Question

Current Ratio of a Company is 2:1. State giving reasons which of the following suggestions would improve the ratio, which would reduce it and which would not change it?

1. Purchase of goods on Credit.
2. Purchase of goods for Cash.
3. Sale of goods Costing ₹ 50,000 for ₹ 60,000 on Credit.
4. To sell a non-current asset at a slight loss.
5. To borrow money on a promissory note (B/P).
6. To give promissory note to a Creditor.
7. Payment of declared dividend.

Answer 1

Current Ratio = 2 : 1

Let Current Assets = ₹ 2,00,000

Current Liabilities = ₹ 1,00,000

I. Purchase of goods on Credit.

Reason: Suppose, goods for ₹ 25,000 is purchased on credit, the revised current ratio will be:

`(2,00,000 + 25,000 ("Inventory"))/(1,00,000 + 25,000 ("Trade Payables"))`

= `(2,25,000)/(1,25,000)`

= 1.8 : 1

∴ Thus, Current Ratio is reduced.

II. Purchase of goods for Cash.

Reason: Suppose, goods for ₹ 25,000 is purchased on cash, the revised current ratio will be:

`(2,00,000 + 25,000 ("Inventory") - 25,000 ("Cash"))/(1,00,000)`

= `(2,00,000)/(1,00,000)`

= 2 : 1

∴ Thus, Current Ratio will not changed.

III. Sale of goods Costing ₹ 50,000 for ₹ 60,000 on Credit.

Reason: This transaction will result in an increase in trade receivables (Current Assets) by ₹ 60,000 and a decrease in inventories (Current Assets) by ₹ 50,000.

`(2,00,000 + 60,000 ("Debtors") - 50,000 ("Stock"))/(1,00,000)`

= `(2,10,000)/(1,00,000)`

= 2.1 : 1

∴ Thus, Current Ratio will be improved.

IV. To sell a non-current asset at a slight loss.

Reason: Let’s suppose ₹ 55,000 of Machinery (Non-Current Assets) sold for ₹ 50,000. As Machinery is not included either in current assets or current liabilities. This event would only raise the current assets via cash.

`(2,00,000 + 50,000 ("Cash"))/(1,00,000)`

= `(2,50,000)/(1,00,000)`

= 2.5 : 1

∴ Thus, Current Ratio will improve.

V. To borrow money on a promissory note (B/P).

Reason: Let’s suppose ₹ 50,000 is borrowed against a Promissory note (B/P). It will increase cash (current assets) and Bills Payable (Current Liabilities) as follows:

`(2,00,000 + 50,000 ("Cash"))/(1,00,000 + 50,000 ("Bill Payable"))`

= `(2,50,000)/(1,50,000)`

= 1.67 : 1

∴ Thus, the Current Ratio will reduce.

VI. To give promissory note to a Creditor.

Reason: This transaction will result in a decrease in Creditor (Current Liabilities) and in increase in B/P (Current Liabilities).

Let’s suppose a ₹ 50,000 Promissory Note is given to the Creditor.

`(2,00,000)/(1,00,000 + 50,000 ("Creditors") - 50,000 ("Promissory Note"))`

= `(2,00,000)/(1,00,000)`

= 2 : 1

∴ Thus, the Current Ratio will not change.

VII. Payment of declared dividend.

Reason: Let’s suppose a ₹ 50,000 declared dividend paid in cash.

It will result in reducing current liabilities (dividends) and reducing current assets (cash).

`(2,00,000 - 50,000 ("Cash"))/(1,00,000 - 50,000 ("Dividend"))`

= `(1,50,000)/(50,000)`

= 3 : 1

∴ Thus, the Current Ratio will improve.