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Question: a) What is the relationship between the predictability of a firm's cash inflows and its...

Question:

a) What is the relationship between the predictability of a firm's cash inflows and its required level of net working capital?How are the net working capital , liquidity , and risk of technical insilveny related?

b)Why does an increase in the ratio of current assets to total assets decrease both profits and risk as measured by net working capital?How do changes in the ratio of current liabilities to total assets affect profitability and risk?

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Answer #1

a. More predictable cashflows means better visibility of future cash requirements and hence, the company has to keep lesser net working capital to meet any unexpected future requirements. Generally, higher net working capital implies higher liquidity. However, if the current assets are comprised mostly of the illiquid assets such as inventory, prepaid expenes, the liquidity levle does not improve much with rise in net working capital. Also, net positive working capital means that the company is deploying long term funds for short term purposes. This results in higher costs as long term funds are generally more costly.

Technical insolvency occurs when the company is not able to meet its short term debt obligations. Generally, the higher the firm’s net working capital, the lower the risk, or chance, of technical insolvency.

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