Question

Jim Tennison, L & B Corporation’s president, called the company’s chief financial officer, Fred Harden, into his office late Friday afternoon. Jim had been reviewing the projected financial statements of L & B Corporation that would be issued as of year-end. Jim told Fred he was worried that the company’s liquidity position had been declining over the past two years. Fred assured Jim that the company still had sufficient liquidity, and it had been steadily decreasing its debt. Jim said that there were three or four major stockholders who were very conservative and would raise lots of questions about the company’s declining liquidity ratios. Jim and Fred then decided to take out a two-year loan secured by some land L & B Corporation owned, put the cash in the bank, and pay the loan off after January 1. Jim told Fred to account for the transaction as a long-term liability for financial reporting purposes. They agreed that this measure would solve the problem of liquidity at the annual stockholders’ meeting because the company’s ratios would be almost identical to last year. Jim was sure that most of the stockholders were only concerned with net income and ratios

2. If the transaction is booked as a debit to Cash and a credit to Long-Term Notes Payable, how will it affect the company's key current ratios and debt ratios?

3. Suppose Jim and Fred decide not to take out the loan. Write a brief note to the stockholders justifying a decrease in liquidity measures. Assure them that the company is still in the "safe range".

Answer 1

2. If the transaction is booked as a debit to cash and credit to long term notes payable, the current assets and quick assets of the company would increase. This would result in an increase in current ratio and acid test ratio of the company as they use the current assets and quick assets as the numerator respectively.

The long term note payable will increase the company's long term liabilities and the debt to asset ratio would increase.

3.

Dear Stockholders,

We would like to tell you that there have been some questions rasied about the company's liquidity position. However, these concerns are invalid as the company has sufficient liquidity to service both its short term and long term liabilties. The current ratio and quick ratio of the company are both greater than 1 which means that the company has enough cash and cash equivalents to service its short term liabilites. Even the long term liabilities are being paid off regularly. Thus, it can be said with assurance that the company is "safe" as far as its liquidity position is concerned.