Which of the following would be most detrimental to a firm’s current ratio if that ratio is currently 2.0?

Question

a: Buy raw materials on credit
b: Sell marketable securities at cost
c: Pay off accounts payable with cash
d: Pay off a portion of long term debt with cash

Answer 1

Current ratio is current assets divided by current liabilities. If your current ratio is 2.0, your CA is double your CL, e.g. your CA could be $200,000 and CL $100,000.

a: Buy raw materials on credit
This would increase your current assets (CA) as well as your current liabilities (CL). Your current ratio will decrease but you don't know by how much. As an e.g., suppose the raw mat'ls cost $20k. Your CA would be $220,000 and your CL would be $120,000, making your current ratio 220,000/120,000 or 1.833.

b: Sell marketable securities at cost
This would not change your current ratio cos you're merely exchanging one CA (marketable securities) with another CA (cash)

c: Pay off accounts payable with cash
This would decrease your CA (cash) as well as your CL (accounts payable). This would increase your current ratio. As an e.g., suppose you pay off AP of $20k, your CA would be $180,000 and your CL would be $80,000, making your current ratio 180,000/80,000 or 2.25.

d: Pay off a portion of long term debt with cash
This would decrease your current ratio cos you're decreasing your CA (cash) while leaving CL untouched cos long term debt is not included in CL. A long term debt is usually a fairly large amount too.

Both (a) and (d) will be detrimental to your current ratio, but (d) will be more detrimental, so the answer is (d)

Answer 2

ARE YOU REFERRING TO A DEBT TO CASH RATIO?