Question

The Nelson Company has $1,391,000 in current assets and $535,000 in current liabilities. Its initial inventory level is $410,000, 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 1.8? Do not round intermediate calculations. Round your answer to the nearest dollar.

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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

Current Ratio measures how well a Company is able to serve its short term obligations by effectively managing its short term assets. Formula: Current Assets/ Current Liabilities

Quick Ratio also measures the short term liquidity of a Company, but it is a more conservative ratio than the Current Ratio. It does not include inventory as a part of current assets since stock will take some time (more than 90 days usually) to get converted into cash. Fomula: (Current Assets-Inventory)/ Current Liabilities

Currently, Nelson's Current Ratio= CA/CL= 13,91,000/ 5,35,000= 2.6:1

Let the short term notes payable to be issued be X which in turn will be used to purchase more inventory; hence both Current assets and Current liabilities shall be increased by the same amount:

therefore, (13,91,000 + X) / (5,35,000 + X)= 1.8

solving for X, we get X= $ 5,35,000

Thus, Nelson Co, can issue notes payable worth $ 5,35,000 so as to maintain a minimum current ratio of 1.8.

Post this issue, Nelson's Quick Ratio= (CA- Inventory) / CL= (13,91,000- 4,10,000) / (5,35,000+5,35,000)= 0.92:1 (approx)