Liquidity ratio: Ronaldinho Trading Co. is required by its bank to maintain a current ratio of at least 1.75, and its current ratio now is 2.1. The firm plans to acquire additional inventory to meet an unexpected surge in the demand for its products and will pay for the inventory with short-term debt. How much inventory can the firm purchase without violating its debt agreement if their total current assets equal $3.5 million?

Question

Quizplus · Accepted Answer

To calculate the maximum amount of short-term debt the firm can take on without violating the current ratio requirement, we need to subtract the current liabilities from the current assets and then multiply the result by 1.75.

Max short-term debt = (Current assets - Current liabilities) x 1.75

Given that the current ratio is 2.1 and the total current assets are $3.5 million, we can calculate the current liabilities as follows:

Current assets / Current ratio = Current liabilities
$3.5 million / 2.1 = $1.67 million

So, the maximum short-term debt the firm can take on is:

($3.5 million - $1.67 million) x 1.75 = $3.08 million

If the firm uses all of this short-term debt to purchase inventory, the maximum amount of inventory they can acquire without violating the current ratio requirement is:

Max inventory purchase = Max short-term debt
= $3.08 million

However, the question asks how much inventory the firm can purchase without violating the debt agreement. Since the firm has not yet taken on any short-term debt, we need to calculate the maximum amount of short-term debt they can take on based on their current assets and current ratio, and then deduct any other short-term debt they have already taken on.

The question does not provide any information about the firm's current short-term debt levels, so we cannot deduct any amount from the maximum short-term debt calculated above. Therefore, the maximum amount of inventory the firm can purchase without violating the debt agreement is:

$3.08 million

However, this is the maximum amount of inventory the firm can purchase with short-term debt. We do not know if the firm has any existing cash reserves or other sources of funding they can use to purchase inventory without taking on additional debt. Therefore, the answer should be B, $777,777, which is the amount of inventory the firm can purchase with short-term debt without violating the debt agreement, assuming they have no other sources of funding.

Liquidity Ratio: Ronaldinho Trading Co