Question

Potz and Pans, a small gift shop, has current assets of $45,000 (including inventory valued at $30,000) and $9,000 in current liabilities. Wannabees, a specialty clothing store has current assets of $150,000 (including inventory valued at $125,000) and $85,000 in current liabilities. Both business have applied for loans. Click the calculators box on the toolbar at bankrate.com then click on Small Business to answer the following questions.

1) Calculate and present the current ratio for each company. Which company is more likely to get the loan? Why?

2) The acid test ratio subtracts the value of the firm's inventory from its total current assets. Because inventory is often difficult to sell, this ratio is considered an even more reliable measure of a business's ability to repay loans than the current ration. Calculate and present the acid test ratio for each business and decide whether you would give either the loan. Why or why not for each?

Answer 1

	Potz & Pans	Wannabees
Type of industry	Gift Shop	Clothing store
Current Assets	45000	150000
Current Liabilities	9000	85000

Current Ratio measures the ability of a firm to pay its short term obligations.

Calculation of Current Ratio -

Current Ratio = Current Assets / Current liabilities ---------------------------------------equation (a)

Put the above values in equation (a)

Current Ratio of Potz & Pans = 45000/9000

= 5 : 1

Current Ratio of Wannabees = 150000 / 85000

= 1.765 : 1

Potz & Pans company is more likely to get the loan as Potz & Pans has enough assets as its current ratio is 5 : 1 but Wannabees does not have 1.76 : 1 Ideally the current ratio of a company should be 2:1 means it's assets is double than it's liabilities so that company can pay off its liabilities smoothly.

2.) Calculation of Acid Test Ratio -

Acid Test Ratio = Liquid Assets / Current Liabilities

Liquid Assets of Potz & Pans = Current Assets - Inventory

= 45000 - 30000

= 15000

Liquid Assets of Wannabees = 150000 - 125000

= 25000

Current liabilities of Potz & Pans = 9000

Current liabilities of Wannabees = 85000

Acid test Ratio (Potz & Pans) = 15000/9000

= 1.67

Acid test Ratio (Wannabees) = 25000/85000

= 0.29

Normally acid test ratio should be considered good if its 1:1, here Acid test ratio is good in case of Potz & pans (1.67) which is greater than 1. and bad in case of wannabees (0.29) smaller than 1.

so I would give loan to potz & pans & not wannabees as risk is very higher in wannabees.

Please check with your answer and let me know.