| Discussion Question: | |||||||||
| Current ratio is an important tool in the financial analysis toolkit. This tool is aimed to determine short term liquidity position of any business entity. It helps to determine an entity’s ability to pay its short term obligations. To compute this ratio, current assets are divided by current liabilities. Ideally, a ratio of 2 is considered appropriate for a manufacturing entity. Current ratio below one indicates that the entity has negative working capital which means the entity’s long term assets have been financed through some portion of short term debt.
Assume that Net Working Capital is positive for a business entity and its current ratio is 1.2 times. How would the following events affect (increase/decrease/no effect) the current ratio of the company. Also provide the conceptual reason behind each effect.
1. Inventory is purchased on credit. 2. Repayment of last installment of a long term loan. 3. A credit customer pays off on a discount of 3%. 4. Improvement in current assets through new equity issue.
Your comments should be in the following format:
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Correct Answers with Explanation:
| Event | Effect | Reason |
| Inventory is purchased on credit. | Decreased | Because liabilities increases due to inventory purchased on credit. That is why liquidity ratio decreases. |
| Repayment of last installment of a long-term loan. | No effect | Because current ratio only deals with the short term loans or obligations |
| A credit customer pays off on a discount of 3%.
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Increase | Because current asset increase for a while and current liabilities stays the same. |
| Improvement in current assets through new equity issue. | Increase | Because currents asstes are not increase through taking long, these are increase through shareholders equity |