Question

What happens to a firm’s current ratio if the firm repays $100 in AP with $100 in cash? Assume the current ratio is currently less than 1.、

Answer 1

Current ratio is given by:

Current ratio = Current assets / Current liabilities

When a firm's current ratio is less than 1, it means that its current assets are less than its current liabilities.

Suppose earlier current assets were $200 and current liabilities were $400, then its earlier current ratio was:

Current ratio = $200 / $400 = 0.5

Now, when AP of $100 were repaid by cash, then it will reduce current assets and current liabilities by $100. So,

New current assets = $200 - $100 = $100

New current liabilities = $400 - $100 = $300

New current ratio = $100 / $300 = 0.33

So, by paying $100 AP, current ratio will further reduce.