Question

Question 1: Short answer 1. Indicate whether each of the actions listed below will immediately increase (1), decreas have no effect on the ratios shown. Assume each ratio is less than 10 before action is taken. 18 points] . Current Ratio = Current Assets / Current Liabilities Acid-test Ratio = Quick Assets / Current Liabilities Quick Assets = unrestricted cash + short-term investments + accounts receivable Action Current Ratio Acid-test Ratio A firm purchased inventory on account A firm received cash from a customer in advance of six months of service b.

Answer 1

Answer to Part a

Purchase of Inventory on account will increase Current Assets(Inventory) and also increase Current Liabilities (Accounts Payable).

Explanation through an example

Let us assume that the

Current Assets were $50,00 and

Current Liabilities were $80,000

Quick assets were $35,000 before action was taken so here

Current Ratio =Current Assets /Current Liabilities

Current Ratio = 50,000/80,000 =0.625 (which is less than 1 as per the requirement of question)

Acid Test Ratio = Quick Assets /Current Liabilities

Acid Test Ratio = 35,000/80,000 =0.4375 (which is less than 1 as per requirement of question)

Now assume that the firm purchases inventory on account of $5,000.

So now Current Assets = $50,000 + $5,000 = $55,000

Current Liabilities = $80,000 + $5,000 = $85,000

Quick Assets = $35,000 (They are not effected with increase in inventory)

Current Ratio = Current Assets /Current Liabilities

Current Ratio = 55,000/85,000 =0.647

Acid Test Ratio = Quick Assets /Current Liabilities

Acid Test Ratio = 35,000/85,000 =0.4117

So we can see that

Current Ratio increases if inventory is purchased on account if Current Ratio was less than 1 before action.

Acid Test Ratio decreases if inventory is purchased on account if Acid Test Ratio was less than 1 before action.

Answer to Part b

Receiving cash from a customer in advance of six months of service will increase Current Assets (Cash) and Current Liabilities ( Cash Advance)

Explanation through an example

Let us assume that

Current Assets were $50,000

Current Liabilities were $80,000

Quick Assets were $35,000 before the action was taken

Current Ratio =Current Assets /Current Liabilities

Current Ratio =50,000/80,000 = 0.625 ( which is less than 1 as per the requirement of the question)

Acid Test Ratio = Quick Assets / Current Liabilities R

Acid Test Ratio = 35,000/80,000 = 0.4375 (which is less than 1 as per the requirement of question

Let us assume that firm received $8,000 cash from customer in advance of six months of service

So Current Assets = $50,000 + $8,000 = $58,000

Current Liabilities = $80,000 +$8,000 = $88,000

Quick Assets = $35,000 + $8,000 = $43,000

Current Ratio =Current Assets /Current Liabilities

Current Ratio = 58,000/88,000 = 0.659

Acid Test Ratio = Quick Assets /Current Liabilities

Acid Test Ratio =43,000/88,000 = 0.488

So we can see that

Current Ratio increases if cash in advance is received from customer if Current Ratio was less than 1 before action.

Acid Test Ratio increases if cash in advance is received from customer if Acid Test Ratio was less than 1 before action.

Action	Current Ratio	Acid Test Ratio
a. A firm purchased inventory on account.	Increases	Decreases
b. A firm received cash from customer in advance of six months of service	Increases	Increases