Longwood Company had a current ratio of 3:1 at the end of Year 1. The asset section of the company's balance sheet is provided below:
Required:1) Compute Longwood Company's end-of-year working capital.2) Compute the company's quick (acid-test) ratio.3) The company has a debt agreement with its bank that authorizes the bank to call in its loan to the company if the company's current ratio falls below 3:1 as of the last day of any month during the term of the loan. During January Year 2, the company engaged in the three following transactions:(a) Collected $100,000 on account;(b) Purchased inventory on account, $50,000(c) Paid accounts payable, $60,000Will
the company be in default after completing these transactions? Justify your answer.Round your answers to two decimal places.
What will be an ideal response?
Answer to part c will vary.
1) $716,000
2) 1.26:1
3) Impact of transactions on current ratio:
(a) Collection on account has no impact on the current ratio.
(b) Purchase of inventory on account reduces the current ratio. Adding $50,000 to both the numerator and the denominator decreases the current ratio from 3:1 to 2.75:1.
(c) Payment on account increases the current ratio. Decreasing both the numerator and the denominator increases the current ratio from 2:75:1 to 3.06:1. Therefore, the company is not in default after these transactions.
1) Current assets = $2,000,000 ? $926,000 = $1,074,000; Current assets ÷ current liabilities = 3
Thus, current liabilities = $1,074,000 ÷ 3 = $358,000; Finally, working capital = current assets ? current liabilities. Thus, $1,074,000 ? $358,000 = $716,000
2) Acid-test = (current assets ? inventory ? prepaid expenses) ÷ current liabilities = ($1,074,000 ? $550,000 ? $74,000) ÷ $358,000 = $450,000 ÷ $358,000 = 1.26:1
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