A Current Ratio That Looks Healthy but Is Not
Rangpur Traders Ltd has revenue from operations of ₹24,00,000 and cost of goods sold of ₹18,00,000 for 2023–24. On 31 March 2024 its current assets were: inventory ₹4,40,000, trade receivables ₹3,00,000 and cash ₹60,000. Current liabilities were ₹4,00,000. Long-term borrowings were ₹12,00,000 and shareholders' funds ₹8,00,000. Inventory on 1 April 2023 was ₹2,80,000. All sales are on credit. The finance manager, whose bonus depends on the current ratio, proposes to take a short-term loan of ₹2,00,000 on 31 March 2024 and hold the proceeds as cash until 2 April 2024, so that the year-end current ratio improves. The managing director is not convinced and asks for an analysis. The company's debt covenant requires debt-equity not to exceed 1.5:1.
1. Compute the current ratio, quick ratio, inventory turnover, receivables turnover and debt-equity ratio, and comment briefly on the company's short-term liquidity.
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- Current ratio = 8,00,000 / 4,00,000 = 2:1
- Quick ratio = (3,00,000 + 60,000) / 4,00,000 = 0.9:1
- Average inventory = (2,80,000 + 4,40,000) / 2 = ₹3,60,000; inventory turnover = 18,00,000 / 3,60,000 = 5 times
- Receivables turnover = 24,00,000 / 3,00,000 = 8 times (about 45 days)
- Debt-equity = 12,00,000 / 8,00,000 = 1.5:1, exactly at the covenant limit
The current ratio of 2:1 looks comfortable, but inventory is ₹4,40,000, i.e. 55% of current assets. The quick ratio of 0.9:1 shows that, without selling stock, the company cannot meet current liabilities. Liquidity therefore depends on inventory turning over five times a year and on receivables being collected. The debt-equity ratio leaves no headroom: any additional borrowing breaches the covenant.
2. Evaluate the finance manager's proposal. Show the ratios after the proposed transaction and explain why it is or is not acceptable.
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After taking the loan and holding the cash:
- Current assets = 8,00,000 + 2,00,000 = ₹10,00,000
- Current liabilities = 4,00,000 + 2,00,000 = ₹6,00,000
- Current ratio = 1.67:1 (down from 2:1)
- Quick ratio = (3,00,000 + 60,000 + 2,00,000) / 6,00,000 = 0.93:1
- Debt-equity = 14,00,000 / 8,00,000 = 1.75:1, which breaches the 1.5:1 covenant
The proposal fails on its own terms: the current ratio actually falls, because equal amounts are added to both sides and the ratio is already above 1. The quick ratio barely moves, and idle cash earns nothing while interest accrues. The debt covenant is breached. This is window dressing: a transaction with no business purpose, timed around the year end and reversed the next day. It misleads users and may trigger loan recall. The bonus linked to the ratio also creates a conflict of interest that the board should address.
3. Suggest two genuine ways to improve liquidity and comment on whether a high current ratio guarantees liquidity.
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Genuine measures include: (i) tighten credit control and follow up overdue receivables, shortening the collection period and converting receivables into cash; (ii) reduce inventory levels by clearing slow-moving stock rather than accumulating it; and, where possible, negotiate longer credit terms with suppliers or replace short-term borrowing with long-term funds. These improve the quality of current assets rather than their mere quantity.
A high current ratio does not guarantee liquidity. The ratio can be inflated by obsolete inventory, doubtful receivables or cash held idle for a few days. It also ignores the timing of cash inflows and outflows. A company can have a current ratio above 2 and still default on a payment due next week. The acid-test ratio, inventory and receivables turnover, and a cash budget give a better picture. The board should judge liquidity by the convertibility of assets into cash, not by a single year-end ratio.