302754 Current Ratio and QR - Liquidity 2161 - 1F Flashcards
Birch Products, Inc., 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
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If Birch’s current liabilities are $1,300,000, the firm’s:
current ratio will not change if a payment of $100,000 cash is used to pay $100,000 of accounts payable.
quick ratio will not change if a payment of $100,000 cash is used to purchase inventory.
quick ratio will decrease if a payment of $100,000 cash is used to purchase inventory.
current ratio will decrease if a payment of $100,000 cash is used to pay $100,000 of accounts payable.
Current ratio = Current assets ÷ Current liabilities:
Current ratio = $2,600,000 / $1,300,000
= 2.0 to 1
Quick ratio = Quick assets* ÷ Current liabilities:
Quick ratio = $1,150,000 / $1,300,000
= .885
* Quick assets = Cash + Marketable securities + Net accounts receivable
So, the firm’s quick ratio will decrease if a payment of $100,000 cash is used to purchase inventory: Quick ratio = $1,050,000 ÷ $1,300,000 = .808 (decrease).
The firm’s current ratio will increase if a payment of $100,000 cash is used to pay $100,000 of accounts payable: Current ratio = $2,500,000 ÷ $1,200,000 = 2.08 to 1 (increase).
What is the current ratio?
A liquidity ratio that measures a firm’s ability to discharge currently maturing obligations from existing current assets that are expected to be converted into cash within the maturing period of the claims. Current ratio is a measure of short-term solvency; however, it is less precise than the quick ratio because a sizable amount of total current assets may be tied up in inventory, which is less liquid.
The computation is:
Current assets ÷ Current liabilities
Because balance sheet account totals are based on historical cost, which does not necessarily represent market value, the use of this ratio is limited.
Compare the current ratio to the quick ratio.
Current ratio is a measure of short-term solvency; however, it is less precise than the quick ratio because a sizable amount of total current assets may be tied up in inventory, which is less liquid.
What is the quick ratio?
liquidity ratio that measures the firm’s ability to discharge currently maturing obligations from most liquid (quick) current assets, cash, marketable equity securities (MES), and accounts receivable (AR). It is more precise than the current ratio because only highly liquid assets are used (i.e., inventories—less liquid and more likely to incur losses in the event of liquidation—and prepaid assets are excluded). It measures immediate liquidity.
The computation is Quick assets ÷ Current liabilities or (Cash + MES + AR) ÷ Current liabilities.
There are limitations on use of this ratio. Accounts receivable may be subject to a lengthy collection period and may have to be factored at less than carrying value to convert to cash immediately. Marketable equity securities are subject to fluctuatio
What are current assets?
These are cash and other assets that will be converted into cash, sold, or consumed within one year or the operating cycle, whichever is longer. Items are usually listed from highly liquid to less liquid. Increasing current assets is a use of short-term funds for a business. Typical categories are the following:
Cash and cash equivalents
Marketable securities (trading and available-for-sale classifications at fair value)
Notes and accounts receivable (at net realizable value)
Inventories
Prepaid expenses (at unexpired cost)
What are current liabilities?
Liabilities that are to be paid within one year or the operating cycle, whichever is longer. Items are usually presented in order of their liquidation dates and reported at the amount to be paid. Increasing current liabilities are a source of short-term funds for a business. Typical categories are:
accounts payable arising from the acquisition of goods and services.
other accrued liabilities, such as wages payable and interest payable.
notes payable, such as but not limited to commercial paper, short-term bank credit loans, and factoring.
collections of amounts in advance (unearned or deferred revenues).
currently maturing portions of long-term debt.
What is working capital?
The difference between current assets and current liabilities. Creditors are especially interested in working capital as it is the source from which they will be paid.
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Liquidity
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Liquidity
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