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Chapter 5: 5 (page 237)

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?

Short Answer

Expert verified

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

Step by step solution

01

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.

02

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 thecurrent assets are reported as the numerator in calculating the current ratio.

03

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.

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Most popular questions from this chapter

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Case 1: Uniroyal Technology Corporation

Uniroyal Technology Corporation (UTC), with corporate offices in Sarasota, Florida, is organized into three operating segments. The high-performance plastics segment is responsible for research, development, and manufacture of a wide variety of products, including orthopedic braces, graffiti-resistant seats for buses and airplanes, and a static-resistant plastic used in the central processing units of microcomputers. The coated fabrics segment manufactures products such as automobile seating, door and instrument panels, and specialty items such as waterproof seats for personal watercraft and stain-resistant, easy-cleaning upholstery fabrics. The foams and adhesives segment develops and manufactures products used in commercial roofing applications.

The following items relate to operations in a recent year.

1. Serious pressure was placed on profitability by sharply increasing raw material prices. Some raw materials increased in price 50% during the past year. Cost containment programs were instituted and product prices were increased whenever possible, which resulted in profit margins actually improving over the course of the year.

2. The company entered into a revolving credit agreement, under which UTC may borrow the lesser of \(15,000,000 or 80% of eligible accounts receivable. At the end of the year, approximately \)4,000,000 was outstanding under this agreement. The company plans to use this line of credit in the upcoming year to finance operations and expansion.

Instructions

(a) Should investors be informed of raw materials price increase, such as described in item 1? Does the fact that the company successfully met the challenge of higher prices affect the answer? Explain.

(b) How should the information in item 2 be presented in the financial statements of UTC?
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