Advantages and Limitation of Current Ratio

When you wish to evaluate the performance of a company the best method to use is the ratio analysis. The ratio analysis uses the financial statements such as the income statement and the statement of financial position.

One of the critical components of the financial ratio is the current ratio that measures the relationship between the current assets and current liability (Cate, 2008).

Current ratio can also be referred to us the working capital ratio. If a company wish to know its liquidity the proper ratio to use is the current ratio.

The primary purpose of the current ratio is to measure the short-term financial position of the company.

The formula for calculating the current ratio is; the current assets divided with the Current Liabilities (Cate, 2008). In this article, we are going to discuss the advantages and limitation of using the current ratio.

It is worth to note that the current ratio is the component of current assets and the current liability.

The current assets are composed of the company assets that easily convertible into cash. The majority of the current assets are used in the normal operation of the company (Cate, 2008).

Examples of the current assets; inventory, the cash, and cash equivalent, account receivable. Likewise, the current liability is composed of the liability which will be due in less than one fiscal year.

Example of the current liability includes; account payable, the current portion of long-term liability, Bank overdraft due in one year and deferred revenue.

In most cases, the current ratio is confused with the acid ration since they are calculated using the same formula and also indicate the liquidity of the company.

The main difference between the current ratio and acid ratio is the inclusion of the inventory in the current assets when calculating the current ratio.

Advantages of the Current Ratio

The current ratio has numerous advantages that make it superior compared to other liquidity ratios, the primary advantage of the current ratio is that the ratio helps the measure the financial health of a company.

If a company record a current ratio of more than one, it indicates that the company is in good health in term of liquidity (“Financial Statement Analysis,” 2012).

If the management realizes they have less than 1 of the current ratios, they must make a swift decision to salvage the situation.

The current ratio has numerous advantages that make it superior compared to other liquidity ratios, the primary advantage of the current ratio is that the ratio helps the measure the financial health of a company.

If a company record a current ratio of more than one, it indicates that the company is in good health in term of liquidity (“Financial Statement Analysis,” 2012).

If the management realizes they have less than 1 of the current ratios, they must make a swift decision to salvage the situation.

Similarly, the current ratio gives the efficiency of the firms operating cycle. The current ratio indicates the efficacy of the management to manage the operating assets.

If the ratio id adverse or below one the company will be able to come up with the strategy to optimize the overhead in the company.

The last advantage of the current ratio is that the ratio indicates the ability of the management to honor the creditor’s obligations. The ratio acts as the litmus paper on how well the administration can manage the working capital (“Financial Statement Analysis,” 2012).

Limitation of the Current Ratio

Although the current ratio has numerous pros, it also has several limitations. The primary disadvantage of the current ratio is that the ratio is not a sufficient indicator of the liquidity of the company.

The company cannot solely rely on the current ratio since it gives little information about the company working capital.

The other limitation of the current ratio is the inclusion of the inventory in the calculation of the current assets. The inventory sometimes may take more than one to be converted into cash or revenue to the firm.

If the company has a high level of stock, it will indicate that the company in an excellent liquidity position but in a real sense, the company is in severe financial health (“Financial Statement Analysis,” 2012).

Lastly, the company may have inconsistent current ratio if the sales are seasonal. If the sales are low, the company will record the lowest current ration but when the sales increase the current ratio will be high.

The fluctuation  of the current ratio will lead to a misconception of the company liquidity

Limitation and Advantages of Fixed Asset Turnover Ratio

Fixed Asset Turnover Ratio is an efficiency ratio which depicts how well business has utilized fixed assets in order to generate sales.

It measures business returns on investment in plants, properties, equipment and other fixed assets by comparison of net sales with fixed assets.

Here is the formula to calculate ratio,

Fixed Assets Turnover Ratio = Net Sales / Average Fixed Assets

Here, Sales is taken annually while average fixed assets is calculated by dividing the opening balance of fixed assets at the beginning of year and closing balance of fixed assets at the end of thee year by 2.

Fixed Assets Balance are net of accumulated depreciation at the end of period.

and,

The reason for taking average fixed assets is that businesses often purchase or sells the fixed assets during the year and also due to fact that this ratio is mainly used in the analysis by manufacturing concerns.

Now, let us look at the advantages and limitations of calculation of fixed assets turnover ratio:

ADVANTAGES:

  • Fit for Manufacturing Industry: Bulk of investments are made in manufacturing industry. Manufacturing concerns buy a lot of plants, equipment and other fixed assets. Fixed Assets Turnover ratio gives a good edge to manufacturing concerns, a different view in analyzing the return on assets with respect to top line growth. The high turnover ratio indicates that fixed assets are working efficiently and effectively in generating good number of sales.
  • Makes Comparison easy for investors: Investors analyze this ratio year over year reflecting the efficiency increment or decrement of fixed assets. It also helps them to know when the reinvestments should be made on fixed assets so as to keep in line with growth guidelines.
  • Helps in planning for Asset Sale and Investment: If fixed assets turnover ratio has suddenly dropped, it means that fixed assets to the operations has become obsolete and it needs to be sold. The comparison with other companies in the same domain also states that when new plants, machineries and equipment should be bought.

LIMITATIONS:

  • Industry Limitations: It is useful mainly in comparing companies across manufacturing concerns. For asset light industries like those based heavily on technologies, fixed assets turnover ratio cannot be put to play.
  • Does not take Profit into account: The fixed assets turnover ratio only measures correlation between fixed assets and net sales and not the cause of what impacted the figures. A drop in asset turnover ratio can lead management on useless manhunt chasing for obsolete assets, while in reality, revenue has dropped for independent reason. Due to such drawback, fixed assets turnover ratio should be analyzed over a variety of profit and revenue ratios.
  • Difference in Accounting Policies: Two companies in the same industry or over separate industry can have different accounting policy with regards to depreciation methods. This skews the results of comparison of fixed assets turnover ratio over the industry. There can be cases where two companies having similar asset model and sales can show different fixed assets turnover ratio due to differences in accounting policies of depreciation. Hence, this ratio suffers from management discretion over employment of accounting policies with respect to sales and fixed assets.
  • Performance Subject to Manipulation: The Fixed Assets turnover ratio is helpful in performing entities having high value investments in assets where board of directors want to assess the efficiency of these fixed assets in relation to turnover of the company. However, the major limitation, the fixed asset turnover ratio suffers is in its use as performance measuring yardstock as it encourages the manager to keep using the old asset without providing for the replacement costs of new one.
  • To take full advantage of fixed assets turnover ratio, one should also correlate profit ratios with this ratio in order to get larger picture.

Average total assets

Definition:

Averages total assets is the average book value of the entity’s assets over the different reporting date. Normally, the value of assets at the reporting date is shown in the balance sheet of the entity. These assets including book current and fixed assets.

Averages total assets is normally uses to assess the return on averages assets which is assessing the efficiency of using assets for the two or more consecutive time. For example, the entity might want to assess the return on averages assets for the last three years.

To assess this, the entity needs to measure the amount of net income for those three years and then calculate the averages of total assets. These averages of total assets are the value of assets that use by the entity to support the sales and operation of the entity.

Average total assets formula:

Averages total assets = Accumulation of total assets at X period / X period

Total assets at X period is the book value of assets at the reporting period that the entity wants to assess. For example, the book value of assets at the end of 31 December 2015, 31 December 2016, and 31 December 2017

X period is the number of periods that the book value of assets is used for calculation. For example, X period of 31 December 2015, 31 December 2016, and December 2017 is 1 + 1 + 1 = 3

The entity could also use the fair value of assets for calculation.

Example:

The entity wants to assess the return average asset over the last three years 2015, 2016, and 2017. Based on financial statements, the value of assets over that last three year is 6,000K, 7000k, and 8,000K. CFO wants his accountant to calculate the average total assets for him.

Calculate the average total assets:

Based on the formula above, we can calculate the average total assets follow:

Average total assets = (6,000 + 7,000 + 8,000) / 3 = 7,000K

Based on the above calculation we can get average total assets equal to 7,000K. This figure could be used for calculating return on averages assets for the entity.

Return on average assets

Definition:

Return on average assets is the profitability ratios that used to assess the profitability that entity could earn or generate from the average of total assets for the period of time.

This ratio use entity’s net income for the period of time that analyst want to assess and then compare to average of total assets.

Return on average assets is not much different from return on assets. This ratio is good is good for investor if we could compare to competitor performance with the same size, others financial and non-financial data, budget, or assets forecasting.

Formula:

Return on average assets = Net income / Average of total assets

  • Net income is the net of profit that entity earn during the period. Normally this income reporting in the entity income statement. Net income that use for calculation usually after profit and tax.
  • Average total assets refer to the value of assets in average between the value of assets at the beginning of the period and the value of assets at the end of the period. This period must be consistent with period of net income above. For example, if net income is covered the period of three years, average of total assets should also cover the period of three years as well. That mean we should use the value of assets from the first year plus second year plus third year then average those total value.
  • The ratio is normally calculated as the percentage and to make sure that the interpretation is useful for users, others ratio, and related non-financial data should also consider.

Example:

For example, Acom is the bank and net income that the bank generate for the last three years is USD 3,000,000. The recorded total assets of the banks for three years are 5,000K, 5900K, and 7500K consistently.

The bank want to assets what is its return on average total assets for the accumulation of three years.

Calculation:

Based on scenario above we have,

  • Net income for three years 3,000K
  • Average of total assets = 6,133K

Based on the formula above, return on average assets = Net income / Average total assets

Then, Average total assets = 3,000/6,133 = 48%

The ratio seen to be high since it is almost 50% of net income that entity could generate from its total assets in average amount $6,133K.

However, to make sure if this perform really that good, we should compare the ratio again others banks at the same size. We should also assess what are the others factors that could lead this ratio become that high.

Advantages:

There certain advantages for users, investors, and managements use this ratio for performance assessment especially focus on efficiency of using and managing assets to add value to the entity at the maximum capacity.

This ratio is not only easy for calculation, but also help the users that do not have financial background to get better understanding the result.

All information that use for calculating this ratio is normally available in the entity financial statements.

For example, net income can be found in the income statement and total value of assets of each period could be found in balance sheet. This ratio is present as percentage is very easy for use to understand.

Disadvantages:

Even though there are number of advantages for users of financial statements to get benefit from return on average assets, this ratio also has number of disadvantages that the related stakeholders should understand and being aware of.

Here is the list:

  • Use financial data to calculate. Financial data can be manipulate by management team if they wish too. For example, depreciation rate might not reflect what it should be for certain assets.
  • Difficult to compare entity with different size. This ratio is recommend to compare with the competitor with the same size only.
  • Use net income to calculate which not more relevance to assets is.

4 Important points to increase return on assets

Overview:

Increasing or maintaining return on assets is one of the most important tasks that need to have serious attention from senior management of most of the big corporate companies.

This is because of this ratio interested by the majority of shareholders, prospective investors, the board of directors, management team themselves, as well as staff.

Yet, group of stakeholders who mostly concern about return on assets are shareholders.

These people want to know how efficiently the senior management of corporation manage their assets.

The higher ratio simply means the assets are well managed and low ratio means the resources do not use efficiency compare to the industry as well as competitors.

The following are the four critical points that management of the company should fix to get the return on assets high or increase to the target points:

Get the idea from Formula:

Return on Assets = Net Income / Total Assets

+ Net income is the net earning for the period of time that we want to assess ROA. We can get the figure from income statement.

+ Total Assets or average of total assets are the net present value of assets at the end of the period. We also can get this figure from balance sheet.

Based on the formula, there are two items that affect ROA ratio, Net income and Total Assets

Improve net income will increase the return on assets ratio, right? And the decrease in total assets will also affect the ratio.

1) Increase Net income to improve ROA:

There are many ways that an entity could increase its net income. For example, the entity could increase total sales for the period, then net income will increase accordingly.

Let sales if 1000K of sales contribute to 10K net income then increase sales ratio will also increase net income ratio and do so ROA.

The cost of goods is one of the most major costs that significantly affect net income. And keep the direct cost low is one of the most effective strategies that could improve gross profit margin as well as net income.

The entity might choice to increase the production volume to reduce direct cost of products.

Entity might also need to review the operating costs to make sure that cost are spending effectively.

For example, if the net profit ratio is 25%. 1$ save equal to 4$ sales. This explanation proves that keep operating costs low is as important as keeping sales increase.

Therefore, increasing net income is very important if the entity wants to increase ROA. And to increase net income, entity should strictly review sales, cost of sales, and operating cost.

2) Decrease Total Assets to improve ROA:

As we mention above, ROA is the ratio that assesses the efficiency of using assets. In others, it compares how much entity generates income from 1$ of assets compare to other entities or industry averages.

Now, let breakdown what does it mean by efficiency of using assets.

As you should know, assets are the balancing items in the balance sheet. Assets equal to equity plus liability. Accounting standards classify those assets into current and fixed assets for user benefit.

Now let breakdown those assets and analyst what does it mean by efficiency of assets.

3) Improve the efficiency of Current Assets:

Current assets consist of cash, receivable as well as inventories. The efficiency of using these assets could keep them low or let them generate additional income.

For example, an entity might make short term investments on cash to generate additional incomes. This will help ROA.

Receivables are also one of the most important current assets that an entity could manage to improve its ROA when they are low and short outstanding. Good credit policy and collection procedures could significantly help to improve this.

4) Improve the efficiency of Fixed Assets:

Expenses on fixed assets are not charged to income statements at the time they are purchased, but at times they are used based on the system basic.

Improve efficiency ratio on using fixed assets could help the company increase its productivity or in other words, reduce operating costs related to fixed assets.

Some companies consider operating lease rather than purchasing their own fixed assets. However, this approach might lead to higher operating costs.

Conclusion:

Improving return on assets is an important key performance indicator for the management team of most of the entities. And there are many ways that management could perform to make its ROA better.

Those include increase gross profit margin, net profit margin, as well as improve the efficiency of both current assets and fixed assets.

Why is return on assets importance?

Importance of return on assets:

Return on assets is the efficiency ratio that use to measure the company use its assets to generate income. This ratio is calculated by using the bottom line that entity generate during the period compare with the averages total assets.

There are many importance factors that why this ratio is so importance for company as well as its management. Here is the list of those:

Resources Efficiency Management

Return on Assets ratio is very importance for management to assess how well they are currently manage the entity resources compare to previous year performance, competitor, as well as industry averages. So this ratio help management to review their resource management when the ratio is going down or maintain current performance when the ratio going up especially when the entity ROA higher than industry averages.

Lower ratio indicate that entity did not generate enough income compare to industry or expected from the shareholders. This also indicate the weak performance by top management especially CFO.

Formula:

Return on assets = Net income/ Averages total assets

Return on assets is calculated by compare the net income of entity for the period of time to the averages total of assets. Net income refer to income that entity generate after interest and income. Net income could be found in the income statement.

Averages of total assets is the averages of total assets at the beginning and ending of the period that selected for assessment.