The Current Ratio Covenant at Marisol's Pet Supply
Marisol owns a two-store pet supply retailer whose fiscal year ends December 31. Her line of credit carries two covenants: a current ratio of at least 1.50 and a debt service coverage ratio of at least 1.20. The bookkeeper's draft balance sheet shows current assets of $186,400 (including inventory of $121,000 and prepaid insurance of $14,000) and current liabilities of $128,000, a ratio of 1.46. Reviewing the file on January 20, you find: (1) $9,000 of inventory shipped December 28 on FOB destination terms arrived January 4 and was never recorded; (2) accrued wages of $6,500 for the last week of December were not booked; (3) $3,000 of the prepaid insurance relates to the year just ended; (4) inventory includes $4,200 of obsolete fish tanks whose net realizable value is $1,000; (5) a $15,000 check dated December 30 was recorded but not mailed until January 5. Marisol proposes drawing $30,000 on the credit line on December 31 and using it to pay down accounts payable, saying 'that will fix the ratio before the bank sees it.' She also mentions that about $35,000 of cash sits idle in the store's checking account.
1. Recompute the year-end current ratio after each required adjustment, explaining the accounting treatment of each of the five items.
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Item-by-item
- FOB destination in-transit inventory, $9,000. Title transfers on delivery, so this is the seller's inventory at December 31 and is correctly excluded. No adjustment - but confirm it truly is not in the count; if it had been included, it would be reversed.
- Accrued wages, $6,500. The wages were earned in the year just ended, so an expense and a current liability belong in the statements: current liabilities +$6,500.
- Prepaid insurance, $3,000. The coverage period has expired; it is an expense, not an asset: current assets −$3,000.
- Obsolete fish tanks. Inventory is carried at the lower of cost or net realizable value: write down $4,200 to $1,000, a $3,200 reduction in current assets (and in income).
- Unmailed check, $15,000. Cash is not reduced until the check is released; recording it early understates cash and payables and amounts to window dressing. Reverse: current assets +$15,000 and current liabilities +$15,000.
Recomputed ratio
- Current assets: 186,400 − 3,000 − 3,200 + 15,000 = $195,200
- Current liabilities: 128,000 + 6,500 + 15,000 = $149,500
- Current ratio: 195,200 ÷ 149,500 = 1.31, not 1.46. The covenant is breached on a corrected basis.
2. Evaluate Marisol's proposal to draw $30,000 on the credit line and pay down accounts payable before year-end. Will it work? Compare it with using the $35,000 of idle cash.
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The borrowing plan does not work, for arithmetic reasons and for substance reasons.
Arithmetic: drawing $30,000 adds $30,000 of cash and $30,000 of short-term debt. Paying suppliers with that cash then reduces cash by $30,000 and payables by $30,000, leaving current liabilities unchanged (the revolver balance simply replaces the trade payables) and current assets unchanged. The ratio stays at 1.31 - and the maneuver costs interest on the draw.
If she drew and simply held the cash, the ratio would fall to (195,200 + 30,000) ÷ (149,500 + 30,000) = 225,200 ÷ 179,500 = 1.25. Any equal increase in numerator and denominator pushes a ratio above 1 downward.
Substance: a year-end borrowing whose only purpose is to alter the reported balance sheet at the measurement date is a classic form of window dressing. It does not change the company's real liquidity, it is expensive, and if the draw is repaid in January it also misleads the lender.
Using the idle cash is legitimate if the cash is genuinely surplus and not needed for payroll or the February inventory buy. Paying $35,000 of trade payables: (195,200 − 35,000) ÷ (149,500 − 35,000) = 160,200 ÷ 114,500 = 1.40. Better, but still below 1.50 - and it only works if suppliers are paid early, which forgoes the float and any early-payment discount trade-off.
3. What should you do about the covenant breach and the bank relationship? Include the ethical dimension and any reclassification consequence.
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Do not paper over it. Recording the unmailed check or booking entries with no economic substance to reach 1.50 would be a knowing misstatement in a document a lender relies on, exposing Marisol and anyone who assists her to fraud claims and possible personal liability. Accounting records must follow GAAP regardless of the covenant, and a preparer's obligation runs to the statements, not to the desired outcome.
Steps
- Post the five adjustments, reverse the early check entry, and issue corrected statements with a short memo documenting each adjustment and its basis.
- Disclose the breach to the lender promptly and request a written waiver for the quarter. Lenders grant waivers routinely when approached early; they react badly when they discover an unreported breach.
- Recognize the classification consequence: once a covenant is breached and no waiver exists, the revolver is typically callable, so the balance must be reclassified out of long-term debt into current liabilities - which worsens the ratio further and must be shown in the very statements used to negotiate.
- Come with a corrective plan: liquidate or return the obsolete tanks, tighten receivables, cut or delay discretionary purchasing, and propose a reset covenant (for example 1.35 with quarterly reporting) or a partial conversion of the revolver to an amortizing term loan, which reduces current liabilities going forward.
- Fix the process: monthly close with a checklist, a written reconciliation of cash and accruals, and a rule that checks are dated when mailed.