Question

3. (a) Define the current ratio and return on assets ratio. (b) State what financial management problem each of these financial ratios could be used to identify. (c) What would be a good benchmark to use for each of these financial ratios?

Answer 1

Current ratio is defined as current assets divided by current liabilities. Its a form of liquidity ratio that measures a company's ability to pay short term obligations which are due within a year. Current assets are those assets which can be converted into cash within a year. In the same way current liabilities will be those liabilities which can be paid off within a year. Every industry has different optimal current ratio so current ratio of a firm above the industry average is considered good and below it is considered bad. Usually current ratio in the range of 1.5 to 2 is considered good.

Return on assets ratio: Its a probability ratio where the net income earned by the average total assets is measured. It is calculated as ROA = Net assets divided by Average total assets. Its tells us how much net income is generated by the total assets employed in the firm. Average total assets is the average of the assets of last two years.

b) Current ratio is used to identify the liquidity of the firm. It helps us to know the firm's capacity to pay up current liabilities if they demand it. The best possible way for the firm to dispose the current liabilities is how fast they can convert the current assets into cash to pay off current liabilities. If the current ratio of the firm is less than 1, it states that the firm has a problem to dispose off its current liabilities with current assets and will need to depend upon its fixed assets. While a current ratio of above 1 is a comfortable position of the firm.

Assets turnover ratio: It is just a measurement of Net income earned by the firm by employing its total assets. The larger the ratio the better it is for the investors and shareholders. It indicates that the firm is able to generate good profits with the same assets and a lower number would indicate the company's inability to earn profits with the deployed assets.

c) While the benchmark for any company will change as per the industry it's in. A heavy machine industry would have a different current ratio than a company in FMCG industry. But usually a current ratio of 1.5 is considered healthy.

For asset turnover ratio it is beneficial if we compare the ratio with its previous year ratio. But usually if a firm is generating profits of more than 5% to 10% is good anything less than that is considered not good. But ideally every ratio must be checked with the average industry ratio and then must be compared with the firm.