The Loan Covenant and the Inventory Number
A lender's covenant requires a distributor to keep its current ratio at or above 1.50 and debt-to-equity at or below 1.20. Draft figures show current assets Tk 4,200,000 (including inventory Tk 1,900,000 and receivables Tk 1,300,000), current liabilities Tk 2,900,000, total liabilities Tk 5,400,000 and equity Tk 4,600,000. The current ratio is therefore 1.45 - a breach. The finance manager proposes three actions before year-end: (a) take a short-term bank loan of Tk 500,000 to pay off Tk 500,000 of trade payables early; (b) delay paying Tk 400,000 of supplier invoices into the next period; (c) sell Tk 300,000 of slow-moving inventory at book value for cash. The auditor notes that inventory is already turning slowly and receivables days have risen from 45 to 68.
1. Compute the current ratio and debt-to-equity under each of the three proposals and state whether each cures the breach.
Read the worked answer
Baseline: CR = 4,200,000 / 2,900,000 = 1.45 (breach). D/E = 5,400,000 / 4,600,000 = 1.174 (within 1.20).
(a) Short-term loan to pay payables: current assets unchanged (cash +500k, payables −500k but loan +500k). Current liabilities stay at 2,900,000 (payables down 500k, loan up 500k). CR stays 1.45 - no cure. D/E rises (liabilities +500k → 5,900,000 / 4,600,000 = 1.283) - now also breaches the debt covenant. Worst option.
(b) Delay paying Tk 400,000 of payables: current liabilities fall to 2,500,000, assets unchanged. CR = 4,200,000 / 2,500,000 = 1.68 - cures the ratio on paper. D/E falls slightly (liabilities 5,000,000 / 4,600,000 = 1.087). But this is window-dressing, not a real improvement.
(c) Sell inventory at book for cash: current assets unchanged in total (inventory −300k, cash +300k). CR stays 1.45 - no cure. Improves liquidity quality only.
2. Which proposal should the board approve, and what are the ethical and analytical concerns?
Read the worked answer
Analytically: only (b) moves the current ratio to 1.68, and (a) actively worsens the debt covenant. But (b) achieves compliance by deferring payables - the liability returns next period, so the covenant is met through timing, not substance. This is aggressive accounting at best and potentially misleading to the lender at worst.
Ethical concerns:
- Deliberately structuring transactions to hit a covenant at the reporting date without disclosing intent is window-dressing; if the lender relies on it, it may border on misrepresentation.
- (a) is self-defeating and worsens the debt covenant - the finance manager has not modelled it properly.
Recommendation: do not approve (a) or (b) as covenant cures. Instead:
- Approach the lender proactively to renegotiate or obtain a waiver, disclosing the inventory and receivables deterioration (68 days vs 45).
- Tackle the real problem - slow inventory and stretched receivables - through collection drives and inventory clearance.
- If (b) is used at all, disclose the deferral and its reversal so the lender is not misled.