Question

P3-16: Debt analysis Springfield Bank is evaluating Creek Enterprises, which has requested a $4,000,000 loan, to assess the firm’s financial leverage and financial risk. On the basis of the debt ratios for Creek, along with the industry average and Creek’s recent financial statements (following), evaluate and recommend appropriate action on the loan request.

Sales revenue	$30,000,000
Less: Cost of goods sold	21,000,000
Gross profits	$ 9,000,000
Less: Operating expenses
Selling expense	$ 3,000,000
General and administrative expenses	1,800,000
Lease expense	200,000
Depreciation expense	1,000,000
Total operating expense	$ 6,000,000
Operating profits	$ 3,000,000
Less: Interest expense	1,000,000
Net profits before taxes	$ 2,000,000
Less: Taxes (rate = 21%)	420,000
Net profits after taxes	$ 1,580,000
Less: Preferred stock dividends	100,000
Earnings available for common stockholders	$ 1,480,000
Creek Enterprises Income Statement for the Year Ended December 31, 2019

Assets		Liabilities and Stockholders’ Equity
Cash	$ 1,000,000	Accounts payable	$ 8,000,000
Marketable securities	3,000,000	Notes payable	8,000,000
Accounts receivable	12,000,000	Accruals	500,000
Inventories	7,500,000	Total current liabilities	$16,500,000
Total current assets	$23,500,000	Long-term debt (includes financial leases)b	$20,000,000
Land and buildings	$11,000,000
Machinery and equipment	20,500,000	Preferred stock (25,000 shares, $4 dividend)	$ 2,500,000
Furniture and fixtures	8,000,000
Gross fixed assets (at cost)a	$39,500,000	Common stock (1 million shares at $5 par)	5,000,000
Less: Accumulated depreciation	13,000,000
Net fixed assets	$26,500,000	Paid-in capital in excess of par value	4,000,000
Total assets	$50,000,000
		Retained earnings	2,000,000
		Total stockholders’ equity	$13,500,000
		Total liabilities and stockholders’ equity	$50,000,000
Creek Enterprises Balance Sheet December 31, 2019

Industry averages
Debt ratio	0.51
Times interest earned ratio	7.30
Fixed-payment coverage ratio	1.85

Answer 1

Loan analysis shall include Creek Enterprises ratios versus the industry averages:

Name of ratio	Formula		Creek's values (in $mil)	Creek's ratio	Industry average
Debt ratio	Total Liabilities / Total assets	(Total current liabilities + Long term debt) / Total assets	(16.5 + 20) / 50	0.73	0.51	Creek's liabilities are 73% of Creek's assets versus 51% of industry average making additional loan on Creek's balance sheet a risky proposition
Times Interest earned ratio	Earnings before Interest & Taxes(EBIT) / Interest	Operating profit / Interest	3 / 1	3.00	7.3	Creek earns $3 in operating profits for every $ of interest payments whereas similar peers on an average earn $7.3 in profits for each $ of interest payments which could imply that Creek's interest burden is already higher than its peers (assuming operating profit levels are consistent with peers)
Fixed-payment coverage ratio	(EBIT + Lease payments) / (Interest + Lease payments)	(Operating profit + Lease payments) / (Interest + Lease payments)	(3 + 0.2) / (1 + 0.2)	2.67	1.85	Compared to the Interest coverage ratio above, the fixed coverage ratio for Creek is actually higher than its industry average. Creek earns $2.67 for every $ of Interest and lease payments payable by the company.

Creek could be a risky venture Springfield bank since it already has a high component of liabilities on its Balance sheet as compared to peers as well as that Creek earns lower per $ profit of interest compared to the industry average and therefore, the loan should not be granted to Creek Enterprises.