Window-Dressing the Current Ratio Before Year-End
Zen Ltd has current assets of ₹18,00,000 and current liabilities of ₹20,00,000 at 31 March 2024. Current assets include inventory ₹10,00,000 and prepaid insurance ₹1,00,000. Current liabilities include a bank overdraft of ₹4,00,000. The company's bankers have set a covenant that the current ratio must be at least 1.5. The finance manager proposes four year-end actions: (i) borrow ₹5,00,000 on a 90-day loan on 31 March and leave it in the bank current account; (ii) sell long-term investments for ₹3,00,000 and use the proceeds to pay trade creditors; (iii) persuade the bank to reclassify the overdraft as a five-year loan; (iv) delay paying ₹2,00,000 of creditors by 60 days without any agreement. He says all four will improve the ratio and satisfy the covenant. The auditors are reviewing the draft financial statements.
1. Compute the current ratio and quick ratio before and after each of the four proposals. Which proposals actually improve the ratios?
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Before: current ratio = 18,00,000/20,00,000 = 0.90. Quick assets = 18,00,000 − 10,00,000 − 1,00,000 = 7,00,000; quick ratio = 0.35.
| Proposal | Current assets | Current liabilities | Current ratio | Quick ratio |
|---|---|---|---|---|
| (i) Borrow ₹5,00,000 | 23,00,000 | 25,00,000 | 0.92 | 0.48 |
| (ii) Sell investments and pay creditors | 18,00,000 | 17,00,000 | 1.06 | 0.41 |
| (iii) Reclassify overdraft | 18,00,000 | 16,00,000 | 1.125 | 0.4375 |
| (iv) Delay creditors ₹2,00,000 | 20,00,000 | 22,00,000 | 0.91 | 0.41 |
All four improve the ratio slightly, but none reaches 1.5. When the current ratio is below 1, equal increases in current assets and current liabilities only move the ratio toward 1. With current liabilities of ₹20,00,000, a current ratio of 1.5 requires current assets of ₹30,00,000 - ₹12,00,000 more than now.
2. Advise the board on whether the proposals should be implemented, considering the covenant and the auditors' review.
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Proposal (ii) is a real transaction, but it may weaken liquidity and future earning capacity. Proposal (i) is pure window dressing: a 90-day loan taken on the last day increases cash and an equal liability, adds interest cost and disappears shortly after the year end; it does not improve the underlying position. Proposal (iii) changes the label, not the obligation; unless the bank genuinely agrees to a five-year loan on different terms, it misstates current liabilities and may breach the covenant in substance. Proposal (iv) is not an accounting transaction if the creditors are already unpaid; if payment is deliberately delayed, it increases both cash and creditors and may damage supplier relationships.
The auditors should apply substance over form, verify the terms and subsequent repayment of the loan, and consider whether the covenant is met on a fair basis. The board should renegotiate the covenant or inject equity, not cosmetics. Deliberately structuring transactions to mislead the bank can amount to misrepresentation.
3. If the company collects ₹2,00,000 from debtors and uses it to pay creditors, what is the effect on the current ratio and quick ratio? Explain.
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Collecting ₹2,00,000 from debtors reduces debtors and increases cash by equal amounts, so current assets stay at ₹18,00,000 and the quick ratio stays at 0.35. Paying creditors with that cash reduces current assets to ₹16,00,000 and current liabilities to ₹18,00,000.
New current ratio = 16,00,000/18,00,000 = 0.889, worse than 0.90. Quick assets fall to ₹5,00,000 and the quick ratio falls to 0.278.
The reason is that when the current ratio is below 1, paying a current liability with a current asset reduces the ratio: the numerator falls proportionately more than the denominator. The transaction is not a remedy.