Question

How does investing more heavily in current assets (while not increasing the firm’s current liabilities) decrease both the firm’s risk and its expected return on its investment?

How does the use of current liabilities enhance profitability and also increase the firm’s risk of default on its financial obligations?

Answer 1

Investing more heavily in current asset decrease both the risk of the firm and expected return on investment of the firm because it would be leading to piling of liquid assets with the company with the company is not able to invest appropriately so there will be a larger chunk of assets which will be present on the hands of the company but the company does not have enough quality projects to reinvest into, in order to make a higher rate of return. It will lead to idle cash in the hands of company which will be leading to loss of opportunities and hence it will decrease the overall expected return on investment.

higher presence of current asset will also reduce the risk associated with the company because it will provide higher amount of liquidity in the hands of the company.

Use of current liability is helpful in enhancing the profitability because it will help the company in order to to borrow from creditors in order to maximize its rate of return by using the short term debt in a proper manner so,it can be said that various long-term debt will also have short term fixed obligation and it will lead to creation of value in the long term for the company so presence of short term liability will be helping the company in fueling the growth and not letting the cash idle and it will be used for payment towards Various creditors and it will help in maximization of the growth of the company & company will be able to make a higher rate of return.

It can also be summarised that higher amount of debt capital and current liabilities on the books of account will be decreasing the overall liquidity and solvency in the hands of company.