Working Capital Management^177
decrease risk, it must decrease profitability. The trade-off between these variables is
such that regardless of how the firm increases its profitability through the manipulation
of working capital the consequence is a corresponding increase in risk as measured
by the level of net working capital. The effects of changing current assets and changing
current liabilities on the firmís profitability-risk trade-off will be discussed separately
prior to integrating them into an overall theory of working capital management.
Current assets The effects of the firmís level of current assets on its profitability-
risk trade-off can be illustrated using a simple ratioóthe ratio of the firmís current
assets to its total assets. This ratio indicates what percentage of the firmís total assets
are current. It may increase or decrease.
Effects of an increase As the ratio of current assets to total assets increases, both
the firmís profitability and its risk decrease. Its profitability decreases because current
assets are less profitable than fixed assets. The risk of technical insolvency decreases
because, assuming that the firmís current liabilities do not change, the increase in
current assets will increase its net working capital.
Effects of a decrease A decrease in the ratio of current assets to total assets will
result in an increase in the firmís profitability since the firmís fixed assets, which
ìThere have been periods when short-term rates have exceeded long-term rates, but
these periods have been exceptions rather than the norm. The second quarter of 1974
through the first quarter of 1975 was a period during which the short-term were above
long-term rates increase, generate higher returns than current assets. However, risk
will also increase since the firmís net working capital will decrease with- the decrease
in current assets. The consequences of a decrease in the ratio of current to total assets
are exactly the opposite of the results of an increase in the ratio.
Example
The balance sheet for the GHI Company presented in Figure 5 indicated the following
levels of assets, liabilities, and equity:
Assets Liabilities and equity
Current assets $2,700 Current liabilities $1,600
Fixed assets 4,300 Long-term debts 2,400
Total $7,000 Equity 3,000
total $7,000
If the GHI Company earns approximately 2 percent on its current assets and 12
percent on its fixed assets, the current balance sheet configuration will allow it to earn
approximate $570 [(2%. $2,700) + (12%. $4,300)1 on its total assets. The firmís
net working capital is currently $1,100 ($2,700 - $1,600). Its ratio of current assets to
total assets is approximately.386 ($2,700 ̃ $7,000).
If the firm decreases this ratio by investing $309 more in fixed assets (and thus $300
less in current assets), the new ratio of current to total assets is.343 ($2,400 s $7,000).
The firmís profits on its total assets will then be $600, [2% ∑ ($2,400)+ 12% ($4,600)].