A 2.09 Current Ratio That Does Not Cover Its Bills
Anandha Textiles Ltd, a Rajapalayam cotton spinner, has asked its bank to renew a ₹2 crore cash credit limit. The credit officer extracts the following from the FY 2024-25 accounts (all figures in ₹ lakh): inventory 126; trade receivables 90; cash and bank 9; prepaid expenses 5; trade payables 70; bank overdraft 30; outstanding expenses 10; long-term borrowings 150; shareholders' funds 170. Sales for the year were 600, of which 80% were on credit; cost of goods sold was 420. Profit after tax was 24, after charging interest of 18 and tax of 8. The previous year's closing inventory was 106 and receivables 74. The promoter points proudly to a current ratio of 2.09, 'well above the 2:1 norm'. The officer also notes that the company has begun offering 75-day credit to two new large buyers, and that a ₹50 lakh long-term loan is proposed to build inventory for the coming season.
1. Compute the current ratio, quick ratio, inventory days, debtor days and interest coverage. Is the promoter's claim of comfortable liquidity justified?
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Workings (₹ lakh):
- Current assets = 126 + 90 + 9 + 5 = 230; current liabilities = 70 + 30 + 10 = 110.
- Current ratio = 230 / 110 = 2.09.
- Quick ratio = (230 − 126 − 5) / 110 = 99 / 110 = 0.90.
- Average inventory = (126 + 106) / 2 = 116; turnover = 420 / 116 = 3.62 times; inventory days = 365 / 3.62 ≈ 101 days.
- Credit sales = 80% of 600 = 480; average receivables = (90 + 74) / 2 = 82; turnover = 480 / 82 = 5.85 times; debtor days ≈ 62 days.
- PBIT = 24 + 8 + 18 = 50; interest coverage = 50 / 18 = 2.78 times.
Verdict: the claim is not justified. The current ratio is flattered by inventory, which is 57% of current assets and takes about 101 days to turn over - plausible for a spinner holding cotton, but it means the ratio depends on selling stock. Strip out stock and prepaid expenses and only 90 paise of liquid assets stand behind each rupee of current liabilities. Debtor days of 62 will stretch further once the new 75-day credit takes effect. Interest coverage of 2.78 times means a 65% fall in operating profit would wipe out the margin of safety - thin for a cyclical cotton business. The correct reading is a firm that is solvent on paper but is financing slow stock with a bank overdraft.
2. Recompute the current ratio, quick ratio and interest coverage if the ₹50 lakh term loan is drawn and held as inventory, assuming interest rises by ₹5.5 lakh a year. What does the comparison show?
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Recomputed (₹ lakh):
- Current assets = 230 + 50 = 280; current liabilities unchanged at 110.
- Current ratio = 280 / 110 = 2.55 - it improves.
- Quick ratio = (280 − 176 − 5) / 110 = 99 / 110 = 0.90 - unchanged, because the entire increase sits in inventory.
- PBIT unchanged at 50; interest = 18 + 5.5 = 23.5; interest coverage = 50 / 23.5 = 2.13 times - it deteriorates.
What the comparison shows: converting long-term debt into inventory mechanically raises the current ratio without improving the firm's ability to pay. If the extra stock also takes longer to sell, inventory days rise further and cash conversion slows, so the bank is being shown a better-looking ratio for a weaker business. Meanwhile the fixed interest obligation grows against a flat operating profit.
The proposal is therefore not a liquidity solution - it funds more of the asset that is already the problem. A defensible use of long-term money would be to replace the ₹30 lakh overdraft (a permanent liability funded by short-term borrowing), not to enlarge stock. The officer should treat the ratio improvement as evidence of window-dressing risk and check whether year-end payables were compressed to flatter the current ratio.
3. As credit officer, would you renew the ₹2 crore limit, reduce it, or sanction with conditions? Set out your decision with reasons.
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Decision: sanction with conditions rather than refuse - the company is profitable and covered, but it is being financed on the wrong structure.
Conditions:
- Reduce the cash credit to ₹1.5 crore and carve out ₹50 lakh as a working capital term loan repayable over 36 months, so the permanent portion of working capital is funded by long-term money instead of a renewing overdraft.
- Decline the ₹50 lakh loan for building inventory in its present form; inventory days of 101 do not justify more stock.
- Monthly stock and receivables statements, quarterly financials, and a covenant that debtor days stay under 75 - realistic given the new 75-day terms, but a trigger for review if breached.
- Price for the risk: margin of about 1.5% over the benchmark rather than the prime rate, and a stipulation that the promoters bring in ₹25 lakh of own funds to demonstrate commitment.
Reasoning: refusal would push a viable employer into costlier borrowing elsewhere and probably worsen recovery. Unconditional renewal repeats the existing mismatch, where an overdraft funds slow cotton stock. The conditions convert the exposure to a structure the cash cycle can actually support and give the bank early warning. The officer should also verify the receivables - two new large buyers taking 75-day credit are exactly where doubtful debts appear a year later.