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Sir John is increase in working capital an increase in liquidity? although I know if current assets contain cash only then it would be true but I am not sure if it hold true for inventory and receivables. if having too much inventory reducing the liquidity? Does liquidity mean cash only? the other question is how does holding little working capital improve profitabilty?
Liquidity refers to cash and assets that can be quickly converted into cash. The current ratio is a measure of liquidity although more important is the acid test / quick ratio because it excludes inventory (inventory takes longer to be able to convert into cash).
Reducing working capital can improve profitability because reducing inventory reduces the cost of the capital tied up in inventory and reducing receivables reduces the risk of irrecoverable debts, and reduces the interest cost of allowing credit to customers.
All of this is explained in my free lectures on working capital. The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
sir is if my working capital increase with buying more inventory by cash does it mean my liquidity decreases although there was an increase in working capital?
Sir increase in receivables by more sales and carrying more inventory to meet the demand. doesn’t it improve my profitability at the expense of liquidity?If more inventory is bought for cash then it does decrease the liquidity.
Certainly selling more is likely to increase profitability. But what is concerned here is carrying more inventory than needed or having more receivables than needed (because of increasing the credit period for customers). In that case it will reduce the profitability for the reasons I stated before.
SO sir John can I sum it up as lower working capital = higher profitability/ lower liquidity
Where as higher working capital = lower profitability/ higher liquidity .?Sorry sir for taking up your time. I have watched your video 3 times already. but what confuses me is. if I look at the kaplan book it looks for me as if it is contradicting. my thought is there needs to be balance between liquidity and profitability but if one is higher then the other aspect has to. suffer. so if you are holding more inventory and giving more credit terms to your customers then you are taking an approach to be more profitable( This is higher working capital = more profitability) but having more inventory and receivables affect the cashflow so you have an liquidity problem…… but this concept doesn’t go with the cost of capital tied up.( higher working capital = more cost so less profit) is there something I am not understanding? can you please correct me. ps: I trust your lecture more than kaplan book I was able to score 90% just watching your video so was very glad to see you in Fm videos.
I think that maybe you are confusing two things.
Certainly if a company sells more then we would expect higher profitability and at the same time they will need to have more receivables etc. and so will have more liquidity.
However, separately, if a company (for example) currently allow customers 1 month to pay, but decides to allow them 2 months to pay instead, then this will mean that that receivables increase (even if their sales stay the same). This will mean that the interest cost of the extra receivables will be higher and the risk of irrecoverable debts will be higher, and thereof they will have more expense (and less profit) than if they had not allowed 2 months credit instead of 1 months credit.
Sir how will a companies receivables increase if the sales were the same. for example I did one sell the entire year of a $100 (on credit) even if the period is 1 month or 2 months the amount to be received(receivables) will be $100.
If the sales are $100 a month and they give one months credit, then the receivables will be $100 throughout the year.
If the sales are $100 a month and they give two months credit, then the receivables through the year will be $200 (because they are always being owed for 2 months sales).
Do watch my lectures on the management of receivables.
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