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What is the Significance of Current Assets over Fixed Assets Ratio?
Significance of Current Assets over Fixed Assets Ratio
Companies need certain levels of current and fixed assets to support a certain level of output. However, in order to support the same level of output, the organization needs to maintain a given level of current assets. The current assets of an organization generally increase with the increase in sales and revenues.
In contrast to popular belief, the amount of current assets does not increase proportionally with the output of the companies. The current asset may generally increase with the decrease in output of a company. This theory is based on the assumption that with the increase in production of fewer levels of output, there may be larger increments in the use of current assets.
In other words, the relationship between productivity and current assets reveals that with the increasing output levels, the measure of current assets increases when the organization can use the current assets more efficiently.
Determining the Level of Current Assets - CA/FA Ratio
Now when we know that current asset levels play an important role in shareholder’s wealth maximization, a general question that arises is - what should be the way to measure the proportion of measuring the contribution of current assets?
In general, this requirement is met by a new ratio of current assets to fixed assets.
The CA/FA ratio is obtained by dividing current assets by the fixed assets of a firm. It is notable that the CA/FA ratio provides some significant outcomes for the firm’s investment policies.
For example, keeping the FA constant, a higher CA/FA ratio gives a conservative CA/FA ratio, while a lack of CA over FA gives an aggressive ratio.
In other words, a higher CA gives a conservative ratio while a lower CA gives an aggressive CA/FA ratio.
Now, when the conservative and aggressive CA/FA ratios are defined, the most common query that comes out is - what are the implications of the two types of ratios?
It is obvious that in an organization that manages a higher level of current assets, or in the case of a conservative ratio, the liquidity is at the best level while the risk is at the lowest level. Similarly, in the case of lower CA or in the case of aggressive CA/FA ratio, the liquidity of the firm is at the lowest while the risk is at the highest level.
Moderate Coverage Ratio
The common question that comes to everyone's mind while judging the outcome of CA/FA ratio is - which of the ratios is the best for the firm?
It has been observed that neither the most aggressive nor the most conservative ratio is the best for an organization’s health. The most applicable and productive CA/FA ratio is the one that falls in between the two types of ratios. This is known as the Moderate Coverage current asset to fixed asset ratio of an organization.
The moderate average current asset policy is considered to fall in the middle of conservative and aggressive policies. It is also considered to be the most efficient form of CA/FA ratio. It not only helps the organizations maintain an adequate level of the current asset but also maximizes the use of current and fixed assets to let the firm enjoy the benefits of all the assets in their best form.
Conclusion
The ultimate aim of all organizations is to maximize the wealth of shareholders and the management of the companies strive in all aspects to maximize shareholder’s wealth. There is an optimum level of current assets for all organizations that maximize the shareholder's wealth. Therefore, organizations need to have a certain level of current assets to maximize the wealth of shareholders.
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