Question

You have been hired as a new loan officer of Union Bank and have received a loan application from the Cory Company for 2019. You compiled the following ratios from the financial statements provided by your client.

                                                2017                2018                2019

Current ratio                           2.0: 1               1.9: 1               1.8: 1

Debt to Equity ratio                     .40                  .55                  .76

A/R turnover                           15 x                 10 x                    8 x

Times interest earned ratio     3.0                 2.5                  1.5

Inventory turnover                  9 x                   7.4 x                5.1 x

Credit terms given to the customers of the company are net thirty days. The industry average for inventory turnover is 8.3 x.

Instructions: Discuss each of ratios, including a comment on any trends the information indicates and the possible reasons for these trends. Would you grant Cory Company the loan it is requesting?

Answer 1

Current Ratio

Current ratio is the ratio of current assets to current liabilities. This ratio indicates the availability of current assets to meet its current liabilities obligation. In the given case the Current ratio is declining year on year basis. Hence it is not a good sign for the firm. The reason for decline over the years is decline in Current assets or increase in current liabilities.

Debt to Equity ratio

This ratio indicates the solvency of the firm. The higher the ratio the firm will have higher debt obligations for repayment. Hence it will increase the risk of the firm and affect its solvency. In the given case the Debt to Equity ratio is increasing year on year it means firm is increasing its capital through debt. The firm should have high cash flows to serve debt obligations

A/R turnover

Accounts receivable turnover ratio indicates the ratio of accounts receivable movement to credit sales of the firm. The higher the ratio is better since it will reduce number of receivable days on hand. In the given case the Accounts receivable ratio has been declining year on year basis thereby increasing the accounts receivable days for the firm which indicates the firm is not managing its AR in a good way

Times interest earned ratio

This ratio indicates the coverage of Operating profit for payment of interest on debt. The higher the ratio it is better for the firm. In the given case the ratio is decreasing year on year basis it means the operating profit of the firm is declining. This is not a good sign from solvency point of view

Inventory turnover ratio

This ratio indicates the movement of the inventory based on cost of goods sold. The higher the ratio it is better for the firm since inventory days on hand will reduce. In the given case the ratio is reducing which means the firm is carrying higher level of inventories which carry risk of obsolescence and write off. The firm needs to have a better system for managing inventory. The inventory turnover ratio is lower than industry average of 8.3X in 2019. So performance of firm is not in line with industry standard.

Conclusion:

The loan should not be granted to Cory Company since the ratios are not indicating better performance over the year.