Page 40 - DBP5043

INTRODUCTION WORKING CAPITAL MANAGEMENT

THE RISK-RETURN TRADE-OFF IN WORKING CAPITAL

MANAGEMENT

The risk-return trade-off in managing a firm’s working capital

is related to a trade-off between the firm’s liquidity and
profitability.

A firm can increase its investment in working capital by
increasing its investment in current assets (This in turn increase

firms liquidity). Example : Increase inventory and cash, firm
more liquid (able to pay bills on time).

However, this may not result in an increase in the firm’s
returns, if profits remain unchanged.

Therefore the financial manager has to determine a balance
between liquidity and profitability which is contribute

positively to the firm’s value.

Therefore the financial manager in considering the risk return

trade off in general should only take on additional risk when
an additional return is expected. We can now see that the risk

return trade off involves an increased risk of insolvency versus
increased profitability.