A Rs 40 Crore Term Loan Where the Covenants Look Comfortable
A Rs 40 crore term loan proposal from a mid-sized auto-component manufacturer reaches the credit committee. Audited FY25 figures are: current assets Rs 120 crore, including inventory Rs 60 crore and debtors Rs 45 crore; current liabilities Rs 80 crore, including creditors Rs 30 crore; long-term borrowings Rs 90 crore; net worth Rs 60 crore; EBITDA Rs 28 crore; interest Rs 9 crore; scheduled term-loan repayment Rs 6 crore; turnover Rs 180 crore.
In the same year the company capitalised Rs 4 crore of interest on a new plant still under construction and credited a Rs 3 crore government grant received against that plant to "other income". The sanction note recommends approval because "all three financial covenants are comfortably met". Loan policy requires a current ratio of at least 1.33, a debt-equity ratio of at most 2.0, and a DSCR of at least 1.50 in every year. The borrower has asked for the full Rs 40 crore as a term loan and says it needs no separate working capital line.
1. Compute the current ratio, quick ratio, debt-equity ratio and DSCR. Do the covenants pass, and does that settle the appraisal?
Read the worked answer
Current ratio = 120/80 = 1.50 (covenant ≥1.33 - pass).
Quick ratio = (120 − 60)/80 = 60/80 = 0.75 (no covenant, but below 1.0, meaning current liabilities are not covered by liquid current assets).
Debt-equity = 90/60 = 1.50 (covenant ≤2.0 - pass).
DSCR = EBITDA ÷ (interest + scheduled repayment) = 28/(9 + 6) = 1.87 (covenant ≥1.50 - pass).
Does that settle it? No - three caveats.
- A 1.50 current ratio is carried by inventory that is 50% of current assets; the quick ratio of 0.75 shows the real liquidity cushion is thin.
- DSCR of 1.87 is calculated before tax and before maintenance capex; a bank normally wants DSCR on cash flow after tax and after fixed obligations, which will be materially lower.
- The covenant test is only as sound as the numbers. The grant and capitalised interest noted in the file directly affect EBITDA and interest - both must be re-examined before the DSCR is accepted.
2. Work out the operating cycle and the working capital requirement. Does the request for a pure term loan hold up?
Read the worked answer
Compute the holding periods on a 360-day year, turnover Rs 180 crore (cost of goods sold taken as Rs 180 crore for this approximation):
- Inventory = 60/180 × 360 = 120 days
- Debtors = 45/180 × 360 = 90 days
- Creditors = 30/180 × 360 = 60 days
Operating cycle = 120 + 90 − 60 = 150 days.
Working capital requirement = 180 × 150/360 = Rs 75 crore.
Available net working capital = current assets − current liabilities = 120 − 80 = Rs 40 crore.
Gap = 75 − 40 = Rs 35 crore.
Judgement: the borrower is asking for the entire Rs 40 crore as a term loan while carrying a working capital deficit of roughly Rs 35 crore. A term loan must fund the creation of the asset and its margin, not the operating cycle; if sanctioned without a working capital assessment, part of the term loan will quietly fund inventory and debtors - a classic diversion of end use. The correct structure is to split the facility: a term loan sized to the project cost with a stipulated margin, plus a separate working capital limit against stock and book debts, preferably with a stock-and-receivables statement as a condition of disbursement.
3. Assess the accounting treatment of the Rs 4 crore capitalised interest and the Rs 3 crore grant, and state the condition under which the DSCR covenant would actually fail.
Read the worked answer
Capitalised interest. Borrowing costs may be capitalised only on a qualifying asset during the period the asset is being actively prepared for its intended use; capitalisation stops when the asset is substantially ready, and it must be suspended if active development is interrupted. Rs 4 crore is acceptable only if the plant was genuinely under active construction throughout. If any part of that interest relates to a period of suspension or to a plant already commissioned, it must be expensed.
Government grant. A grant relating to a specific asset cannot be taken to profit in the year of receipt. It is either deducted from the carrying amount of the asset or recognised as deferred income and released to profit over the asset's useful life. Crediting the full Rs 3 crore to "other income" overstates FY25 profit and, because it sits above the EBITDA line, inflates DSCR.
Sensitivity test:
- Remove the grant from EBITDA: EBITDA = 25, DSCR = 25/15 = 1.67 - still above 1.50.
- Additionally expense the Rs 4 crore as interest: interest = 13, DSCR = 28/(13 + 6) = 1.47 - breach of the 1.50 covenant.
Conclusion: the covenant fails if the capitalised interest is disallowed, and it passes only marginally if the grant is merely reclassified. The sanction should be conditional on the auditor's confirmation of active construction, on the grant being restated as deferred income, and on a DSCR recalculated on restated, post-tax cash flows with a documented cushion.