LIQUIDITY VERSUS PROFITABILITY

An important aspect of a working capital policy s to maintain and provide sufficient liquidity  to the firm. The net effect on the value of the firm should have a negative effects on the cash flows.  A firm must maintain enough cash balance or other liquid assets so that it  never  faces problems of payment to liabilities. 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 chances of (i) production stoppages and the lost sales from the inventory shortages and (ii) the liability 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.  This means that the firm’s return on 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 on the short term debts or current liabilities in financing its current assets, the greater the risk of illiquidity.  On the other hand, the use of current liability can be advantageous as it is less costly and 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 the profitability.  In order to discuss the risk-return trade-off, the following assumptions are made:

a)    That the current assets are less profitable than the fixed assets.
b)    Short terms funds are cheaper than long term funds, and
c)    The firm has a fixed level of total funds inclusive of long term funds and short term funds; and a fixed level of total assets inclusive of current assets and fixed assets.

The effect of changing levels of current assets on the risk-return trade-off can be demonstrated as follows:

For a given firm, if the level of current assets is increased (it impliedly means that the fixed assets will reduce by the same amount) then the liquidity position of the firm will also increase and it will be easily meeting its payment commitments.  But simultaneously its profit will decrease as the level of fixed assets has gone down.  In other words, when the level of current assets is increased, the liquidity of the firm increases but there is always a cost associated with the increased liquidity.  More and more funds will be blocked in current assets which are less profitable and therefore, the profitability of the firm will suffer.

Now, in order to increase the profitability, the firm reduces the current assets (and thereby increasing the 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 but the profitability is also reduced.  However, when the liquidity is reduced, the profitability increases but the risk of insolvency also increases.  So, the 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.   

The effect of change in current liabilities on the risk-return position of the firm can also be demonstrated.  If the ratio of short term (current) liabilities to total liabilities increases, the firm’s profitability will increase but the risk will also increase.  The profitability will increase as a result of decrease in costs associated with using more of short term funds and less of long term funds.  As the short term funds (current liabilities) are cheaper than the long term funds, the total cost will decrease resulting in higher profits.  However, as the current liabilities increases, then the net working capital increases the overall risk.

Similarly, decrease in current liabilities will decrease the profitability of the firm as larger amount of financing will be raised using more and more of expensive long term sources of funds.  However, there will be a corresponding decrease in risk also as the net working capital will increase as a result of decrease in current liabilities.

The combined effects of changes in current assets and in current liabilities can also be measured by considering them simultaneously.  The effects of a decrease in ratio of current assets to total assets and the effects of increase in ratio of current liabilities to total liabilities can be measured simultaneously.

Therefore, it can be said that the levels of the current assets and current liabilities have a bearing on the risk and profitability composition of the firm.  A financial manager should balanced these effects and try to achieve a sound working capital structure of the firm.

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