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Hi John,
Would you please be able to help me with the following question?
“A company 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?”
A: Current Ratio Decreases & Quick Ratio Decreases
B: Current Ratio Decreases & Quick Ratio Increases
C: Current Ratio Increases & Quick Ratio Decreases
D: Current Ratio Increases & Quick Ratio IncreasesThe answer in my exam kit is A and I don’t understand why. The exam kit says:
“The value of the inventory will be added to both current assets and current liabilities. It will add proportionately more to liabilities and so reduce the current ratio. The effect on the quick ratio will be even greater as inventory is excluded from assets.”
Ok so this is how I’ve looked at it…
Let’s say the inventory was bought for $100.
Current Ratio = Current Assets / Current Liabilities.
DR Inventory (Current Asset) $100
CR Payables (Current Liability) $100Should it not then be that this ratio doesn’t change, because they both move in the same proportion?
Many thanks for your help!
Andrew
They are both moving by the same amount, but not by the same proportion!
Suppose at the moment current assets are 150 and current liabilities are 100 (so a current ratio of 1.5)
Suppose the then buy more inventory for 50.Current assets become 200, and current liabilities become 150. The current ratio is now 200/150 = 1.33 🙂
@johnmoffat said:
They are both moving by the same amount, but not by the same proportion!Suppose at the moment current assets are 150 and current liabilities are 100 (so a current ratio of 1.5)
Suppose the then buy more inventory for 50.Current assets become 200, and current liabilities become 150. The current ratio is now 200/150 = 1.33 🙂
this s great answer.
Andrew if you wanna learn more about Financial Ratio Analysis you can contact me.
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