Black Sparrow Aviation, Inc. has been reviewing more of their financial ratios a
ID: 354813 • Letter: B
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.
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?
Explanation / Answer
Q1) Working capital = Current Assets - Current Liabilities
Increase in current assets/total assets => Increase in working capital i.e. the ability of the firm to finance its short-term obligations based on the working capital formula above.
As the firm has high working capital, it means it has either good cash reserves or inventory which might result in inventory might increase the holding costs or there might be a loss of income through interest from the cash resulting in decrease of profits for the long-term.
Q2) As working capital increases, it helps the firm to easily liquidate the current assets leading to lesser risk in case of any unexpected financial issues. The firm can convert the current assets into cash easily heloing it to reduce the risk for its investors.
Q3) As the ratio of current liabilities to total assets increases, it reduces the working capital thus resulting in reducing profitability as the capital is tied up for long-term and cannot be used for growing profits.
Another logic is that as the working capital increases, there might be inventory available in huge quantities thus increasing the costs and reducing profitability.
Risk is increased if the working capital is less as the assets get tied up in events of a financial risk making it difficult to liquidate.
Q4) The firm needs to consider both the scenarios and ensure an optimal ratio is maintained for current assets to total assets as an increase will result in increase of working capital or vice-versa.
It is important to have the right balance of holding sufficient working capital to meet short-term obligations while ensuring there are non-current assets to avail interest income and keep as a back-up for future.
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