Question

General Hospital has a current ratio of 0.5. Which of the following actions would im- prove (increase) this ratio? (Hint: Create a simple balance sheet that has acurrent ratio of 0.5. Then, judge how the transactions below would affect the balance sheet.)
1. Use cash to pay off current liabilities. 2. Collect some of the current accounts receivable. 3. Use cash to pay off some long-term debt. 4. Purchase additionalinventory on credit (i.e., accounts payable). 5. Sell some of the existing inventory at cost (book valu

Answer 1

The answer is: #4. Purchase inventory on credit.
Current ratio = current assets/current liabilities. You need transactions that increase current assets and/or decrease current liabilities.
Suppose your current ratio is 0.5 because current assets = 100 and current liabilities = 200.
1. Use cash to pay off current liabilities. - If $50 cash was used to pay off $50 in current liabilities, then current ratio would equal 50/150 = 0.33.This does not improve the current ratio.
2. Collect some of the current accounts receivable. These accounts are both current assets, so there would be no effect of current ratio.
3. Use cash to pay off some long-term debt. This would decrease current assets and have no effect on current liabilities because long-term debt is notcurrent. Decreasing current assets will decrease the current ratio.
4. Purchase additional inventory on credit (i.e., accounts payable). This will increase current assets and increase current liabilities. Suppose they areboth increased by $50. Then current ratio will be 150/250 = 0.6. So this would increase the current ratio.
5. Sell some of the existing inventory at cost (book value). These accounts are both current assets, and so this transaction would have no effect on thecurrent ratio.