Question

Dolly Harding owns and operates Dolly Jo’s Café. Dolly has requested a credit application from LRM, Inc., a major food supplier from which she hopes to begin purchasing inventory. LRM, Inc., has requested that Dolly submit a full set of financial statements for Dolly Jo’s Café with the credit application. Dolly is concerned because the most recent balance sheet for Dolly Jo’s Café reflects a current ratio (current assets divided by current liabilities) of 1.24. Dolly has heard that most creditors like to see a current ratio that is 1.5 or higher. To increase Dolly Jo’s Café’s current ratio, Dolly has convinced her parents to loan the business $25,000 through an 18-month long-term note payable. Dolly’s parents are apprehensive about having their money “tied up” for over a year. Dolly reassured them that even though the loan is for 18 months, Dolly Jo’s Café can, and probably will, repay the $25,000 sooner.

Requirements

1. Discuss the ethical issues related to the loan from Dolly’s parents.

2. Why do you think creditors like to see current ratios of 1.5 or higher?

Answer 1

1. There are a lot of ethical issues involved with the loan Dolly has taken from her parents. First of all Dolly is basically falsifying her accounts so that she can obtain the credit line from LRM Inc. which is not a good ethical practice. Dolly's current ratio is already at the lower side which is 1.24 which means that she is hardly able to meet her current obligations without the credit line from LMR Inc.. The loan taken from her parents is not actually a loan, it is just a cash inflow to inflate the amount of current assets to show a better current ratio. It does not actually improve the cash flow problems of Dolly as it is to be repaid soon to her parents and hence there is a high probability of a situation coming in the future where Dolly will not be able to meet its current obligations and will have to declare bankruptcy.

2. Current ratio is calculated by dividing current assets by current liabilities. It basically shows the company's ability to meet its current obligations. For most industries, current ratio of 1.5 or more is treated as acceptable as creditor will always prefer current ratio to be on a higher side rather than on a lower side as it shows that the company will be able to meet its current obligations over the period of next 12 months which also means that the company will be able to pay the creditors timely.