Fact Pattern: Tosh Enterprises reported the following account information: Accounts receivable $400,000 Accounts payable 260,000 Bonds payable, due in 10 years 600,000 Cash 200,000 Interest payable, due in 3 months 20,000 Inventory $800,000 Land 500,000 Short-term prepaid expense 80,000 '; What will happen to the ratios below if Tosh Enterprises uses cash to pay 25% of the accounts payable

Current ratio will increase

Quick ratio will increase

Explanation:

Note: The complete question is what will happen to Current ratio and the Quick ratio if Tosh Enterprises uses cash to pay 25% of the accounts payable?

These can be determined as follows:

a. Initial values

Current assets = Accounts receivable + Cash + Inventory + Short-term prepaid expense = $400,000 + $200,000 + $800,000 + 80,000 = $1,480,000

Current liabilities = Accounts payable + Interest payable, due in 3 months = $260,000 + $20,000 = $280,000

Initial current ratio = Current assets / Current liabilities = $1,480,000 / $280,000 = 5.29

Initial Quick ratio = (Current assets - Inventory) / Current liabilities = ($1,480,000 - $800,000) / $280,000 = 2.43

b. New values

20% of Accounts payable = 260,000 * 20% = $52,000

If Tosh Enterprises uses cash to pay 25% of the accounts payable, both the current assets and liabilities will fall by $52,000 by subtracting it from each of them to obtain new values as follows:

New current assets = $1,480,000 - $52,000 = $1,428,000

New current liabilities = $280,000 - $52,000 = $228,000

New current ratio = New current assets / New current liabilities = $1,428,000 / $228,000 = 6.26

New quick ratio = (New current assets - Inventory) / New current liabilities = ($1,428,000 - $800,000) / $228,000 = 2.75

c. Summary and Conclusion

Since the initial current ratio of 5.29 is less than the new current ratio of 6.26, this shows that current ratio will increase if Tosh Enterprises uses cash to pay 25% of the accounts payable.

Also, since initial quick ratio of 2.43 is less than the new qucik ratio of 2.75, this also shows that quick ratio will increase if Tosh Enterprises uses cash to pay 25% of the accounts payable.

Therefore we have:

Current ratio will increase

Quick ratio will increase

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