An important aspect of a working capital policy is to maintain and provide sufficient liquidity to the firm.
1: Liquidity vs Profitability
An important aspect of a working
capital policy is to maintain and provide sufficient liquidity to the firm.
Like most corporate financing decisions, the decision on how much working
capital should be maintained involves a trade-off. Having a large net working
capital may reduce the liquidity-risk faced by the firm, but it can have a
negative effect on the cash flows. Therefore, the net effect
on the value of the firm should be used to determine the optimal amount of
working capital. A firm must maintain enough cash balance or other liquid
assets so that it never faces problems of payment to liabilities. Does it mean
that a firm should maintain unnecessarily large liquidity to pay the creditors?
Can a firm adopt such a policy? Certainly not. “There is also another side for
a coin”. Greater liquidity makes it easy for a firm to meet its payment
commitments, but simultaneously greater liquidity involves cost also.
The risk-return trade-off
involved in managing the firm’s working capital is a trade-off between the firm’s
liquidity and its profitability. By maintaining a large investment in current
assets like cash, inventory etc., the firm reduces the chance of (1) production
stoppages and the loss from sales due to inventory shortage and (2) the
inability to pay the creditors on time. However, as the firm increases its
investment in working capital, there is not a corresponding increase in its
expected returns. As a result the firm’s return on investment drops because the
profit is unchanged while the investment in current assets increases.
In addition to the above, the
firm’s use of current liability versus long-term debt also involves a
risk-return trade-off. Other things being equal, the greater the firm’s
reliance is on the short-term debts or current liability in financing its
current investment, the greater the risk of illiquidity. On the other hand, the
use of current liability can be advantageous as it is less costly and is a
flexible means of financing. A firm can reduce its risk of illiquidity through
the use of long-term debts at the cost of reduction in its return on investment.
The risk-return trade-off thus involves an increased risk of illiquidity and
So, there exists a trade-off
between profitability and liquidity or a trade-off between risk (liquidity) and
return (profitability) with reference to working capital. The risk in this
context is measured by the profitability that the firm will become technically
insolvent by not paying current liability as they occur; and profitability here
means the reduction of cost of maintaining current assets. The greater the
amount of liquid assets a firm has, the less risky the firm is. In other words,
the more liquid is the firm, the less likely it is to become insolvent.
Conversely, lower levels of liquidity are associated with increasing levels of
risk. So, the relationship of working capital, liquidity and risk of the firm
is that the liquidity and risk move in opposite
direction. So, every firm, in order to reduce the risk will tend to increase
the liquidity. But, increased liquidity has a cost. If a firm wants to increase
profit by reducing the cost of maintaining liquidity, then it must also
increase the risk. If it wants to decrease risk, the profitability is also
decreased. So, a trade-off between risk and return is required.
From the above discussion, it is
clear that, in order to increase the profitability, the firm reduces the
current assets (and thereby increases fixed assets). Consequently, the
profitability of the firm will increase but the liquidity will be reduced. The
firm is now exposed to a greater risk of insolvency. The risk return syndrome
can be summed up as follows: when liquidity increases, the risk of insolvency
is reduced. However, when the liquidity is reduced, the profitability increases
but the risks of insolvency also increase. So, profitability and risk move in
the same direction. What is required on the part of the financial manager is to
maintain a balance between risk and profitability. Neither too much of risk nor
too much of profitability is good. This can be explained by means of the
balance sheet of PQR Ltd.
following is the balance sheet of PQR Ltd. as on 31st
The firm is earning 10% return on fixed assets and 2% return on current asset. Find out the effect on liquidity and profitability of the firm for the following:
1. Increase in current asset by 25%.
2. Decrease in current asset by 25%
The present earning of the firm may be ascertained as follows:
(from ` 2,00,000 to Rs 2,50,000), the ratio of current asset to total asset
also increase from 16.7% to 20.8%. The ratio of current asset to current
liabilities also increases from 2 to 2.5 times indicating lesser risk of
insolvency. However, with this increase, the overall earning of the firm has
reduced from ` 1,04,000 to ` 1,00,000 or from 8.67% to 8.33%
of the total assets. Thus, if the firm opts to increase the current assets in
order to increase the liquidity, the profitability of the firm also goes down. In case, the firm opts to reduce
the level of current assets by 25% from ` 2,00,000
to ` 1,50,000, the ratio of current asset to total asset will go down from
16.7% to 12.5% and the ratio of current asset to current liabilities will also go down from 2 to 1.5 times.
However, the profitability increases from 8.67% to 9%. Thus the problem shows that
liquidity and return are opposite forces and the financial manager will have to
find out a level of current asset where the risk as well as the return, both
optimum. The firm just cannot decrease the current asset to increase the
profitability because it will result in increase of risk also. The firm should
maintain the current asset at such a level at which both the risk and profitability
Tags : Financial Management - WORKING CAPITAL MANAGEMENT
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