Assuming an initial current ratio greater than one, a company’s current ratio will increase if it: A) buys fixed assets on credit. B) pays off accounts payable from cash. C) buys inventory on account. D) sells marketable securities for cash. Your answer: D was incorrect. The correct answer was B) pays off accounts payable from cash. 1. Inventory up and Accounts payable up. Since the ratio started off above 1 the ratio will fall. 2. Sell MS for cash. No affect on CA so CR is unaffected. 3. Cash down and Acc payable down the same amount. Since initial ratio is above 1 ratio will go up. 4. Buying fixed assets does not affect CA, increases CL. CR falls. Why is D not the correct answer? Isn’t cash a part of current asset and, if u sell MS for cash, cash goes up and so will current asset, correct?
because marketable securities are part of current assets. what that would do is replace one item of current assets with another one so the ratio would remain the same. for A and C the ratio would go down B is correct answer
For Option B ------------------- CR = CA/CL just take simple numbers to visualize what’s happening… For Example, CR > 1 (given) CR = 100/80 Now suppose you took 20$ cash (Asset decrease) and decreased you Account Payables (Liability decreases) CR1 = 100-20/80-20 = 80/60 CR was 1.25 and by doing stepB you effectively increased it to 1.33 For Option D ------------------- you are redusing Marketible secruties (Assets) by say 20$ and getting a cash of 20$ … so effectively there is no change in the Numerator… and hence this is not the correct answer Hope I clarified, rather than confuse you any further? - Dinesh S
answer is b)
just think of the accounting entries to each choice… D debits cash, credits marketable securities, so total current assets dont change…
As Dinesh mentioned above, examples are the best way to tackle these questions.
B) pays off accounts payable from cash. i do exact same thing dinesh does… i always start these types of problems with a base ratio and work off of it. for example, set CA / CL = 10/5 = 2. then just run through the scenarios mathmatically to see what happens. A) buys fixed assets on credit. CA = no change / CL = increase. 10/6 = 1.67. B) pays off accounts payable from cash. CA = decrease / CL = decrease. 9/4 = 2.25 C) buys inventory on account. CA = increase / CL = increase = 11/6 = 1.83 D) sells marketable securities for cash. no impact to current ratio since you offset current assets.
oh, MS is classified as current asset? That makes sense, because ur holding shares of other company and their considered an asset. Gotcha thx all.
CA = C + MS + AR + I