Kanan Packaging: Record Profit, Bank Overdraft
Kanan Packaging Ltd reported profit before tax of ₹7.40 crore on sales of ₹128.0 crore, up 35% from ₹95.0 crore. Depreciation was ₹2.60 crore and interest on the term loan ₹1.90 crore. A surplus plot was sold during the year at a profit of ₹2.40 crore, and plant and machinery costing ₹2.20 crore was purchased for cash. Trade receivables rose from ₹14.2 crore to ₹22.3 crore, inventories from ₹11.5 crore to ₹15.1 crore, and trade payables from ₹8.4 crore to ₹9.5 crore. Income tax paid was ₹1.20 crore and dividend paid ₹2.00 crore; no fresh borrowing was taken. The bank account moved from a credit balance of ₹1.0 crore to an overdraft of ₹5.4 crore. The draft cash flow statement prepared by a junior accountant shows 'cash from operations ₹9.50 crore' - the figure before working-capital movements - and records the overdraft as an operating inflow. The board wants to know why a record profit produced an overdraft.
1. Prepare the operating section by the indirect method and reconcile the ₹7.40 crore profit to the movement in the bank balance.
Read the worked answer
Operating activities (indirect method)
| Item | ₹ crore |
|---|---|
| Profit before tax | 7.40 |
| Add: depreciation | 2.60 |
| Add: interest on term loan | 1.90 |
| Less: profit on sale of plot | (2.40) |
| Operating profit before working capital | 9.50 |
| Increase in receivables | (8.10) |
| Increase in inventories | (3.60) |
| Increase in payables | 1.10 |
| Cash generated from operations | (1.10) |
| Income tax paid | (1.20) |
| Net cash used in operating activities | (2.30) |
Investing: sale proceeds of plot 4.00 (2.40 profit + 1.60 book value), less purchase of plant (2.20) = +1.80. Financing: interest paid (1.90), dividend paid (2.00) = (3.90).
Net decrease in cash = −2.30 + 1.80 − 3.90 = −₹4.40 crore - exactly the move from ₹1.0 crore credit to ₹5.4 crore overdraft.
The explanation in one line. Growth of ₹33 crore in sales was financed by ₹10.6 crore of net working-capital absorption; operations consumed cash, and the plot sale plus the existing bank balance covered both the working capital and the dividend. The profit is real but it is sitting in receivables and stock.
2. Identify the errors in the junior accountant's draft and state the correct AS-3 treatment of the interest, the dividend and the overdraft.
Read the worked answer
Error 1 - calling ₹9.50 crore 'cash from operations'. That is operating profit before working-capital changes, an internal subtotal. It ignores the ₹10.6 crore absorption and the tax paid, overstating operating cash by ₹11.8 crore - the entire story of the year. A reader would conclude the business is highly cash-generative when it is not.
Error 2 - the overdraft as an operating inflow. A bank overdraft is a borrowing. Under AS-3 it belongs to financing activities, and movements in it are shown net only where the arrangement is repayable on demand and forms an integral part of cash management (the overdraft is then part of cash and cash equivalents, with the movement disclosed). Either way it is not an operating inflow, and classifying it there would conceal the operating deficit behind a financing source. If it is treated as a cash equivalent, the closing cash is a negative ₹5.4 crore and the reconciliation still has to show the operating outflow.
Error 3 - interest and dividend. Under AS-3, interest paid is a financing outflow for a non-financial enterprise (the option to treat it as operating exists and must be applied consistently); interest received is investing. Dividends paid are financing. The junior accountant's draft buries the ₹1.90 crore of interest in the ₹9.50 crore instead of disclosing it.
Suggested presentation. Show the operating section as computed, disclose non-cash items and the working-capital schedule as a note, and add a cash-conversion ratio (CFO / EBITDA) so the board sees the trend rather than one year's number.
3. Quantify how much of the receivables increase is growth and how much is collection failure, and recommend actions with a target.
Read the worked answer
Days outstanding
- Opening: 14.2 / 95.0 × 365 = 54.6 days
- Closing: 22.3 / 128.0 × 365 = 63.6 days - a 9-day deterioration.
Split the ₹8.1 crore increase
- If collection had held at 54.6 days, receivables at the closing sales level would be 128.0 × 54.6/365 = ₹19.15 crore. That is ₹4.95 crore of the increase, explained purely by growth.
- The remaining 22.3 − 19.15 = ₹3.15 crore is collection slippage - money owed for goods already delivered and accepted, simply not collected.
Interpretation. Growth is the larger driver, so this is not purely a credit-control failure. But the ₹3.15 crore is avoidable and it is what turned a near-break-even operating cash flow into a deficit. Note also that the opening 54.6 days was itself above a common 45-day norm; holding 45 days would release a further ₹3.5 crore.
Actions, in order of speed
- Ageing review of the top ten customers within 15 days; freeze credit on any account over 75 days (target: 2,000 accounts reviewed, ₹1 crore collected in 30 days).
- Tie sales incentives to cash collection, not billing, from the next quarter.
- Introduce a 1% settlement discount for payment within 15 days, costing roughly ₹1.2 crore a year at current volumes but avoiding ₹1.3 crore of interest on the overdraft and restoring covenant headroom.
- Target 50 days by year end: receivables of ₹17.5 crore, releasing ₹4.8 crore and turning operating cash flow positive without fresh borrowing.