Question

In recent years, Game Co. has greatly increased its current ratio. At the same time, the quick ratio has fallen. What has happened? Has the liquidity of the company improved? (The Answer Must Be A Minimum of 350 Words Thank You)

Answer 1

Both the current ratio and the quick ratio are measures of the liquidity of a firm.

While, the current ratio is given by:

Total current assets (cash+receivables+inventory+prepaid expenses)/Total current liabilities

the quick ratio is given by:

(Cash+Marketable Securities+Receivables)/Total current liabilities

As can be seen, the current ratio takes into account all current assets in the numerator, while the quick ratio considers only the cash, marketable securities and accounts receivable. Thus the quick ratio excludes inventory and prepaid expenses which are not as liquid as cash, marketable securities and receivables. Hence, the quick ratio is a more stringent and reliable measure of the liquidity of a firm.

In the case Game Co, the current ratio has been increasing and the quick ratio has been decreasing over the years which, indicates a trend. It means that the value of the inventory has been increasing more than proportionately when considering the changes in other constituents of current assets and current liabilities.

The situation indicates that the quality of the current assets is decreasing and liquidity of the company has been deteriorating over the years.

The inventory must have been increasing over the years, which can be found out by calculating the number of days sales in inventory. [The ratio is caluclated as (Average inventory*365)/Cost of goods sold].

The increase in inventory may be due to excessive stocking, presence of slow or non-moving items, etc.

As a component of current assets inventory is the one that takes the maximum number of days to convert into cash. Hence, its increasing trend will give rise to higher current ratio and falling quick ratio.

These ratios of the firm can be compared with the industry average to judge the relative position. This is required as the requirement of current assets in relation to current liabilities can vary from industry to industry.