A firm has experienced an increasing current ratio, but a decreasing operating cash flow to current liabilities ratio, during the last three years. What is the likely explanation for these results?
Ratios can be compiled with any aspect of the balance sheet, income statement, or statement of cash flow. Ratios can also be modified to serve the users' needs.
Answer and Explanation:
The current ratio is a liquidity ratio that assesses the ability of a company to utilize current assets to service current liabilities. Operating cash flow is similar to the current ratio however the ratio assumed that operating cash flow is utilized to service current liabilities in lieu of current liabilities. The interpretation of the ratio is the same with a ratio greater than 1:1 indicates that the company has excess current assets to service current liabilities. A firm experiencing an increasing current ratio and lower operating cash flow could have an accumulation of non-cash assets such as inventory and prepaid or non-conversion of receivables into cash in a timely manner. Situations such as these can artificially inflate the current ratio. A decreasing operating cash flow utilizes income statement operations in the calculation and is considered a more accurate view of the servicing ability of an entity. Decreasing operating cash flow could increase expenses decreasing overall profitability such as one-time expansion costs. Another possibility could be a decreasing gross profit or sales of the firm. Despite the reason, both ratios provide valuable insight into the resiliency of operations.
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from Geometry: High SchoolChapter 7 / Lesson 1