Kang's management has the option of converting $100,000 in debt into common shares of the company.What impact would the conversion have on the company's solvency as measured by the debt-to-total-assets and its liquidity as measured by the current ratio?
A)The solvency would improve, but the liquidity would deteriorate.
B)Both the solvency and the liquidity would improve.
C)The solvency would improve, but the liquidity would remain unchanged.
D)The solvency would not be affected, but the liquidity would improve.

Question

Quizplus · Accepted Answer

The conversion of debt into equity would increase the equity portion of the balance sheet while decreasing the debt portion. This would improve the debt-to-total-assets ratio (solvency) since there is less debt relative to total assets. However, the current ratio (liquidity) would remain unchanged since the total assets and liabilities would not change, only the composition of the liabilities would change. Therefore, the best choice is C, the solvency would improve, but the liquidity would remain unchanged.

Kang's Management Has the Option of Converting $100,000 in Debt