Question

The current ratio of a company is 2.5 : 1. State giving reasons which of the following suggestions would improve, reduce and not change it:

1. Payment to trade payables.
2. Sell machinery for cash.
3. Sale of inventory at loss on credit.
4. Cash collected from trade receivables.
5. B/R dishonoured.
6. Issue of shares.
7. Issue of shares against the purchase of a building.
8. Redemption (Repayment) of Debentures maturing during the year.
9. Purchase of Loose Tools against Cash.

Answer 1

Current Ratio = 2.5 : 1

Current Assets = ₹ 2,50,000

Current Liabilities = ₹ 1,00,000

i. Payment to trade payables.

Reason: Let’s suppose, ₹ 50,000 Trade payables. Payment to trade payables will decrease the current liabilities and decrease the current assets.

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

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

= 4 : 1

∴ Thus, The Current Ratio will Improve.

ii. Sell machinery for cash.

Reason: Let’s suppose the machinery is sold for ₹ 50,000 for a cheque. It will increase the Cash at Bank (Current Assets) only, as machinery does not fall under neither in Current Assets nor in Current Liabilities.

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

= `(3,00,000)/(1,00,000)`

= 3 : 1

∴ Thus, The Current Ratio will improve.

iii. Sale of inventory at loss on credit.

Reason: Let’s suppose, Inventory of ₹ 50,000 is sold for ₹ 40,000 on credit. It will decrease the current assets and increase the current liabilities. it will reduce the current ratio.

`(2,50,000 - 50,000 ("Inventory"))/(1,00,000 - 40,000)`

= `(2,00,000)/(60,000)`

= 3.33 : 1

∴ Thus, The Current Ratio will reduce.

iv. Cash collected from trade receivables.

Reason: Let’s suppose ₹ 50,000 is received from Trade Receivables. It will reduce and increase the current assets with the same amount. As current assets and current liabilities are intact.

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

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

= 2.5 : 1

∴ Thus, The Current Ratio will not change.

v. B/R dishonoured.

Reason: Let’s suppose ₹ 50,000 Bills Receivables dishonoured. It will increase debtors (Current Assets) and decrease Bills Receivable (Current Assets) with same amount. It will not change the Current Ratio.

`(2,50,000 - 50,000 ("Trade Rceivable") + 50,000 ("Debtors"))/(1,00,000)`

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

= 2.5 : 1

∴ Thus, The Current Ratio will not change.

vi. Issue of shares.

Reason: Issue of shares will increase the cash (current assets). The current liabilities remain intact.

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

= `(3,00,000)/(1,00,000)`

= 3 : 1

∴ Thus, The Current Ratio will improve.

vii. Issue of shares against the purchase of a building.

Reason: Issue of shares increases Share Capital and purchase of building increases the Non-Current Assets. Current Assets and Current Liabilities remain unchanged.

∴ Thus, The Current Ratio will not change.

viii. Redemption (Repayment) of Debentures maturing during the year.

Reason: Let’s suppose, ₹ 50,000 Debentures maturing during the year redeemed. Debentures maturing during the year is considered as Current Liabilities. It will reduce the current liabilities and Current assets (cash) with the same amount.

`(2,50,000 - 50,000 ("Cash"))/(1,00,000 - 50,000 ("Debentures maturing in Current year"))`

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

= 4 : 1

∴ Thus, The Current Ratio will improve.

ix. Purchase of Loose Tools against Cash.

Reason: Let’s suppose, ₹ 50,000 Loose Tools are purchased. Purchasing of the Loose Tools will result in the decrease in Cash (Current Assets), Loose Tools are not included in Current Assets for the calculation of Current Ratio.

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

= `(3,00,000)/(1,00,000)`

= 3 : 1

∴ Thus, The Current Ratio will reduce.