Question

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

2) In most economic conditions, current liabilities are a cheaper form of financing than long-term funds...Think about what this means for the financing costs and the firm’s profits.

Answer 1

1)

• Current liabilities are those liabilities which are required to be paid by the company within a period of 12 months. Any liability paid or unpaid after 12 months period becomes non-current liability.
• Total assets are the sum total of all the assets owned by the company whether current assets or non-current/long-term assets.

The changes in the ratio of current liabilities to total assets directly affects profitability or risk as this ratio shows the ability of the company to pay its current liabilities

Whenever this ratio is less than 1, it shows that the company is having more Assets than liabilities and there is no risk and more profitability.

2)

It can be truly said that in most economic conditions, current liabilities are a cheaper form of financing than long term funds as :

• Long term funds requires a huge financing costs and this is not so in current liabilities, as current liabilities do not require any financing cost. So, reduced financing costs may increase the firm's profit.
• Another point here is that long term liabilities/funds will attract a huge interest costs as compared to current liabilities and this interest costs/expenses would be shown in profit and loss statements which will ultimately decrease the firm's profit.