Safeco's current assets total to $20 million versus $10 million of current liabilities, while Risco's current assets are $10 million versus $20 million of current liabilities. Both firms would like to "window dress" their end-of-year financial statements, and to do so they tentatively plan to borrow $10 million on a short-term basis and to then hold the borrowed funds in their cash accounts. Which of the statements below best describes the results of these transactions?
A) The transactions would raise Safeco's financial strength as measured by its current ratio but lower Risco's current ratio.
B) The transactions would lower Safeco's financial strength as measured by its current ratio but raise Risco's current ratio.
C) The transaction would lower both firms' financial strength as measured by their current ratios.
D) The transaction would improve both firms' financial strength as measured by their current ratios.

Question

Quizplus · Accepted Answer

The current ratio is calculated by dividing current assets by current liabilities. Therefore, by borrowing $10 million and holding it in their cash accounts, both firms would increase their current assets by $10 million while keeping their current liabilities the same.

For Safeco, their current assets would increase from $20 million to $30 million ($20 million + $10 million borrowed), while their current liabilities would remain at $10 million. This would lower their current ratio from 2 ($20 million / $10 million) to 1.5 ($30 million / $10 million), indicating a lower financial strength.

For Risco, their current assets would increase from $10 million to $20 million ($10 million + $10 million borrowed), while their current liabilities would remain at $20 million. This would raise their current ratio from 0.5 ($10 million / $20 million) to 1 ($20 million / $20 million), indicating a higher financial strength.

Therefore, the transaction would lower Safeco's financial strength as measured by its current ratio but raise Risco's current ratio. The best choice is B.

Safeco's Current Assets Total to $20 Million Versus $10 Million