Fifer Co has a current ratio of 1.2:1 which is below the industry average. Fifer co wants to increase its current ratio by the year end
Which of the following actions taken before year end would lead to increase in current ratio
a) Return some inventory which had been purchased for cash and obtain a full refund on cost
b) Make a bulk purchase of inventory for cash to obtain a large discount
c) Make an early payment to suppliers even though the amount is not due
d) Offer early payment discounts in order to collect recievables more quickly
Correct ans is c but can you please explain me that why c is correct and why others are not correct?
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mcq on ratios
Hi,
This is a tricky one to explain on here but I'll give it a go.
A) This cannot be the answer as the inventory will reduce but the cash will increase by the same amount and hence no change to the ratio.
B) In a similar fashion to answer A, this adjustment will impact cash and inventory in an equal fashion. Inventory will go up and cash will go down, hence no change to the ratio.
C) Here is the correct answer. Imagine the payment made is 0.2. The current assets fall from 1.2 to 1.0, whilst the liabilities fall from 1.0 to 0.8. The ratio is now 1.0/0.8 = 1.25 and an increase in the ratio
D) Offering the discounts here will reduce the receivables and cash balance, so no impact on the ratio.
Hope that clears it up a bit.
Thanks
But sir here why the answer cannot be B, because let say bulk purchase of inventory is worth of 0.4 but we get large discount on it , due to which we will have to pay 0.2 cash , so in this way it will make 1.2 + 0.4 - 0.2 = 1.4. hence ratio is increased?
That isn't how we deal with a bulk discount. We pay cash of 0.2 and the inventory is recorded at 0.2.
Sir there is 1 confusion in option c and d.
In option d where it says that "Offer early payment discounts in order to collect recievables more quickly"
So here suppose receivables are 0.4 , and we offer discount of 0.2 , so here cash will increase by 0.2, discount allowed will increase by 0.2 and receiavbles will decrease by 0.4, right? Hence 1.2+0.2-1.4 = 1:1 hence the ratio has decreased. Right?
In the same way for option c where it says that " Make an early payment to suppliers even though the amount is not due"
So here suppose payables are 0.4 and due to early payment we get cash discount of 0.2, so here cash will decrease by 0.2, discount received will increase by 0.2 and payables will decrease by 0.4. Am I right here or wrong in this approach?
d) how do we know the customers are taking advantage of the prompt payment discount? We don't, so therefore we just look at the entry for making the sale.
c) follows on from what is said above. We are not told if they discounts are taken.
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