Question

If a company buys equipment with cash, what will happen to the following ratios?

a. ROA

b. Quick

c. Debt

thanks

Answer 1

When a company buys equipment with cash, then it will increase the assets on one hand as equipment will be added to it and similarly it will decrease the assets also, as cash will be decreased since cash is being paid out. So, total assets will be same after this transaction.The effect of this transaction on the given ratios is below:

(a) Return on assets (ROA): ROA can be calculated by :

ROA = Net income / Total assets

When when equipment will be purchased on cash, then there will be no effect on numerator for ROA as net income will not be affected (as long as depreciation is not charged on the equipment). Total assets will also be not affected as same amount is increased and decreased from total asset. So, denominator will also be same in the above formula. So, overall effect is there is no change in ROA.

(b) Quick ratio:Quick ratio can be calculated by :

Quick ratio = (Current assets - Inventories - Prepaid expenses) / Current liabilities

When equipment will be purchased on cash, then there will be a decrease in numerator in the above formula as cash will be decreased from the current assets. Current liabilities will not be affected, So, denominator will remain same in the above formula. When numerator decreases and denominator remains the same, then overall effect will be the decrease in the quick ratio.

(c) Debt ratio: Debt ratio can be calculated by :

Debt ratio = Total liabilities / Total assets

When when equipment will be purchased on cash, then there will be no effect on numerator for debt ratio as total liabilities will not be affected (since equipment purchase will be on cash, so no liabilities will be there for this transaction). Total assets will also be not affected as same amount is increased and decreased from total asset. So, denominator will also be same in the above formula. So, overall effect is there is no change in Debt ratio.