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Hello,
I come across the following question: Magenta Ltd has a current ratio of 1.5, a quick ratio of 0.4 and a positive cash balance. If it purchases inventory on credit, what is the effect on these ratios? The answer says they will BOTH DECREASE because “the value of inventory will add proportionally more to liabilities and so reduce the current ratio. The effect on quick ratio will be even greater..”
I don’t get why the value of inventory will add more to liabilities? Doesn’t it add equally to liabilities and assets? Please advise. Thank you!Hi,
It is a tricky one as it does add equal amounts to the assets and liabilities, but the answer is correct.
If we look at the 1.5 as being assets of 3 and liabilities of 2, then by buying say 1 of inventory the assets increase to 4 and the liabilities to 3. We now have 4/3 or 1.33 as the current ratio, so a decrease in the ratio.
Hope that clears it up.
Thanks
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