Question

Victoria has 3.2 mi. of accounts receivable and 5mi. of current assets. It’s DSO (days sales outstanding in receivables) is 40 (based on a 365-day year), and it’s current ratio is 1.5. The firm plans to reduce its DSO to the industry average of 30 without causing a decline in sales. The resulting decrease in accounts receivable will free up cash that will be used to reduce current liabilities. If this plan succeeds, what will be the new current ratio?

Answer 1

DSO = (accounts receivable/credit sales)*365

Therefore, credit sales = (accounts receivable/DSO)*365

credit sales when DSO = 40; accounts receivable = 3.2 million:

credit sales = (3.2/40)*365 = 29.2 million

Even when DSO changes from 40 to 30, sales remains same, so new accounts receivable when DSO = 30 and credit sales = 29.2 million is:

Accounts receivable = (DSO*credit sales)/365 = (30*29.2)/365 = 2.4 million

Thus, change in accounts receivable = 3.2 million - 2.4 million = 0.8 million

Current ratio = current assets/current liabilities

Current ratio = 1.5 when DSO = 40 and current assets = 5 million.

Therefore, current liabilities = current assets/current ratio = 5/1.5 = 3.33 million

Now, when DSO changes to 30, then the freed up cash of 0.8 million (due to reduction in accounts receivable) is use dto reduce the current liabilities.

So, current liabilities now becomes 3.33 million - 0.8 million = 2.53 million

Thus, new current ratio = current assets/current liabilities = 5 million/2.53 million = 1.97 (Answer)