Effect of an Increase In the Ratio
One effect of an increase in the ratio of current liabilities total assets would be that profitability will increase. The reason for the increased profitability lies in the fact that current liabilities, which are a short term source of finance, will increase whereas the long term sources of finance will be reduced. As short term sources of firm are less expensive than long run sources, increase in the ratio will, in effect, mean substitution less expensive sources for more expensive sources of financing. There will, therefore, be decline in cost and a corresponding rise in profitability.
The increased ratio will also increase the risk. Any increase in the current liabilities, assets no change in current assets, would adversely affect the NWC. A decrease in NWC leads to increase in risk. Thus, as the current liabilities total assets ratio increases, profitability increases, so does risk.
Effect of a Decrease In the Ratio
The consequences of a decrease in the ratio are exactly opposition to the results of an increase. That is, it will lead to a decrease in profitability as well as risk use of more long-term funds which, by definition, are more expensive will increase the cost; implication, profits will also decline. Similarly, risk will decrease because of the lower level current liabilities on the assumption that current assets remain unchanged.
Effect of Changes in Current Liabilities of Hypothetical Ltd