Question

Airport Accessories (AA) has several loans outstanding with a local bank. The loan contract contains an agreement that AA must maintain a current ratio of at least 0.90. Micah, the assistant controller, estimates that the year-end current assets and current liabilities will be $2,100,000 and $2,400,000, respectively. These estimates provide a current ratio of only 0.875. Violation of the debt agreement will increase AA’s borrowing costs because the loans will be renegotiated at higher interest rates.

Micah proposes that AA purchase an inventory of $600,000 on credit before year-end. This will cause both current assets and current liabilities to increase by the same amount, but the current ratio will increase to 0.90. The extra $600,000 in inventory will be used over the next year. However, the purchase will cause warehousing costs and financing costs to increase.

Micah is concerned about the ethics of his proposal. What do you think?

Answer 1

On purchasing inventory on credit for $600000 both current assets and current liability will shoot up and will result in desired current ratio. However this will increase warehousing and finance cost. There is nothing inethical about this decision as company can purchase inventory at any time on credit or cash on its own wish.

Here Micah shoul analyse the cost of buying new inventory and increased interest expense from change in rates by bank. Compare both and if buying inventory proves to be more feasible than paying higher interest, he must store inventory for the upcoming year in previous year itself bearing warehousing and finance cost. Otherwise should do vice versa.