Question

List and discuss two reasons why a business which is making profits can have difficulties in meeting its debts.                                                                                       

Answer 1

A business making profits can have difficulties in paying it's debts because

• When the sales are huge books shows profit as per accounting terms but in reality business faces problems regarding collections from debtors. Due to this even though firm has made profits in books it has not realised such profits. As a result, firm faces problems to pay it's various creditors due to lack of cash.
• Prepaid expenses also causes problems to the business. For example, business has paid electricity bill in advance for a three years. In books only one year expense will be accounted as per accrual accounting but in reality firm has paid more cash than accounted expense. Because of this books shows profit but business is lacking liquidity to pay creditors.