The 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)
The current ratio (CR) is one of the most sacrosanct concepts in banking, especially Indian banking. A CR of 1.33 or more is what differentiates a lendable proposition from one which is not. That is, if a borrowing entity's CR is more than 1.33, it is considered an acceptable credit risk, otherwise not. This level of acceptable CR was laid down by the Tandon Committee way back in the mid-1970s and still holds strong sway.
There are reams of literature on the subject; why the CR is important; how to calculate it; what all items on the balance sheet qualify to be classified as current assets and as current liabilities and under what circumstances and its implications. There is also an army of aggressive consultants who help borrowers present their accounting figures in a way that they reach the magical CR figure of 1.33 and, in case it falls short, on justifying why the shortfall is acceptable.
But the question that arises is, whether this figure is relevant in making credit decisions and to what extent!
One of the prime due diligences that the bank does before actually parting with funds is to ensure that the borrower has the ability to use the funds productively so that it is able to repay it as well as has the intention of doing so.
Relying on the sale value of collateral security or the worth of the guarantee is not very sound in view of the various infirmities. To give one stray example, if the activity for which money has been lent is found to be illegal, the security is liable to be confiscated by the authorities while the loan outstanding remain on the bank's books. There are many more such exceptions.
Moreover, relying on tangible security would mean that some very good ideas from able and sincere entrepreneurs would not get funded, leaving society as a whole much worse off. Therefore, ascertaining the ability of the borrower to use the funds productively and their intention of returning it as per agreed terms is of prime importance.
The future is uncertain and while the money is borrowed in the present, its repayment is in future. This makes all lending decisions extremely complicated and difficult.
The ability and intention of repayment by any borrower is best evaluated by considering the 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 or the intentions of the borrower for repaying the loan. Therefore, there is always asymmetry of information between the lender and the borrower.
Asymmetrical information exposes all lenders to two kinds of risks. First is the risk of ‘Adverse Selection’, and second is 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. Hence, the income from the business might be short of what is required to make the repayment.
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, or because market conditions change, the lender is said to have made an 'Adverse Selection'.
The risk of moral hazard arises after the funds are lent, i.e., after end-use of the funds is at the discretion of the borrower. Once the money is lent, the borrower may be tempted to utilise it for ventures with very high risks which is also expected to give very high return (not the original venture for which the funds were made available). In such a case, the lender tends to take 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 from making out a case for refund of his funds. Anyway, the borrowed funds would have been frittered away and there may be little available to collect!
Borrowers may also fudge their accounts (they do it quite often) and inform the lender that the business actually made losses and that is the reason they cannot repay the borrowed funds.
The entire complex of analysis and procedures for appraisal, monitoring, and recovery of loans used by lenders to protect themselves from the risk of bad debts is a play of these two simple concepts of 'Adverse Selection' and 'Moral Hazard', irrespective of the size of the loan.
The framework for bank lending in India developed out of lending for trade in commodities, wherein risks arising out of asymmetrical information was largely covered 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 financing trading in commodities has been extended for extending working capital funds to industry, services, and agriculture. And that is where the root of the problem lies. Since the operations of the various segments of the economy vary considerably, the underlying assumptions for assessing risk are quite different.
The whole gamut of stock statements, stock inspections, maximum permissible bank finance, and the elusive optimum level of current ratio are extensions of the original line of thinking for lending for trade in commodities. And this has kept Indian bankers blissfully occupied in forever analysing the optimal level of current ratio.
The most important question which needs to be asked before taking any credit risk is, does the borrower have debt servicing capacity and the intention—and this is missing in this analysis. The credit risk is based on sale of security and effectively considers borrowers as a 'gone concern' rather than a 'going concern'!
The basic idea that bankers should treat any lending to a 'going concern' and the borrower’s ability and intention to service its debt, is lost in the discussion on optimality of the current ratio. They fail to realise that no bank can run its business by depending on recourse to foreclosure of collateral security—the transaction costs would be too high.