Question

If a company's current ratio increases from 1.2 to 1.4 from one year to the next, and its acid test ratio decreases from 0.20 to 0.15 over the same time period, the most likely explanation is that:

Answer 1

The inventory has been reportedly increased and it should be checked.

Inventory management should be further examined.

Step-by-step explanation:

Current Ratio = Current Assets/ Current liabilities

An increase in the current ratio means that there is an increase in the current assets or decrease in the current liabilities.

Acid test Ratio= Current Assets - Inventory / Current liabilities

If the acid test ratio is decreased it means that there is an increase in current liabilities or the current assets have decreased.

If we carefully look at the two formulas we find that inventory has increased and deduction of inventory from current assets reduces the amount of current assets and increases the current liabilities giving a bigger acid test ratio.

The inventory has been reportedly increased and it should be checked.

Inventory management should be further examined.