A firm must maintain a minimum current ratio of 2 to 1 in order to be in compliance with one of its bond covenants. Sales are forecast to be $10,000 next year. Historically, current assets
Have averaged 75% of sales. Accounts payable have averaged 20% of sales. Assuming these
Historical ratios will continue, determine the maximum amount of additional short-term debt
Available to the firm next year.

Question

Quizplus · Accepted Answer

Given that current assets are historically 75% of sales, the projected current assets for next year would be 75% of $10,000, which equals $7,500. Accounts payable, being 20% of sales, would amount to $2,000. To maintain a current ratio of 2:1, the current assets ($7,500) must be twice the sum of current liabilities (including accounts payable). Therefore, if we let X be the additional short-term debt the firm can take on, the equation would be $7,500 = 2 * ($2,000 + X). Solving for X gives us X = $1,750 as the maximum amount of additional short-term debt available to the firm next year.

A Firm Must Maintain a Minimum Current Ratio of 2