Question

2. Liquidity ratios

Most firms borrow money to finance some of their assets, and most will choose to borrow some long-term funds and some short-term funds. Which group of lenders would put greater emphasis on a firm’s liquidity ratio when evaluating a potential borrower?

Short-term lenders

Long-term lenders

The most recent data from the annual balance sheets of Free Spirit Industries Inc. and LeBron Sports Equipment Inc. are as follows:

Balance Sheet December 31stst(Millions of dollars)

	LeBron Sports Equipment Inc.	Free Spirit Industries Inc.		LeBron Sports Equipment Inc.	Free Spirit Industries Inc.
Assets			Liabilities
Current assets			Current liabilities
Cash	$861	$553	Accounts payable	$0	$0
Accounts receivable	315	203	Accruals	190	0
Inventories	924	594	Notes payable	1,075	1,012
Total current assets	2,100	1,350	Total current liabilities	1,265	1,012
Net fixed assets			Long-term bonds	1,547	1,238
Net plant and equipment	1,650	1,650	Total debt	2,812	2,250
			Common equity
			Common stock	610	488
			Retained earnings	328	262
			Total common equity	938	750
Total assets	3,750	3,000	Total liabilities and equity	3,750	3,000

Free Spirit Industries Inc.’s quick ratio is   , and its current ratio is   ; LeBron Sports Equipment Inc.’s quick ratio is   , and its current ratio is   .

Which of the following statements are true? Check all that apply.

Free Spirit Industries Inc. has less liquidity but also a greater reliance on outside cash flow to finance its short-term obligations than LeBron Sports Equipment Inc..

A current ratio of 1 indicates that the book value of the company’s current assets is equal to the book value of its current liabilities.

If a company has a quick ratio of less than 1 but a current ratio of more than 1 and if the difference between the two ratios is large, then the company depends heavily on the sale of its inventory to meet its short-term obligations.

Free Spirit Industries Inc. has a better ability to meet its short-term liabilities than LeBron Sports Equipment Inc.

An increase in the current ratio over time always means that the company’s liquidity position is improving.

Answer 1

Short Term Lenders look to evaluate the liquidity position when evaluating a potential borrower because long term borrowers look to evaluate the solvency position of the business.

Free Spirit Industries Inc.’s quick ratio = Current Assets - Inventory/Current Liabilities = (1350-594)/1012 = 0.75

Free Spirit Industries Inc.’s Current Ratio = Current Assets/Current Liabilities = 1350/1012 =1.33

LeBron Sports Equipment Inc.’s quick ratio = Current Assets - Inventory/Current Liabilities = (2100-924)/1265 = .93

LeBron Sports Equipment Inc.’s Current Ratio = Current Assets/Current Liabilities = 2100/1265 = 1.66

Statements that are true?

Free Spirit Industries Inc. has less liquidity but also a greater reliance on outside cash flow to finance its short-term obligations than LeBron Sports Equipment Inc.. Thsis can be seen by the liquidity ratios of Free Spirit Industries Inc. as it is less than LeBron Sports Equipment Inc. and has to heavily depend on outside cash flow to finance it's operations.

A Current Ratio of 1 indicates that the book value of the company’s current assets is equal to the book value of its current liabilities. Current Ratio is equal to Current Assets/Current Liabilities and hence, a current ratio of 1 means that the current assets is equal to current liabilities.

If a company has a quick ratio of less than 1 but a current ratio of more than 1 and if the difference between the two ratios is large, then the company depends heavily on the sale of its inventory to meet its short-term obligations. This is also true and can be seen by the example of Free Spirit Industries Inc. and LeBron Sports Equipment Inc. as both the firms make it heavily dependent on the sale of inventory to meet short term obligations.

Free Spirit Industries Inc. has a better ability to meet its short-term liabilities than LeBron Sports Equipment Inc. This statement is not true since the liquidity ratios of Lebron Sports Equipment Inc. is way better than the Free Spirit Industries Inc. which means that Free Spirit is not better equiped to meet its short term obligations than LeBron Sports Equipment Inc.

An increase in the current ratio over time always means that the company’s liquidity position is improving. This is true as the current ratio signifies the liquidity position of a caompany and if it is improving , it does mean that the company's liquidity position is improving.