A Current Ratio Above Covenant: Testing the Quality of Current Assets
Bihar Agro Equipments Ltd supplies farm machinery. Extracts from its draft financial statements for the year ended 31 March 2024 (₹ lakh) are: revenue from operations 2,400; cost of goods sold 1,800; inventory 560 (previous year 380); trade receivables 260 (previous year 200); cash and cash equivalents 30; trade payables 300 (previous year 240); other current liabilities 50; equity share capital 600; reserves and surplus 300; 12% debentures 500; credit purchases 1,700. Two facts are known to you but are not reflected in the draft: the cash figure is stated after netting off a bank overdraft of ₹50 lakh repayable on demand, and inventory includes ₹120 lakh of a discontinued model for which no buyer has been found and no scrap value is expected. The loan covenant with the banker requires a current ratio of at least 2:1 and a debt-equity ratio not exceeding 1:1, tested on the audited balance sheet, and the test falls due in four weeks.
1. Compute the current ratio as drafted, then restate it for the netted overdraft and for the obsolete stock. Compute the quick ratio on the restated figures and advise whether the covenant is met.
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As drafted. Current assets = 560 + 260 + 30 = ₹850 lakh. Current liabilities = 300 + 50 = ₹350 lakh. Current ratio = 850 / 350 = 2.43 : 1 - apparently comfortable.
Restatement 1 - gross up the overdraft. An overdraft repayable on demand is a current liability and cannot be netted against cash unless the entity has both a legal right of set-off and an intention to settle net. Neither applies here. Cash becomes ₹80 lakh and current liabilities ₹400 lakh. Current assets = 560 + 260 + 80 = ₹900 lakh; current ratio = 900 / 400 = 2.25 : 1.
Restatement 2 - write inventory down to net realisable value. Inventory is carried at the lower of cost and NRV; a discontinued model with no buyer and no scrap value has NRV of nil, so ₹120 lakh must be written off. Inventory = ₹440 lakh; current assets = ₹780 lakh; current ratio = 780 / 400 = 1.95 : 1.
Quick ratio = (780 − 440) / 400 = 340 / 400 = 0.85 : 1.
Debt-equity. Debentures ₹500 lakh ÷ (600 + 300) = 0.56 : 1 as drafted; after the ₹120 lakh write-off, reserves fall to ₹180 lakh and the ratio becomes 500 / 780 = 0.64 : 1.
Advice. The debt-equity covenant is met on any view. The current ratio covenant is not met once the obsolete stock is written off: 1.95 : 1 against a required 2 : 1, a shortfall that exists only because the draft carried an asset that has no realisable value. A quick ratio of 0.85 confirms that the firm depends on selling inventory to pay current liabilities. The board should disclose the write-down before the audit is signed, open negotiations with the bank for a waiver or a reset covenant, and not rely on the drafted 2.43.
2. Compute inventory days, receivable days and payable days, derive the operating cycle, and explain what these figures reveal that the current ratio does not.
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Inventory turnover (on reported figures) = Cost of goods sold ÷ Average inventory = 1,800 ÷ [(560 + 380)/2 = 470] = 3.83 times. Inventory days = 365 ÷ 3.83 = 95 days.
Receivable days = 365 × Average receivables ÷ Revenue = 365 × 230 ÷ 2,400 = 35 days.
Payable days = 365 × Average payables ÷ Credit purchases = 365 × 270 ÷ 1,700 = 58 days.
Operating cycle = 95 + 35 − 58 = 72 days.
What this adds. A current ratio only compares stocks of assets and liabilities on one date; it says nothing about how fast those assets turn into cash. Here the firm waits about 95 days to sell its stock and a further 35 days to collect, and finances only 58 days through suppliers - so roughly ₹72 days of cost is permanently tied up in working capital. Three specific warnings:
- Inventory is the whole problem. 95 days of stock against a 35-day collection cycle means stock, not receivables, is absorbing the money. Writing off ₹120 lakh of obsolete stock lifts the turnover ratio to 1,800 ÷ [(440 + 380)/2 = 410] = 4.39 times - the ratio improves precisely because the asset base shrank, which is why turnover ratios must always be read with the absolute figures.
- The remaining inventory may still be slow. 95 days is long for a machinery trader and suggests either over-buying before the season or items already ageing.
- Payables cannot be stretched much further without damaging supplier terms, so the cycle cannot be financed by deferring creditors.
The bank should look at the cycle, not the current ratio, before sanctioning any enhancement.
3. Before the audit, the CFO proposes two steps to 'protect' the current ratio: (a) draw a nine-month ₹200 lakh term loan on 25 March 2024 and hold the proceeds as cash on 31 March; and (b) reclassify the ₹120 lakh of discontinued stock as 'raw material held for a new product line'. Evaluate both, with figures.
Read the worked answer
(a) Borrowing cash at the year end makes the ratio worse, not better. Using the restated figures (current assets ₹780 lakh, current liabilities ₹400 lakh at 1.95 : 1): New current assets = 780 + 200 = ₹980 lakh; new current liabilities = 400 + 200 = ₹600 lakh; current ratio = 980 / 600 = 1.63 : 1.
The reason is arithmetic, not opinion: whenever the ratio is below 1, adding equal amounts to both sides pulls it towards 1; when it is above 1, equal additions pull it down towards 1. The firm's ratio is 1.95, so the borrowing drags it to 1.63. The transaction also adds nine months of interest, leaves the firm holding cash it does not need, and creates a liability that matures inside the next year - a classic example of window dressing that defeats itself. If cash were genuinely needed, the borrowing would be a business decision; taken on 25 March purely to shift a year-end ratio, it is cosmetic and should be disclosed.
(b) The reclassification is not permitted and does not work. Inventory must be measured at the lower of cost and net realisable value, and this stock has nil NRV. Renaming it 'raw material for a new product line' does not change that: there is no new product line, no buyer and no scrap value, and the label would be a misdescription of an asset in the audited accounts. Even on the ratio arithmetic, the item is inventory under either label, so current assets stay at ₹780 lakh and the ratio stays 1.95 : 1 - the only effect is to make the disclosure false.
What the board should do: pass the ₹120 lakh write-down, disclose the covenant breach and the negotiation with the bank, and present the operating cycle analysis in the notes. Lenders routinely reset covenants once a breach is disclosed early; a discovered misclassification, by contrast, taints the audit and the loan file for years.