This table is a representation of the trade-off in Liquidity and Financing in se

Question

This table is a representation of the trade-off in Liquidity and Financing in selecting an Optimal Policy for your business. Explain : Asset liquidity, Financing Plan, and Inventory Policy. Then explain If you were to ran a business and you look at this table where do you see your risk profile? Explain what type of business and what would you choose for Liquidity, Financing and Inventory policy.

Figure 6-11 Net working capital as a percentage of sales and the current ratio Current ratio Working capital to sales expressed as % 18 1.8 Average current ratio 1.6 1.4 1.2 1.0 0.8 0.6 0.4 16 Average working capital to sales (%) 14 12 10 8 0.2

Explanation / Answer

The concept of trade-off is balancing the costs & benefits of choosing one course of action or taking one decision over another --ie. To moderate between two alternatives--by analysing the respective costs and benefits. That said, a company needs to have just- adequately liquid assets --so as not to be either, an over-investment nor a poorly under -invested so as to lose any profitable opportunities , for lack of current assets or working capital funds. Asset liquidity is the quickness within which an asset can be sold & converted to cash ,that too , with as little loss as is possible-- to settle any liability/obligation ,that may arise suddenly. Financing plan is a blue-print of the level of debt & internal fundings that are going to be employed by a company. It is also a plan of action for how much short-term & long-term outside funding is going to be procured --so that interest costs can be budgeted ahead. Inventory policy is deciding on the level of inventory to be maintained, taking into account the demand from customers , production runs --level of investment required so that not too much funds are locked in inventory, ensuring at the same time, no feasible customer's project is denied for want of stock. Maintaining the right quantity of stock ,most of the times,is really a challenge to the inventory managers. In the graph, even though Current ratio is consistently maintained above 1.2, ie. Net working capital is always positive,ie. 1.2-1=0.2,% of net working capital to sales ,is lowest in the years 2005-2007 Following points need to be ensured in all the above three areas: Asset liquidity to the extent of twice the immediate obligations that may arise, ie. 2:1 asset :Liabilities ratio, especially working capital or current assets & liabilities. Financing plan should take into account ,the above point ,& avail that much credit for short-term purposes.Long-term debts need to be incurred ,after analysing the net income posiible & its coverage of interest expense . Inventory levels should be just adequate so as not to lose on orders & also ensuring not much stock is idle & obsolete--- which may result in unnecessary carrying costs.

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