Question

Consider

Black Sparrow Aviation, Inc. has been reviewing more of their financial ratios and noticed an increase in the ratio of current assets to total assets. They also noticed a decrease in profit and risk as measured by working capital. Senior management has come to you, the financial manager, to try to get an understanding of what is happening.

Discuss

Explain the following:

• Why does an increase in the ratio of current assets to total assets decrease profits as measured by working capital?
• Why does an increase in the ratio of current assets to total assets decrease risk as measured by working capital?
• How do changes in the ratio of current liabilities to total assets affect profitability and risk?
• What recommendations do you make to help alleviate some of management's concern about the increase of current assets to total assets?

Answer 1

1]

An increase in the ratio of current assets to total assets decreases profits as measured by working capital.

This is because there are a higher amount funds locked up in working capital, which are essentially idle and do not earn any return for the firm. Thus, the profitability is lower because of the drag created by high investment in current assets

2]

An increase in the ratio of current assets to total assets decreases risk because there are a higher amount of short-term assets available to pay off short-term liabilities as they become due. Thus, the risk of short-term insolvency and illiquidity is reduced.

3]

A higher ratio of current liabilities to total assets increases profitability because the investment in working capital is reduced. Thus, funds are freed up from idle uses and can be invested in more productive, return-generating uses.

A higher ratio of current liabilities to total assets increases risk because there are a higher amount of short-term liabilities which must be supported by the same level of short-term assets. Thus, there is higher risk of short-term insolvency and illiquidity..

4]

To help alleviate some of management's concerns about the increase of current assets to total assets, the following recommendations are made :

• Offer an incentive to customers to pay the invoices earlier. This will reduce the collection period and reduce the investment in current assets
• Optimize inventory ordering and storage so that investment in materials and finished goods is reduced
• Invest idle cash in short term marketable securities to earn some return on cash