Question

Assume that you are a Loan Officer at the local bank. Company A wants to get a long-term loan from your bank.    Company B wants to get a long-term loan from your bank. Company C also wants to get a long-term loan from your bank.

The TOTAL DEBT RATIO for Company A is .70 and the TIMES INTEREST EARNED RATIO for Company A is .70 for the year.

The TOTAL DEBT RATIO for Company B is .75 and the TIMES INTEREST EARNED RATIO for Company B is 30 for the year.

The TOTAL DEBT RATIO for Company C is .65 and the TIMES INTEREST EARNED RATIO for Company C is 1 for the year.

The Current Ratio for Company A is 1 for the year. The Current Ratio for Company B is 1 for the year. The Current Ratio for Company C is 1 for the year.

Assume that you only have enough money to lend to one company. Which company would you lend to?

A)        Company A

B)        Company B

C)        Company C

D)        You are indifferent amongst Company A and Company B and Company C.

Answer 1

Now for all 3 companies we have 3 ratios:

We will compare one ratio at a time:

1. Total Debt Ratio

For Company A it is 0.7 Company B it is 0.75 and Company C it is 0.65. So the best is of Company C as it has least debt with respect to its total assets. But this does not decide everything. It has lower debt but we also need to see the earning capacity

2. Times Interest Earned Ratio

For Company A it is 0.7 and Company B it is 30 and Company C has 0.65 As we know Times Interest Earned Ratio is the ratio of EBIT (Earnings before interest and Tax) to Total Interest Payable. So if a Company has a ratio higher than 1 than it has earned more EBIT than the Interest Payable. So ratio of 1 means that the interest payable and EBIT are equal thus company would only pay to bank but won't make any profits. Even for ratio of 0.7 it means that the company has EBIT which is 70% of debt payment which means it will default on loans.So the best is of Company B.

3. Current Ratio

The ratio is same for all the companies thus we would be indifferent for the all three. As we know current ratio means that the current assets are enough to pay current liabilities.

From all three ratios Times Interest Earned Ratio is most important as Banker as we provide loan to earn interest only Company B can repay it properly. So Option B is correct.

Ans. Option B Company B