The Liquidity-Profitability Trade-off: a Quantitative Approach

Net working capital management is critical because net working capital affects profitability and liquidity of a firm. The article aims to adjust an existing optimization framework determining the optimal allocation of net working capital factors to non-financial small and medium-sized enterprises from the UK given a certain level of liquidity. Using regression analysis with panel data, functional relationships between profitability and net working capital as well as between profitability and liquidity are proven to be concave; thus, the optimal value of liquidity (measured with adjusted current ratio) and net working capital (as a share of total assets) exist. These values are used as constraints for an optimization program, which objective function coefficients are estimated with regression containing return on assets as dependent variable and net working capital components, fixed assets, cash & equivalents and long-term debt as independent. The optimization program uses several specified and user-defined constraints to maximize profitability, finding the optimal allocation of net working capital components and other variables.