DETERMINING THE RATIO OF CURRENT ASSETS TO SALES

There is an inevitable relationship, between the sales and the current assets.  The actual and the forecasted sales have a major impact on the amount of current assets which the firm must maintain.  So, depending upon the sale forecast, the financial manager should also estimate the requirement of current assets.  However, as the sales forecast cannot be certain, so is the case with the forecast of current assets also?  This uncertainty may also result in spontaneous increase in current assets in line with the increase in sales level, and may bring the firm to face tight working capital position.  In order to overcome this uncertainty, the financial manager may establish a minimum level as well as a safety component for each of the current assets for different levels of sales.  But how much should be this safety component?   It may be noted that in fact, this safety component determines the type of working capital policy a firm is pursuing.  There are three types of working capital policies which a firm may adopt i.e., moderate working capital policy, conservative working capital policy and aggressive working capital policy.  These policies describe the relationship between sales level and the level of current assets. 

In case of moderate working capital policy, the increase in sales level will be coupled with proportionate increase in level of current assets also e.g., if the sales increase or are expected to increase by 10%, then the level of current assets will also be increased by 10%. 

In case of conservative working capital policy, the firm does not like to take risk.  For every increase in sales, the level of current assets will be increased more than proportionately.  Such a policy tends to reduce the risk of shortage of working capital by increasing the safety component of current assets.  The conservative working capital policy also reduces the risk of nonpayment to liabilities.

On the other hand, a firm is said to have adopted an aggressive working capital policy if the increase in sales does not result in proportionate increase in current assets.  For example, for 10% increase in sales the level of current assets is increased by 7% only.  This type of aggressive policy has many implications.  First, the risk of insolvency of the firm increases as the firm maintains lower liquidity.  Second, the firm is exposed to greater risk as it may not be able to face unexpected change in market and, third, reduced investment in current assets will result in increase in profitability of the firm.

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