Question

Company A has a current ratio of 2.0 and its quick ratio is 1.6. The company has $5 million in current liabilities. The company’s inventory turnover ratio is 5. The company wants to improve its inventory turnover ratio so that it is equal to the industry average of 6.2, without changing its sales. Assume that the company can do this, and that the company uses the freed-up cash from the decline in inventory to reduce its accounts payable. What would be the company’s quick ratio after this change?

Answer 1

Current Ratio = 2 CA/CL = 2 CA = 2CL,  

Quick Ratio = 1.60 (CA - Inventory) / CL = 1.60 ;   CA - Inventory = 1.60 CL: 2CL - Inventory = 1.60 CL Inventory = 0.40 CL

Inventory Turnover Ratio = Sales/Inventory. Let us assume Sales = 100, Inventory = 100/5 = 20

Thus CL = 20/0.4 = 50

CA = 2 * CL = 2*50 = 100,

Other CA = 100 - 20 = 80

To increase Inventory Turnover Ratio to 6.2, Inventory should be = 100/6.20 = 16.13, thus decrease in Inventory = 20 - 16.13 = 3.87. This money will be used to reduce bills payable.

So new current liab = 50 - 3.87 = 46.13.

Current Assets (other than Inventory) = 80

Thus Quick Ratio new = new CA except inventory / Current Liab = 80/46.13 = 1.73.

Thus the quick ratio will increase to 1.73 times.