Can someone please check my answer to this question:
In recent years, a company 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?
My answer: The decrease in the quick ratio shows that the company spent money on purchasing inventory. The liquidity of the company has not improved because inventory is not liquid.
To check your answer, let's understand the concepts of current ratio and quick ratio and analyze the given information:
1. Current Ratio: It is a financial metric that measures a company's ability to pay off its short-term liabilities with its short-term assets. It is calculated by dividing current assets by current liabilities. A higher current ratio indicates better liquidity.
2. Quick Ratio: Also known as the acid-test ratio, the quick ratio is a more stringent measure of a company's liquidity. It measures the ability to pay off current liabilities without relying on the sale of inventory. It is calculated by subtracting inventory from current assets and dividing the result by current liabilities.
Based on this information, let's analyze the given situation:
The fact that the company has greatly increased its current ratio suggests that it has increased its current assets relative to its current liabilities. This could be due to factors such as an increase in cash and cash equivalents, accounts receivable, or other liquid assets.
On the other hand, the decrease in the quick ratio indicates that inventory has increased. The company might have spent money on purchasing more inventory. Since inventory is not easily converted into cash, it is considered less liquid than other current assets. Therefore, the quick ratio has fallen.
Now, let's evaluate whether the liquidity of the company has improved:
Based on the given information, the liquidity of the company has not improved. The increase in the current ratio might give the impression of improved liquidity, but the decrease in the quick ratio suggests otherwise. The increase in inventory, which is less liquid, indicates a potential reduction in the company's ability to pay off its immediate obligations without relying on the sale of inventory.
In conclusion, your answer that the liquidity of the company has not improved because of the decrease in the quick ratio is correct.