1.2 Liquidity

Question 1

Formula for the current ratio

Answer 1

Current Ratio = Total current assets / Total current liabilities

Question 2

Formula for the quick ratio (acid-test)

Answer 2

Quick (acid-test) ratio = (Cash + Marketable securities + Net receivable) / Current liabilities

Question 3

In analyzing the short-term liquidity of a firm, many analysts prefer to use the quick (or acid test) ratio rather than the current ratio. The primary reason for this preference is that the

A. Quick ratio excludes account receivable
B. Current ratio includes marketable securities that may be mispriced.
C. Pro-forma cash flow statements focus on cash only.
D. Conversion of inventory into cash is less reliable.

Answer 3

D. Conversion of inventory into cash is less reliable.

Question 4

The company has $80 million in current assets, comprised of $30 million in inventory and $50 million in cash and marketable securities. The company’s current liabilities total $50 million. If the company purchases an additional $10 million in inventory with $10 million in cash, the effect of this transaction on the company would be to

A. Decrease the current ratio and increase the quick ratio
B. Decrease the quick ratio while the current ratio remains unchanged
C. Leave both the current ratio and the quick ratio unchanged
D. Decrease the current ratio and decrease the quick ratio

Answer 4

B. Decrease the quick ratio while the current ratio remains unchanged

Quick ratio:
Before: $50 mil / $50 mil = 1.0
After: $40 mil / $50 mil = 0.8

Current ratio:
Before: $80 mil / $50 mil = 1.6
After: $80 mil / $50 mil = 1.6

The quick ratio decreases from 1.00 ($50 million ÷ $50 million) to .80 ($40 million ÷ $50 million) due to the $10 million decrease in cash. The current ratio remains unchanged because the $10 million decrease in cash is offset by the $10 million increase in inventory.

Question 5

Tosh Enterprises reported the following account information:

Accounts receivable $400,000
Accounts payable 260,000
Bonds payable, due in 10 years 600,000
Cash 200,000
Interest payable, due in 3 months 20,000
Inventory $800,000
Land 500,000
Short-term prepaid expense 80,000

The current ratio for Tosh Enterprises is
A. 1.68
B. 2.14
C. 5.00
D. 5.29

Answer 5

D. 5.29

The current ratio equals current assets divided by current liabilities. Current assets consist of cash, accounts receivable, inventory, and prepaid expenses, a total of $1,480,000 ($400,000 + $200,000 + $800,000 + $80,000). Current liabilities consist of accounts payable and interest payable, a total of $280,000 ($260,000 + $20,000). Hence, the current ratio is 5.29 ($1,480,000 ÷ $280,000).

Question 6

Tosh Enterprises reported the following account information:

Accounts receivable $400,000
Accounts payable 260,000
Bonds payable, due in 10 years 600,000
Cash 200,000
Interest payable, due in 3 months 20,000
Inventory $800,000
Land 500,000
Short-term prepaid expense 80,000

What is Tosh Enterprises’ quick (acid-test) ratio?
A. 0.68
B. 1.68
C. 2.14
D. 2.31

Answer 6

C. 2.14

The quick (acid-test) ratio equals the quick assets divided by current liabilities. For Tosh, quick assets consist of cash ($200,000) and accounts receivable ($400,000), a total of $600,000. Current liabilities consist of accounts payable ($260,000) and interest payable ($20,000) for a total of $280,000. Hence, the quick ratio is 2.14 ($600,000 ÷ $280,000).

Question 7

Tosh Enterprises reported the following account information:

Accounts receivable $400,000
Accounts payable 260,000
Bonds payable, due in 10 years 600,000
Cash 200,000
Interest payable, due in 3 months 20,000
Inventory $800,000
Land 500,000
Short-term prepaid expense 80,000

Tosh Enterprises’ amount of working capital is
A. $600,000
B. $1,120,000
C. $1,200,000
D. $1,220,000

Answer 7

C. $1,200,000

Working capital equals current assets minus current liabilities.

For Tosh Enterprises, current assets consist of cash, accounts receivable, inventory, and prepaid expenses, a total of $1,480,000 ($400,000 + $200,000 + $800,000 + $80,000). Current liabilities consist of accounts payable and interest payable for a total of $280,000 ($260,000 + $20,000). Accordingly, working capital is $1,200,000 ($1,480,000 – $280,000).

Question 8

Formula for net working capital

Answer 8

Net Working Capital = Current assets - Current liabilities

Question 9

A financial analyst has obtained the following data from financial statements:

Cash $ 200,000
Marketable securities 100,000
Accounts receivable, net 300,000
Inventories, net 480,000
Prepaid expenses 120,000
Total current assets $1,200,000
Accounts payable $250,000
Income taxes 50,000
Accrued liabilities 100,000
Current portion of long-term debt 200,000
Total current liabilities $600,000

In order to determine ability to pay current obligations, the financial analyst would calculate the cash ratio as

A. 0.50
B. 0.80
C. 1.00
D. 1.20

Answer 9

A. 0.50

The cash ratio, a more conservative measure of liquidity than the quick ratio, is calculated as follows:

Cash ratio = (Cash + Marketable securities) ÷ Current liabilities
= ($200,000 + $100,000) ÷ $600,000 = 0.50

Question 10

Formula for cash ratio

Answer 10

(Cash + Marketable securities) / Current liabilities

Question 11

Given an acid-test ratio of 2.0, current assets of $5,000, and inventory of $2,000, the value of current liabilities is

A. $1,500
B. $2,500
C. $3,500
D. $6,000

Answer 11

A. $1,500

The acid-test, or quick, ratio equals the quick assets (cash, marketable securities, and accounts receivable) divided by current liabilities.

Current assets equal the quick assets plus inventory and prepaid expenses. (This question assumes that the entity has no prepaid expenses.)

Given current assets of $5,000, inventory of $2,000, and no prepaid expenses, the quick assets must be $3,000. Because the acid-test ratio is 2.0, the quick assets are double the current liabilities. Current liabilities therefore are equal to $1,500 ($3,000 quick assets ÷ 2.0).

Question 12

A company has a current ratio of 1.4, a quick, or acid-test, ratio of 1.2, and the following partial summary balance sheet:

Cash $ 10
Accounts receivable ___
Inventory ___
Fixed assets ___
Total assets $100
Current liabilities $___
Long-term liabilities 40
Stockholders’ equity 30
Total liabilities and equity $___

The company has an accounts receivable balance of

A. $26
B. $36
C. $66
D. $100

Answer 12

A. $26

Total assets equal total liabilities and equity. Hence, if total assets equal $100, total liabilities and equity must equal $100, and current liabilities must equal $30 ($100 – $40 – $30). Because the quick ratio equals the quick assets (cash + accounts receivable) divided by current liabilities, the quick assets must equal $36 ($30 × 1.2 quick ratio), and the accounts receivable balance is $26 ($36 – $10 cash).

Question 13

What is the acid-test (or quick) ratio?

Cash $ 10,000
Marketable securities 18,000
Accounts receivable 120,000
Inventories 375,000
Prepaid expenses 12,000
Accounts payable 75,000
Long-term debt – current portion 20,000
Long-term debt 400,000
Sales 1,650,000

A. 1.56
B. 1.97
C. 2.13
D. 5.63

Answer 13

A. 1.56

The acid-test (quick) ratio equals the quick assets (cash, marketable securities, and accounts receivable) divided by current liabilities.

The acid-test ratio is thus 1.558 [($10,000 + $18,000 + $120,000) ÷ ($75,000 + $20,000)].

Question 14

A company has current assets of $400,000 and current liabilities of $500,000. The company’s current ratio will be increased by

A. The purchase of $100,000 of inventory on account.
B. The payment of $100,000 of accounts payable.
C. The collection of $100,000 of accounts receivable.
D. Refinancing a $100,000 long-term loan with short-term debt.

Answer 14

A. The purchase of $100,000 of inventory on account.

The current ratio equals current assets divided by current liabilities. An equal increase in both the numerator and denominator of a current ratio less than 1.0 causes the ratio to increase. The company’s current ratio is .8 ($400,000 ÷ $500,000). The purchase of $100,000 of inventory on account would increase the current assets to $500,000 and the current liabilities to $600,000, resulting in a new current ratio of .833.

Question 15

A corporation has a current ratio of 2 to 1 and a quick ratio (acid test) of 1 to 1. A transaction that would change the quick ratio but not the current ratio is the

A. Sale of inventory on account at cost.
B. Collection of accounts receivable.
C. Payment of accounts payable.
D. Purchase of a patent for cash.

Answer 15

A. Sale of inventory on account at cost.

The quick (acid test) ratio equals the quick assets (cash, marketable securities, and accounts receivable) divided by current liabilities. The current ratio is equal to current assets divided by current liabilities. The sale of inventory (not a quick current asset) on account increases accounts receivable (a quick asset), thereby changing the quick ratio. The sale of inventory on account, however, replaces one current asset with another, and the current ratio is unaffected.

Question 16

Firm’s ability to pay its current obligations as they come due and thus remain in business in the short run

Answer 16

Liquidity

Question 17

Prepaid items

A. Current assets
B. Non-current assets
C. Current Liabilities
D. Non-current liabilities

Answer 17

A. Current assets

Question 18

Marketable securities

A. Current assets
B. Non-current assets
C. Current Liabilities
D. Non-current liabilities

Answer 18

A. Current assets

Question 19

Current maturities of long-term debt

A. Current assets
B. Non-current assets
C. Current Liabilities
D. Non-current liabilities

Answer 19

C. Current liabilities

Question 20

Unearned revenues

A. Current assets
B. Non-current assets
C. Current Liabilities
D. Non-current liabilities

Answer 20

C. Current liabilities

Question 21

Other accruals

A. Current assets
B. Non-current assets
C. Current Liabilities
D. Non-current liabilities

Answer 21

C. Current Liabilities

Question 22

Formula for cash flow ratio

Answer 22

Cash flow ratio = Cash flow from operations / current liabilities

Question 23

A firm has the following current assets.

Cash € 250,000
Marketable securities 100,000
Accounts receivable 800,000
Inventories 1,450,000
Total current assets € 2,600,000

If current liabilities are €1,300,000, the firm’s

A. Current ratio will decrease if a payment of €100,000 cash is used to pay €100,000 of accounts payable.
B. Acid-test (quick) ratio will decrease if a payment of €100,000 cash is used to purchase inventory.
C. Current ratio will not change if a payment of €100,000 is used to pay €100,000 of accounts payable.
D. Acid-test (quick) ratio will not change if a payment of €100,000 cash is used to purchase inventory.

Answer 23

B. Acid-test (quick) ratio will decrease if a payment of €100,000 cash is used to purchase inventory.

The only difference between the current ratio and the quick ratio is the removal of inventories from the numerator of the quick ratio. Thus, a shift from cash to inventory will have a reducing effect on the quick ratio but not on the current ratio.

Question 24

A credit manager considering whether to grant trade credit to a new customer is most likely to place primary emphasis on

A. Growth ratios.
B. Profitability ratios.
C. Valuation ratios.
D. Liquidity ratios.

Answer 24

D. Liquidity ratios.

Liquidity is a firm’s ability to pay its short-term obligations as they come due. Trade payables are the most common form of short-term obligation. Thus, a credit manager is most interested in assessing a potential customer’s liquidity.

Question 25

A mobile home manufacturer has a quick ratio of 2.0. Assuming nothing else changes, which of the following actions would decrease the firm’s quick ratio?

A. Writing off obsolete inventory.
B. Buying inventory on credit with 30-day terms
C. Converting short-term debt into long-term debt
D. Collecting cash from issuing stock

Answer 25

B. Buying inventory on credit with 30-day terms

Buying inventory on credit with 30-day terms would increase current liabilities (the denominator). Additionally, inventory is not considered in the quick ratio, so there would be no corresponding increase in the numerator. Therefore, this action would decrease the quick ratio.

• Choice C is wrong because converting short-term debt into long-term debt reduces current liabilities without a corresponding reduction in current assets. Thus, the quick ratio would increase as a result of this action.
• Choice D is wrong because issuing stock for cash would increase current assets (cash) and stockholders’ equity (common stock). With no corresponding increase in current liabilities, this action would increase the quick ratio.

Question 26

During the current year, Corporation A had 100,000 shares of common stock outstanding. On July 1, Corporation A issued a 4-for-1 stock split. Additionally, on September 2, A declared a dividend of $0.75 per common share, and the payment is expected to be made in January of the following year. If A had current assets of $2,000,000 and current liabilities of $1,200,000 before the declaration of the stock dividend, what is the percentage change in the current ratio as a result of the dividend declaration?

A. 6% decrease
B. 20% decrease
C. 2% decrease
D. 15% decrease

Answer 26

B. 20% decrease

Prior to dividend, the current ratio is 1.67 ($2,000,000 / $1,200,000). The stock split increases the number of outstanding shares to 400,000. The declaration of dividends increases current liabilities by $300,000 (400,000 x $0.75). Additionally, because the dividends are not paid until the next year, current assets is unaffected by the declaration. Thus, the new current ratio after the declaration is 1.33 ($2,000,000 / 1,500,000). Accordingly, the current ratio has decreased by 20%. [(1.67 - 1.33) / 1.67]

Question 27

Galad Corp. has current assets of $180,000 and current liabilities of $360,000. Which of the following transactions would improve Galad’s current ratio?

A. Refinancing a $60,000 long-term mortgage with a short-term note.
B. Purchasing $100,000 of merchandise inventory with a short-term account payable.
C. Paying $40,000 of short-term accounts payable.
D. Collecting $20,000 of short-term accounts receivable.

Answer 27

B. Purchasing $100,000 of merchandise inventory with a short-term account payable.

If a current ratio is less than 1.0, a transaction that results in equal increases in the numerator and denominator will improve the ratio. The current ratio is 0.5 ($180,000 / 360,000). Debiting inventory and crediting accounts payable increases the ratio to .61 (280,000 / 460,000).

Question 28

Which of the following ratios is(are) useful in assessing a company’s ability to meet currently maturing or short-term obligations?

Acid-Test Ratio: yes/no
Debt-to-Equity Ratio: yes/no

Answer 28

Acid-Test Ratio: yes
Debt-to-Equity Ratio: no

The acid-test, or quick, ratio measures liquidity, which is ability of a company to meet its short-term obligations. The debt-to-equity ratio is a leverage ratio. Leverage ratios measure the impact of debt on profitability and risk.

Question 29

Jensen Corporation’s board of directors met on June 3 and declared a regular quarterly cash dividend of $.40 per share for a total value of $200,000. The dividend is payable on June 24 to all stockholders of record as of June 17. Excerpts from the statement of financial position for Jensen Corporation as of May 31 are presented as follows.

Cash $ 400,000
Accounts receivable (net) 800,000
Inventories 1,200,000
Total current assets $2,400,000
Total current liabilities $1,000,000

Assume that the only transactions to affect Jensen Corporation during June are the dividend transactions.
Jensen’s quick (acid test) ratio would be

A. Decreased by the dividend declaration and increased by the dividend payment.
B. Decreased by the dividend declaration and unchanged by the dividend payment.
C. Unchanged by the dividend declaration and decreased by the dividend payment.
D. Unchanged by either the dividend declaration or the dividend payment.

Answer 29

B. Decreased by the dividend declaration and unchanged by the dividend payment.

The quick ratio is computed by dividing quick assets (cash, marketable securities, and receivables) by current liabilities.

The dividend declaration will increase the current liabilities to $1,200,000 and decrease the quick ratio to 1.0 (1,200,000 quick assets / 1,200,000 current liabilities). The payment of cash dividend will decrease quick assets (cash) and the current liabilities by the same amount. Accordingly, the ratio (1.0) remains unchanged by the payment.

Question 30

A company has a 2-to-1 current ratio. This ratio would increase to more than 2 to 1 if

A. The company wrote off an uncollectible receivable.
B. A previously declared stock dividend were distributed.
C. The company purchased inventory on open account.
D. The company sold merchandise on open account that earned a normal gross margin.

Answer 30

D. The company sold merchandise on open account that earned a normal gross margin.

The current ratio equals current assets divided by current liabilities. Thus, an increase in current assets or a decrease in current liabilities, by itself, increases the current ratio. The sale of inventory at a profit increases current assets without changing liabilities. Inventory decreases, and receivables increase by a greater amount. Thus, total current assets and the current ratio increase.

• The purchase of inventory increase current assets and current liabilities by the same amount. The transaction reduces a current ratio in excess of 1.0 since the numerator and denominator of the ratio increase by the same amount.

Question 31

An entity has total assets of $7,500,000 and a current ratio of 2.3 times before purchasing $750,000 of merchandise on credit for resale. After this purchase, the current ratio will

A. Be lower than 2.3 times
B. Be exactly 2.53 times
C. Be higher than 2.3 times
D. Remain at 2.3 times

Answer 31

A. Be lower than 2.3 times

The current ratio is the ratio of current assets to current liabilities. When the ratio is greater than one, any change of equal dollar amount on both the numerator and denominator will result in a lowering of the overall ratio (since the denominator will increase by a proportionally greater amount). The purchase of merchandise on credit is an example of such a change: Inventory increases in the numerator and accounts payable increases in the denominator by an equal dollar amount.

Question 32

A financial analyst has gathered the following select financial data on three companies.

Total current assets
Company A: €500,000
Company B: €1,250,000
Company C: €870,000
Total current liabilities
Company A: €445,000
Company B: €970,000
Company C: €620,000

On the basis of the information provided above, the financial analyst is able to conclude that

A. Company A has the highest liquidity
B. Company A and Company B both have a higher liquidity than Company C
C. Company B and Company C both have a higher liquidity than Company A
D. Company B has the highest liquidity

Answer 32

C. Company B and Company C both have a higher liquidity than Company A

The current ratio is determined by dividing current assets by current liabilities. The current ratio of Company A is 1.12 (500,000 / 445,000). The current ratio of Company B is 1.29 (1,250,000 / 970,000). The current ratio of Company C is 1.40 (870,000 / 620,000). Company B and Company C both have a higher liquidity than Company A.

Question 33

In comparing the current ratios of two companies, why is it invalid to assume that the company with the higher current ratio is the better company?

A. The current ratio includes assets other than cash.
B. A high current ratio may indicate inadequate inventory on hold.
C. A high current ratio may indicate inefficient use of various assets and liabilities.
D. The two companies may define working capital in different terms.

Answer 33

C. A high current ratio may indicate inefficient use of various assets and liabilities.

The current ratio measures only the ratio of current assets to current liabilities. It does not measure the efficiency of handling the individual current asset accounts. A high ratio may indicate, for example, slow collection of accounts receivable, holding of excess inventory, or retention of more cash than needed for the cash flow requirements of the firm. The weaker and less efficient company may have the higher current ratio.

Question 34

North Bank is analyzing Belle Corp.’s financial statements for a possible extension of credit. Belle’s quick ratio is significantly better than the industry average. Which of the following factors should North consider as a possible limitation of using this ratio when evaluating Belle’s creditworthiness?

A. Belle may need to sell its available-for-sale investments to meet its current obligations.
B. Increasing market prices for Belle’s inventory may adversely affect the ratio.
C. Fluctuating market prices of short-term investments may adversely affect the ratio.
D. Belle may need to liquidate its inventory to meet its long-term obligations.

Answer 34

C. Fluctuating market prices of short-term investments may adversely affect the ratio.

The quick ratio equals current assets minus inventory and prepaid expenses, divided by current liabilities. Because short-term marketable securities are included in the numerator, fluctuating market prices of short-term investments may adversely affect the ratio if Belle holds a substantial amount of such current assets.

Question 35

Excerpts from the statement of financial position for Markham Corporation as of April 30 of the current year are presented as follows:

Cash $ 725,000
Accounts receivable (net) 1,640,000
Inventories 2,945,000
Total current assets $5,310,000
Accounts payable $1,236,000
Accrued liabilities 831,000
Total current liabilities $2,067,000

The board of directors of Markham met on May 5 of the current year and declared a quarterly cash dividend in the amount of $800,000 ($.50 per share). The dividend was paid on May 28 of the current year to shareholders of record as of May 15 of the current year. Assume that the only transactions that affected Markham during May of the current year were the dividend transactions and that the closing entries have been made.

Markham’s working capital would be

A. Decreased by the dividend declaration and unchanged by the dividend payment.
B. Increased by the dividend declaration and unchanged by the dividend payment.
C. Unchanged by either the dividend declaration or the dividend payment.
D. Decreased by the dividend declaration and increased by the dividend payment.

Answer 35

A. Decreased by the dividend declaration and unchanged by the dividend payment.

Working capital is the excess of current assets over current liabilities. The declaration of a dividend reduces retained earnings and creates a new current liability. Thus, the declaration of a dividend reduces working capital because current liabilities are increased without a corresponding increase in current assets. The subsequent payment of the dividend has no effect on working capital because current assets (cash) will be reduced by the same amount that current liabilities (dividends payable) are reduced.

Question 36

Lisa, Inc.
Statement of Financial Position
December 31, Year 2
(000s)

Year 2 & Year 1
Assets
Current assets:
Cash $ 30 & $ 25
Trading securities 20 & 15
Accounts receivable (net) 45 &30
Inventories (at lower of cost or market) 60 & 50
Prepaid items 15 & 20
Total current assets 170 & 140
Long-term investments:
Securities (at cost) 25 & 20
Property, plant, & equipment:
Land (at cost) 75 & 75
Building (net) 80 & 90
Equipment (net) 95 & 100
Intangible assets
Patents (net) 35 & 17
Goodwill (net) 20 & 13
Total long-term assets 330 & 315
Total assets $500 & $455
Liabilities & Shareholders’ Equity
Current liabilities:
Notes payable $ 23 & $ 12
Accounts payable 47 & 28
Accrued interest 15 & 15
Total current liabilities 85 & 55

Lisa, Inc.’s acid-test (quick) ratio at December 31, Year 2, was

A. 2.5:1.0
B. 1.1:1.0
C. 2.0:1.0
D. 1.8:1.0

Answer 36

B. 1.1:1.0

The acid-test, or quick, ratio is calculated by dividing total quick assets by current liabilities. Quick assets are those that can be quickly converted into cash. Beside cash, they include trading securities and accounts receivable. Lisa’s quick assets total $95,000 (30,000 + 20,000 + 45,000). Dividing 95,000 by the 85,000 of current liabilities results in a ratio of 1.1.

Question 37

Both the current ratio and the quick ratio for Spartan Corporation have been slowly decreasing. For the past two years, the current ratio has been 2.3-to-1 and 2.0-to-1. During the same time period, the quick ratio has decreased from 1.2-to-1 to 1.0-to-1. The disparity between the current and quick ratios can be explained by which one of the following?

A. The inventory balance is usually high
B. The accounts receivable balance has decreased
C. The cash balance is usually low
D. The current portion of long-term debt has been steadily increasing

Answer 37

A. The inventory balance is usually high

The only difference the current ratio and the quick ratio is the removal of inventories from the numerator of the quick ratio. Thus, a high inventory balance can account for the disparity between the current and quick ratios.

Question 38

Excerpts from the statement of financial position for Markham Corporation as of April 30 of the current year are presented as follows:

Cash $ 725,000
Accounts receivable (net) 1,640,000
Inventories 2,945,000
Total current assets $5,310,000
Accounts payable $1,236,000
Accrued liabilities 831,000
Total current liabilities $2,067,000

The board of directors of Markham met on May 5 of the current year and declared a quarterly cash dividend in the amount of $800,000 ($.50 per share). The dividend was paid on May 28 of the current year to shareholders of record as of May 15 of the current year. Assume that the only transactions that affected Markham during May of the current year were the dividend transactions and that the closing entries have been made.

Markham’s current ratio would be

A. Unchanged by the dividend declaration and decreased by the dividend payment
B. Increased by the dividend declaration and unchanged by the dividend payment
C. Decreased by the dividend declaration and increased by the dividend payment
D. Unchanged by either the dividend declaration or the dividend payment

Answer 38

C. Decreased by the dividend declaration and increased by the dividend payment

The current ratio equals current assets divided by the current liabilities. The declaration of a dividend results in a decrease in retained earnings and an increase in current liabilities. The effect is to decrease the current ratio because current liabilities are increased at the time of declaration without change in current assets.

The April 30 current ratio is 2.57 ($5,310,000 / $2,067,000). Following the declaration of an $800,000 dividend, the current ratio is 1.85 ($5,310,000 / $2,867,000). The subsequent payment of the dividend will increase the ratio because the ratio is greater than 1.0 and both current assets and current liabilities will decline by the same amount. The current ratio after the payment is 2.18 ($4,510,000 / $2,067,000).

Question 39

A firm must increase its acid test ratio above the current 0.9 level in order to comply with the terms of a loan agreement. Which one of the following actions is most likely to produce the desired results?

A. Expediting collection of accounts receivable
B. Selling auto parts on account
C. Making a payment to trade accounts payable
D. Purchasing marketable securities for cash

Answer 39

B. Selling auto parts on account

The acid test (quick) ratio consists of the quick assets (cash, marketable securities, and net accounts receivable) divided by current liabilities. Exchanging merchandise inventory for accounts receivable increase the numerator while having no effect on denominator, resulting in an increase in the overall ratio.

Question 40

Depoole Company is a manufacturer of industrial products that uses a calendar year for financial reporting purposes. Assume that total quick assets exceeded total current liabilities both before and after the transaction described. Further assume that Depoole has positive profits during the year and a credit balance throughout the year in its retained earnings account.

Depoole’s early liquidation of a long-term note with cash affects the

A. Quick ratio to a greater degree than the current ratio
B. Current ratio but not the quick ratio
C. Current ratio to a greater degree than the quick ratio
D. Current and quick ratio to the same degree

Answer 40

A. Quick ratio to a greater degree than the current ratio

The numerators of the quick and current ratios are decreased when cash is expended. Early payment of a long-term liability has no effect on the denominator (current liabilities). Since the numerator of the quick ratio, which includes cash, net receivables, and marketable securities, is less than the numerator of the current ratio, which includes all current assets, the quick ratio is affected to a greater degree.

Question 41

At the beginning of the year, Company C had the following items on its balance sheet:
Cash $100,000
Marketable securities 70,000
Inventory 25,000
Prepaid assets 50,000
Net accounts receivable 30,000
Current liabilities 125,000

During the course of the year, C declared and paid dividends of $1 per share on its 40,000 shares of common stock. Assuming that the dividend payment is the only transaction in the year, what is the percentage change in the quick ratio as a result of the dividends?

A. 18% increase.
B. 26% increase.
C. 20% decrease.
D. 15% decrease.

Answer 41

C. 20% decrease.

The quick ratio does not include inventory or prepaid assets as current assets; thus, the quick ratio prior to the dividend declaration and payment is 1.6 [($100,000 + $70,000 + $30,000) ÷ $125,000]. Accordingly, the declaration of dividends increases current liabilities by $40,000. However, the payment of dividends decreases current liabilities by $40,000 as well as current assets (cash) by $40,000. As such, the quick ratio after the dividend is 1.28 [($60,000 + $70,000 + $30,000) ÷ $125,000]. Therefore, the dividends reduce the quick ratio by 20% [(1.6 – 1.28) ÷ 1.6].

Question 42

All of the following are included when calculating the acid-test ratio except

A. Six-month treasury bills
B. Accounts receivable
C. 60-day certificates of deposit
D. Prepaid insurance

Answer 42

D. Prepaid insurance

The acid-test (quick) ratio consists of the quick assets (cash, marketable securities, and net accounts receivable) divided by current liabilities. Prepaid insurance is an illiquid current asset and thus not appropriate to include in the numerator.

Question 43

Jensen Corporation’s board of directors met on June 3 and declared a regular quarterly cash dividend of $.40 per share for a total value of $200,000. The dividend is payable on June 24 to all stockholders of record as of June 17. Excerpts from the statement of financial position for Jensen Corporation as of May 31 are presented as follows.

Cash $ 400,000
Accounts receivable (net) 800,000
Inventories 1,200,000
Total current assets $2,400,000
Total current liabilities $1,000,000

Assume that the only transactions to affect Jensen Corporation during June are the dividend transactions.
Jensen’s current ratio would be

A. Decreased by the dividend declaration and increased by the dividend payment.
B. Decreased by the dividend declaration and unchanged by the dividend payment.
C. Unchanged by the dividend declaration and decreased by the dividend payment.
D. Unchanged by either the dividend declaration or the dividend payment.

Answer 43

A. Decreased by the dividend declaration and increased by the dividend payment.

The current ratio is computed by dividing current assets by current liabilities. The declaration of a dividend increases liabilities (to $1,200,000) and thus decrease the ratio. After the declaration, the ratio is 2.0 ($2,400,000 / $1,200,000). It was originally 2.4 ($2,400,000 / $1,000,000). The subsequent payment decreases both current assets and current liabilities by $200,000. The ratio is then 2.2 ($2,200,000 / $1,000,000). Therefore, the payment of the current liability increases the current ratio.

Question 44

A company has a current ratio of 2 to 1. This ratio will decrease if the company

A. Sells merchandise for more than cost and records the sale using the perpetual inventory method.
B. Borrows cash on a 6-month note.
C. Receives a 5% stock dividend on one of its marketable securities.
D. Pays a large account payable which had been a current liability.

Answer 44

B. Borrows cash on a 6-month note.

If a ratio is greater than 1.0, an equal increase in the numerator (current assets) and denominator (current liabilities), like borrowing cash on a short-term basis, decreases the ratio.

Question 45

If allowance for credit losses is increased, this adjustment will

A. Increase working capital
B. Reduce the current ratio
C. Increase the acid test ratio
D. Reduce debt-to-asset ratio

Answer 45

B. Reduce the current ratio

The current ratio is the ratio of current assets to current liabilities. By reducing net receivables, an increase in the allowance for credit losses lowers the amount of current assets (the numerator), reducing the overall ratio.

Question 46

The following transactions occurred during a company’s first year of operations:

I. Purchased a delivery van for cash
II. Borrowed money by issuance of short-term debt
III. Purchased treasury stock

Which of the items above caused a change in the amount of working capital?

A. I and III only
B. I and II only
C. II and III only
D. I only

Answer 46

A. I and III only

Working capital is computed by deducting total current liabilities from total current assets. The purchase of a delivery van for cash reduces current assets and has no effect on current liabilities. The borrowing of cash by incurring short-term debt increases current assets by the same amount as it increases current liabilities; hence, it will have no effect on working capital. The purchase of treasury stock decreases current assets but has no effect on current liabilities. Thus, the purchases of the van and treasury stock affect working capital.

Question 47

On June 30 of this year, Oliva Co., a calendar-year entity, issued a 6-month note payable in exchange for stock that it intends to hold as a long-term investment. Oliva Company’s current and quick ratios are 1.8 and 1.5, respectively. What is the effect of issuing the note?

Increase/decrease

Current ratio:
Quick ratio:
Working Capital:

Answer 47

Current ratio: decrease
Quick ratio: decrease
Working Capital: decrease

Issuing a short-term note payable in exchange for a long-term investment increases current liabilities and noncurrent assets. The current ratio (current assets / current liabilities), the quick ratio [(current assets - inventory) / current liabilities], and the working capital (current assets - current liabilities) will decrease. The increase in non current assets has no effect on these ratios.

Question 48

Excerpts from the statement of financial position for Landau Corporation as of September 30 of the current year are presented as follows.

Cash $ 950,000
Accounts receivable (net) 1,675,000
Inventories 2,806,000
Total current assets $5,431,000
Accounts payable $1,004,000
Accrued liabilities 785,000
Total current liabilities $1,789,000

The board of directors of Landau Corporation met on October 4 of the current year and declared the regular quarterly cash dividend amounting to $750,000 ($.60 per share). The dividend is payable on October 25 of the current year to all shareholders of record as of October 12 of the current year. Assume that the only transactions to affect Landau Corporation during October of the current year are the dividend transactions and that the closing entries have been made.

Landau Corporation’s current ratio was

A. Decreased by the dividend declaration and increased by the dividend payment.
B. Unchanged by either the dividend declaration or the dividend payment.
C. Decreased by the dividend declaration and unchanged by the dividend payment.
D. Increased by the dividend declaration and unchanged by the dividend payment.

Answer 48

A. Decreased by the dividend declaration and increased by the dividend payment.

The dividend declaration decreased retained earnings and increased current liabilities by $750,000. The subsequent payment decreased both current assets and current liabilities by $750,000. Before the dividend declaration, the current ratio was 3.03 (5,431,000 ÷ $1,789,000). The declaration increased current liabilities to $2,539,000, and the new current ratio was 2.14 ($5,431,000 ÷ $2,539,000). The payment reduced current assets to $4,681,000 and current liabilities to $1,789,000. Thus, after the payment, the current ratio was 2.61 ($4,681,000 ÷ $1,789,000).

Question 49

If a company converts a short-term note payable into a long-term note payable, this transaction will

A. Increase both working capital and the current ratio.
B. Increase working capital only.
C. Decrease both working capital and the current ratio.
D. Decrease working capital only.

Answer 49

A. Increase both working capital and the current ratio.

Converting a short-term note to a long-term note reduces current liabilities but not current assets. Thus, the transaction increases both working capital and the current ratio.