Question

Mattel Toy Manufacturing has an outstanding $11 million loan with Wells Fargo Bank for the current year. As required in the loan agreement, Mattel reports selected data items to the bank each month. Based on the following information, is there any indication of a developing problem loan? About what dimensions of the firm’s performance should Wells Fargo Bank be concerned?

		One	Two	Three	Four
	Current	Month	Months	Months	Months
	Month	Ago	Ago	Ago	Ago
Cash account (millions of dollars)	$33	$57	$51	$44	$43
Projected sales (millions of dollars)	$298	$295	$294	$291	$288
Stock price per share
(monthly average)	$6.60	$6.50	$6.40	$6.25	$6.50
Capital structure (equity/debt ratio
in percent)	32.8%	33.9%	34.6%	34.9%	35.7%
Liquidity ratio (current assets/
current liabilities)	1.10x	1.23x	1.35x	1.39x	1.25x
Earnings before interest and taxes
(EBIT; in millions of dollars)	$15	$14	$13	$11	$13
Return on assets (ROA; percent)	3.32%	3.25%	2.98%	3.13%	3.11%
Sales revenue (millions of dollars)	$290	$289	$290	$289	$287

Answer 1

Before jumping to the case. Let us know what all factors play importance role in knowing firms liquidity and its ability to pay meet monthly payments of the loan.

1) Cash flows. Liquid cash is used to pay loans. If a company has healthy cash flows and cash balances, it is likely that it will pay its loan timely. Cash flow is different from net income in accrual based accounting. So, cash is one of the important factor.

2) Current Ratio : It is defined as Current Asset divided by Current liability. It tells us the ability of a business to pay short term or current liabilities. Current Asset includes accounts receivables, cash in hand etc. So, it helps us to know that if the companies current asset are healthy enough to meet the current liability.

3) EBIT to sales ratio : Not as important as above but it tells you what amount of earning we are generating before interest and tax in regards to sales. the EBITDA-to-sales ratio shows the total amount a company can expect to receive after operating costs have been paid. So, not as importance as above two but you should consider this.

Now lets come to case.

1) The company has adequate amount of cash balance. You can notice that the loan amount is $11 million. However, the company $33 millions of cash balance. Apart from this, the cash balance reduced a lot from last month to current month as last month had a balance of 57 million. Wells Fargo Bank should ask the company its cash flow statement and figure out what drained the cash balance in a month. But the cash balance is healthy for the month.

2) If the current ratio is 2:1, it is considered to be an ideal situation. We have a reduced current ratio in our situation. A drop in the cash balance would have played a significant role in the reducing the current ratio. However, 1.10x is a fair ratio. The company will be able to meet is current liabilities. The company had 1.25 and 1.36 of current ratio in the past month. It still becomes important for Wells Fargo Bank to dig in the current assets and understand the reducing trend of cash and current ratio.

3) Sales number are good. The company is able to match the projected sales. However, what is concerning is the EBIT to sales ratio. Let us calculate the ratio for current month by simply dividing EBIT by sales and that comes out to be 0.051 or 5.1%. The company might have issue with profitability in near future.

The company is fairly valued for now. It has a fair liquidity position with current ratio being 1.10x and cash balance for $33 million. Wells Fargo Bank should be concerned with reducing trend in the current asset. We can conclude the company will be able to pay loan with given cash balances. However, Wells Fargo Bank should dig into cash flows statement.

If you have any doubt, please ask me in the comment section.