Accounting – 6.2 Interpretation of accounting ratios | e-Consult
6.2 Interpretation of accounting ratios (1 questions)
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(a) The current ratio indicates a company's ability to pay off its short-term liabilities (working capital) with its short-term assets. A current ratio of 1.5 suggests that for every £1 of current liabilities, the company has £1.50 of current assets. This indicates a reasonable, but not necessarily excellent, level of liquidity.
(b) Two recommendations for improving working capital are:
- Improve Inventory Management: Reduce the amount of inventory held.
- Negotiate Extended Payment Terms with Suppliers: Ask suppliers for longer periods to pay invoices.
(c) How each recommendation improves the current ratio:
- Improve Inventory Management: By reducing inventory levels, the current assets (specifically inventory) will decrease. If current liabilities remain the same, the current ratio will increase.
Current Ratio = Current Assets / Current Liabilities. Reducing Current Assets (Inventory) while keeping Current Liabilities constant increases the ratio. - Negotiate Extended Payment Terms with Suppliers: By delaying payments to suppliers, the current liabilities (accounts payable) will decrease. If current assets remain the same, the current ratio will increase.
Current Ratio = Current Assets / Current Liabilities. Reducing Current Liabilities (Accounts Payable) while keeping Current Assets constant increases the ratio.