Safeco's current assets total to $20 million versus $10 million of current liabilities,while Risco's current assets are $10 million versus $20 million of current liabilities.Both firms would like to "window dress" their end-of-year financial statements,and to do so they tentatively plan to borrow $10 million on a short-term basis and to then hold the borrowed funds in their cash accounts.Which of the statements below best describes the results of these transactions?
A)The transactions would improve Safeco's financial strength as measured by its current ratio but lower Risco's current ratio.
B)The transactions would lower Safeco's financial strength as measured by its current ratio but raise Risco's current ratio.
C)The transactions would have no effect on the firm' financial strength as measured by their current ratios.
D)The transactions would lower both firm' financial strength as measured by their current ratios.
E)The transactions would improve both firms' financial strength as measured by their current ratios.

Question

Quizplus · Accepted Answer

The current ratio is calculated by dividing current assets by current liabilities.

Before borrowing, Safeco's current ratio is 2 ($20 million / $10 million) and Risco's current ratio is 0.5 ($10 million / $20 million).

After borrowing, Safeco's current assets increase to $30 million while current liabilities remain at $10 million. This results in a current ratio of 3 ($30 million / $10 million), which is an improvement in financial strength.

On the other hand, Risco's current assets also increase to $20 million, but current liabilities increase to $30 million due to the borrowing. This results in a current ratio of 0.67 ($20 million / $30 million), which is a decrease in financial strength.

Therefore, option B is the correct answer.

Safeco's Current Assets Total to $20 Million Versus $10 Million