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Q.A company has a liquidity ratio equal to 0.5. The directors believe that the company has to reduce its bank overdraft and have agreed to alter the company’s credit terms to customers from two months to one month.
What would be the effects on the company’s cash operating cycle and liquidity ratio if this change were to be achieved?
Cash operating cycle. Liquidity ratio
A.decrease. Decrease
B.decrease. No change
C.decrease. increase
D.increase. increaseCan u pls help me with this question?The answer given is A but I didnt get the logic behind it.
If they collect payment from receivables sooner then the receivables collections period reduces, which automatically reduced the operating cycle.
Collecting sooner will reduce receivables (and therefore current assets) and reduce the overdraft (current liabilities) by the same amount. This will result in a lower current ratio.
Have you watched my free lectures on working capital? The lectures are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.
I have watched ur lecture and i do watch them before every chapter. They are really helpful!
1.isnt overdraft a payable? And if so, when its reduced won’t the operating cycle increase?
2.when receivables are converted into cash quickly how would the current assets reduce as cash is also a current asset. Isnt the only form of current asset changing?
Can u pls clarify these 2 doubts.
1. No, the overdraft is a negative cash balance and is not part of the operating cycle.
2. Because an overdraft is a negative cash balance, it is a current liability (not a current asset).
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