Question

Springfield Bank is evaluating Creek​ Enterprises, which has requested a $ 3,750,000 ​loan, to assess the​ firm's financial leverage and financial risk. On the basis of the debt ratios for​ Creek, along with the industry averages and​ Creek's recent financial​ statements, evaluate and recommend appropriate action on the loan request.

Industry Averages

Debt ratio: 0.46             

Times interest earned ratio: 7.31

Fixed-payment coverage ratio: 2.00

Creek Enterprises Income Statement for the Year Ended December 31, 2019          
Sales revenue        $30,005,000  
Less: Cost of goods sold       20,988,000  
Gross profits        $9,017,000  
Less: Operating expenses          
Selling expense    $2,991,000      
General and administrative expenses    1,832,000      
Lease expense    203,000      
Depreciation expense   1,004,000      
Total operating expense       6,030,000  
Operating profits        $2,987,000  
Less: Interest expense       1,003,000  
Net profits before taxes        $1,984,000  
Less: Taxes (rate=21%)       416,640  
Net profits after taxes        $1,567,360  
Less: Preferred stock dividends       107,100  
Earnings available for common stockholders        $1,460,260   

Creek Enterprises Balance Sheet December 31, 2019                  
      Assets                                                     Liabilities and Stockholders' Equity      
Current assets                             Current liabilities      
Cash    $1,030,000          Accounts payable    $7,990,000  
Marketable securities    2,959,000                      Notes payable    7,972,000  
Accounts receivable    11,967,000          Accruals    458,000  
Inventories    7,528,000                                     Total current liabilities    $16,420,000  
Total current assets    $23,484,000         Long-term debt (includes financial leases)**   $19,867,500     
                                                                                         
Gross fixed assets (at cost)*               Stockholders' equity      
Land and buildings    $10,984,000                               Preferred stock (25,200 shares, $4.25 dividend)    $2,457,000
                
Machinery and equipment    20,547,000               Common stock (1.11 million shares at $4.75 par)    5,272,500   
Furniture and fixtures    8,049,000            
Gross fixed assets    $39,580,000          Paid-in capital in excess of par value    4,004,000  
Less: Accumulated depreciation 13,015,000         Retained earnings    2,028,000  
Net fixed assets    $26,565,000          Total stockholders' equity    $13,761,500  

Total liabilities and
Total assets    50,049,000                                    stockholders' equity   $50,049,000  

*The firm has a 4-year financial lease requiring annual beginning-of-year payments of $203,000. Three years of the lease have yet to run.                  
**Required annual principal payments are $799,000.              

Answer the following:

Creek​ Enterprises's debt ratio is: _______ (Round to two decimal​ places.)

Creek​ Enterprises's times interest earned ratio is _______ ​(Round to two decimal​ places.)

Creek​ Enterprises's fixed-payment coverage ratio is:_______ ​(Round to two decimal​ places.)

Complete the following summary of ratios and compare Creek​ Enterprises's ratios vs. the industry​ average:_______ ​(Round to two decimal​ places.)

                                                                                       Creek                Industry

Debt ratio :            

Times interest earned ratio :

Fixed-payment coverage ratio:

Do you agree or disagree with the decision​ below?

Because Creek Enterprises has a much higher degree of indebtedness and much lower ability to service debt than the average firm in the​ industry, the loan should be rejected.

Answer 1

1). Debt ratio = Total debt/total assets = (A/C payable + notes payable + accruals + long-term debt)/total assets

= (7,990,000 + 7,972,000 + 458,000 + 19,867,500)/50,049,000 = 0.73

2). Times interest earned ratio = EBIT/ interest expense = 2,987,000/1,003,000 = 2.98

3). Fixed payment coverage ratio = (EBIT + lease payment)/[(Interest + lease payment) + (After-tax fixed payment)]

After-tax fixed payment = (Debt principal + preferred stock dividends)/(1 - tax rate)

Debt principal = 799,000

Preferred stock dividends = dividend per share *number of preferred shares = 4.25*25,200 = 107,100

Tax rate = 21% (from the income statement)

After-tax fixed payment = (799,000+107,100)/(1-21%) = 1,146,962.03

Lease payment = 203,000

Fixed payment coverage ratio = (2,987,000 + 1,003,000)/(1,003,000 + 203,000 + 1,146,962.03] = 3,990,000/2,352,962.03 = 1.70

4). Summary of Creek's ratio vs industry average:

	Creek	Industry
Debt ratio	0.73	0.46
Times interest earned ratio	2.98	7.31
Fixed payment coverage ratio	1.70	2.00

As can be seen from the table, Creek has a much higher debt ratio as compared to the industry. Also, its ability to service debt is much lower than the industry average, as is seen from the times interest earned ratio and fixed payment coverage ratio. Based on this, the loan should be rejected.  The decision given in the question is correct.