Difficulty: Easy

Average Score: 76%

A company overestimates its ending inventory for a year. Which effect will this have on the company's working capital and current ratio?

Rationale

Overstatement of working capital and current ratio.

When a company overestimates its ending inventory, it inflates the total current assets reported on its balance sheet. Since working capital is calculated as current assets minus current liabilities, this inflation results in an overstatement of working capital, which also leads to a higher current ratio, as current assets are a key component of this financial metric.

A (Understatement of working capital and current ratio) YOUR ANSWER

If the company were to underestimate its ending inventory, it would lower current assets, consequently reducing working capital and the current ratio. However, an overestimation, as stated in the question, directly contradicts this choice.

B (Understatement of working capital and overstatement of current ratio) YOUR ANSWER

This option suggests a lower working capital while implying a higher current ratio, which is inconsistent with an overestimated inventory. Overstated inventory increases both current assets and working capital, therefore this choice is incorrect.

C (Overstatement of working capital and current ratio) CORRECT

Correctly identifies that overestimating ending inventory inflates current assets, thus increasing both working capital and the current ratio. This relationship is fundamental in understanding the financial implications of inventory misstatements.

D (Overstatement of working capital and understatement of current ratio) YOUR ANSWER

This choice contains a contradiction; while working capital is indeed overstated due to inflated inventory, the current ratio should also reflect this increase, not a decrease. Therefore, this option is inaccurate.

Conclusion

In summary, overestimating ending inventory leads to an overstatement of both working capital and the current ratio. This reflects the direct relationship between current assets and these financial measures, highlighting the importance of accurate inventory reporting in financial analysis and decision-making.

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