The profitability and risk trade-off in net working capital management

Net Working Capital May Be Defined as:

A firm's current assets minus current liabilities.

OR

The total amount of liquid resources available to a business. ("Net working capital" 2005).

The above stated definitions are, in fact, two sides of the same coin since "the total amount of liquid resources available to a business" is actually its "current assets minus its current liabilities."

Net Working Capital is important for businesses because it represents the amount of current assets a firm would be left with if it was liquidated to pay the company's short-term debt. The amount of net working capital that a business decides to have available is a trade-off between profitability and risk. In other words, a large amount of net working capital means reduced profitability for a firm but a precarious working capital position puts it at greater risk. This is because holding of current assets is not very profitable as cash (or current accounts) earn no interest, there are no returns on accounts receivable, and inventory does not earn a profit until it is sold. On the other hand, businesses can earn profits on their assets if they are invested in longer term securities etc. However, such "invested" assets cannot be classified as "current assets" since they are not liquid and cannot be converted into cash quickly. (Danh, 1999)