A firm is currently employing an aggressive working capital policy with regard to the level of

QUESTION

A firm is currently employing an aggressive working capital policy with regard to the level of current assets it maintains (relatively low levels of current assets for each possible level of output). The firm has decided to switch to a more conservative working capital policy. What effect will this decision probably have on the firms profitability and risk?
Answer: Under conservative working capital policy, current assets will be increased. Accordingly, more liberal credit policy will be followed for customers and accounts receivables will go up. Stock holding period will be increased and inventories will go up. Cash balance maintenance will also increase. All of these will reduce the risk of the company. Company will have more money in short term instruments like receivables and inventory thereby better protection to suppliers. Increased inventory will reduce the risk of

ng out of inventory and will reduce the likelihood of loosing any sales or production stoppage. Profitability is also expected to go up if company can increase its sales by giving extended credit to customers under its liberal credit policy. Otherwise profitability will go down because of cost of additional funds blocked in receivables and inventories.

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