may 2005

[salj67]

A company expects to have net current liabilities at the financial year end. Raising
funds by taking out a short term loan would:
A increase the current ratio
B reduce the current ratio
C have no effect on the current ratio
D either increase or decrease the current ratio depending on the balances
involved and the extra funds raised
the answer is A.. how?

 

[Aditya mohan mathur]

Maybe because taking out loan will increase it's bank balance, thus increasing it's current assets and a loan would not affect the current liabilities.
So overall increase in ratio.

 

[salj67]

but short term loan is current liability

 

[Aditya mohan mathur]

Ya but if we assume it as current liability, than we cannot find out the ratio change.
As we need the previous values and the loan amount.
(Option D says about the extra fund raised, which has no relevance here)

So if we assume it to be current liability, than we do not get the required answer available in the options.
Therefore, option by eliminating other and considering it to be noncurrent liability.

I think this can be best applied here

 

[Simon James]

If a company has net current liabilities, this means that current assets are less than current liabilities.
Thus the current ratio as it stands (current assets / current liabilities) would be a positive number less than 1.
If the company raises cash through a short-term loan, both the current assets would rise (due to the cash raised) and the current liabilities would rise (due to the addition of the short-term loan).
Thus the current ratio would rise.
A simple numeric example should demonstrate this effect. eg consider A=5, L=10 then CR=0.5. A loan of 3 increases A=8 and L=13, CR=0.6.