Question

Current and Quick Ratios The Nelson Company has $1,250,000 in current assets and $500,000 in current liabilities. Its initial inventory level is $400,000, 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 1.2

Answer 1

Answer:

Nelson's short-term debt (notes payable) can increase by $541,667 without pushing its current ratio below 1.2.

Explanation:

We know that the formula for calculating the current ratio is as follows:

Current ratio = Current Assets / Current Liabilities .................... (1)

Where;

Existing Current assets = $1,250,000

Existing current liabilities = $500,000

Existing Current ratio = $1,250,000 / $500,000 = 2.50

Since we want to keep the current assets at $1,250,000, and targeted current ratio is 1.2; we want to determine the following:

Targeted current liabilities = ?

We therefore also use and substitute into equation (1) as follows:

Targeted current ratio = Existing Current assets / Targeted current liabilities

Therefore, we have:

1.2 = $1,250,000 / Targeted current liabilities

Solving for Targeted current liabilities, we have:

Targeted current liabilities = $1,250,000 / 1.2 = $1,041,667

Therefore, we have:

Targeted increase in  short-term debt = Targeted current liabilities - Existing current liabilities = $1,041,667 - $500,000 = $541,667

Therefore, Nelson's short-term debt (notes payable) can increase by $541,667 without pushing its current ratio below 1.2.