Nkem runs a business. Her current financial position is as follows. Current assets $ Inventory 18 000 Trade receivables 22 000 Bank 5 000 Total current asse...

(a) Calculating the current ratio and acid test ratio

Current ratio:

\( \text{Current ratio} = \frac{\text{Total current assets}}{\text{Current liabilities}} = \frac{45\,000}{25\,000} = 1.8 : 1 \) [1]

Current assets ($45,000) include inventory ($18,000), trade receivables ($22,000), and bank ($5,000). Current liabilities are trade payables ($25,000). [1]

Acid test ratio:

\( \text{Acid test ratio} = \frac{\text{Current assets} - \text{Inventory}}{\text{Current liabilities}} = \frac{45\,000 - 18\,000}{25\,000} = \frac{27\,000}{25\,000} = 1.08 : 1 \) [1]

Inventory is excluded because it is the least liquid current asset and may not be quickly converted to cash. [1]

(b) Effect of each transaction on the current ratio

(i) Purchased goods on credit for $3,000

Inventory increases by $3,000 (to $48,000) and trade payables increase by $3,000 (to $28,000). Both current assets and current liabilities rise by the same amount. [1]

\( \text{New current ratio} = \frac{48\,000}{28\,000} = 1.71 : 1 \)

The ratio decreases from 1.8 : 1 to 1.71 : 1. When the original ratio is above 1 : 1, adding the same amount to both numerator and denominator brings the ratio closer to 1 : 1. [1]

(ii) A customer paid $4,000 by cheque

Bank increases by $4,000, but trade receivables decrease by $4,000. Total current assets remain at $45,000. Current liabilities remain at $25,000. [1]

\( \text{New current ratio} = \frac{45\,000}{25\,000} = 1.8 : 1 \)

The ratio is unchanged because this transaction merely converts one current asset (receivables) into another (bank) with no change in totals. [1]

(iii) Sold goods costing $2,000 for $3,500 cash

Inventory decreases by $2,000 (cost of goods sold), and bank increases by $3,500 (sale proceeds). The net effect on current assets is an increase of $1,500 (the profit element), bringing total current assets to $46,500. Current liabilities remain at $25,000. [1]

\( \text{New current ratio} = \frac{46\,500}{25\,000} = 1.86 : 1 \)

The ratio increases because the profit on the sale adds to current assets without affecting current liabilities. [1]

(iv) Paid a trade payable $5,000 by cheque

Bank decreases by $5,000 (current assets fall to $40,000) and trade payables decrease by $5,000 (current liabilities fall to $20,000). [1]

\( \text{New current ratio} = \frac{40\,000}{20\,000} = 2.0 : 1 \)

The ratio increases from 1.8 : 1 to 2.0 : 1. When the original ratio is above 1 : 1, subtracting the same amount from both numerator and denominator pushes the ratio further above 1 : 1. [1]

(c) Two users of accounting ratios other than the owner

User 1: Bank or lender [1]

A bank would find liquidity ratios (such as the current ratio and acid test ratio) most useful. These ratios help the bank assess whether the business has sufficient short-term assets to meet its obligations, which is critical for deciding whether to grant a loan and whether the business can make regular repayments. [1]

User 2: Potential investor or partner [1]

An investor would find profitability ratios (such as return on capital employed and profit margins) most useful. These ratios reveal how effectively the business generates returns, helping the investor decide whether the expected return justifies the risk of investing. [1]

(d) Two reasons why a very high current ratio may indicate inefficiency

Reason 1: A very high current ratio may indicate that too much capital is tied up in inventory. [1] Excess inventory is inefficient because goods may become obsolete, damaged, or require markdowns, and holding costs such as storage, insurance, and handling increase unnecessarily. [1]

Reason 2: It may indicate that trade receivables are excessively high, meaning customers are taking too long to pay. [1] The cash locked in unpaid receivables could be used more productively elsewhere in the business, such as investing in new equipment, negotiating supplier discounts for early payment, or reducing borrowing. [1]