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Question
How does working capital affect both the liquidity as well as profitability of a business?
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Solution
Working capital is the difference between current assets and current liabilities. It affects both liquidity and profitability of the business.
- The increase in current assets increases the liquidity position of the business but affects the profitability adversely because the return on current assets is quite low.
- Low working capital will affect the liquidity of the business which may disturb the day to day operation.
So the working capital should be maintained at such a level that a proper balance could be maintained between profitability and liquidity.
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Mr. A. Bose is running a successful business. Mr. Bose is the owner of R. K. Cement Ltd. Mr. Bose decided to expand his business by acquiring a Steel Factory. This required an investment of Rs. 60 crores. To seek advice in this matter, he called his financial advisor Mr. T. Ghosh who advised him about the judicious mix of equity (40%) and Debt (60%). Employ more of cheaper debt may enhance the EPS. Mr. Ghosh also suggested him to take loan from a financial institution as the cost of raising funds from financial institutions is low. Though this will increase the financial risk but will also raise the return to equity shareholders. He also apprised him that issue of debt will not dilute the control of equity shareholders. At the same time, the interest on loan is a tax-deductible expense for computation of tax liability. After due deliberations with Mr. Ghosh, Mr. Bose decided to raise funds from a financial institution.
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