Chapter 3, Problem 1CTCR

Current Ratio. What effect would the following actions have on a firm’s current ratio? Assume that net working capital is positive.

a.    Inventory is purchased.

b.    A supplier is paid.

c.    A short-term bank loan is repaid.

d.    A long-term debt is paid off early.

e.    A customer pays off a credit account.

f.    Inventory is sold at cost.

g.    Inventory is sold for a profit.

Summary Introduction

To discuss: The effect of certain actions on a firm’s current ratios. The net working capital is assumed positive.

Introduction:

The process of analyzing and calculating financial ratios in order to evaluate the firm’s performance and to find actions that are necessary to improve the firm’s performance is ratio analysis

Explanation of Solution

The effects that certain actions have on the firm’s current ratio:

Purchase of inventory:

The current ratio has no change if the inventory is purchased with cash. If the purchase of inventory is on credit, then the current ratio decreases if it was initially greater than one.

Conclusion

The current ratio comes under the liquidity ratio. The liquidity ratio focuses on the ability of the firm to pay back short-term debt obligations. To measure this ability, the current ratio takes the current total assets and the current total liabilities of the company.

Summary Introduction

To discuss: The effect of certain actions on a firm’s current ratios. The net working capital is assumed positive.

Introduction:

The process of analyzing and calculating financial ratios in order to evaluate the firm’s performance and to find actions that are necessary to improve the firm’s performance is ratio analysis

Explanation of Solution

The effects that certain actions have on the firm’s current ratio:

Payment made to a supplier:

The current ratio increases by decreasing the accounts that have to be paid by cash if it was initially greater than one.

Conclusion

The current ratio comes under the liquidity ratio. The liquidity ratio focuses on the ability of the firm to pay back short-term debt obligations. To measure this ability, the current ratio takes the current total assets and the current total liabilities of the company.

Summary Introduction

To discuss: The effect of certain actions on a firm’s current ratios. The net working capital is assumed positive.

Introduction:

The process of analyzing and calculating financial ratios in order to evaluate the firm’s performance and to find actions that are necessary to improve the firm’s performance is ratio analysis

Explanation of Solution

The effects that certain actions have on the firm’s current ratio:

Repayment of the short-term bank loan:

Decreasing short-term debt with cash tends to increase the current ratio, if it was initially greater than one.

Conclusion

The current ratio comes under the liquidity ratio. The liquidity ratio focuses on the ability of the firm to pay back short-term debt obligations. To measure this ability, the current ratio takes the current total assets and the current total liabilities of the company.

Summary Introduction

To discuss: The effect of certain actions on a firm’s current ratios. The net working capital is assumed positive.

Introduction:

The process of analyzing and calculating financial ratios in order to evaluate the firm’s performance and to find actions that are necessary to improve the firm’s performance is ratio analysis

Explanation of Solution

The effects that certain actions have on the firm’s current ratio:

Early payment of the long-term debt:

As long-term debt matures, the remaining interest expenses and the principal amount that has to be repaid become current liabilities. Thus, the current ratio increases if the debt is paid off by cash and the current ratio at that time must be initially greater than one.

Conclusion

The current ratio comes under the liquidity ratio. The liquidity ratio focuses on the ability of the firm to pay back short-term debt obligations. To measure this ability, the current ratio takes the current total assets and the current total liabilities of the company.

Summary Introduction

To discuss: The effect of certain actions on a firm’s current ratios. The net working capital is assumed positive.

Introduction:

The process of analyzing and calculating financial ratios in order to evaluate the firm’s performance and to find actions that are necessary to improve the firm’s performance is ratio analysis

Explanation of Solution

The effects that certain actions have on the firm’s current ratio:

A customer is paying off a credit account:

The current ratio remains unchanged when there is a increase in receiving the cash and there is a reduction in the accounts receivables.

Conclusion

The current ratio comes under the liquidity ratio. The liquidity ratio focuses on the ability of the firm to pay back short-term debt obligations. To measure this ability, the current ratio takes the current total assets and the current total liabilities of the company.

Summary Introduction

To discuss: The effect of certain actions on a firm’s current ratios. The net working capital is assumed positive.

Introduction:

The process of analyzing and calculating financial ratios in order to evaluate the firm’s performance and to find actions that are necessary to improve the firm’s performance is ratio analysis

Explanation of Solution

The effects that certain actions have on the firm’s current ratio:

Selling of inventory at cost:

The selling of inventory at cost decreases the inventory and increases the cash, thus there is no change in the current ratio.

Conclusion

The current ratio comes under the liquidity ratio. The liquidity ratio focuses on the ability of the firm to pay back short-term debt obligations. To measure this ability, the current ratio takes the current total assets and the current total liabilities of the company.

Summary Introduction

To discuss: The effect of certain actions on a firm’s current ratios. The net working capital is assumed positive.

Introduction:

The process of analyzing and calculating financial ratios in order to evaluate the firm’s performance and to find actions that are necessary to improve the firm’s performance is ratio analysis

Explanation of Solution

The effects that certain actions have on the firm’s current ratio:

Selling of inventory for profit:

The current ratio increases when the inventory is sold for profit. This is because the selling of inventory for profit increases excess cash in the inventory that is recorded at cost.

Conclusion

The current ratio comes under the liquidity ratio. The liquidity ratio focuses on the ability of the firm to pay back short-term debt obligations. To measure this ability, the current ratio takes the current total assets and the current total liabilities of the company.