Thoughts & Ideas

Wednesday, December 07, 2005

A Joke Called Current Ratio

This (Current Ratio) appears to have been developed by bankers towards the end of the 19th century as one of their first and, as it proved, one of their last contributions to financial analysis.

Bob Vause (Guide to Analysing Companies - Published by The Economist)

In any lending situation a person (or bank which acts on behalf of a group of persons) having excess funds feels that he would be better of if he made it available to someone who is in a position to use it productively. That is, the lender expects the borrower to use the funds and generate a return, which the lender himself is not in a position to do. This would enable the borrower to return the borrowed funds with interest (cost of use of funds) and the surplus would be profit for the borrower. This is a classical win-win position, which keeps any market functioning.

One of the prime due diligences that any lender has to do before actually parting with funds is to ensure that the borrower can actually use the funds productively so as to enable him return the funds along with interest on it. He tries to protect himself from failure of the borrower to productively use the funds and return it by having a loan agreement, which seeks to ensure that the borrower uses the funds in the manner intended. The second line of defence for the lender is to have collateral security which can be disposed in case of failure of the venture for which the funds were borrowed.

Relying on the sale value of collateral is the second line of defence for the lender and that too, not a sound one in view of the various infirmities of the Indian legal system. Therefore, the prudent first step, is to take a view on the ability of the borrower to use the funds productively. This analysis is difficult due to asymmetry in information between the lender and the borrower. That is, the lender does not (and cannot know) all the risks involved in running the business of the borrower.

Asymmetrical information exposes the lender to two kinds of risks. First the risk of ‘Adverse Selection’, and second the risk of ‘Moral Hazard’. Adverse selection, is the risk that the lender takes prior to committing or lending the funds. This happens due to the lender not being in a position to fully appreciate or understand the risks involved in the business. Borrowers, by nature, are inclined to take an optimistic view of their businesses. In case the lender believes the optimistic view and lends money, when actually the business does not have as rosy prospects as depicted by the borrower, the lender is said to have made an “Adverse Selection”.

The risk of Moral Hazard, arises after the funds are lent, i.e. after use of the funds is at the discretion of the borrower. Once the utilisation of funds is at the discretion of the borrower, he may be tempted to utilise it for a venture with very high risks (not the original venture for which the funds were made available – say speculating in the stock market or betting on horses) since the entire benefits of the risky venture would go to the borrower. The lender being only entitled to the contracted rate of interest, takes the full brunt of the downside risk, since in case the risky venture fails (as it is most likely to), the poor and anachronistic shape of the Indian legal system would prevent the lender to make out a case for refund of his funds. Anyway, the borrowed funds have been frittered away and there is nothing to collect!

The framework for bank lending in India developed out of lending to trade in commodities. Under the traditional system, asymmetrical information was covered in its entirety by the Current Ratio. Moral hazard being eliminated by having goods under lock and key of the banker, and by inspecting stocks to ensure that they confirmed in terms of specified quantity and quality. Adverse selection was eliminated by keeping a margin over market value of security. Margins varied depending on the volatility in the price of the commodity financed. That is, the risk of diminution in value of stocks (primary security) against which money had been lent was covered by a suitable margin in calculating permissible Drawing Power.

Over time, the conceptual framework developed for bank funding for trading in commodities has been extended for extending working capital funds to industry. The whole gamut of stock statements, stock inspections, maximum permissible bank finance, and the elusive optimum level of Current Ratio is extension of the original line of thinking. And it has kept Indian bankers, right from RBI, to Tandon and Chore committees, to commercial banks occupied. For example, Tandon Committee speaks of methods of lending and permissible bank finance. But in any lending situation, two related decisions are involved. First, does one lend money or not. If the answer to the first question is in the affirmative, then one comes to the second question. How much?

However, asking the first question is conspicuous by its absence. As such, we have reams written on permissible levels bank finance and by corollary the most appropriate level of Current Ratio which would enable the borrower to seek (or be eligible for bank funding). We have borrowers who insist on having a right to a certain quantum of bank finance based on estimation of projected levels of current assets. No questions asked on the basic viability of the entity. We have a legions of consultants who are adept at constructing projections which enable corporates get the working capital limits they desire. This makes the current ratio an extremely holy concept, with countless man-hours spent discussing it. The out come is detailed instructions as to how to calculate the current ratio and as to what all items in the B/S would or would not go into classification of Current Assets and Current Liabilities.

The net result is that for bankers the Current Ratio of 1.33 has become as sacrosanct as Chandrashekar’s constant (1.44 Solar Mass) is for astrophysicists. Chandrashekar’s constant, named after Nobel Laureate S Chandrashekhar, specifies, based on size, as to which stars would explode into a supernova in course of its lifetime. Similarly, a current ratio of 1.33 or more for the typical Indian banker differentiates a bankable proposition from one, which is not. If the current ratio is more than 1.33 it is becomes advisable to lend, otherwise not and the entire credit appraisal system has become a joke (which is fast turning into a fraud).

The basic idea that bankers should treat any lending to a going concern and its ability to keep generating surpluses is lost in the discussion on optimality of the Current Ratio. They fail to realise that no banker can run his business by depending solely on recourse to collateral security.

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