Suppose that a firm's current ratio is 1.2, i.e., $$ \frac{C A}{C L}=1.2 $$. Determine what effect each of the following actions would have on its current ratio. a) Inventory is purchased with cash. Answer: b) Short-term loan is repaid with cash. Answer: c) Long-term debt (with the maturity $$ 1 $$ year) is repaid with cash. Answer:

Question

Suppose that a firm's current ratio is 1.2, i.e., $$ \frac{C A}{C L}=1.2 $$. Determine what effect each of the following actions would have on its current ratio. a) Inventory is purchased with cash. Answer: b) Short-term loan is repaid with cash. Answer: c) Long-term debt (with the maturity $$ >1 $$ year) is repaid with cash. Answer:

UpStudy AI · Accepted Answer

**Problem a)**  
*Inventory is purchased with cash.*

**Effect on Current Ratio:**

- **Current Assets (CA):** 
  - **Inventory** increases by the amount of the purchase.
  - **Cash** decreases by the same amount since it is used to buy the inventory.
  - **Net Effect on CA:** No change (increase in one current asset is offset by a decrease in another).

- **Current Liabilities (CL):**
  - No change, as this transaction does not involve any liabilities.

**Conclusion:**  
The **current ratio (CA/CL)** remains **unchanged** because the composition of current assets changes, but their total value does not.

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**Problem b)**  
*Short-term loan is repaid with cash.*

**Effect on Current Ratio:**

- **Current Assets (CA):**
  - **Cash** decreases by the amount used to repay the loan.

- **Current Liabilities (CL):**
  - **Short-term loan** (a current liability) decreases by the same amount.

**Conclusion:**  
The **current ratio (CA/CL)** increases because current assets decrease by a smaller proportion than current liabilities decrease. Specifically, since both CA and CL are reduced by the same amount, but CL is smaller to begin with (given CA/CL = 1.2), the ratio increases.

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**Problem c)**  
*Long-term debt (with the maturity >1 year) is repaid with cash.*

**Effect on Current Ratio:**

- **Current Assets (CA):**
  - **Cash** decreases by the amount used to repay the long-term debt.

- **Current Liabilities (CL):**
  - No change, as long-term debt is not classified under current liabilities.

**Conclusion:**  
The **current ratio (CA/CL)** decreases because current assets decrease while current liabilities remain unchanged.

Answer:
Problem a Answer:

When inventory is purchased with cash, one current asset (cash) decreases while another current asset (inventory) increases by the same amount. Therefore, total current assets remain unchanged and current liabilities are unaffected. As a result, the current ratio stays the same.
When inventory is bought with cash, the current ratio stays the same. --- **Problem b Answer:** Repaying a short-term loan with cash decreases current assets (cash) and current liabilities (short-term loan) by the same amount. Since current liabilities are smaller, the current ratio increases. --- **Problem c Answer:** Repaying long-term debt with cash decreases current assets (cash) but does not affect current liabilities. Therefore, the current ratio decreases.

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