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.
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.
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