Decisions that affect the liquidity of the assets of the firm (i.e. the turnover of these assets into cash) include :
(a) the management of cash and marketable securities;
(b) the management of receivables - i.e. credit policy and procedures;
(c) inventory management and control; and
(d) the administration of fixed assets.
For purposes of illustrations, the latter three factors are held to be constants (and these are studied subsequently); also it is assumed that the liquid assets, viz. cash and marketable securities, held by the firm yield a return lower than the return on investment in other assets. By extension, current assets, in general, and liquid assets more particularly so, are less profitable than fixed assets. By further extension, short-term funds are less expensive than long-term funds.
For evaluating a firm's status as regards its NWC, consideration of trade-off between profitability and risk is very important. Herein, profitability is measured by profits afler expenses. And, risk is defined as the probability that a firm will become technically insolvent, becoming unable to meet its obligations when they become due for payment.Obviously, the greater the NWC, the more liquid the firm, hence, it is less likely to become insolvent, i.e. less risky the firm. Conversely, lower the NWC, more increased is the level of risk. To summarise, NWC and liquidity on one hand and the firm's risk on the other hand, behave oppositely.Then, to increase profitability, risk must also be increased; if risk is decreased, profitability too is decreased. To establish this dictum, we now consider the effect of changing the current assets and current liabilities on the firm's profitability-risk trade-off.
Profitability-Risk Trade-off by Change of CA and CL
This is studied by employing the ratio of current assets to total assets or by the ratio of current liabilities to total assets. Let it be assumed that current assets earn 4% p.a. and fixed assets earn 15% p.a. Let it also be assumed that current liabilities cost 5% and the weighted average cost of long-term funds is 10%. Consider the core elements of a Balance Sheet (BS) as under :
(a) the management of cash and marketable securities;
(b) the management of receivables - i.e. credit policy and procedures;
(c) inventory management and control; and
(d) the administration of fixed assets.
For purposes of illustrations, the latter three factors are held to be constants (and these are studied subsequently); also it is assumed that the liquid assets, viz. cash and marketable securities, held by the firm yield a return lower than the return on investment in other assets. By extension, current assets, in general, and liquid assets more particularly so, are less profitable than fixed assets. By further extension, short-term funds are less expensive than long-term funds.
For evaluating a firm's status as regards its NWC, consideration of trade-off between profitability and risk is very important. Herein, profitability is measured by profits afler expenses. And, risk is defined as the probability that a firm will become technically insolvent, becoming unable to meet its obligations when they become due for payment.Obviously, the greater the NWC, the more liquid the firm, hence, it is less likely to become insolvent, i.e. less risky the firm. Conversely, lower the NWC, more increased is the level of risk. To summarise, NWC and liquidity on one hand and the firm's risk on the other hand, behave oppositely.Then, to increase profitability, risk must also be increased; if risk is decreased, profitability too is decreased. To establish this dictum, we now consider the effect of changing the current assets and current liabilities on the firm's profitability-risk trade-off.
Profitability-Risk Trade-off by Change of CA and CL
This is studied by employing the ratio of current assets to total assets or by the ratio of current liabilities to total assets. Let it be assumed that current assets earn 4% p.a. and fixed assets earn 15% p.a. Let it also be assumed that current liabilities cost 5% and the weighted average cost of long-term funds is 10%. Consider the core elements of a Balance Sheet (BS) as under :
As in above BS, earnings in a year on total assets are : Rs. 1,50,000 on fixed assets plus Rs. 20,000 equalling Rs. 1,70,000. The NWC is Rs. 2,00,000 (being CA - CL). Also current-total assets ratio is 0.333 (being Rs. 5,00,000 vs. Rs. 15,00,000). Also ratio of current liabilities to total assets is 0.200. This ratio indicates the percentage of total assets financed by current liabilities. The cost of funds will be Rs. 15,000 on current liabilities,plus Rs. 1,20,000 on both the long-term funds taken together, totalling to Rs. 1,35,000.
Change Proposition 1
Let CA be increased by Rs. 1,00,000 and, correspondingly, fixed assets be decreased by Rs. 1,00,000, keeping total assets unchanged.
Earnings in a year = Rs. 1,35,000 + Rs. 24,000 = Rs. 1,59,000;
NWC = Rs. 3,00,000; and, current-total assets ratio 6/15 = 0.400
Change Proposition 2
Let CA be decreased by Rs. 1,00,000 and fixed assets increased by the same amount to keep total assets unchanged.
Earnings in a year = Rs. 1,65,000 + Rs. 16,000 = Rs. 1,81,000;
NWC = Rs. 1,00,000; and, current-total assets ratio 4/15 = 0.267.
Change Proposition 3
Lea CL be increased by Rs. 1,00,000 and corresponding NCL decreased by Rs. 1,00,000 to keep total liabilities unchanged.
Then cost of financing will be = Rs. 20,000 on CL plus Rs. 1,10,000 on NCL,totalling to Rs. 1,30,000. NWC will be = Rs. 1,00,000; and ratio of CL to total
assets will become 4/15 = 0.267.
Change Proposition 4
Let CL be decreased by Rs. 1,00,000, simultaneously increasing NCL by Rs. 1,00,000, thereby keeping total liabilities unchanged.
Then cost of financing will be : Rs. 10,000 on CL plus Rs. 1,30,000 on NCL,totalling to Rs. 1,40,000. NWC will be = Rs. 3,00,000; and ratio of CL to total
assets will become 2/15 = 0.133.
Summary of Effects of Changes
Changes 1 and 2 considered the change in earnings; changes 3 and 4 considered the changes in cost of financing. Clearly, any increase is cost of financing will have the same effect on profitability as a decrease in earnings; and vice-versa. In what follows, the effects of changes are given with reference to the initial (original) status as given in the BS. Increases are shown by I and decreased by D.Here, in the table, the values are given in lakhs of Rupees.
Change Proposition 1
Let CA be increased by Rs. 1,00,000 and, correspondingly, fixed assets be decreased by Rs. 1,00,000, keeping total assets unchanged.
Earnings in a year = Rs. 1,35,000 + Rs. 24,000 = Rs. 1,59,000;
NWC = Rs. 3,00,000; and, current-total assets ratio 6/15 = 0.400
Change Proposition 2
Let CA be decreased by Rs. 1,00,000 and fixed assets increased by the same amount to keep total assets unchanged.
Earnings in a year = Rs. 1,65,000 + Rs. 16,000 = Rs. 1,81,000;
NWC = Rs. 1,00,000; and, current-total assets ratio 4/15 = 0.267.
Change Proposition 3
Lea CL be increased by Rs. 1,00,000 and corresponding NCL decreased by Rs. 1,00,000 to keep total liabilities unchanged.
Then cost of financing will be = Rs. 20,000 on CL plus Rs. 1,10,000 on NCL,totalling to Rs. 1,30,000. NWC will be = Rs. 1,00,000; and ratio of CL to total
assets will become 4/15 = 0.267.
Change Proposition 4
Let CL be decreased by Rs. 1,00,000, simultaneously increasing NCL by Rs. 1,00,000, thereby keeping total liabilities unchanged.
Then cost of financing will be : Rs. 10,000 on CL plus Rs. 1,30,000 on NCL,totalling to Rs. 1,40,000. NWC will be = Rs. 3,00,000; and ratio of CL to total
assets will become 2/15 = 0.133.
Summary of Effects of Changes
Changes 1 and 2 considered the change in earnings; changes 3 and 4 considered the changes in cost of financing. Clearly, any increase is cost of financing will have the same effect on profitability as a decrease in earnings; and vice-versa. In what follows, the effects of changes are given with reference to the initial (original) status as given in the BS. Increases are shown by I and decreased by D.Here, in the table, the values are given in lakhs of Rupees.
In the above Table, if earnings are increased or cost of financing is decreased,profitability increases; and vice-versa. If NWC is increased, risk decreases; and vice-versa.It is clearly established that profitability increases with increasing risk; and vice-versa.Also, profitability increases if CL is increased or CA is decreased; and vice-versa, with keeping total assets the same (which implies total liabilities being same).
Exlanation of Implicit Reasons for the Increase or Decrease;and Impact on Construction Contracting
Vide change proposition 1, an increase in current-total assets ratio leads to a decline in profitability. This is because current assets are iess profitable than fixed assets. However,since NWC increases, the risk of technical insolvency would also decrease.In construction industry, materials constitute a major paii of the cost, and, in the contractor's hands, these are essentially part of WC. That profitability in construction contracting is decreasing is thus understandable. To the extent that bills have been raised on the "Owner", the contractor's assets are in terms of accounts receivable; and together with his materials inventory, his solvency is not under jeopardy.
As per inference at change proposition 2, a decrease in the current-total assets ratio results in an increase in profitability as well as risk. The increase in profitability is primarily due to the increase in fixed assets which are expected to generate higher returns. Also, the decrease in CA without a corresponding decrease in CL, causes a decrease in NWC, thereby increasing risk. In construction industry, this is reflected in increased profitability whenever the job on hand is more mechanised, or involves less of materials inputs.
Change proposition 3, suggests an increase in profitability if the ratio of current liabilities to total assets increases. Current liabilities, as short-term sources of finance, are less expensive than long-term sources. Thus, if current liabilities increase, it means substituting less expensive sources for more expensive sources of financing. For the construction industry, credit purchase of goods and outstanding expenses (say, for labour payment, etc.) come under this purview. However, risk is also increased by reason of decreased NWC.
With change proposition 4, with decrease in CL, there is decrease in profitability as well as in risk. This is a situation of slack business climate. Also, since long-term funds continue to be on hand, and since these are more expensive, the costs increase, and this implies decline in profits.
Combined Effects of Changes in CA and CL
The changes can be considered simultaneously. It is fundamental to note that the trade-off is clear that increased profitability goes with increased risk (and decreased NWC).
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