Current liabilities would not be affected so the

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Unformatted text preview: eeds and an increase in long-term debt. Current liabilities would not be affected, so the current ratio would rise. Finally, note that an apparently low current ratio may not be a bad sign for a company with a large reserve of untapped borrowing power. EXAMPLE 3.1 Current Events Suppose a firm were to pay off some of its suppliers and short-term creditors. What would happen to the current ratio? Suppose a firm buys some inventory. What happens in this case? What happens if a firm sells some merchandise? (continued ) CHAPTER 3 Financial Statements Analysis and Long-Term Planning 49 ros82361_ch03.indd ros82361_ch03.indd 49 5/27/08 10:14:58 AM Confirming Pages The first case is a trick question. What happens is that the current ratio moves away from 1. If it is greater than 1 (the usual case), it will get bigger, but if it is less than 1, it will get smaller. To see this, suppose the firm has $4 in current assets and $2 in current liabilities for a current ratio of 2. If we use $1 in cash to reduce current liabilities, then the new current ratio is ($4 − 1)/($2 − 1) 3. If we reverse the original situation to $2 in current assets and $4 in current liabilities, then the change will cause the current ratio to fall to 1/3 from 1/2. The second case is not quite as tricky. Nothing happens to the current ratio because cash goes down while inventory goes up—total current assets are unaffected. In the third case, the current ratio would usually rise because inventory is normally shown at cost and the sale would normally be at something greater than cost (the difference is the markup). The increase in either cash or receivables is therefore greater than the decrease in inventory. This increases current assets, and the current ratio rises. QUICK (OR ACID-TEST) RATIO Inventory is often the least liquid current asset. It’s also the one for which the book values are least reliable as measures of market value since the quality of the inventory isn’t considered. Some of the inventory may later turn out to be damaged, obsolete, or lost. More to the point, relatively large inventories are often a sign of short-term trouble. The firm may have overestimated sales and overbought or overproduced as a result. In this case, the firm may have a substantial portion of its liquidity tied up in slow-moving inventory. To further evaluate liquidity, the quick, or acid-test, ratio is computed just like the current ratio, except inventory is omitted: Quick ratio Current assets Inventory _____________________________ Current liabilities [3.2] Notice that using cash to buy inventory does not affect the current ratio, but it reduces the quick ratio. Again, the idea is that inventory is relatively illiquid compared to cash. For Prufrock, this ratio in 2008 was: Quick ratio $____________ 422 _ 708 $540 .53 times The quick ratio here tells a somewhat different story than the current ratio, because inventory accounts for more than half of Prufrock’s current assets. To exaggerate the point, if this inventory consisted of, say, unsold nuclear power pla...
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This note was uploaded on 10/28/2009 for the course FINA 505 taught by Professor Deborahcernauskas during the Summer '09 term at Northern Illinois University.

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