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Survey of Accounting (Accounting I)

8th Edition
Carl Warren
ISBN: 9781305961883

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Survey of Accounting (Accounting I)

8th Edition
Carl Warren
ISBN: 9781305961883
Textbook Problem

Favorable business conditions may bring about certain seemingly unfavorable ratios, and unfavorable business operations may result in apparently favorable ratios. For example. Shaddox Company intreased its sales and net income substantially for the current year, yet the current ratio at the end of the are is lower than at the beginning of the year. Discuss some possible causes of the apparent weakening of the current position, while sales and net income have increased substantially.

To determine

Introduction:

Liquidity ratios are used to evaluate the ability of a business to pay its short term dues.

Current ratio is used to interpret the liquidity position of a business or ability of business to pay short term dues. It can be calculated by dividing current assets with current liabilities

Current assets include cash held, inventory, receivables and prepayments

Current liabilities are owings of the business payable within one year.

To discuss:

Increase in sales and net income which may lead to decrease in liquidity.

Explanation

Increase in sales decreases the level of inventory which may lead to decrease in current assets, due to the following reasons:

  • Business may need to spend more on expansion which may lead to shortage in cash, large sales will necessitate more facilities, equipments and require additional investment.
  • Business may need to borrow more which will lead to increase in liabilities...

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