Chapter 2, Problem 2.1C

What is the relationship between current assets and current liabilities in a healthy firm?

Summary Introduction

To discuss: The relationship between current assets and current liabilities in a healthy company.

Introduction:

Current assets refer to the assets that the company can convert into cash within a period of one year. Inventory, accounts receivable, and cash are some of the examples of current assets.

Current liabilities refer to the liabilities that the company can pay off within a period of one year. Accounts payable, notes payable are some of the examples of current liabilities.

Explanation of Solution

In a healthy firm the relationship between the current assets and current liabilities should be 2:1. In other words, the ratio of current assets to current liabilities should be 2:1. The company should have twice the amount of current liabilities in current assets in order to avoid financial distress. The relationship between the current assets and current liabilities also indicates the liquidity of the firm.

Conclusion

A healthy firm should hold twice the amount of current liabilities in current assets.