Question

Question 3 10 marks Barton Company requested a large loan from First National bank to acquire a large piece of land for future expansion. Bart reported current assets of R1,900 ,000 (R430 000 in cash) and current liabilities of R1,075,000. FNB denied the request for a number of reasons. When the Company received the news, the financial controller immediately paid R420 000 that was owed to several trade creditors. He then asked the bank to reconsider the loan application. Based on the abbreviated facts would you advise FNB to advance the loan? Why? Are the actions of the financial controller ethical? 1) What could be the reasons for the denial of the request for a loan? (2) 2. After the actions of the controller what would be your advice for FNB and why (7) 3. Are the actions of the financial controller ethical? (1) NB: limit your answer for all 3 sub-questions to 500 words or less.

Answer 1

1) Possible Reasons for denial of the request for loan :

First of all, let's understand what a "current ratio" means and indicates. Current ratio is calculated by dividing current assets with current liabilities and indicates the company's ability to meet its current obligations. Hence, higher the current ratio, the better it is and higher are the chances of a creditor/bank sanctioning you a loan.

Generally a current ratio of 1.5 or higher is considered as acceptable by any industry. In the current case, Barton had a current ratio of 1.77 (19,00,000/10,75,000) which shows that the company will be in a good position to meet its current obligations including interest payments on a loan.

However current ratio is not the only financial ratio a bank looks for while providing a loan. While the current ratio might be able to indicate the entity's ability to meet the current interest payment obligations, it does not guarantee anything about the repayment of the principal amount.

Hence one possibility is that Barton company's debt to equity ratio or debt to total assets ratio which indicates the overall position and ability of the company to meet its debt obligations was in a bad position and hence FNB had denied the loan. Another possibility is that the financial performance of the company had been poor basis factors and ratios such as net profit ratio or return on total assets ratio. One more possibility is that even though Barton had current assets of R19,00,000, cash was only R430,000 and the major balance portion could be related to inventories or prepaid expenses where the capital is actually blocked and Barton's acid test or liquid ratio could have been in a very bad position.

Hence there could be many reasons for denial of loan to Barton, majority of which have been listed above.

2. My advice to FNB :

After actions of controller of Barton, my advice to FNB would be to blacklist such a company and to stop their dealings with them altogether. It is evident that the finance controller has tried to manipulate the accounts and show a better liquidity position for the company than what it should be. FNB should never deal with such a company whose finance controller is highly unethical. FNB will not only be bearing the risk of non-payment of their loan including both principal and interest amounts but it will also be bearing the consequences of loss of reputation when such unethical actions of finance controller of Barton come to light.

Current ratio of Barton before repayment of creditors was 1.76 as calculated above.

Current ratio of Barton after repayment of loan from creditors become 2.26 (14,80,000/6,55,000).

Even though current ratio of 2.26 is something that is highly attractive and indicates that their loan would be safe, it is just a manipulated figure wherein the finance controller of Barton has made immediate payments to its creditors out of their normal expected credit cycle of payment. Hence it does not show a true and fair view of the liquidity position of Barton and hence I advice FNB to still not grant any loan to Barton.

3. Are actions of finance controller ethical :

No, the actions of finance controller are not ethical at all. It is a clear and an evident case of manipulation of accounts by making early and unexpected payments to its creditors in order to depict a better liquidity position of the company. Such actions should have stringent consequences. Finance controller of Barton should be fired and replaced by someone who understands and values the need for ethical values and policies.

It is possible that the credit period provided by the creditors still had some time left for their payment and their could have been another current liability which had to meet in the forthcoming days, however, now that the finance controller has made payments to the creditors in order to depict a better liquidity position and exhausted its cash balance, the company might end up defaulting on the payment of such other current liability tarnishing the reputation of the company.