Question

The Nelson Company has $1,875,000 in current assets and $625,000 in current liabilities. Its initial inventory level is $375,000, and it will raise funds as additional notes payable and use them to increase inventory.
(a) How much can Nelson's short-term debt (notes payable) increase without pushing its current ratio below 1.2?
(b) What will be the firm's quick ratio after Nelson has raised the maximum amount of short-term funds?

Answer 1

Answer:

A) Short-term debt increase = 5,625,000

B) Quick Ratio= 0.24

Explanation:

a) Current Ratio = Current Asset (CA) / Current Liabilities (CL)

Acording to the current ratio formula, to calculate the amount of short-term debt increase, to the amount of current assets and current liabilities we must add an amount such that the result is 1.2.  

(1,875,000 + x) / (625,000 + x) = 1.2

(1,875,000 + x) = 1.2 * (625,000 + x)

 1,875,000 + x = (1.2* 625,000) + (1.2 x)

 1,875,000 + x = 750,000 + 1.2 x

 1,875,000 - 750,000 = 1.2 x – x

 1,125,000 = 0.2 x    

1,125,000 / 0.2 = x

x = 5,625,000

So the maximum that should be borrowed to buy inventory is 5,625,000

b) Quick Ratio = (Current Asset (CA) – Inventory (I) – Prepaid Expenses (PE))/Current Liabilities (CL)

For the Current Asset, the taken is 1,500,000 (1,875,000 - 375,000) because we don't include the original inventory and the maximum increase. For the current liabilities, we take 6,250,000 (625,000 + 5,625,000) that is the original amount add to the maximum increase

Quick Ratio = 1,500,000/ 6,250,000

Quick Ratio= 0.24