Profitability Liquidity Trade-off
One of the two key objectives of working capital management is to ensure liquidity. A business with insufficient working capital will be unable to meet obligations as they fall due, leading to late payments to employees, suppliers and other providers of credit. Late payments can result in lost employee loyalty, lost supplier discounts and a damaged credit rating. Non-payment (default) can lead to the compulsory liquidation of assets to repay creditors.
The other key objective is profitability. Funds tied up in working capital tend to earn little, or no, return. Hence, a company with a high level of working capital may fail to achieve the return on capital employed (Operating profit ÷ (Total equity and long-term liabilities)) expected by its investors.
Therefore, when determining the appropriate level of working capital there is a trade-off between liquidity and profitability:
The trade-off is perhaps most obvious with regards to the holding of cash. Although cash obviously provides liquidity it generates little return, even if held in the form of cash equivalents such as treasury bills. This is particularly true in an era of low interest rates (for example, in November 2016 the annualised yield on three-month US dollar treasury bills was approximately 0.4%).
Although an optimal level of working capital may exist it may not be achievable due to factors beyond management’s control, such as an unreliable supply chain influencing inventory levels. However businesses must at least avoid the extremes:
- Overtrading: insufficient working capital to support the level of business activities. This can also be described as under-capitalisation and is characterised by a high and rising proportion of short-term finance to long-term finance
- Over-capitalisation: an excessive level of working capital, leading to inefficiency.