1. What effect would the following actions have on a firm’s current ratio? Assume that new working capital is positive.
a. A short term bank loan is repaid.
b. A long-term debt is paid off early.
For a, would the current ratio move away from 1.
For b, would the current ratio be unaffected because the long-term debt is not factored into the current ratio, just current liabilities.
a. When a short-term bank loan is repaid, the firm's current liabilities will decrease, while its current assets will also decrease by the same amount (assuming no other changes). This will generally cause the current ratio to increase since the reduction in liabilities is greater in proportion to the reduction in assets. Therefore, the current ratio would move away from 1 in the upward direction.
b. You are correct that the long-term debt is not factored into the current ratio. Therefore, paying off a long-term debt early would not have a direct effect on the firm's current ratio, as it only involves long-term liabilities and not current liabilities. However, it is important to note that depending on how the firm pays off the long-term debt (using cash, sale of assets, or another method), it might indirectly affect the current ratio.
To determine the effect of these actions on a firm's current ratio, let's first understand what the current ratio represents. The current ratio is a financial metric that measures a company's ability to meet its short-term obligations with its current assets. It is calculated by dividing current assets by current liabilities.
a. Repayment of a short-term bank loan: When a short-term bank loan is repaid, it reduces the company's current liabilities. Since the current liabilities decrease, the current ratio will generally move towards 1 or potentially increase. This happens because the company's ability to meet its short-term obligations becomes relatively stronger when current liabilities decrease.
b. Early repayment of a long-term debt: The current ratio is not directly affected by the repayment of long-term debt. This is because the current ratio only considers current assets and current liabilities. Long-term debt is not classified as a current liability since it typically has a maturity longer than one year. Therefore, paying off a long-term debt early does not impact the current ratio.
In summary, repaying a short-term bank loan will generally move the current ratio towards 1 or potentially increase it, while paying off a long-term debt early will have no direct effect on the current ratio.