Question

Assertion :Current ratio shows the ability of the firm to meet its short-term obligations. Reason: Current ratio is also used in inventory valuation.

• A. Both Assertion and Reason are correct and Reason is the correct explanation for Assertion.
• B. Both Assertion and Reason are correct but Reason is not the correct explanation for Assertion.
• C. Assertion is correct but Reason is incorrect.
• D. Both Assertion and Reason are incorrect.

Answer 1

The correct option is C Assertion is correct but Reason is incorrect.

Let us understand the actual use of Current Ratio.

Current Ratio = Current Asset (C.A)/Current Liabilities (C.L)

Scenario 1: C.A = $Rs.100000$ and C.L = $Rs.50000$

Current Ratio = $100000/50000$ = $2$

Scenario 2: C.A = $Rs.80000$ and C.L = $Rs.50000$

Current Ratio = $80000/50000$ = $1.6$

Now, what we can interpret from above is that in Scenario $1$ the current assets of the same are sufficient enough to pay $2$ times the amount of current liabilities, whereas in Scenario $2$ it is only $1.6$ times.

So from the above examples it is clear that the Current ratio is used to monitor the ability of the firm to meet its obligations and not in inventory valuation.