Question

Explain and illustrate the profitability liquidity trade off in working capital management

Answer 1

Answer:

There should be proper flow of funds for running any business. This fund is called working capital. ... The trade-off between profitability and risk is the key to working capital management. Too little working capital increases profit but reduces liquidity, as current assets are more expensive than fixed assets.

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Answer 2

Answer:

The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits.

Explanation:

Profitability and liquidity directly influence the value of company, whose maximization is a trade-off between maximum earnings and minimum cost of capital related to risk. The trade-off between profitability and liquidity maximization determines the decisions in a company and is the result of their relationship.

The risk return syndrome can be summed up as follows: when liquidity increases, the risk of insolvency is reduced. However, when the liquidity is reduced, the profitability increases but the risks of insolvency also increase. So, profitability and risk move in the same direction.

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