Question

Page 133 Ethical Dilemma The Raintree Cosmetic Company has several loans outstanding with a local bank. The debt agreements all contain a covenant stipulating that Raintree must maintain a current ratio of at least 0.9. Jackson Phillips, company controller, estimates that the 2021 year-end current assets and current liabilities will be $2,100,000 and $2,400,000, respectively. These estimates provide a current ratio of only 0.875. Violation of the debt agreement will increase Raintree's borrowing costs as the loans are renegotiated at higher rates. Jackson proposes to the company president that Raintree purchase inventory of $600,000 on credit before year-end. This will cause both current assets and current liabilities to increase by the same amount, but the current ratio will increase to 0.9. The extra $600,000 in inventory will be used over the later part of 2022. However, the purchase will cause warehousing costs and financing costs to increase. Jackson is concerned about the ethics of his proposal. What do you think?

I have to argue in favor of Jackson. Not sure where to start because this is unethical.

Answer 1

In this situation the Intention of Mr.Jackson is to Purchase the stock on credit so that company can maintain the Current Ratio of 0.9 and at the same time It can utilise the stock for business in later part of year 2022.Here we need to consider two aspects one is ethical aspect and the other financial aspect.

Ethical Aspect - Since the company is doing the business regularly, any how it requires stock. If it is purchased now the company can have two advantages which are -

1)The company can maintain the current ratio of 0.9 .

2) It can utilise the inventory in the later part of 2022.

Any how the company has to purchase the stock for the purpose of its business, but it is just pre poned so that they can maintain the current ratio as well.This is a genuine transaction and there is no window dressing.Considering these aspects it is not unethical to purchase inventory at the end of 2021. (Assumption : Inventory is non perishable for atleast one year from the date of purchase).

Financial Aspect - Here there are some positives and negatives in this aspect. let us see

positives : 1) The company can maintain the Current ratio of 0.9 so that it can comply with the bankers loan agreement.

2) Interest rates will not be increased.

Negatives : 1) since the company is purchasing the stock long before its expected usage, it indicates that idle stock is maintained in the godown for some period which will have a negative impact on stock turnover ratio and stock holding period as well.

2) Increase in Warehousing costs and financing costs.

3) The stock is expected to be utilised at the later part of 2022. But normally the creditors wont allow that much long credit period (Assuming Normal credit period of Maximum 60days as per many industries Trade Practice). It means that the company has to repay the creditors before the stock is utilised (or) before the revenue is generated from that particular stock.Which is a Financial burden in short term.

Opinion : It is not unethical proposal, but the company needs to consider the financial aspects as well before taking a decision.If the negatives as said above are impacting more than the positives discussed above then the decision is not financially viable because eventhough the company can save from Increased interest costs but it has to face the financial crunch in the short term period.Otherwise the company can continue with its proposal if it is financially viable.