Question

Eugene Wright is CFO of Caribbean Cruise Lines. The company designs and manufactures luxury boats. It's near year-end, and Eugene is feeling kind of queasy. The economy is in a recession, and demand for luxury boats is way down. Eugene did some preliminary liquidity analysis and noted the company's current ratio is slightly below the 1.2 minimum stated in its debt covenant with First Federal Bank. Eugene realizes that if the company reports a current ratio below 1.2 at year-end, the company runs the risk that First Federal will call its $10 million loan. He just cannot let that happen.Caribbean Cruise Lines has current assets of $12 million and current liabilities of $10.1 million. Eugene decides to delay the delivery of $1 million in inventory purchased on account from the originally scheduled date of December 26 to a new arrival date of January 3. This maneuver will decrease inventory and accounts payable by $1 million at December year-end. Eugene believes the company can somehow get by without the added inventory, as manufacturing slows down some during the holiday season.Required:Limit your written answer (not including calculation) to 150 words.1. How will the delay in the delivery of $1 million in inventory purchased on account affect the company's current ratio on December 31? Provide supporting calculations of the current ratio before and after this proposed delivery delay.2. Is this practice ethical? Provide arguments both for and against.

Answer 1

1.

The company's current ratio on December 31 after the delay in the delivery of $1 million in inventory purchased on account will be 1.21; which is an increase when we compare to the current ratio of 1.19 in case the delivery of inventory is taken place before year end.

Supporting calculations:

* In case the inventory taken before year end:

Current ratio = Current asset/ Current liabilities = 12/10.1 = 1.19

* In case the inventory taken after year end:

Inventory will go down by $1 million causing Current asset to the balance of $11 million ( $12 million - $1 million).

Account Payable will go down by $1 million causing Account Payable to the balance of $9.1 million ($10.1 million - $1 million)

=> Current ratio = Current asset/ Current liabilities = 11/9.1 = 1.21

2.

The practice may be considered to be ethical or unethical depending on the actual circumstances ( which needs more information to evaluate) as well as the point of view of different persons.

However, from the given information, we may come up with some arguments for and against the practice as below:

* For the practice:

- Maximize the shareholders' value by increasing the working capital usage through optimizing the level of inventory ( do not store more inventory than it is required)

- Decreasing the liquidity risk of the company by not breach the loan government to the bank without negative effect on the normal business of the firm.

* Against the practice:

- Negative effect caused to stakeholders which are suppliers as the practice decrease the revenue which should have been recognized by the suppliers under the normal business conditions.

- Does not truly reflect what would have been happened under normal business conditions. Instead, what is reported has much been affected by the loan covenants.

Step-by-step explanation: