Answers to Concepts Review and Critical Thinking Questions
If inventory is purchased with cash, then there is no change in the current ratio. If inventory is
purchased on credit, then there is a decrease in the current ratio if it was initially greater than 1.0.
Reducing accounts payable with cash increases the current ratio if it was initially greater than 1.0.
Reducing short-term debt with cash increases the current ratio if it was initially greater than 1.0.
As long-term debt approaches maturity, the principal repayment and the remaining interest
expense become current liabilities. Thus, if debt is paid off with cash, the current ratio increases
if it was initially greater than 1.0. If the debt has not yet become a current liability, then paying it
off will reduce the current ratio since current liabilities are not affected.
Reduction of accounts receivables and an increase in cash leaves the current ratio unchanged.
Inventory sold at cost reduces inventory and raises cash, so the current ratio is unchanged.
Inventory sold for a profit raises cash in excess of the inventory recorded at cost, so the
current ratio increases.
The firm has increased inventory relative to other current assets; therefore, assuming current liability
levels remain unchanged, liquidity has potentially decreased.
A current ratio of 0.50 means that the firm has twice as much in current liabilities as it does in current
assets; the firm potentially has poor liquidity. If pressed by its short-term creditors and suppliers for
immediate payment, the firm might have a difficult time meeting its obligations. A current ratio of
1.50 means the firm has 50% more current assets than it does current liabilities. This probably
represents an improvement in liquidity; short-term obligations can generally be met com-pletely with
a safety factor built in. A current ratio of 15.0, however, might be excessive. Any excess funds sitting
in current assets generally earn little or no return. These excess funds might be put to better use by
investing in productive long-term assets or distributing the funds to shareholders.
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.
Using the formula for NWC, we get:
NWC = CA – CL
CA = CL + NWC = BMD 2,450 + 9,230 = BMD 11,680
So, the current ratio is:
Current ratio = CA / CL = BMD 11,680/BMD 9,230 = 1.27 times
And the quick ratio is:
Quick ratio = (CA – Inventory) / CL = (BMD 11,680 – 3,540) / BMD 9,230 = 0.88 times