Question 3.1: Suppose a firm pays off some of its suppliers and short-term...
Suppose a firm pays off some of its suppliers and short-term creditors. What happens to the current ratio? Suppose a firm buys some inventory. What happens in this case? What happens if a firm sells some merchandise?
The first case is a trick question. What happens is that the current ratio moves away from 1. If it is greater than 1 (the usual case), it will get bigger, but if it is less than 1, it will get smaller. To see this, suppose the firm has $4 in current assets and $2 in current liabilities for a current ratio of 2. If we use $1 in cash to reduce current liabilities, then the new current ratio is ($4 – 1)/($2 – 1) = 3. If we reverse the original situation to $2 in current assets and $4 in current liabilities, then the change will cause the current ratio to fall to 1/3 from 1/2.
The second case is not quite as tricky. Nothing happens to the current ratio because cash goes down while inventory goes up—total current assets are unaffected.
In the third case, the current ratio will usually rise because inventory is normally shown at cost and the sale will normally be at something greater than cost (the difference is the markup). The increase in either cash or receivables is therefore greater than the decrease in inventory. This increases current assets, and the current ratio rises.