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Thatch plc’s current ratio this year is 1.33:1 compared to that of 1.25:1 last year. Which of the following would be possible explanations?
1 Thatch made an unusually large sale immediately prior to the year end.
2 Thatch paid its payables earlier than usual out of a bank overdraft.
3 Thatch made an unusually large purchase of goods for cash immediately prior to the year end and
these goods remain in inventory.
4 Thatch paid its payables earlier than usual out of a positive cash balance.Current ratio = Current assets/ Current liabilities
=> The correct choices in this question are the option in which “current assets” increase or “current liabilities” decrease from last year to current year.
Otherwise, I can give example for each options, can you help me giving 4 examples for 4 options above.
Thank you so muchhhI don’t know what sort of examples you want!!
1) If they make a big sale, then receivables (or cash) increase, and inventory decreases. However, since the sale will be at selling price and inventory will have been at cost, this would increase current assets overall (and therefore increase the current ratio).
2) If they pay payables earlier than usual, then payables will fall and overdraft will increase. Therefore the total current liabilities will not change, and so neither will the current ratio.
3) If they buy goods then inventory goes up and cash goes down by the same amount, so current assets stay the same, and therefore the current ratio does not change.
4) This is best explained with a made-up example. Suppose current liabilities are 1,000 and current liabilities are 1,250 (so current ratio = 1.25). Now suppose they pay 500 to payables out of cash. Current assets fall to 500 and current liabilities fall to 750. So current ratio goes to 0.67. So the current ratio falls (not increases). Try it with any numbers you want 🙂
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