Increasing current ratio question

What actions taken by company management will increase the current ratio? a. Making cash payment on accounts payable when the current ratio was below 1.0x before the payment. b. Accruing direct labor costs when the current ratio was below 1.0x prior to the accrual. c. Entering into a long-term capital lease for equipment to be used in the inventory production facility when the current ratio was above 1.0x prior to entering the lease. d. Using a revolving credit facility rather than cash to pay a portion of long-term debt when the current ratio was above 1.0x prior to the restructuring. Just happened to be an interesting question. I agree with the answer. Dreary

I’d say D- is the correct answer: A- means that the percentage decrease in assets will be greater than the percentage decrease in liabilities (since the ratio is less than 1.0), so the ratio will be lower B- means that current liabilites are higher (by the amount of costs payable), hence ratio is lower C- has no effect on current ratio since it’s the long term assets and liabilities that are affected D- means current liabilities (the current portion of long term debt ) will be decreased without affecting the assets, hence the ratio will increase. Am i correct?

for part c – there would be the current portion of the LT Liabilities - which would go into the current liability – wouldn’t it and thus increase the CL – there fore reduce Current Ratio? CP

Couldn’t differenciate between C and D, Since both are long-term debts and would be having some current portion of the long-term debts in their current liabilities. But for D, we are paying for debt using credit (so the cash still stays with us). So I’ll go with answer ‘D’ - Dinesh S

I think you’re right CP, your analysis for answer C seems accurate… Dinesh, i’m not sure if revolving credit implies current liabilities since usually the only obligation on the short term (fore revolving credit products such as a credit line) is the interest payment, so all of the debt amount is classified as long-term (you can pay it anytime in the future as long as you respect the periodic interest payments) if i’m not mistaken… I’m not a 100% sure, but that’s what i believe is true…in cases like that, since i certainly eliminated the first 3 answer choices, I would select D even if i couldn’t explain it fully! (the beauty of multiple choice)

yup D seems like the only logical choice. What’s the answer Dreary?

My guess is B. If they pay labor costs, the current ratio would be lower since it reduces both CA, and CL by the same amount.

That’s correct, the answer is B. The trick is that labor costs increase both inventory and current liabilitiy. Dreary

That means incurring labor costs translate into having more inventories?

could someone explain what a revolving credit line is exactly? - Dinesh S

Direct labor cost is part of inventory cost. The cost of a product goes through stages from material cost to unfinished components to the final finished goods, and all the way there is a direct labor cost to each item produced. Dreary

Revolving line of credit is like a credit card, you keep on borrowing and making payments all the time… Dreary

Dreary I got ur point on direct labor cost, but what about option D, if we use cash to pay then again wont the CA reduce and the ratio too. Also it says to pay a “portion of long term debt”, now if we were paying short term debt then the effect would be nullified, but since it is long term debt it wont have an effect? Secondly, does above 1.0x or below 1.0x in the question have something to do??? shweta

Thanks Dreary for the explaination on Revolving-Credit, but I still can’t discern, why D should not be the answer? - Dinesh S

skashyap, if you use a revolving credit facility rather than cash to pay a portion of long-term debt when the current ratio was above 1.0x prior to the restructuring, then your current liabilities will go up, while CA unchanged, so that won’t increase the CR. Yes, above 1 and below 1 make a big difference. Try this: 1) CR = 200/100 = 2. If you add 100 to both, you get CR = 1.5 (it went down). 2) CR = 100/200 = 1/2. If you add 100 to both, you get CR = 0.67 (it went up). Dreary

Thanks Dreary for explaining direct labor cost. Now I got it. Dinesh, my guess is that increasing current ratio means having more Current Assets relative to Current Liabilities. Option D talks about paying off Long-Term Debt (which is not included in Current ratio formula). So, it is out. Correct me, if I am wrong.