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In: Finance

Assume that a corporation needs to enter the private debt market to raise funds for plant...

Assume that a corporation needs to enter the private debt market to raise funds for plant expansion. The corporation expects debt covenants to place restrictions on the levels of its current ratio and total-liabilities-to-assets ratio. Considering the accounts that comprise these ratios, provide examples of accounting estimates, accounting judgments, and structured transactions that the lender should examine closely and explain why each is important. In replies to peers, discuss additional information the lender should consider

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Expert Solution

CURRENT RATIO:

  • The current ratio is calculated by dividing current assets by current liabilites
  • The current ratio helps investors understand the liquidity of a company and how easily that company will be able to pay off its current liabilities. The ratio expresses a firms current debt in terms of current assets. So a current ratio 3 would mean that the company has 3 times more current assets than current liabilities.
  • A higher current ratio is always more favorable than a lower current ratio because it shows the company can more easily make current debt payment .
  • Example : suppose a company reported 100,000 of current liabilities and only 20,000 of current assets. Then the company current ratio will be 0.2. As you can see the company has enough current assets to pay off 20 percent of his current liabilities. This shows that company is highly leveraged and highly risks. Bank would prefer a current ratio of atleast 1 or 2 . so that all the current liabilities would be cover by the current assets.

TOTAL LIABILITIES TO ASSETS RATIO:

  • Total liabilities to asset ratio is a ratio to determine the extent of leverage in a company .
  • It is calculated by dividing the total liabilities by the total assets.The ratio aims to measure the ability of a company to pay off its debt with its assets.
  • There is a general practice of showing the total liabilities to assets ratio in the decimal format and ranges from 0.00 to 1.00. A ratio of 0.5 indicates that half of the total assets of the company are financed by the liabilities. in other words, the debts is only 50 percent of the total assets.
  • A higher Total liabilities to asset ratio is very unfavorable for a company because it indicates that a higher percentage of assets are financed through debt. This means that the creditors have more claims on the companys assets.

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