Lakeshore Packaging: A 1.42 Current Ratio with Negative Operating Cash Flow
Lakeshore Packaging Ltd. has asked its bank for a $500,000 operating line. Revenue grew 22% to $18.4 million last year, but gross margin fell from 24.1% to 19.8% as it chased volume from two large grocery customers. EBITDA was $1.1 million; cash from operations was negative $340,000. Accounts receivable are $4.6 million, inventory $3.9 million, and accounts payable $2.2 million, up from $1.5 million a year earlier with days payable stretching from 34 to 54. Cost of goods sold was $14.76 million. Current assets total $9.1 million, of which $0.6 million is cash; current liabilities are $6.4 million. Total debt is $4.0 million against EBITDA of $1.1 million, and the existing term loan requires annual principal and interest payments of $1.22 million. Capital expenditure last year was $300,000 and cash taxes were $50,000. The owner points to the 1.42 current ratio and offers a personal guarantee. Bank policy requires minimum DSCR of 1.25x and total debt to EBITDA of no more than 3.0x.
1. Calculate the liquidity, leverage and debt service metrics and explain what they say about the business.
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Liquidity
- Current ratio: 9.1 / 6.4 = 1.42 - as the owner says.
- Quick ratio: (9.1 - 3.9) / 6.4 = 5.2 / 6.4 = 0.81. Once inventory is removed, current liabilities exceed liquid assets.
- Cash conversion cycle (daily COGS = 14.76 / 365 = $40,438):
- DSO = 4.6 / (18.4 / 365) = 4.6 / 0.0504 = 91 days
- DIO = 3.9 / 0.0404 = 96 days
- DPO = 2.2 / 0.0404 = 54 days
- CCC = 91 + 96 - 54 = 133 days
Leverage
- Total debt / EBITDA = 4.0 / 1.1 = 3.6x, against a 3.0x policy ceiling.
Debt service
- EBITDA / debt service = 1.1 / 1.22 = 0.90x
- (EBITDA - capex - taxes) / debt service = (1.1 - 0.30 - 0.05) / 1.22 = 0.61x, against a 1.25x minimum.
Interpretation. Growth is being funded by suppliers, not by profit. Payables rose $700,000 while EBITDA was $1.1 million and operating cash flow was negative $340,000 - effectively, the supplier base financed the working capital increase. The 133-day cycle means Lakeshore waits roughly four and a half months to convert a dollar of inventory into cash. The current ratio looks acceptable only because inventory, which is slow, is carrying it. Both policy tests fail on every measure.
2. What is your credit decision on the $500,000 line, and what would change it?
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Decision: decline as structured. A personal guarantee does not fix a debt service shortfall.
The guarantee addresses recovery after default, not the cause of default. Lakeshore cannot service existing debt from operations (0.61x DSCR after capex and taxes), so adding $500,000 of interest-bearing demand debt makes the shortfall worse, not better.
The real question is the margin. Gross margin fell 420 basis points on 22% growth. Doing the arithmetic: $18.4 million x 4.3 points is roughly $790,000 of gross profit lost to pricing. If volume growth is being bought with price, the line would fund loss-making working capital.
What would make this bankable:
- Margin recovery - two quarters showing gross margin back above 22%, with the two grocery contracts repriced or exited.
- Working capital release: a documented plan to bring DSO from 91 to 70 days and DIO from 96 to 75 days. That alone releases about $1.5 million of cash and removes the need for most of the line.
- Payables discipline - returning DPO to 40 days will cost cash, so the plan must be funded before the line is drawn.
- A smaller facility ($250,000) fully margined against eligible receivables, with a borrowing base certificate, a clean-up covenant, and a cash dominion arrangement.
- Equity injection or subordinated owner loan sufficient to bring debt/EBITDA under 3.0x.
Why not just approve and monitor? A line drawn to cover operating losses is repaid from asset liquidation, not operations. The bank would be lending into a 133-day cycle with a 0.61x DSCR - the definition of a workout waiting to happen.
3. The sales-side argument is that the current ratio of 1.42 is healthy and that payables stretching is normal for a growing company. Rebut that using the numbers.
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On the current ratio. A current ratio is only as good as the assets behind it. Of the $9.1 million in current assets, $3.9 million is inventory turning in 96 days - for a packaging converter selling to grocery customers on short cycles, that is slow-moving stock, likely obsolete or customer-specific, and not worth book value in a liquidation. Strip it out and the ratio is 0.81. The correct read is that Lakeshore is funding slow inventory with stretched suppliers and a demand loan that can be called.
On payables stretching. Stretching from 34 to 54 days released roughly $700,000 of cash in one year, and that $700,000 is precisely the size of the operating cash shortfall plus part of the capex. In other words, suppliers financed the growth. That works once. Days payable cannot keep extending by 20 days a year, and the suppliers who are now at 54 days are the ones who will place the account on hold the week Lakeshore misses a run.
Three tests to put to the sales side:
- If growth is profitable, why was operating cash flow negative $340,000?
- If liquidity is adequate, why did payables have to grow 47% to support a 22% revenue increase?
- If the business is sound, what is the DSCR - because the term lender is already being paid 0.61x from operations.
Growth that consumes cash is a credit deterioration, not an improvement. The line request is a symptom; the margin collapse is the disease.