5 - Intermediate Accounting (Kieso)

Question

Perez Company reported an increase in inventories in the past year. Discuss the effect of this change on the current ratio (current assets ÷ current liabilities). What does this tell a statement user about Perez Company’s liquidity?

Step-by-Step Solution

Answer

The current ratio and liquidity of the company will increase with the increase in inventory.

Definition of Current Ratio

The financial metric reflecting the liquidity position of the business entity by comparing the current obligation and resources is known as the current ratio.

Change in Current Ratio

Due to an increase in the inventories of the business entity, the current assets of the business entity will also increase. An increase in current assets will increase the current ratio because the current assets are reported as the numerator in calculating the current ratio.

Liquidity of the Company

The current ratio provides information about the company’s liquidity. Due to an increase in the current ratio due to an increase in inventory, the company’s liquidity will also increase as more current assets will be available for paying current liabilities.