Kaveri Auto Components: Debt, Equity and 140 Days of Locked Cash
Kaveri Auto Components Pvt Ltd, near Ramanagara, has equity capital of ₹40 lakh (4,00,000 shares of ₹10 each) and a term loan of ₹60 lakh at 12%. EBIT last year was ₹14 lakh and the tax rate is 25%. The company needs ₹50 lakh for a new machining line expected to add ₹6 lakh of EBIT every year. The banker has offered a further ₹50 lakh of debt at 14%; alternatively the promoters can bring ₹50 lakh as equity at par; a third option is ₹25 lakh each. The current ratio is 1.2, inventory is held for 95 days against an industry average of 45 days, and creditors are paid in 30 days while debtors take 75. The promoter believes debt is cheap because interest is tax-deductible and wants the all-debt option.
1. Work out the effect of the three financing options on earnings per share and interest coverage, and advise the promoter.
Read the worked answer
Computations (₹ lakh, tax at 25%)
| EBIT | Interest | EBT | Tax | PAT | Shares | EPS (₹) | Interest cover | |
|---|---|---|---|---|---|---|---|---|
| Present | 14.00 | 7.20 | 6.80 | 1.70 | 5.10 | 4,00,000 | 1.28 | 1.94 |
| (a) All equity | 20.00 | 7.20 | 12.80 | 3.20 | 9.60 | 9,00,000 | 1.07 | 2.78 |
| (b) All debt | 20.00 | 14.20 | 5.80 | 1.45 | 4.35 | 4,00,000 | 1.09 | 1.41 |
| (c) ₹25 + ₹25 | 20.00 | 10.70 | 9.30 | 2.33 | 6.98 | 6,50,000 | 1.07 | 1.87 |
Reading the numbers. The all-debt option gives the highest EPS - but by about two paise over the other two. That is a rounding-level gain for a large change in risk: interest cover falls from 1.94 to 1.41, meaning a 30% fall in EBIT would leave the company unable to cover interest. EPS is a residual figure and says nothing about the risk taken to produce it.
Why the gain is so small. The new line earns ₹6 lakh on ₹50 lakh, a pre-tax return of 12%. Debt costs 14% pre-tax, or 10.5% after tax. Trading on equity pays only when the return on funds employed exceeds the cost of those funds. Here the margin is a thin tax artefact, not a business gain.
Recommendation. Take the mixed option (c), or equity if cash flows stay tight. More debt should be raised only after the working capital position improves, because the fixed obligation rises from ₹7.2 lakh to over ₹10 lakh a year whatever the sales do. Also note that the promoter's argument - interest is tax-deductible - is true but incomplete: the tax shield reduces the cost of debt, it does not remove the obligation to pay.
2. Comment on the working capital position and suggest what the company should fix before taking on more debt.
Read the worked answer
The current ratio is flattering. A current ratio of 1.2 looks merely tight, but with 95 days of inventory most of the current assets are slow-moving stock. Strip inventory out and the quick ratio is poor; the company may be technically liquid only because it cannot sell its stock quickly.
The operating cycle tells the story: inventory 95 days + debtors 75 days − creditors 30 days = 140 days from paying for material to collecting cash. The company funds nearly five months of operations from its own resources, which is why it needs ₹50 lakh and will need more if it grows.
What to fix, in order:
- Inventory. Move from 95 days towards the 45-day industry norm. Use ABC analysis, produce fast movers to a schedule and slow movers to order, and check whether some stock is obsolete.
- Debtors. Tighten credit checks, invoice on time, offer a small early-payment discount, and use bill discounting for large customers. Target 45–50 days.
- Creditors. Negotiate 45–60 days from major suppliers instead of 30, without losing cash discounts that are worth more than the delay.
- Cash budgeting. A rolling 13-week cash forecast so the repayment schedule is matched to collections.
The trade-off: cutting inventory too hard causes stock-outs and lost orders; squeezing debtors too hard loses sales. The aim is not the lowest possible working capital but the lowest that does not damage operations.
Fix this first. A company with a 140-day cycle and thin cover should not add a fixed 14% obligation; improving the cycle releases cash and improves the very interest cover that makes debt safe.