Auditing and Attestation- Certified Public Accountant (CPA) Practice Exam -

What effect does using cash to reduce accounts payable have on a company's current ratio and quick ratio?

1. Decreased VS. Increased

2. Decreased VS. No Effect

3. Increased VS. Decreased

4. Increased VS. No Effect

The correct answer is: Increased VS. Decreased

When a company uses cash to reduce its accounts payable, it results in a decrease in both current assets and current liabilities, which has distinct effects on financial ratios such as the current ratio and quick ratio. Focusing first on the current ratio, which is calculated by dividing current assets by current liabilities, the use of cash reduces current assets because cash is a current asset. Simultaneously, it decreases current liabilities as accounts payable is also classified as a current liability. When both the numerator (current assets) and denominator (current liabilities) decrease, the overall effect on the current ratio can potentially be an increase, depending on the amounts involved. In this case, if the reduction in current liabilities proportionally exceeds the reduction in current assets, the current ratio would indeed increase. Now examining the quick ratio, which measures a company's ability to meet its short-term obligations with its most liquid assets and is calculated as (current assets - inventory) / current liabilities, cash reduction does not affect other liquid assets or inventory. Since both cash and accounts payable are adjusted, the quick ratio will decrease because cash is decreasing in the numerator while the liability in the denominator also decreases, leading to a scenario where the quick ratio will reflect a lower level when the quick assets are compared to