Debt analysis Springfield Bank is evaluating Creek Enterprises, which has reques

Question

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 averages (see the top of
the next page) and Creek’s recent financial statements (following), evaluate and
recommend appropriate action on the loan request.

Creek Enterprises Income Statement for the Year Ended December 31, 2015

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 5 40%) 800,000
Net profits after taxes $ 1,200,000
Less: Preferred stock dividends 100,0000
Earnings available for common stockholders $ 1,100,000

Creek Enterprises Balance Sheet December 31, 2015

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
Land and buildings $11,000,000 financial leases)(b) $20,000,000
Machinery and equipment 20,500,000 Preferred stock (25,000
Furniture and fixtures 8,000,000 shares, $4 dividend) $ 2,500,000
Gross fixed assets (at cost)(a) $39,500,000 Common stock (1 million
Less: Accumulated depreciation 13,000,000 shares at $5 par) 5,000,000
Net fixed assets $26,500,000 Paid-in capital in excess of
Total assets $50,000,000 par value 4,000,000
Retained earnings 2,000,000
Total stockholders’ equity $13,500,000
Total liabilities and stockholders’ equity $50,000,000
(a). The firm has a 4-year financial lease requiring annual beginning-of-year payments of $200,000. Three
years of the lease have yet to run.
(b). Required annual principal payments are $800,000.
INDUSTRY AVERAGES

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

Explanation / Answer

To evaluate the Creek's suitability for the loan, we will have to calculate the debt ratios (as specified in the question) and compare them with the industry averages.

The formulas for calculating various ratios are given below:

Debt Ratio = Total Liabilities/Total Assets

Times Interest Earned Ratio = EBIT/Interest Expenses

Fixed Payment Coverage Ratio = (EBIT + Lease Payment)/(Interest + Lease Payment), here lease payment indicates fixed charge.

_______________

Using the values provided in the question, we get,

Debt Ratio = (16,500,000 + 20,000,000)/50,000,000 = .73 [preferred stock is treated as a part of stockholder's equity]

Times Interest Earned Ratio = 3,000,000/1,000,000 = 3

Fixed Payment Coverage Ratio = (3,000,000 + 200,000)/(1,000,000 + 200,000) = 2.67

_______________

The comparision table is given below:

Analysis:

Based on the above ratios, it can be concluded that Creek's loan request shouldn't be considered for approval. The company's debt ratio of .73 is very high when compared to the industry average of .51 indicating that the company is highly dependant on debt to meet its assets requirements. Additionally, the times interest earned ratio of 3 of the company is too low when compared to the industry average of 7.30 which means that the company's EBIT is only 3 times sufficient to pay for its interest expenses. In general, higher the times interest earned ratio, the better it is for the company. The fixed-payment coverage ratio is more or less close to the industry average and thus its value should not be used as the basis for approving loan.

Ratio Creek Enterprises Industry Average Debt Ratio 0.78 0.51 Times Interest Earned Ratio 3.00 7.30 Fixed-Payment Coverage Ratio 2.67 1.85

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