Sunrise Traders: Is the Current Ratio Telling the Truth?
Sunrise Traders' position on 31 March 2024: inventory ₹3,00,000; trade receivables ₹2,00,000; bills receivable ₹50,000; prepaid insurance ₹20,000; cash and cash equivalents ₹30,000; trade payables ₹2,20,000; outstanding salary ₹30,000; bank overdraft ₹50,000. Revenue from operations for the year was ₹24,00,000, of which ₹20,00,000 was on credit; gross profit ratio 25%. The proprietor has applied for a working-capital loan and the bank's rule is that the quick ratio must be at least 1. Meanwhile a supplier offers a 2% discount for payment within 10 days against normal 30-day terms. The accountant advises accepting the offer using the ₹30,000 cash balance, arguing that 'paying creditors in cash reduces current assets and current liabilities by the same amount, so the current ratio will stay unchanged'. Inventory has risen 40% over the year while credit sales rose only 8%.
1. Compute the current ratio, quick ratio and debtors turnover, and say what the three figures together reveal.
Read the worked answer
Current assets = 3,00,000 + 2,00,000 + 50,000 + 20,000 + 30,000 = ₹6,00,000
Current liabilities = 2,20,000 + 30,000 + 50,000 = ₹3,00,000
Current ratio = 6,00,000 / 3,00,000 = 2:1
Quick assets = 6,00,000 − 3,00,000 (inventory) − 20,000 (prepaid) = ₹2,80,000
Quick ratio = 2,80,000 / 3,00,000 = 0.93:1
Debtors turnover = credit revenue 20,00,000 / (2,00,000 + 50,000) = 8 times, i.e. about 46 days (365/8).
Reading them together: the 2:1 current ratio is flattered by inventory, which is half of current assets. Collection is reasonably brisk at 46 days, so receivables are not the problem - inventory is. A quick ratio below 1 means the liquid assets cannot discharge the current liabilities, and the 40% inventory build against only 8% credit-sales growth signals slow-moving or obsolete stock. The short-term liquidity is weaker than the headline ratio suggests.
2. Evaluate the accountant's reasoning about paying ₹30,000 to creditors early. Support your answer with figures.
Read the worked answer
The claim is wrong on both ratios; only the direction differs.
After paying ₹30,000: current assets 6,00,000 − 30,000 = 5,70,000; current liabilities 3,00,000 − 30,000 = 2,70,000.
Current ratio = 5,70,000 / 2,70,000 = 2.11:1 - it rises, because when a ratio exceeds 1 an equal reduction in numerator and denominator increases it.
Quick ratio: quick assets 2,80,000 − 30,000 = 2,50,000; quick ratio = 2,50,000 / 2,70,000 = 0.93:1, marginally lower than 0.933, because with a ratio below 1 an equal reduction pushes it down.
The arithmetic is trivial but the conclusion is serious: the firm would drain its entire cash balance to earn a 2% discount. On 30-day terms, 2% for 20 days early works out to roughly 2/98 × 365/20 ≈ 37% annualised, so the discount is genuinely valuable - but only out of surplus cash. Here it would leave nil cash and a quick ratio still under 1, exactly the condition the bank is testing.
3. Suggest two actions that would raise the quick ratio without fresh borrowing and without reducing current liabilities, and explain why collecting receivables does not qualify.
Read the worked answer
Convert inventory into cash or receivables. A cash sale moves ₹1 of inventory into ₹1 (or more) of quick assets with no change to current liabilities, so the numerator rises while the denominator stands still. This attacks the actual weakness - the 40% stock build - and is preferable to any purely financial fix.
Bring in proprietor's capital, or sell a surplus non-current asset for cash. Either injects a quick asset without adding a current liability, which is precisely what the bank's covenant rewards.
Why not collect receivables? Book debts already count as quick assets. Collecting them merely swaps trade receivables for cash, leaving quick assets and current liabilities unchanged, so the ratio is unaffected. Students frequently offer this as an answer because cash 'goes up' - but a ratio compares totals, not individual line items.
Note also that paying creditors (the accountant's plan) cannot help here, since with a quick ratio below 1 it lowers the ratio further.