ACCA Financial Management (F9) Certification Practice Exam

In terms of liquidity ratios, how might they change when a business is overtrading?

1. They improve significantly

2. They remain stable

3. They worsen dramatically

4. They become irrelevant

The correct answer is: They worsen dramatically

When a business is overtrading, it typically means that it is expanding its operations beyond its available financial resources, often resulting in a situation where the business does not have enough working capital to support its growth. This rapid expansion can lead to a strain on cash flow, which directly impacts liquidity ratios such as the current ratio and quick ratio. Liquidity ratios measure a company's ability to meet its short-term obligations. When overtrading occurs, the business may hold increasing amounts of inventory or extend credit to customers without securing sufficient funding or cash reserves. As a consequence, the company could struggle to convert assets into cash quickly enough, leading to deterioration in liquidity ratios. For instance, if a company's current liabilities rise due to increased borrowing to support its rapid growth, while its current assets (like cash and receivables) do not increase at the same pace, the liquidity ratios will significantly decrease. This in turn signals to stakeholders that the company may be at risk of liquidity issues, unable to meet its short-term debts, and this situation is more pronounced in overtrading scenarios where financial pressures are consistently high. Thus, it is evident that the liquidity ratios would worsen dramatically in the context of overtrading, as the company faces challenges in managing its