Textbook Problem

What are some pros and cons of holding high levels of current assets in relation to sales? Use the DuPont equation to help explain your answer.

Summary Introduction

To explain: The pros and cons related to keep high current assets in reference to sales.

Introduction:

DuPont Analysis:

Under DuPont analysis the return on equity can be calculated as a product of profit margin, total assets turnover and equity multiplier.

Current Assets:

Any asset which can be reported in the form of cash within duration of 1 financial year is classified as current assets.

Return on Equity (ROE):

Return on equity represents the amount of return earned by equity shareholders; it can be calculated by dividing earnings available for equity shareholders to total equity capital.

Explanation of Solution

Pros:

The excess availability of current assets will report an increase in the balance of accounts receivable due to relaxed credit policy. This will increase the sales and earnings of the company.

Cons:

The high balance of current assets will result in a lower assets turnover ratio, which will indicate low efficiency of the company in relevance to sales generation.

As per DuPont equation:

Formula to calculate return on equity (ROE),

$\text{Return on equity}=\left(\begin{array}{l}\text{Profit margin on sales}\times \text{Total}\text{assets}\text{turnover}\text{ratio}\\ \times \text{Equity}\text{multiplier}\end{array}\right)$

Conclusion

Hence, the situation related to high level of current assets has advantages and disadvantages.