Question

Liquidity ratios

A liquid asset can be converted to cash quickly without significantly impacting the asset’s value. Which of the following asset classes is generally considered to be the least liquid?

Inventories

Accounts receivable

Cash

The most recent data from the annual balance sheets of Blue Pencil Publishing and Fuzzy Button Clothing Company are as follows:

Balance Sheets
As of December 31, Year 1
	Fuzzy Button	Blue Pencil		Fuzzy Button	Blue Pencil
Assets			Liabilities and Equity
Cash	$344,400	$221,400	Accounts payable	$0	$0
Accounts receivable	126,000	81,000	Accruals	75,938	0
Inventories	369,600	237,600	Notes payable	430,312	405,000
Total current assets	$840,000	$540,000	Total current liabilities	$506,250	$405,000
			Long-term bonds	618,750	495,000
			Total debt	$1,125,000	$900,000
Net plant and equipment	$660,000	$660,000	Common stock	243,750	195,000
			Retained earnings	131,250	105,000
			Total common equity	$375,000	$300,000
Total assets	$1,500,000	$1,200,000	Total liabilities and equity	$1,500,000	$1,200,000

Blue Pencil Publishing’s quick ratio is   , and its current ratio is   ; Fuzzy Button Clothing Company’s quick ratio is   , and its current ratio is   .

Which of the following statements are true? Check all that apply.

Fuzzy Button Clothing Company has a better ability to meet its short-term liabilities than Blue Pencil Publishing

A current ratio of 1 indicates that the book value of the company’s current assets is equal to the book value of its current liabilities.

If a company has a quick ratio of less than 1 but a current ratio of more than 1 and if the difference between the two ratios is large, then the company depends heavily on the sale of its inventory to meet its short-term obligations.

Compared to Blue Pencil Publishing, Fuzzy Button Clothing Company has less liquidity and a relatively greater reliance on outside cash flow to finance its short-term obligations.

An increase in the current ratio over time always means that the company’s liquidity position is improving.

Answer 1

Answer a.

Inventories is generally considered to be the least liquid.

Answer b.

Fuzzy Button Clothing Company:

Current Ratio = Current Assets / Current Liabilities
Current Ratio = $840,000 / $506,250
Current Ratio = 1.6593

Quick Ratio = (Current Assets - Inventories) / Current Liabilities
Quick Ratio = ($840,000 - $369,600) / $506,250
Quick Ratio = 0.9292

Blue Pencil Publishing:

Current Ratio = Current Assets / Current Liabilities
Current Ratio = $540,000 / $405,000
Current Ratio = 1.3333

Quick Ratio = (Current Assets - Inventories) / Current Liabilities
Quick Ratio = ($540,000 - $237,600) / $405,000
Quick Ratio = 0.7467

Blue Pencil Publishing’s current ratio is 1.3333, and its quick ratio is 0.7467; Fuzzy Button Clothing Company’s current ratio is 1.6593, and its quick ratio is 0.9292.

Answer c.

Fuzzy Button Clothing Company has a better ability to meet its short-term liabilities than Blue Pencil Publishing

A current ratio of 1 indicates that the book value of the company’s current assets is equal to the book value of its current liabilities.
If a company has a quick ratio of less than 1 but a current ratio of more than 1 and if the difference between the two ratios is large, then the company depends heavily on the sale of its inventory to meet its short-term obligations.
An increase in the current ratio over time always means that the company’s liquidity position is improving.