The current ratio is calculated as the current assets divided by the current liabilities. If the current liabilities are $200,000 and the ratio is 2 to 1, that means that current assets are currently $400,000. New short-term debt will increase both the current assets and the current liabilities by the same amount. Therefore, in order to determine the maximum amount of debt that can be issued while maintaining a current ratio of at least 1.5 to 1, we need to set up the following formula, letting X represent the amount of increase in both current assets and current liabilities: (400 + X) = 1.5 (200 + X) We can now solve for X. The steps are: 1. Multiply both sides of the equation by (200 + X) to get the (200 + X) out of the denominator, then simplify: (400 + X) = 1.5(200 + X) 400 + X = 300 + 1.5X 2. Subtract 1X from both sides of the equation: 400 = 300 + .5X 3. Subtract 300 from both sides of the equation: 100 = .5X 4. Divide both sides of the equation by .5: 200 = X If the company issues $200,000 of new short-term debt, they will have current assets of $600,000 and current liabilities of $400,000. This will give them a current ratio of 1.5 to 1. Any amount of debt greater than $200,000 will cause the current ratio to decrease below 1.5 to 1, and any amount less than $200,000 is not the maximum amount that they can borrow and still maintain a current ratio of 1.5 to 1.
If the current liabilities are $200,000 and the ratio is 2 to 1, that means that current assets are currently $400,000. New short-term debt will increase both the current assets and the current liabilities by the same amount. New short-term debt in the amount of $66,667 would increase current assets to $466,667 and would increase current liabilities to $266,667. The current ratio would become 1.75, not 1.5. Hint: Since both current assets and current liabilities will increase by the same amount, the formula needed to solve this is (400 + X) = 1.5 (200 + X) where X is the amount of the new short-term debt.
If the current liabilities are $200,000 and the ratio is 2 to 1, that means that current assets are currently $400,000. New short-term debt will increase both the current assets and the current liabilities by the same amount. New short-term debt in the amount of $150,000 would increase current assets to $550,000 and would increase current liabilities to $350,000. The current ratio would become 1.57, not 1.5. Hint: Since both current assets and current liabilities will increase by the same amount, the formula needed to solve this is (400 + X) = 1.5 (200 + X) where X is the amount of the new short-term debt.
If the current liabilities are $200,000 and the ratio is 2 to 1, that means that current assets are currently $400,000. New short-term debt will increase both the current assets and the current liabilities by the same amount. New short-term debt in the amount of $266,667 would increase current assets to $666,667 and would increase current liabilities to $466,667. The current ratio would become 1.43, not 1.5, and the company would not be in compliance with the covenant in its bond indenture. Hint: Since both current assets and current liabilities will increase by the same amount, the formula needed to solve this is (400 + X) = 1.5 (200 + X) where X is the amount of the new short-term debt.
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