How would affect (increase/decrease/no effect) the current ratio

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
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:

Event Effect Reason
Example:

Inventory is purchased on cash.

 

No effect

The cash will be reduced by the same amount of inventory.
Inventory is purchased on credit. ?? ??

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%.

 

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

 

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