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A company has current assets of $1·8m, including inventory of $0·5m, and current liabilities of $1·0m.
What would be the effect on the value of the current and acid test ratios if the company bought more raw material inventory on three months’ credit?
Current ratio Acid test
A Increase Increase
B Decrease Increase
C Increase Decrease
D Decrease DecreaseThe correct answer is D, both ratios will decrease.
The opening current ratio (current assets /current liabilities) is $1.8m/$1.0m = 1.8, and the opening acid test (current assets less stock/ current liabilities) is $1.3m/$1.0m =1.3.The answer continued with this:
Purchasing (say) $1.0m of inventory on short term credit will decrease the current ratio to ($1.8m + $1m)/ ($1.0m+ $1.0m) = 1.4. The acid test would also decrease to $1.8m/ ($1.0m+ $1.0m) = 0.9.I do not understand this last paragraph sir. Why we calculate Current assets for both current ratio and quick acid test ratio that way? Why the new current assets become $1.8m + $1m for current ratio and why the quick ratio suddenly becomes $1.8m? Shouldn’t the quick ratio be Current assets of $1.3m?
The old and new current ratios are correct – current assets include inventory and so buying more inventory for $1M will increase the current assets by $1.0M
The quick ratio does not include inventory in current assets, and so assuming that you have copied out the question correctly, the answer is wrong and you are right. Both the old and the new quick ratio would have current assets as $1.3M.
Thank you so much sir, this was the answer from ACCA’S FMA Examiner report December 2011 in the ACCA website. In BPP along with the ACCA website all have written this answer so I am confused why all use $1.8m as part of the new quick ratio. Is it because of any financial accounting terms I am not aware of?
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