Page 38 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 2: Planning of Working Capital

Self Assessment Notes

Fill in the blanks:
10. The term ‘production or manufacturing cycle’ refers to the ................................. involved in
the manufacture of goods.

11. Higher profit margin would ................................. the prospects of generating more internal
funds.
12. The calculation of WC is based on the assumption that the production/sales is carried on
................................. throughout the year.
13. The relevant costs to determine work-in-process inventory are the .................................
share of cost of raw materials and conversion costs.
14. The effect of rising prices is that a ................................. amount of working capital is needed.
15. The working capital needs of business firms are lower where such needs are met through
the .................................
16. The payment of dividend ................................. WC of a firm.

2.5 Liquidity and Profitability

There is a trade-off between liquidity and profitability; gaining more of one ordinarily means
giving up some of the other.

Task Take a balance sheet of any company of your choice and determine the firms
liquidity and profitability.
Liquidity means having enough money in the form of cash, or near-cash assets, to meet your
financial obligations. Alternatively, it also signifies the ease with which assets can be converted
into cash. Whereas profitability is a measure of the amount by which a company’s revenues
exceed its relevant expenses.

Figure 2.2: Liquidity and Profitability

Let us see picture “liquidity” as being on one end of a straight line and “profitability” on the
other end of the line as in Figure 2.2. If we are on the line and move toward one, we automatically
move away from the other. In other words, there is the trade-off between liquidity and
profitability.
This is easy to illustrate with a simple example.

Example: The items on the asset side of a company’s balance sheet are listed in order of
liquidity, i.e., the ease with which they can be converted into cash, in order, the most important
of these assets are:

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