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2Theeffects on both profitability and risk of an increase or decrease in this ratio aresummarized in the upper portion of Table 14.1. When the ratio increases—thatis, when current assets increase—profitability decreases. Why? Because currentassets are less profitable than fixed assets. Fixed assets are more profitablebecause they add more value to the product than that provided by current assets.Without fixed assets, the firm could not produce the product.The risk effect, however, decreases as the ratio of current assets to total assetsincreases. The increase in current assets increases net working capital, therebyreducing the risk of technical insolvency. In addition, as you go down the assetside of the balance sheet, the risk associated with the assets increases: Investmentin cash and marketable securities is less risky than investment in accounts receiv-able, inventories, and fixed assets. Accounts receivable investment is less riskythan investment in inventories and fixed assets. Investment in inventories is lessrisky than investment in fixed assets. The nearer an asset is to cash, the less risky
600PART 5Short-Term Financial DecisionsTABLE 14.1Effects of Changing Ratioson Profits and RiskChange Effect Effect Ratioin ratioon profiton riskIncreaseDecreaseDecreaseDecreaseIncreaseIncreaseIncreaseIncreaseIncreaseDecreaseDecreaseDecreaseCurrent liabilitiesTotal assetsCurrent assetsTotal assetsit is. The opposite effects on profit and risk result from a decrease in the ratio ofcurrent assets to total assets.Changes in Current Liabilities