Question

Firm XXX has $4.5 million in current assets and 3.7 million in current liabilities. The firm wants to increase its inventory, which will be financed by a short term note with the bank. What level of inventories can the firm carry without its current ratio falling below 1.1?

Firm XXX has $4.5 million in current assets and 3.7 million in current liabilities. The firm wants to increase its inventory, which will be financed by issuing a 3-year bond. What level of inventories can the firm carry without its current ratio falling below 1.5?

Answer 1

1.

The firm can increase its inventory without its current ratio falling below 1.1 by

1.1 times = $4,500,000 / $3,700,000

1.1 times = ($4,500,000 + y) / ($3,700,000 + y)

$4,500,000 + y = $4,070,000 + 1.1y

$430,000 = 0.1y

y = $4,300,000

2.

Current Assets = $ 4500000
Current liabilities = $ 3700000
let, the amount financed for purchase of inventory be 'x'
Now, Revised current assets = 4500,000+ x (as amount invested in inventory will increase the current assets)
Revised current liabilities = 3700000 (There will be no change as the amount borrowed thrugh long term bonds)
Now, as per question, current ratio shall be minimum 1.50
Therefore, the maximum amount of inventory which shall be purchased shall be computed as under:
Current ratio = Current assets / Current liabilities
1.50 =   (4500,000+x) / 3700000
x= 1050000
Hence, the maximum amount of inventory the firm shall purchase is $ 1050,000