Page 235 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes
Example: in the case of vanaspati manufacturing company enjoying high reputation and
credit terms in the market, a current ratio of 1.6 has been serving as ideal. On the other hand, a
company engaged in manufacturing heavy electrical equipment and machinery and the business
mostly being static electricity board might have to maintain a current ratio of more than 3.

The Trade-off between Profitability and Risk

The conversion of current assets for inventory to receivables to cash provides the sources of cash
used to pay the current liabilities. The cash outlays for current liabilities are relatively preferable.
When an obligation is incurred, the firm generally knows the corresponding payment will be
due. What is difficult to predict are the cash inflows – the conversion of the current assets to more
liquid term. The more predictable its cash inflows, the less net working capital a firm needs.
Since most firms are unable to match cash inflows to cash outflows with certainty, current assets
that more than cover outflows for current liabilities are usually necessary. In general, the greater
the margin by which a firm’s current assets cover its current liabilities, the better able it will be
to pay its bills as they become due.

A trade-off exists between a firm’s profitability and its risk probability. In this context, is the
relationship between resources and costs generated by using the firm’s assets – both current and
fixed – in productive activities? A firm’s profits can be increased by (1) increasing revenues or (2)
reducing costs.. A firm that cannot pay its bills when due, is said to be technically insolvent.

Did u know? What is risk in short term context?
Risk, in the context of short-term financial management (working capital management) is
the probability that a firm will be unable to pay its bills as they become due.

Changes in Current Assets

How changing the level of firm’s current assets affects its profitability – risk trade-off can be
demonstrated using the ratio of current assets to total assets. This ratio indicates the percentage
of total assets that is current. (It is assured that the level of total assets remains unchanged).
When the ratio increases, that is, when current assets increase – profitability decreases. Why?
Because, current assets are less profitable than fixed assets. Fixed assets are more profitable
because they add more value to the product than provided by current assets.
The risk effect, however, decreases, as the ratio of current assets to total assets increase. The
increase in current assets increases net working capital, thereby reducing the risk of technical
insolvency. The opposite effects on profits and risk result from a decrease in the ratio of current
assets to total assets.

Changes in Current Liabilities

How changing the level of firm’s current liabilities affects its profitability – risk trade- off can be
demonstrated by using the ratio of current liabilities to total assets. This ratio indicates the
percentage of total assets that has been financed with current liabilities. (Assume that the total
assets remain unchanged). Then ratio increases, profitability increases, because the form uses
more of the less expensive current liabilities financing and less long term financing current
liabilities are basically debts on which the firm pays no charge or interest. However, when the
ratio of current liabilities to total assets increases, the risk of technical insolvency also increases,
because the increase in current liabilities in turns decreases not working capital. The opposite
effects on profit and risk result from a decrease in the ratio of current liabilities to total assets.

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