Question

P 6-24 Required Answer the following multiple-choice questions: a. A company's current ratio is 2.2 to 1 and quick (acid-test) ratio is 1.0 to 1 at the beginning of the year. At the end of the year, the company has a current ratio of 2.5 to 1 and a quick ratio of 0.8 to 1. Which of the following could help explain the divergence in the ratios from the beginning to the end of the year? (continued

Answer 1

(A) The correct answer is (1). "An increase in inventory levels during the year"

There has been an increase in current ratio and a simultaneous decrease in quick ratio. Quick ratio does not include inventory. Hence, the only reasonable explanation is that the inventory levels have risen during the year.

Option (2) and (4) will have no impact on current and quick ratio, as they would lead to a similar increase and decrease in accounts receivable and cash balance. Hence, the net impact on the ratios would be NIL. Option (3) would increase the net liabilities, thus decreasing the current and quick ratio. While option (5) would reduce the current assets, thus decreasing the ratios.

(B) The correct answer is (4) "Decrease the current ratio and increase inventory turnover"

Closing stock will be lower under LIFO in a period of rising prices. Lower closing stock i.e lower current assets and hence a lower current ratio. Simultaneously, there will be a higher inventory turnover ratio. The reason being that the Cost of Goods sold (Opening stock + Purchase - Closing Stock) will be higher

[Inventory turnover ratio = COGS/ Average Inventory]

[Current ratio = Current assets/ Current liabilities]

(C) The correct answer is (3). i.e. 1.67

Inventory turnover = Cost of sales/ Average Inventory

= $500,000/ $300,000*

= 1.67

*Calculation of Average Inventory

Current Liabilities = $600,000

Current ratio = 3

Thus, Current assets = 600,000 * 3 = $1,800,000

Now, Acid test ratio [(Current assets - Inventory)/ Current liabilities] = 2.50

Thus, [(1,800,000 - Inventory)/ 600,000 = 2.50

Solving for Inventory, we get Inventory = $300,000

(D) The correct answer is (2), "The firm has a large investment in inventory"

A company has a high current ratio and a simultaneous low quick ratio. Quick ratio does not include inventory. Hence, the only reasonable explanation is that the inventory levels have risen during the year.

Refer ques (A), solved above, for more understanding.

Answer 2

An increase in inventory levels during the current year