Funding a Uniform-Stitching Unit's New Machine
A partnership firm in Guwahati stitches school uniforms. It plans to buy an automatic embroidery machine costing ₹18 lakh and needs ₹7 lakh more working capital for fabric and thread, so the project cost is ₹25 lakh. The firm has ₹6 lakh in retained earnings. A bank offers a ₹15 lakh term loan at 11% per annum, repayable in five years, with interest of about ₹1.65 lakh in the first year. The firm expects annual sales of ₹40 lakh, a gross margin of 25%, and cash operating expenses of ₹6 lakh. Debtors pay in 60 days and creditors are paid in 30 days. The remaining ₹4 lakh gap could be met by a ₹5 lakh personal loan from a cousin at 15% or by delaying the owner's drawings. The owners are worried about pledging their homes as collateral.
1. Compute the debt-equity ratio and the interest coverage ratio. Assess whether the financing plan is comfortable.
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Debt-equity ratio. Long-term debt is ₹15 lakh and own funds are ₹6 lakh, so debt-equity = 15 ÷ 6 = 2.5:1. Most banks prefer a ratio up to about 2:1 for a small unit, so 2.5:1 is on the higher side. If the cousin's ₹5 lakh loan is also treated as debt, the ratio becomes 20 ÷ 6 = 3.33:1, which is weaker.
Interest coverage ratio. Gross margin = 25% of ₹40 lakh = ₹10 lakh. Cash operating expenses = ₹6 lakh. Earnings before interest and tax = ₹10 lakh − ₹6 lakh = ₹4 lakh. Interest = ₹1.65 lakh. Interest coverage = 4 ÷ 1.65 = 2.42 times. This means operating profit covers interest about 2.4 times. That is acceptable but not generous for a first-year unit.
Assessment. The plan can service interest if sales and margins hold. But the cushion is thin. A 20% fall in sales would reduce gross margin to ₹8 lakh and EBIT to ₹2 lakh, giving coverage of only 2 ÷ 1.65 = 1.21 times. The firm should bring in more equity, reduce the loan, or arrange a longer moratorium. The 15% cousin loan is expensive and worsens the ratio; it should be avoided for a long-term asset.
2. Distinguish the sources appropriate for machinery and for working capital, and recommend a financing plan for the ₹4 lakh gap.
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Machinery is a long-term asset. It should be financed by long-term funds: retained earnings, partner's capital, or a term loan repayable over several years. The bank's ₹15 lakh term loan at 11% is suitable because the machine will generate cash over five years. A 15% personal loan repayable quickly would create a mismatch: the asset is long-lived but the liability is short and costly.
Working capital is a short-term need. Fabric and thread are converted into uniforms and debtors within the operating cycle. A cash credit or working capital demand loan, secured by stock and book debts, is more suitable than a term loan. Supplier credit of 45 days also helps. The firm's debtors take 60 days, so it funds about two months of sales; creditors at 30 days fund only one month of purchases.
Recommendation for the ₹4 lakh gap. First, reduce the project cost or phase the machine purchase. Second, bring in at least ₹4 lakh as partner's capital rather than a 15% personal loan; this brings debt-equity to 15 ÷ 10 = 1.5:1. Third, negotiate a cash credit limit for working capital and use the bank term loan only for the machine. Finally, ask the bank whether collateral can be partly replaced by a credit guarantee scheme; the owners should not pledge more than necessary.
3. If sales fall by 20%, what happens to the interest coverage ratio, and what risk-management steps would you advise?
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Sales fall to ₹32 lakh. Gross margin at 25% becomes ₹8 lakh. After cash operating expenses of ₹6 lakh, EBIT is ₹2 lakh. Interest remains ₹1.65 lakh, so interest coverage falls to 2 ÷ 1.65 = 1.21 times. Profit before tax is only ₹35,000. A small further fall in sales, or a rise in thread prices, would push the firm close to default.
Risk-management steps.
- Build a cash buffer. Keep at least three months of interest and operating expenses in a reserve instead of paying out all profits.
- Match debt to cash flow. Ask for a moratorium or a step-up repayment schedule so that repayments are lower in the first year.
- Shorten the operating cycle. Offer a small cash discount for early payment, reduce debtor days from 60 to 45, and negotiate 45-day supplier credit.
- Stress-test the loan. Before signing, check whether the firm can survive a 20% sales fall and a 10% rise in raw material cost.
- Avoid the 15% cousin loan. It adds fixed cost and worsens the debt-equity ratio. If more funds are needed, admit a partner or bring in owner's capital.