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CA Intermediate · Financial Management and Strategic Management · Introduction to Working Capital Management

A company moves from a conservative to an aggressive working capital policy by cutting the ratio of current assets to sales and relying more on short-term finance. Other things being equal, what is the most likely result?

An aggressive working capital policy raises expected profitability but also raises the risk of illiquidity. Holding fewer current assets and using more short-term finance reduces funds tied up and financing cost, but leaves little cushion against cash shortages, stock-outs or refinancing problems.

  1. AHigher expected profitability and higher risk of illiquidityCorrect
  2. BLower expected profitability and higher risk of illiquidity
  3. CHigher expected profitability and lower risk of illiquidity
  4. DLower expected profitability and lower risk of illiquidity

Explanation

An aggressive policy holds fewer current assets and uses cheaper short-term funds, so less capital is tied up and returns rise. However, thin liquidity buffers and frequent refinancing raise the risk of cash shortages and stock-outs. The conservative policy is the one that gives lower return with lower risk.

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