financial equilibrium, that is, solvency.
• The basic objectives of the enterprise, maximum profit and financial equilibrium, have a negative or limiting effect on one another.
• Just as with liquidity, breaching ecological equilibrium can endanger the continued existence of the enterprise.

Companies

In economics, private households, companies and the state are regarded as the centres of will of any economy. In finance, companies are defined as an “economic unit geared towards continued existence and directed by a centre of will, which takes part in one or more sub-processes of the social production process”. In economic terms, then, the entrepreneur is defined as the centre of will. Actually quite an interesting insight, since entrepreneurial will, and thus the forming of that will, is at the centre.

And it goes on. “On the one hand, economic goods are acquired on their procurement markets and, after being converted into more marketable products, are on the other hand sold on the relevant sales markets.” So it is about acquiring, converting and selling resources. Here, resources are certainly to be understood in a tangible sense, as goods, and also in the sense of services.

Let us move on to business administration. There the object of study is the company. In market-oriented economic systems, the enterprise appears as a production unit oriented towards the commercial principle, with the task of generating added value for its owners. Through business administration’s in-depth engagement with the enterprise, the following definition has developed out of systems theory:

“The enterprise is regarded as an extremely complex, open, dynamic and social system.” A circumstance of which every entrepreneur is very well aware.

Characteristic of this system is the large number of connections to other systems, that is, to the corporate environment. Exchanges of every kind take place continuously and influence the company and its development – this is also referred to as the dynamic component.

Because of the many changes and influences that arise in this way, the decision-makers (aka entrepreneurs or centres of will) are forced constantly to guarantee that corporate objectives are met by means of steering interventions. This is also understood as the social component of companies.

The relationships with other market partners have a substantial influence on the company’s continued existence in that the consideration received must be sufficient to make input factors available. The economic efficiency principle (that is, achieving a given objective with as little input as possible, or achieving a maximum with a given input) should be observed as the basic principle behind all decisions.

It can be observed, however, that the application of this principle depends heavily on the economic cycle. In boom times, that is, when the company is developing well or satisfactorily and generating profits, the principle of economical management is often neglected, whereas in times of negative business performance people are happy to be reminded of it. In a somewhat different setting we also see this behaviour in the startup world in connection with liquidity decisions. While startups in “bootstrap” mode handle the available resources very consciously, once funding has been secured from external investors the efficiency principle is often neglected.

Setting corporate objectives

Are there universally valid objectives for the enterprise? If we assume that the highest objective of an enterprise is to survive economically, the question arises of how this can be achieved.

The long-term maximisation of profit is often described as one of the main objectives of the enterprise. This is then understood as achieving maximum profitability or creating potential for success. This objective depends, however, on the economic system in which the enterprise is embedded. It applies to market economy mechanisms. In this system the basic assumption is that the economic unit, and therefore the entrepreneur, is free to decide.

Although it is almost forgotten by now: by contrast, the organ principle prevails in centrally administered economic systems. This principle points to the monetary (creaming off profits and receiving subsidies) and non-monetary (being tied to economic plans) dependence of the enterprise. Because of the possibility of political subsidy or support, profit maximisation recedes strongly into the background.

An essential insight in the analysis of corporate objectives is that the principle of profit maximisation is not pursued without limits, but with regard to subjective secondary conditions. The human component moves centre stage. There is therefore a number of combinations of objectives that guide entrepreneurial decisions.

The most important secondary condition: solvency

One of the most important secondary conditions for the continued existence of the enterprise is maintaining financial equilibrium, that is, solvency. This is the prerequisite, the restrictive secondary condition so to speak, for striving after maximum profit, since profit alone does not automatically promise secure liquidity. “A profitable enterprise must go under if it becomes illiquid, whereas a temporarily unprofitable company can remain liquid.” I beg your pardon? Profitability ratios are calculated figures that put a result into relation. Illiquidity is a point-in-time figure, absolute and unforgiving. Anyone who cannot pay their liabilities as they fall due is illiquid. And, as a first step, that has little to do with profitability. I will come back to that.

Because the public has become increasingly sensitised, and because of the legal rules that have arisen as a result, ecological objectives have also been considerably upgraded. A social pressure developed that has recently led, and will continue to lead, to shifts in political power as well. But why?

The efficiency principle, and thus long-term profit maximisation, and the secondary condition of liquidity both relate to the enterprise’s economic value creation. This must be organised as efficiently as possible. But: “Starting from this value creation, emissions, immissions and damage give rise to operational harm creation, that is, to the perception of the damage by society.” Value creation / harm creation – slowly the open, dynamic and complex system starts to make more sense, does it not?

“Raising” ecological objectives to the rank of a restrictive secondary condition is justified once the consequences of not meeting these objectives are set out: closure of the business or interruption of operations, falling demand, competition from environmentally friendly products, pressure to innovate technologically and pressure to innovate in products.

Just as with liquidity, though to a limited extent, breaching ecological equilibrium can endanger the continued existence of the enterprise. The sector that illustrates this danger very clearly is energy supply.

The dates discussed in Germany for exiting the coal industry have had a substantial influence on corporate decisions for years. RWE, for example, has split itself over recent years into an “old” and a “new” division in order to take account of social change.

Conflicting objectives

These three basic objectives of the enterprise,

1. striving for sufficient profit (performance component) and
2. striving to maintain financial equilibrium (financial component), as well as
3. striving for “ecological efficiency” (social component),

therefore form a combination of objectives. But how do these objectives influence one another?

Systems of objectives consist of various relationships between objectives. The dependencies between the individual objectives are described as complementarity, conflict and indifference. What has to be considered, then, is whether objectives reinforce one another, whether they compete with one another or whether they are independent of one another. The greatest planning challenge lies in coordinating the resources used to reach objectives where conflicts prevail or arise. For that reason these relationships are of particular interest.

Competitors: profitability and liquidity

“Classic competing objectives are the pursuit of profitability and of liquidity.” That means that the basic objectives of the enterprise, maximum profit and financial equilibrium, have a negative or limiting effect on one another. The dilemma here is, among other things, a problem of differences in timing.

Profitability follows from the ratio of the result (in the form of profit, net income for the year and so on) to the capital employed, and is therefore a question of a period. Liquidity, by contrast, in its payment-oriented sense refers to a company’s ability to service its payment obligations at all times (that is, at every point in time). Liquidity is therefore a question of a point in time.

This can mean that the divergence in timing between the dates of payments and the dates on which they affect performance leads to different assessments of performance and liquidity. The assessment of the company’s situation can then, in turn, be crucial for the decisions to be taken.

Maintaining liquidity as a core task

Moreover, measures to improve profitability can significantly influence liquidity and vice versa. The leverage effect plays an important role here. “If the return on the total capital employed in the company is higher than the cost of debt, using debt leads to an increase in the return on equity.”

Subsequently, however, taking on debt can lead to a liquidity squeeze despite an improvement in the return on equity. Namely when liabilities can no longer be serviced because of the higher absolute interest on the debt. Such a situation is of course made worse by a general rise in interest rates, whether when refinancing fixed-rate loans or through the immediate increase in debt service in the case of variable-rate debt. Optimising or maxing out the leverage effect can therefore be very damaging. Especially in real estate (and in times of low interest rates) this is a danger to be taken very seriously.

On the other hand, the desire to hold a large stock of cash in order to meet payment demands can lead to an excessive cash reserve. “At a point in time when no payments have to be made, the cash balance can even be zero. Greater payment capacity than the payment demands require is unnecessary and, from the point of view of profitability, uneconomical.” Finance therefore recognises maintaining liquidity as a permanent core task of financial management.

If we look at how ecological objectives relate to the other basic corporate objectives, complementarity can be observed throughout. An ecological orientation of the enterprise can, for example, create potential for success and thus have a positive long-term influence on the company. This can be seen above all in the startup world, where young companies orient their value creation towards ecological aspects from the very beginning and can thereby open up new target groups quickly. Only in short-term areas of profit generation and cost savings can conflicting objectives arise, and mainly in longer-established companies.

For small and medium-sized companies, with their characteristic limited access to capital but also because of their strong dependence on dominant entrepreneurs, these considerations give liquidity an overriding importance.

Topics covered within the theory series

Part 1: companies, objectives and liquidity

Part 2: corporate management and liquidity management

Part 3: decisions and liquidity management

Part 4: reporting in the company

Credits: Photo by Álvaro Serrano on Unsplash