Question

Baker & Co. has applied for a loan from the Trust Us Bank to invest in several potential opportunities. To evaluate the firm as a potential debtor, the bank would like to compare Baker & Co. to the industry. The following are the financial statements given to Trust Us Bank:

Balance Sheet     12/31/13    12/31/14

Cash     $305    270

Accounts receivable     275    290

Inventory     600    580

Current assets     1,180    1,140

Plant and equipment     1,700    1,940

Less: acc depr     (500)    (600)

Net plant and equipment     1,200    1,340

Total assets     $2,380    $2,480

Liabilities and Owners' Equity

Accounts payable     $150    $200

Notes payable      125    0

Current liabilities      275    200

Bonds      500    500

Owners' equity

Common stock     165    305

Paid-in-capital     775    775

Retained earnings      665    700

Total owners' equity     1,605    1,780

Total liabilities and owners' equity     $2,380    $2,480

Income Statement

Sales (100% credit)     $1,100    $1,330

Cost of goods sold      600    760

Gross profit     500    570

Operating expenses     20    30

Depreciation      160    200

Net operating income     320    340

Interest expense        64    57

Net income before taxes     256    283

Taxes      87    96

Net income     $169    $187

a. Use ratios to discuss 2 of each of the firm’s financial strengths and weaknesses? (3 pts.)

b. If you are a loan officer, explain why you would or wouldn’t grant the loan. (3 pts.)

Answer 1

a. Strengths:

Current ratio and Quick ratio have improved significantly. Hence company has sufficient short term assets to cover short term liabilities

Current Ratio₂₀₁₃ = 1180/275 = 4.29

Current Ratio₂₀₁₄ = 1140/200 = 5.70

Quick Ratio₂₀₁₃ = (305+275)/275 = 2.11

Quick Ratio₂₀₁₄ = (270+290)/200 = 2.80

Debt Ratio has also decreased, hence the company has less financial risk

Debt Ratio₂₀₁₃ = (150+125+500)/2380 = 0.33

Debt Ratio₂₀₁₄ = (200+500)/2480 = 0.28

Weakness:

Operating Profit margin has decreased significantly

Current Ratio₂₀₁₃ = 320/1100 = 29%

Current Ratio₂₀₁₄ = 340/1330 = 25.56%

Return on equity has decreased

ROE₂₀₁₃ = 169/1605 = 10.52%

ROE₂₀₁₄ = 187/1780 = 10.50%

b) The company has improved their liquidity to fund short term liabilities, but operating profit margins is decreasing significantly. Therefore in future the company will not able to serve the loan if margins continue to fall. The company should have a reasonable reason for the falling margins, after assessing the reasons loan officer may or may not grant a loan. Hence loan decision can go either way.