Quite a few family business owners have engaged our services, either to review existing agreements and compare their financial results against those covenants, or to review proposed agreements. During our analysis, one trend became extremely clear: Many family businesses are having difficulty with current ratio requirements. We weren’t surprised.
Purchasing long-term assets with cash and increases in inventory prices and taxes can have a negative impact on ratios. But before we discuss what’s been happening, let’s look at the current ratio requirement from a banker’s perspective.
First, current ratio is defined as current assets divided by current liabilities. Current assets typically include all cash balances, receivables and inventory. Current liabilities typically include your accounts payable, the amount owed on your line of credit, the current portion of your long term-debt (principle due over the next 12 months) and miscellaneous accrued expenses.
Bankers will also include any money your company owes you as current debt, regardless of the stated repayment terms. They think – and probably with good reason – that under severe financial stress, you’re likely to pay yourself before other creditors.
Bankers are trained to include current ratio requirements in their loan agreements as a measure of your company’s ability to repay any amounts owed to the bank on your working capital line of credit. From their perspective, they want your company to be able to pay off all current obligations from cash, sale of inventory and collection of receivables. This scenario translates to a 1.00 current ratio.
Being pessimists by training, however, bankers normally require a 1.50 ratio. Why? Because they think you could have some stale inventory, or perhaps some uncollectible receivables in your current assets. The extra cushion in a 1.50 current ratio requirement makes it even more probable they’ll get paid. And for most industries (notice we said most!), 1.50 is a normal current ratio. Therefore, you may have to educate your banker about your industry and why your current ratio may be less than they would require for other businesses.
If your bank was reluctant to provide you with long-term financing for your projects, they, in essence, weakened your current ratio by forcing you to use 100% cash for your necessary projects. You depleted your current ratio by using a current asset (cash) to purchase a long-term asset.
Let’s look at an example of an owner needing $500,000 for a project. Before the project, the current portion of the balance sheet is as follows:
| Cash | $600,000 | Bank Line | $600,000 | |
| Receivable | 900,000 | A/P | 600,000 | |
| Inventory | 500,000 | Accruals | 300,000 | |
| Current Assets | $2,000,000 | Current Debt | 200,000 | |
| Current Liabilities | $1,700,000 |
This company presently has a current ratio of 1.18. If they invest in a $500,000 project using 75% bank financing to be paid back over 10 years, the balance sheet looks like the following:
| Cash | $475,000 | Bank Line | $600,000 | |
| Receivable | 900,000 | A/P | 600,000 | |
| Inventory | 500,000 | Accruals | 300,000 | |
| Current Assets | $1,875,000 | Current Debt | 250,000 | |
| Current Liabilities | $1,750,000 |
Notice that even with bank financing, the company’s current ratio decreased to 1.07.
Notice that even with bank financing, the company’s current ratio decreased to 1.07.
Now let’s assume the bank declines the company’s loan request, but company management decides they need to complete the project anyway. Now the balance sheet looks like this:
| Cash | $100,000 | Bank Line | $600,000 | |
| Receivable | 900,000 | A/P | 600,000 | |
| Inventory | 500,000 | Accruals | 300,000 | |
| Current Assets | $1,500,000 | Current Debt | 200,000 | |
| Current Liabilities | $1,700,000 |
Under this scenario, the company’s current ratio is now 0.88. The same banker who wouldn’t give you the loan is now panicking because your current ratio is unacceptable. In his eyes, this company cannot pay its current obligations from its current assets.
Secondly, when tax and/or product price increases come suddenly, your current ratio is negatively impacted. Why? Your payables immediately increase, but there is a lag time in your receivables.
Conversely, when prices go down (taxes never do!), your current ratio improves because your receivables are up at the old prices, but your payables are based on the new, lower prices. If only we could figure out a way to end each financial period on a price decline, we’d keep the bankers happy!
Since none of us controls the market, however, what can you do? First, examine your historical current ratio. Do not accept a current ratio loan covenant that is higher than your lowest month ratio.
Second, educate your banker about your industry. If possible, negotiate out of a current ratio requirements.
