AboutArthur Naman Expertise General accounting and bookkeeping questions. How to do monthly bookkeeping, how to prepare financial reports. How to reconcile accounts.
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Experience 30 years' experience doing tax and accounting work
Education/Credentials MPA from Univ. of Texas at Austin, MBA Golden Gate Univ, San Francisco CA
Question QUESTION: Hello Sir I want to ask about Current ratios.
Sir, what happened when we use cash i.e current assets to pay the account payable i.e current liabilities?
Cash would be decrease but in good sense liabilities also decrease ... is that mean it won't effect the current ratio value?
Thanks
Take care!
ANSWER: I believe your conclusion would be correct.
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QUESTION: Sir, I need help to clear this point.
What happened when we use cash to pay the account payable liabilities?
Thanks for the reply
ANSWER: Well, write down an example of current assets and current liabilities. Then reduce current assets by an amount used to reduce current liabilities.
What is the current ratio before and after the payment is made and current liabilities reduced accordingly.
Let me know.
---------- FOLLOW-UP ----------
QUESTION: Hello Sir.
As you instructed, i take any two values divide them (numerator high,lessor denominator) note its reading and then decrease them proportionally.
Sir I am confuse, beside of decreasing the Current ratio in fact increased. Could you please explain why?
Take care!
Answer I have copied the figures below from a spreadsheet; I hope you can read them okay. In this example, we begin with current assets of 100 and current liabilities of 90. I have excluded any currency sign because this example is independent of any specific currency.
A B C D E F Columns
Original Scenario
100 90 80 70 60 50 Line 1 current assets
90 80 70 60 50 40 Line 2 current liab.
1.11 1.13 1.14 1.17 1.2 1.25 Line 3 current ratio
Second Scenario
100 90 81 72.9 65.61 59.05 Line 1 current assets
90 81 72.9 65.61 59.05 53.14 Line 2 current liab.
1.11 1.11 1.11 1.11 1.11 1.11 Line 3 current ratio
Line 1 shows current assets; Line 2 shows current liabilities; and line 3 shows a calculated current ratio.
In your original scenario above, an amount, let's say 10 of current assets was used to pay current liabilities. The question is how does that affect the current ratio. The current ratio changes in your original scenario because current assets is reduced for the following reason. Current assets is reduced by an amount of 10 which equals 10% of current assets. That amount, 10, is then used to reduce current liabilities. However, that amount, 10, is not the same percentage of current liabilities. 10 = 10% of current assets, but 11% of current liabilities (10/90 = 11%). The reason the current ratio changes is because current liabilities are reduced by a different percentage than the reduction of current assets.
In the second scenario above, if current liabilities is reduced by the same percentage as the reduction in current assets, then the ratio remains the same.
In your original example, since the percentage decrease in current liabilities is more than the corresponding decrease in current assets, the current ratio increases.
If this is still not clear, please e-mail me at anaman@naman.com and we can discuss this further. If needed we can exchange spreadsheets to assist in the explanation. If needed the spreadsheet can be in either .xls, or .xlsx (Microsoft format) or .ods (Open Office format).
