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The level of current assets is a key factor in a companys liquidity position. A company must have or be
able to generate enough cash to meet its short-term needs if it is to continue in business. Therefore,
working capital management is a key factor in the companys long-term success: without the oil of
working capital, the engine of non-current assets will not function. The greater the extent to which
current assets exceed current liabilities, the more solvent or liquid a company is likely to be, depending on
the nature of its current assets.
The two main objectives of working capital management are to increase the protability of a
company and to ensure that it has sufcient liquidity to meet short-term obligations as they fall due
and so continue in business (Pass and Pike 1984). Protability is related to the goal of shareholder wealth
maximisation, so investment in current assets should be made only if an acceptable return is obtained.
While liquidity is needed for a company to continue in business, a company may choose to hold more
cash than is needed for operational or transaction needs, for example for precautionary or speculative
reasons. The twin goals of protability and liquidity will often conict since liquid assets give the lowest
returns.
How can we determine the level of working capital that should be carried by the business?
It will depend in your current investment policy.
Three basic alternative policies are:
1. Conservative or Relaxed Current Asset Investment Policy
- maintaining larger cash balance perhaps even investing in short-term securities, offering more generous
credit erms to customers and holding higher level of inventory.
- An aggressive policy will increase profitability since less cash will be tied up in current assets, but it will
also increase risk since the possibility of cash shortages or running out of inventory is increased
How does Working capital affects both the liquidity and profitability of a business?
Short term Investment decisions are concerned with the decisions about the level of cash, inventory and
debtors etc. (working capital) Efficient cash management, Inventory management and receivable
management are essential ingredients of sound working capital management.
The working capital should be neither more or less than required. Both the situations are harmful. If the
amount of working capital is more than required, it will no doubt increase the liquidity but decrease the
profitability. Similarly if there is a shortage of working capital, it will face the problem of meeting day to day
requirements.
Thus optimum amount of current assets and current liabilities should be determined so that the
profitability of the business remains intact and there is no fall in the liquidity.
Goodwill
Cash Discount.
Easy loan from banks
Exploitation of good opportunities
Distribution of dividends
High morale
Sense of security and confidence
Problem:
Currently I have P500,000 current assets of which 15% are permanent and P700,000 in fixed assets. The current
long-term rate is 11% and the current short-term rate is 8.5%. (TAX rate 40%). Now, I am confused as to which
financing plan to pursue whether to apply the conservative with 80% of assets financed by long-term sources or apply
the aggressive with only 60% of assets financed by long-term sources? Which plan can you recommend and what
are the risks associated with each plan?