Question

A company has current assets of $200 (cash of $65 and inventory of $135) and current...

A company has current assets of $200 (cash of $65 and inventory of $135) and current liabilities of $120. At year end, management uses cash of $60 to repay accounts payable. After the repayment, what is the effect on the company's current ratio, and is liquidity better or worse?

A

The current ratio has increased by 0.67 and liquidity will appear worse.

B

The current ratio has increased by 0.67 and liquidity will appear better.

C

The current ratio has decreased by 0.5 and liquidity will appear worse.

D

None of the above.
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Answer #1

Correct Answer is A The current ratio has increased by 0.67 and liquidity will appear worse.

Current ratio before cash payment:

Current assets = $200

Current liabilities = $120

Current ratio = Current assets/ Current liabilities

= $200/$120 = 1.67

Current ratio after cash payment:

Current assets = $200 - $60 = $140

Current liabilities = $120 - $60 = $60

Current ratio = $140 / $60 = 2.34

Increase in current ratio = 2.34 - 1.67 = 0.67

Liquidity will appear worse because there is decrease of cash to pay accounts payable. Decrease in cash will reduce liquidity.

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