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**Unformatted text preview: **irm’s assets—both
current and fixed—in productive
activities.
risk (of technical insolvency)
The probability that a firm will be
unable to pay its bills as they
come due.
technically insolvent
Describes a firm that is unable to
pay its bills as they come due. A tradeoff exists between a firm’s profitability and its risk. Profitability, in this
context, is the relationship between revenues and costs generated by using the
firm’s assets—both current and fixed—in productive activities. A firm’s profits
can be increased by (1) increasing revenues or (2) decreasing costs. Risk, in the
context of short-term financial management, is the probability that a firm will be
unable to pay its bills as they come due. A firm that cannot pay its bills as they
come due is said to be technically insolvent. It is generally assumed that the
greater the firm’s net working capital, the lower its risk. In other words, the more
net working capital, the more liquid the firm and therefore the lower its risk of
becoming technically insolvent. Using these definitions of profitability and risk,
we can demonstrate the tradeoff betwe...

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