You have done the work. The business is understandable, the returns on capital are respectable, the accounts reconcile and the price is defensible. One question is left, and it is not whether the company is worth owning. It is whether it reaches the far side of the next twelve months without needing somebody’s permission — and if it does need permission, whose, and for what. This lesson is a procedure for answering that from published numbers. It takes about half an hour on a company whose notes you have already opened, and its output is not a probability of failure. It is a sentence describing what your holding is resting on, which is a different and considerably more useful thing.
A household has a comfortable annual surplus. It also has a June in which the school fees, the annual insurance premium and the vehicle renewal all fall within the same fortnight, and a bonus that arrives in October. The year is fine. June is not. Nothing about the annual surplus tells you that, and nothing about June tells you the family is in difficulty.
A company’s year and a company’s dates are two different assessments. Profitability, returns on capital and leverage describe the year. Only a sources-and-uses schedule across the next twelve months describes the dates.
The procedure
- 1Sources: cash the company can genuinely lay hands on
Cash and cash equivalents, plus current investments that are actually liquid and actually unencumbered, plus expected operating cash flow for the year after interest and after the maintenance capital expenditure the business needs simply to keep running. Deduct anything the notes describe as pledged, held as margin, restricted, or lying in a subsidiary that the parent cannot readily draw on. Notice what that deduction implies about net debt, the figure most commentary quotes: netting cash off borrowings assumes the cash is available to settle them, and the cash you have just struck out of this column is exactly the cash that is not.
- 2Uses: cash the company must find
Current maturities of long-term borrowings, plus short-term borrowings that fall due within the year, plus contractual capital commitments already entered into, plus any dividend the company intends to maintain. Interest belongs in this column or the sources column but not neither, and forgetting it is the commonest error in this exercise.
- 3Treat facilities honestly
Undrawn sanctioned limits are a comfort, not a source, unless the facility is genuinely committed for a defined period. An ordinary working capital limit is repayable on demand and its drawing power is recomputed against stock and receivables, so it shrinks in exactly the circumstances that would make you want it. Run the test with those limits at zero, then note separately how much undrawn headroom exists.
- 4Divide, and then classify rather than score
The ratio of sources to uses is a homemade debt service coverage ratio — the same question a lender asks when it divides the cash available for servicing by the interest and principal falling due — and, like the lender’s version, it is a starting point rather than a verdict. Most working capital borrowing is designed to be rolled rather than repaid, so a figure below one is ordinary. What matters is which of three categories the company falls into, and that is the section after the worked example.
The three categories, which are the actual output
| Category | What the schedule shows | What it means for a holder |
|---|---|---|
| Self-sufficient | Everything falling due in twelve months can be met from cash on hand and cash generated, with the maturities modest and spread | The next year is decided inside the company. Ordinary business risk applies and nothing else does |
| Dependent on ordinary rollover | A large part of what falls due is working capital and short paper, with lenders who have rolled it for years and no reason to stop | Normal for most leveraged Indian companies. It is a live exposure to credit conditions rather than to this company, and it belongs in position sizing rather than in the valuation |
| Dependent on a specific event | The schedule only balances if something particular happens: a new facility that is not yet sanctioned, an asset sale not yet agreed, a promoter infusion promised on a call, a fundraise at a price the market has not offered | The thesis now contains somebody else’s decision, with a date on it. This is the category to identify explicitly, because it is the one where being right about the business is not sufficient — and the one in which an auditor eventually reaches for the words material uncertainty related to going concern, long after the schedule would have shown you why |
Five ways this test is run wrongly
- Counting undrawn limits as cash. A sanctioned working capital limit is a permission that the lender can review, and the drawing power against it is recalculated against stock and book debts every month. It contracts when the business contracts. Run the test without it.
- Counting cash that belongs to a subsidiary. Consolidated cash sits in whichever entity holds it. Moving it to the parent requires a dividend, a loan or a repayment, each with tax and, where the subsidiary is overseas, other constraints. A parent servicing debt cannot spend a subsidiary’s bank balance by consolidating it.
- Counting pledged investments. Current investments are often held as margin against guarantees, as security for a facility, or under a lien. The note says so, and the amount is stated.
- Using last year’s operating cash flow for a bad year. It will be lower. It will also be flattered in the first bad year by the working capital that a shrinking business releases — receivables collected on a smaller book, inventory not replaced. That release happens once and is frequently mistaken for resilience.
- Forgetting interest. Interest is a use of cash and it does not stop. Either deduct it in arriving at operating cash flow or list it in the uses column; doing neither overstates the position by the whole finance cost.
Move leverage and interest cover and watch where a balance sheet stops being comfortable. The schedule in this lesson is the same question asked about dates rather than about ratios.
Module checkpoint: what is due, and when
5 questions. Answers are revealed once you submit all of them.
1.Two companies each report gross borrowings of ₹2,400 crore and operating profit before depreciation of ₹600 crore. Company A shows ₹2,150 crore of non-current borrowings; Company B shows ₹900 crore. Which has the harder twelve months, and why does the long-term debt column mislead?
2.Finance cost is ₹186 crore, including ₹22 crore of lease interest and ₹4 crore of discount unwinding. ₹104 crore of borrowing costs were capitalised into a plant under construction. Average gross borrowings were ₹2,200 crore. What is the implied cost of borrowing?
3.A company breaches a leverage covenant at 31 March. Nothing is agreed with the lender by 31 March, and nothing by the time the accounts are approved in May; a written waiver follows in June. How is the long-term loan presented at 31 March, and what does that presentation mean?
4.A company funds a fifteen-year asset with ninety-day commercial paper. It has rolled the paper successfully for four years at narrowing spreads. What is the risk being carried?
5.You run the twelve-month test on a company and sources come to ₹630 crore against uses of ₹1,910 crore, a ratio of 0.33. What have you established?
Saal bhar ka hisaab aaram se theek hai. Par June mein school fees, insurance ka premium aur gaadi ka renewal ek hi pandrah din mein — aur bonus October mein. Saal galat nahi hai, June galat hai. Company ka test bhi do column ka hai: haath mein ₹180 crore cash + ₹150 crore asli khula investment (₹90 crore girvi hai) + ₹300 crore saal bhar ki kamai = ₹630 crore. Aur dena hai ₹500 crore + ₹1,000 crore + ₹350 crore capex + ₹60 crore dividend = ₹1,910 crore — yaani teen mein se ek hissa. Iska matlab default nahi. Iska matlab yeh ki aapki thesis lenders ke agle "haan" pe tiki hai.
- Build two columns: cash genuinely available in twelve months, against cash contractually required in twelve months.
- Exclude undrawn working capital limits, pledged investments and cash sitting in subsidiaries the parent cannot readily reach.
- Interest belongs in the schedule; leaving it out overstates the position by the entire finance cost.
- The output is a category — self-sufficient, dependent on ordinary rollover, or dependent on a specific event that has not happened yet.
- Write the dependency into the thesis as a sentence with a date, because the third category is where being right about the business is not enough.
Mark it done to track your progress through the curriculum.
Common questions
Short, direct answers to what people ask about this topic.
- debt service coverage ratio meaning
- Debt service coverage compares the cash available for servicing debt over a period against the interest and principal falling due in that period. A version you can build yourself divides everything the company can lay hands on in the next twelve months — unencumbered cash, genuinely liquid current investments, operating cash flow after interest and maintenance capital expenditure — by what it must find: current maturities of long-term borrowings, short-term borrowings, contractual capital commitments and any dividend it intends to hold. It is a starting point, not a verdict.
- drawing power meaning in a cash credit account
- Drawing power is the amount a borrower may actually draw against a sanctioned working capital limit at a given time, recomputed periodically against the value of stock and book debts after margin. It is why a limit is not the same thing as available cash: drawing power contracts as inventory and receivables shrink, which is exactly when a company under strain would want to use it. Run a liquidity test with such limits at zero, then note the undrawn headroom separately.
- netting cash off borrowings to arrive at net debt assumes that
- That the cash is available to settle those borrowings — which is precisely what pledged, restricted or subsidiary-held cash is not. Balances held as margin against guarantees, lying under a lien, or sitting in a subsidiary the parent cannot readily draw on should come out before any liquidity conclusion is drawn from net debt. Consolidation moves a subsidiary’s bank balance onto one statement, not into the parent’s account.
- is a sources and uses ratio below 1 a sign of distress
- Not on its own. Almost every leveraged company fails a strict twelve-month sources-and-uses test, because short-term borrowing exists to be rolled rather than repaid, and a test that marks all of them as failures has told you nothing. The distinction that carries information is between a company depending on lenders continuing to do the ordinary thing and a company whose schedule only balances if something new happens by a particular date — a facility not yet sanctioned, an asset sale not yet agreed, an infusion promised on a call.
- what does material uncertainty related to going concern mean in an audit report
- It is the auditor stating that events or conditions exist which may cast significant doubt on the company’s ability to continue as a going concern, while the accounts are still drawn up on that basis. It is not an opinion that the company will fail and it is not, by itself, a qualification. It also tends to arrive long after a twelve-month sources-and-uses schedule would have shown the same dependence on a refinancing, a disposal or a fresh facility.