The Current ratio

Question

A company's current ratio is 1.5. If the company uses cash to retire notes payable due within one year, this transaction would  the current ratio and  the return on assets ratio.

(a) increase, increase

(b) increase, decrease

(c) decrease, decrease

(d) decrease, increase

Answer 1

Answer: A (Both ratio should increase)

Current Ratio = Current Asset/ Current Liability

Cash = Current Asset

Notes Payable = Current Liability

Because we used cash to reduce notes payable, this will decrease both the numerator and denominator.

You may think that the ratio does not change because both the numerator & denominator reduces by the same amount but if we use a simple example we can see that it actually increases.

ie. Assume $6 in Current Assets & $4 in Current Liabilities that has a current Ratio of 1.5. But if notes payable is $1 & we use cash to reduce it, then both numerator & denominate will reduce by $1, so we would have $5 in current assets & $3 in current liabilities, therefore current ratio will be 1.67 (Increase).

ROA = Net Income/ Total Assets

In this example, Net Income has no impact because cash & notes payable does not go on the Income Statement (Net Income is the bottom line in Income Statement). Notes payable is a liability so that does not affect assets but the reduction of cash will. Because we used cash to reduce notes payable, total assets decreases. If the denominator (Total Assets) decrease, then the ratio will increase.