Liquid makes you solid

DOLPHY D’SOUZA

  

A higher current ratio indicates that a company is liquid and solid; but excessively high may be indicative of problems in working capital management.

February 19, 2012:  

In a recent survey of Ernst & Young, 67 per cent of the respondents were of the view that current and non-current classification is the most significant change in revised Schedule VI. The classification of assets and liabilities into current and non-current provides the necessary input for determining the current ratio, which is expressed as current assets divided by current liabilities. The ratio and its many variations are mainly used to give an idea of a company's ability to pay back its short-term liabilities with its short-term assets. A higher current ratio indicates that a company is liquid and solid; but excessively high may be indicative of problems in working capital management. A lower current ratio in some industries may be indicative of solvency problems but could be a norm in other industries.

The current ratio also gives a sense of a company's ability to turn its product into cash. Companies that have trouble getting paid on receivables (power sector companies may have difficulty in receiving cash from the State electricity boards) or have long gestation period (infrastructure companies) can run into liquidity problems if they maintain a low current ratio. On the other hand, companies that purchase on credit but sell on cash (for example, restaurant chain) can afford to operate on a current ratio of less than one (for example, McDonalds). Therefore, to obtain a more meaningful analysis, it is always useful to compare companies within the same industry.

Proper classification into current or non-current is important, as it could affect a borrower's evaluation of compliance with debt covenants or a lender's evaluation of the risk of repayment. A guarantor uses the information to determine whether or not surety should be provided and the fees for the same. The borrower's auditor uses the information to evaluate if the company is a going concern, and rating agencies to determine the appropriate credit rating. A conservative equity investor may refrain from buying stocks of companies that have liquidity problems.

Most companies would like a non-current classification for its borrowings, as that would make it look stronger. As a result, companies may make attempts to rollover short-term obligations on a long-term basis. Lenders are experiencing liquidity and regulatory capital difficulties and may include due-on-demand clauses in their debt agreements. Such clauses provide lenders with the ability to require payment on an accelerated basis, but on the other hand the borrower's financial position could look bad, though such clauses are not generally evoked.

Current and non-current

The definition of current assets and liabilities is based on whether the asset or liability is expected to be realised, or settled within the company's operating cycle or in the next 12 months or is held for trading. A seemingly simple definition is in practice highly complex. For example, inventory of finished goods is held for trading and hence will be classified as current even though it may be sold on an extended credit period and may not be realised within the next 12 months.

On the other hand, machinery spares are not held for trading and if it is not expected to be consumed within the next 12 months it would be classified as noncurrent. A derivative entered into by an entity to gain from short-term price fluctuation will be treated as current because the primary purpose is trading. On the other hand, a long term derivative for hedging purposes is treated as non-current. In such cases, understanding the intention of the management becomes critical; particularly so, when the management uses a derivative for hedging but may not have applied hedge accounting.

Determining an operating cycle is one of the key factors to the classification as current or non-current and can be very tricky. A real-estate developer could be collecting progressive payments from the customer, reflecting the proportionate value of land and the work-in-progress and may have a short operating cycle. On the other hand, a real-estate developer building multiple projects having different demand and payment terms could have multiple operating cycles.

Schedule VI

For many Indian companies, the impact of demand loans, foreign currency convertible bonds, derivatives, related party balances, sticky receivables, refund of direct and indirect taxes, and so on, have a very significant impact on the classification and, consequently, the current ratio. With revised Schedule VI, the current ratio would become more transparent and, in turn, could make the possibility of breach greater for some companies, particularly those that have huge debts. In the Ernst & Young survey, 13 per cent respondents were in discussion with the lenders; probably to seek clarification, changes or forgiveness on the covenants. Thirty per cent respondents had not yet reviewed the impact of revised Schedule VI on the debt covenants, which is worrisome and may lead to last minute surprises. In a worse case situation, violation of debt covenants could result in a chain reaction and could have a more pervasive impact.

(The author is Partner & National Leader, IFRS Services, Ernst & Young Pvt. Ltd.)