Question

The Current Ratio of a Company is 2 : 1. State, giving reasons which of the following transactions would (i) improve, (ii) reduce of (iii) not alter, the current ratio:

(a) Repayment of a Current Liability

(b) Purchasing goods on credit

(c) Sale of an Office Equipment for Rs. 4,000 (Book Value Rs. 5,000)

(d) Sale of goods for Rs. 11,000 (Cost Rs 10,000)

(e) Redemption of Debentures.

Answer 1

Current Ratio as given in the question is 2 : 1. In order to understand the question in a simple manner, it may be assumed that current assets are Rs. 2,00,000 and current liabilities are Rs. 1,00,000.

(a) Repayment of a Current Liability : Suppose, a current liability amounting to Rs. 50,000 is repaid, the revised current ratio will be : -

$\frac{2,00,000-50,000\left(Cash\right)}{1,00,000-50,000\left(CurrentLiability\right)}=\frac{1,50,000}{50,000}=3:1$

$\therefore$ Current Ratio is improved.

(b) Purchasing Goods on Credit : Suppose, goods for Rs. 25,000 is purchased on credit, the revised current ratio will be :

$\frac{2,00,000+25,000\left(Inventory\right)}{1,00,000+25,000\left(TradePayables\right)}=\frac{2,25,000}{1,25,000}=1.8:1$

$\therefore$ Current Ratio is reduced.

(c) Sale of an Office Equipment for Rs. 4,000 (Book Value Rs. 5,000) : Sale of Office Equipment (e.g., Typewriter ) results in an increase in Cash balance by Rs. 4,000 and this leads to an increase in current assets. There will be no other effect of the sale of office equipment since it is a fixed asset. As such,

$\frac{2,00,000+4,000\left(Cash\right)}{1,00,000}=\frac{2,04,000}{1,00,000}=2.04:1$

$\therefore$ Current Ratio is improved.

(d) Sales of Godds for Rs. 11,000 (cost Rs.10,000): The revised ratio will be:

$\frac{2,00,000+11,000\left(Cash\right)-10,000\left(Inventory\right)}{1,00,000}=\frac{2,01,000}{1,00,000}=2.01:1$

(e) Redemption Of Debentures : Debentures redeemable during the current year are included in Current Liabilities. Suppose, debentures amounting to Rs. 10,000 are included in current liabilities. They are now paid off. It will reduce the amount of current liabilities on the one hand and on the other hand it will also reduce the current assets, as the cash balance is reduced because of payment of debentures. Thus, the revised ratio will be :

$\frac{2,00,000-10,000\left(Cash\right)}{1,00,000-10,000\left(DebenturesRedeemed\right)}=\frac{1,90,000}{90,000}=2.11:1$

$\therefore$ Current Ratio is improved.