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(^178) Financial Management
Its net working capital will be-$800, ($2,400 ó $1,600). These results are tabulated
in Table 2.
Table 2: The effects of a change in GHIís current assets
V alue
Initial value after change
Ratio of current to total assets .386 .343
Profits on total assets $570 $600
Net working capital $1,100 $800
As Table 2 indicates, as the firmís ratio of current to total assets decreases from .386
to .343 its profits on its total assets increase from $570 to $600. Its risk, measured by
the amount of net working capital, increases since its net working capital, and thus its
liquidity, is reduced. This supports our earlier conclusions concerning the profitability-
risk trade-off as related to the firmís current assets.
Current liabilities The effects of changing the level of a firmís current liabilities on
its profitability-risk trade-off can also be demonstrated using a simple ratioóin this
case, the ratio of the firmís current liabilities to its total assets. This ratio indicates the
percentage of the firmís total assets that have been financed by current liabilities. It
can either increase or decrease.
Effects of an increase As the ratio of current liabilities to total assets increases, the
firmís profitability increases; but so does its risk. Profitability increases due to the
decreased costs associated with using more short-term financing and less long-term
financing. Since short-term financing involving accounts payable, notes payable, and
accruals is less expensive than long-term financing, the firmís costs decrease, driving
its profits higher. Assuming that the firmís current assets remain unchanged, its net
working capital will decrease as its current liabilities increase. A decrease in net
working capital means an increase in overall risk.
Effects of a decrease A decrease in the ratio of current liabilities to total assets will
decrease the profitability of the firm, since a larger amount of financing must be raised
using the more expensive long-term instruments. There will be a corresponding decrease
in risk due to the decreased level of current liabilities, which will cause an increase in
the firmís net working capital. The consequences of a decrease in the ratio of current
liabilities to total assets are exactly the opposite of the results of an increase in this
ratio.
Example
The balance sheet for the GHI Company in the preceding section can be used to show
the effects of an increase in the firmís current liabilities. Initially the ratio of current
liabilities to total assets is .229 (%1,600 ̃$7,000). Assume that the firmís current
liabilities cost approximately 3 per cent to maintain while the average cost of its ions-