linds0121 – this is how I understand it, I hope I'm right.
The question says there is inventory, so production is greater than sales, which means that absorption costing net income will be greater than variable costing.
With that said, if there is inventory, than current assets will increase. The current ratio = CA/CL. If you increase inventory, you increase CA. An increase in CA will cause the current ratio to increase.
Return on stockholders equity = Net income/Equity. Also remember that Assets = Liabilities + Equity. When you increase your inventory, you increase your assets. Liabilities will remain unchanged, causing your equity to increase. When equity increases, return on equity decreases.
Example:
Original numbers:
CA = 10,000
CL = 5,000
Equity = 5,000
10,000 = 5,000+5,000
Example Numbers (increasing inventory the 5000)
CA = 15,000 (original 10000 + 5000)
CL = 5,000 (unchanged)
Equity = 10,000 (5000 increase to make CA=CL+Equity)
Current Ration = CA/CL
Original = 10,000/5,000 = 2 current ratio
Example = 15,000/5,000 = 3 current ratio
Therefore, increase in current ratio
Return on Equity = NI/Equity
Assume NI = 500,000
Original = 500,000/10,000 = 50
Example = 500,000/15,000 = 33.33
Therefore, decrease in return on equity
Hope this helps!
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