Question

Martin Company and Winter Company are each merchandising companies applying for nine-month bank loans in order to finance the acquisition of new equipment. Both companies are seeking to borrow the amount of $210,000 and have submitted the following balance sheets with their loan application.

	MARTIN COMPANY
CURRENT ASSETS:		ASSETS
Cash			$57,000
Accounts receivable			153,000
Inventories			162,000
Short-term prepayments			6,000
Total current assets			$ 378,000
PLANT AND EQUIPMENT:
Land		$150,000
Building	$600,000
Less: Accumulated depreciation	90,000	510,000
Store equipment	180,000
Less: Accumulated depreciation	45,000	135,000
Total plant and equipment			195,000
Total assets			$1,173,000

LIABILITIES & OWNER'S EQUITY
CURRENT LIABILITIES
Accounts payable			$135,000
Accrued wages payable			45,000
Total current liabilities			$180,000
Long-term liabilities:
Mortgage payable (due in 13 months)			330,000
TOTAL LIABILITIES			$510,000
Owner’s equity:
Steven Martin, capital			663,000
Total liabilities & owner’s equity			$1,173,000

WINTER COMPANY BALANCE SHEET
Current Assets
Cash			$384,000
U.S. government bonds			210,000
Accounts receivable			603,000
Inventories			567,000
Total current assets			$ 1,764,000
PLANT AND EQUIPMENT:
Land		$180,000
Building & Equipment	$1,230,000
Less: Accumulated depreciation	180,000	1,050,000
Total plant & equipment			1,230,000
Total assets			$2,994,000
CURRENT LIABILITIES
Notes payable			$600,000
Accounts payable			480,000
Miscellaneous accrued liabilities			180,000
Total current liabilities			$1,260,000
Long-term liabilities:
Mortgage payable (due in 10 years)			420,000
TOTAL LIABILITIES			$1,680,000
Owner’s equity:
Jack Winter, capital			1,314,000
Total liabilities & owner’s equity			$2,994,000

Write 600 words analysis and response.

From the viewpoint of a bank loan officer, to which company would you prefer to make a $210,000 nine-month loan? Explain. Include in your answer a discussion of the ability of each company to meet its obligations in the near future

Answer 1

Liquidity is the ability of a business to meet its short term obligations when they fall due. An enterprise should have enough current assets, which can be converted into cash so that it can pay its suppliers and lenders on time.

The current ratio is a ratio of current assets to current liabilities. It is a widely used indicator of a company's ability to pay its obligations in the near future, and shows the amount of current assets a company has per dollar of current liabilities.

All current assets are however not equally liquid. While cash is readily available to make payments to suppliers, and accounts receivables can be converted into cash with some effort, inventories are two steps away from cash ( sale and collection ). Therefore, a large current ratio by itself is not a satisfactory measure of liquidity when inventories constitute a major part of the current assets.Therefore, the quick ratio or the acid-test ratio is computed as a supplement to the current ratio, which relates relatively more liquid assets ( current assets less inventories less prepaid expenses ) to current liabilities.

As a rule of thumb, the current ratio is expected to be at least 2 : 1 and the quick ratio 1 : 1.

Between the two companies, Martin Company fares better as far as liquidity is concerned, as evidenced by the table below.

	Martin Company	Winter Company
Current Ratio ( Total Current Assets / Total Current Liabilities)	2.1	1.4
Quick Ratio [ ( Total Assets - Inventories - Short Term Prepayments) / Total Current Liabilities)	1.2	0.95
Debt-to-Equity Ratio ( Total Liabilities / Owner's Equity )	76.9 %	127.9 %
Debt Ratio ( Total Liabilities / Total Assets )	43 %	56 %

Further, both the Debt-to-equity and the Debt ratio for Martin Company are lower than Winter Company, thereby signifying lower financial leverage and financial risk. Financial risk refers to the inability of the firm to absorb finance costs in its income stream. A lower Debt-to-equity ratio also indicates better financial flexibility for Martin Company.

Keeping all this in view, the $ 210,000 nine month loan should be granted to Martin Company.