Question

Current and Quick Ratios

The Nelson Company has $1,667,500 in current assets and $575,000 in current liabilities. Its initial inventory level is $402,500, and it will raise funds as additional notes payable and use them to increase inventory.

How much can Nelson's short-term debt (notes payable) increase without pushing its current ratio below 1.3? Round your answer to the nearest cent.

$   

What will be the firm's quick ratio after Nelson has raised the maximum amount of short-term funds? Round your answer to two decimal places.

Answer 1

Current Ratio = Current Assets/Current Liabilities

Quick ratio = (Current Assets - Inventories)/Current Liabilities

Part 1

Let us assume that the amount Nelson can raise via short term debt = x. This x will be added to current assets as well as inventories.

Assume the current ratio to be 1.30

1.30 = (Existing Current Assets + x)/(Existing Current Liabilities + x)

1.30 = (1667500 + x)/(575,000 + x)

747,500 + 1.30x = 1667500 + x

=> 0.3x = 920,000

x = $3,066,666.7

Hence, Nelson can raise maximum $3,066,666.7 withough pusing current ratio below 1.30

Part b

If Nelson raises the above amount of short term debt,

We should not the new inventory in correct quick ratio and also remove the existing ones from the current assets, since inventories are not icnluded in quick ratio. But new short term debt would be added to existing current liabilities

Quick ratio = (1,667,500 - 402,500)/3,641,666.7) = 1,265,000/3,641,666.7 =0.3437