Question

Gale & Co. has applied for a loan from the Trust Us Bank in order to invest in several potential opportunities. In order to evaluate the firm as a potential debtor, the bank would like to compare Gale & Co. to the industry. The following are some key financial ratios

                                                            2016                2017                Industry Norm(2017)

Current Ratio                                      4.3X                5.7X                            5.0X

Quick Ratio                                         2.1X                2.8X                            3.0X

Inventory Turnover                             1.0X                1.3X                            2.2X

Average Collection Period                 90days             78.3days                      90days

Debt Ratio                                           33%                 28%                             33%

Times Interest Earned                         5.0X                6.0X                            7.0X

Total Asset Turnover                          .46X                .54X                            .76X

Fixed Asset Turnover                          .92X                .99X                            1.0X   

Operating Profit Margin                     29.1%              25.6%                          20%

Net Profit Margin                                12.0%              14.6%                          16.3%

Return on Total Assets                       7.1%                7.5%                            9.0%

Basic Earning Power Ratio                 13.4%              13.7%                          15.0%

Return on Equity                                10.6%              10.4%                          13.4%

What are the firm’s financial strengths and weaknesses? Should the bank make the loan? Why or why not?

Answer 1

Strength:

Company’s main strength is current ratio, average collection period, and debt ratio.

Current ratio: This has increased from the last year, 4.3 to 5.7, and it just crossed the industry average, 5. it means company’s ability of paying debts is high, which creates good liquidity.

Average collection period: Company’s debt collection is good, since in the recent year (2017) it is lower than the industry average; 78.3 days < 90 days. It indicates availability of cash for paying debts as and when required.

Debt ratio: (Total liabilities / Total assets). This indicates how much liability the company has; lower ratio is always favorable for new loan. Such ratio is gone down in 2017, which is good.

Weakness:

Company’s main weakness is quick ratio.

Quick ratio = (Total current assets – Inventory) / Total current liabilities

Since the ratio is lower than average in both these years, the company must have higher inventory level. This thing hampers company’s liquidity; immediate payment of loan may not be possible always because of shortage of cash and cash equivalent.

The bank should make the loan although there is a weakness. High current ratio makes a favorable situation of company’s liquidity. Since profit margin ratio is good, the bank can expect that inventory will be rolled fast in near future; it makes quick ratio to increase in future too.