Question

At the end of 2016, burger food truck The Patty Wagon’s preliminary trial balance indicated a current ratio of 1.20. Management is contemplating paying some of its accounts payable balance before the end of the fiscal year. Explain the effect this transaction would have on the current ratio. Would your answer be the same if the preliminary trial balance indicated a current ratio of 0.8?

Answer 1

No

Step-by-step explanation:

Lets assume that for current ratio to be 1.2, the current assets were $120000 and Current liabilities were $100000. [120000 / 100000 = 1.2]

Now, if say $20000 of accounts payable were paid, the new current ratio would be:

= ($120000 - $20000) / ($100000 - $20000)

= $100000 / $80000

= 1.25.

Hence, the current ratio would Increase and this should be encouraged.

If current ratio were 0.8, (Current Assets $ 80000 and Current Liabilities $ 100000, 80000 / 100000 = 0.8] and $ 20000 were paid, the new current ratio would be:

= ($80000 - $20000) / ($100000 - $20000)

= $60000 / $80000

= 0.75

Hence, the current ratio would Decrease. This should be discouraged.

Conclusion: No, the answer would not be the same if current ratio were 0.8 instead of 1.2.