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:

• 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

Answer 1. An increase in the ratio of current assets to total assets will lead to a decline in profitability because current assets are assumed to be less profitable than fixed assets, assuming no change in current liabilities, will increase Net Working Capital. This implies additional costs of doing business as cash realization will be slower as well.

Answer 2. A decrease in the ratio of current assets to total assets will result in an increase in profitability as well as risk. The increase in profitability will primarily be due to the corresponding increase in fixed assets which are likely to generate higher returns. Since the current assets decrease without a corresponding reduction in current liabilities, the amount of Net Working Capital will decrease, thereby increasing risk. Reduced working capital is higher risk as every function in the Company will have to function with high levels of efficiency. This implies that in case receivables dont come on time as expected, then the Company will face a liquidity crunch.

Answer 3. An increase in the ratio of current liabilities to total assets will lead to a increase in profitability because it will reduce Net Working Capital. This implies lower costs of doing business as cash realization will be slower as well. However, it will also mean higher risk as liquidity will be low and fixed asset cannot be sold quickly to pay-off liabilities. The opposite is true for a decrease in current liabilities to total assets ratio.

Steps to alleviate some of management's concern about the increase of current assets to total assets:

1. Reduce credit period of customers and speed-up collections so that cash realizations are quicker.

2. Also look at the cash turnover cycle which will ensure continuous circulation of cash which will increase efficiency in financial operations.

3. Reducing the Current Ratio (i.e Current Assets / Current Liabilities) is at industry levels or optimal levels such as 2:1 or such other ratio. (2:1 is the thumb rule).