Question

Part A

A Company has a current ratio of 2.0. If the company purchases inventory on credit what happens to their current ratio and their working capital?

	current ratio decreases working capital decreases
	current ratio stays the same working capital decreases
	current ratio decreases working capital stays the same
	current ratio stays the same working capital stays the same

Part B

A Company has cash of $50,000, accounts receivable of $100,000, inventory of $250,000, prepaid insurance of $200,000 and current liabilities of $300,000. What is their current ratio?

	600,000
	300000
	2.0
	1.33

Answer 1

Part A

Current ratio is 2.0

That means current assets are two times the current liabilities.

Assume that the current assets are $100 and the current liabilities are $50.

Current ratio = $100 / $50 = 2

Working capital = $100 - $50 = $50

Now assume that the company purchased inventory for $10 on credit.

The purchase will increase current assets and current liabilities by $10.

So now the current assets will be $110 ($100 + $10) and the current liabilities will be $60 ($50 + $10).

Now,

Current ratio = $110 / $60 = 1.83

And

Working capital = $110 - $60 = $50

So from the above calculations we see that if inventory is purchased on credit, the:

current ratio decreases

working capital stays the same

Part B

Current ratio = Total current assets / Total current liabilities

Here,

Total current assets

= cash + accounts receivable + inventory + prepaid insurance

= $50,000 + $100,000 + $250,000 + $200,000

= $600,000

And,

Total current liabilities = $300,000

Therefore,

Current ratio = $600,000 / $300,000 = 2.0