Question

In: Finance

1. Jacob’s monthly income is $2,800 and his monthly expenses total around $2,000. He has been...

1. Jacob’s monthly income is $2,800 and his monthly expenses total around $2,000. He has been contemplating how to use his about $800 surplus. He has the following financial records: Cash in his bank account $560 Investment in a mutual fund which he can easily convert to cash $850 Car (valued at) $12,000 Household personal possessions $2,850 Credit card balances $1,250 Miscellaneous short-term debts $520 Student loan balance $8,500 Balance on car loan $4,500

a) Calculate current ratio, liquidity ratio and debt ratio. Comment on his financial position; does he live within his means?

b) What do you recommend Jacob to do with his monthly surplus income?

Expert Solution

(a)

Current Ratio is defined as the ration of Current Assets to Current Liabilities

Current Assets are liquid assets that are expected to be sold or consumed within one year. Current Liabilities are amounts due to be paid to creditors usually within next one year.

Current Ratio = Current Asset / Current Liability

Current Asset: Cash in Bank Account + Investment in Mutual Fund + Personal Possession = 560 + 850 + 2,850= 4,260

Current Liability: Credit Card Balances + Miscellaneous short-term Debt = 1,250 + 520 = 1,770

Hence Current Ratio = 4,260 / 1,770 = 2.4067

Current Ratio = 2.41

Liquidity Ratio is ratio of Liquid Asset to Current Liability

Liquidity Ratio = (Cash in Bank Account + Investment in Mutual Fund) / (Credit Card Balances + Miscellaneous short-term Debt)

Liquidity Ratio = 1,410 / 1,770 = 0.7966

Liquidity Ratio = 0.80

Debt Ratio is the ratio of Total Debt to Total Assets

Debt Ratio = (Credit Card Balances + Miscellaneous short-term Debt + Car Loan + Student Loan) / (Cash in Bank + Investment in Mutual Fund + Car + Household personal possession)

Debt Ratio = (1250 + 520 + 4500 + 8500) / (560 + 850 + 12000 + 2850)

Debt Ratio = 0.91

Jacob's financial position is weak, he does not live within his means which is clearly indicated by the amount of Credit Card Balance outstanding ($1,250) compared to his monthly net savings ($800). ALso his Liquidity Ratio is less tahn 1 which is not a good indicator. He is clearly spending more than his net monthly savings which is a poor financial practice.

(b)

Jacob is recommended to pay off his short term liability ( i.e. Credit Card Balances & Short Term Debt) with his monthly surplus income at the earliest. This will improve his financial position drastically.

Once the short term debts are cleared, he can look forward to pay off his Long Term Debt (Car Loan & Student Loan) with his monthly surplus income to avoid paying interest.

jeff jeffy answered 2 years ago

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