You are the chief financial officer of a local manufacturing company, Larsen Enterprises. This company is run by two brothers, Steve and John Larsen. The Larsen brothers have built this company up from a small 5-man shop to a company now employing over 200 people. The national economy has recently taken a turn for the worse, which has affected the Larsen’s business. In fact, the company’s performance of late has been such that it is in jeopardy of violating several of its debt covenants (promises made to the lending institution). If the company violates these covenants, the bank has the option of calling the debt due immediately. If the debt is called, Larsen is not sure what will happen, but it will certainly not be good.
The covenant that is in jeopardy relates to the current ratio. If the current ratio drops below 2, Larsen Enterprises is considered in technical default on its debt. Steve and John have come to you and asked you to suggest ways in which the current ratio, which currently stands at 1.9, could be increased.
Take a moment and think of ways in which the current ratio might be manipulated. Identify specific actions that the Larsen brothers might take to increase the current ratio. Is it in the best interests of shareholders and lending institutions for Steve and John to make business decisions that have cosmetic effects on the financial statements?