Working Capital Management^175
The Trade-off between Profitability and Risk
A trade-off exists between a firmís profitability and risk. Profitability, in this context,
is measured by profits after expenses, while risk is measured by the probability that
a firm will become technically insolvent (i.e., unable to pay bills as they come due). A
firmís profits can be increased in two ways: (1) by increasing sales or (2) by decreasing
costs. Both methods are discussed in the following pages. Costs can be reduced by
paying less for an item or a service or by using existing resources more efficiently. Any
reduction in costs should increase a firmís profits. Profits can also be increased by
investing in more profitable, assets, which are capable of generating higher levels of
sales. An understanding of how profits are increased and reduced is critical to grasping
the idea of a profitability-risk trade-off.
The risk of becoming technically insolvent is most commonly measured using either the
amount of net working capital or the current ratio. In this chapter the amount of net
working capital is used as a measure. It is assumed that the greater the amount of
net working capital a firm has, the less risky the firm is. In other words, the more
net working capital the more liquid the firm and, therefore, the less likely it is to become
technically insolvent. The opposite is also considered to be true; lower levels of liquidity
(i.e., net working capital) are associated with increasing levels of risk on the part of
the business firm. The relationship between liquidity, net working capital, and risk is
such that if either net working capital of liquidity increases the firmís risk decreases.
Some basic assumptions
In talking about a profitability-risk trade-off, a number of basic assumptions, which are
generally true, must be made. The first concerns the nature of the firm being analyzed,
the second concerns the basic differences in the earning power of assets, and the third
concerns differences in the cost of various methods of financing. Each of these
assumptions will be discussed separately.
The nature of the firm: The kind of firm we are talking about in this chapter is a
manufacturing firm, not some type of merchandising or service organization. As we
stated earlier in the text, the emphasis in this book is generally on manufacturing firms
since they provide the best laboratory for investigating most of the basic principles of
managerial finance.
The earning power of assets: A manufacturing firm is expected to be able to earn
more on its fixed assets than on its current assets. Fixed assets represent the true
earning assets of the firm. Plants, machines, and warehouses all enable the firm to
generate finished products that can ultimately be sold for a profit. The firmís current
assets, except for marketable securities, are not generally earning assets. Rather, they
provide a buffer that allows the firm to make sales and extend credit. The importance