Question

Current and Quick Ratios

The Nelson Company has $1,392,000 in current assets and $480,000 in current liabilities. Its initial inventory level is $355,000, and it will raise funds as additional notes payable and use them to increase inventory.

1. How much can Nelson's short-term debt (notes payable) increase without pushing its current ratio below 2.2? Do not round intermediate calculations. Round your answer to the nearest dollar.

2. What will be the firm's quick ratio after Nelson has raised the maximum amount of short-term funds? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

1. Let's assume the amount of short-term debt and inventory increase is x. new current ratio after increase in short-term debt and inventory can't be below 2.2.

Current ratio = Current assets/current liabilities

new current ratio = Current assets + x/current liabilities + x

2.2 = $1,392,000 + x/$480,000 + x

2.2*($480,000 + x) = $1,392,000 + x

$1,056,000 + 2.2x = $1,392,000 + x

2.2x - x = $1,392,000 - $1,056,000

1.2x = $336,000

x = $336,000/1.2 = $280,000

Nelson's short-term debt (notes payable) can increase by $280,000 without pushing its current ratio below 2.2.

2. quick ratio = (Current assets - inventory)/Current liabilities

Inventory after maximum amount of short-term funds raised = original inventory + addition = $355,000 + $280,000 = $635,000

New current liabilities after maximum amount of short-term funds raised = original current liabilities + short-term debt raised = $480,000 + $280,000 = $760,000

New current assets after maximum amount of short-term funds raised = original current assets + inventory increased = $1,392,000 + $280,000 = $1,672,000

quick ratio = ($1,672,000 - $635,000)/$760,000 = $1,037,000/$760,000 = 1.36