Question

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.

Explain the following:

1. Why does an increase in the ratio of current assets to total assets decrease profits as measured by working capital?

2. Why does an increase in the ratio of current assets to total assets decrease risk as measured by working capital?

3. How do changes in the ratio of current liabilities to total assets affect profitability and risk?

4. 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. Current assets majorly comprise of cash in hand, inventory, prepaid expenses etc. In any business if a large amount of cash/capital doest not get utilised, it losses the opportunity cost. Which means,if that cash/capital would have invested some buisness, same would have brough more profit to the organisation.

For every type of industry there is a standard current assets to total assests ratio, which can be calculated if we compare the competitors balance sheet. So, any higher current assets to total assests ratio compared to industry avergae is going to lower the profit due to opportunity loss.

2. ACurrent assets majorly comprise of cash in hand, inventory, prepaid expenses etc. So if any organisation is having large cash in hand, it is always secure from the risk of bankrupt. In case, anything goes wrong and revenue flow stops, the cash in hand supports the business to run for few more days/months. In that period of time, business may rise again and start making profit.

That is the reason why increasing current assets to total assests ratio always reduce the risk of any business.

3. Current liability is an obligation which have to paid within an year. It comprises of taxes payabale, account payable, short term loans etc. Current liabilities are typically paid by liquidating current assets. If within the total asset, current assest is sufficient enough to paid off the current liabilities, the business is doing OK.

So to sum up, higher current liabilities to total assets ratio causes lower profit and higher risk. on the other hand, lower current liabilities to total assets ratio causes higher profit and lower risk.

4. Recommendations are as follows:

• First, check the industry average of current assets to total assets ratio.
• If the company's ratio is lower than the industry average, the company should reduce the creditor's cycle. It will bring cash in the company much faster and keep the current assests high. The lower the sales cycle, the cash flow will be ore and better for any company. Also, it can increase it's inventory. This will results in lower risk also.
• In case the ratio is much higher than the industry average, it should invest it's extra cash/capital in some other business/capability increase so that company can increase it's revenue by producing more products/services and get more profit out of it as well as optimising the risk.