Neelachal Spinning Mills: Two Covenants, One Cash Problem

Liquidity

• Current ratio = 35.4 / 21.9 = 1.62 - passes 1.50.
• Quick ratio = (35.4 − 15.0) / 21.9 = 0.93 - below 1, so the 'pass' rests entirely on inventory.
• Receivable days = 18.0 / 84.0 × 365 = 78 days; inventory days = 15.0 / (0.68 × 84.0) × 365 ≈ 96 days. Both are far outside industry norms, so the current assets are of poor quality: roughly ₹5.3 crore of receivables and ₹3.7 crore of inventory are excess relative to median norms.

Solvency

• Interest cover = (5.6 + 3.9) / 3.9 ≈ 2.4 times, down from a healthier level in prior years.
• DSCR = (4.2 + 5.0 + 3.9) / (3.9 + 4.5) = 13.1 / 8.4 = 1.56 - passes 1.30.

The catch. Both covenants pass on accruals while operations consumed ₹2.6 crore of cash. Growth of ₹9 crore in sales was funded by roughly ₹7.3 crore of extra receivables and ₹5.2 crore of extra inventory, net of a small payables increase. Profit is therefore an accounting figure financed by the bank, not by customers. A cash-based DSCR - (CFO + interest paid) / (interest + instalment) = (−2.6 + 3.9) / 8.4 ≈ 0.15 - shows the true position. The covenant is technically met but economically meaningless.

Reclassification of ₹6.0 crore. The facility is repayable in 14 months, so it is a current liability unless it has been formally refinanced on a long-term basis before the reporting date. Simply relabelling it is not refinancing. The mechanical effect is large - current ratio becomes 35.4 / 15.9 = 2.23 - which is exactly why it should be resisted: it changes the covenant test without changing the obligation.

Capitalising ₹0.8 crore of working-capital interest. Borrowing costs may be capitalised only when they relate to a qualifying asset that necessarily takes a substantial period to be ready for use. A cash-credit line funding receivables and stock is not a qualifying asset. Capitalising it lifts PBT by ₹0.8 crore and PAT by about ₹0.6 crore, and moves a real cash outflow from operating to investing - flattering both profit and operating cash flow. The cash is still gone.

Conclusion. Neither adjustment creates a rupee of cash or reduces a rupee of obligation; both are window dressing that would mislead the bank and breach the duty of faithful representation. The auditor should decline both, disclose the negative operating cash flow and the working-capital build-up as a key matter, and present the covenant test on the contractual definitions with a note that compliance depends on a working-capital release plan. If the bank's definition is accrual-based, the auditor should still draw attention to the cash position so the lender can reassess.

1. Collect receivables to 55 days. Target receivables = 84.0 × 55/365 = ₹12.66 crore against ₹18.0 crore now, releasing ₹5.3 crore. Actions: stop supply on credit beyond 60 days, monthly ageing review with the top ten customers, and a 1% early-settlement discount costing about ₹0.13 crore - trivial against the release.

2. Cut inventory to 72 days. Target = 57.1 × 72/365 = ₹11.26 crore against ₹15.0 crore, releasing ₹3.7 crore. Actions: ABC classification, reorder levels built from actual consumption rather than the 96-day habit, and a vendor-managed stock arrangement for the fast-moving yarn counts.

3. Fund growth with the release, not the overdraft. The combined ₹9.0 crore release converts negative CFO of ₹2.6 crore into a positive figure and restores cash-based DSCR above 1.30 without new borrowing.

Presentational point. Each target should be stated as a days figure with an owner and a monthly milestone, because a rupee target invites cutting the wrong inventory or refusing good customers. The auditor's note to the bank should quantify the release plan rather than accept a reclassification, so that covenant compliance reflects performance and not presentation.