Springfield Bank is evaluating Creek Enterprises, which has requested a $4,000,0
ID: 2637648 • Letter: S
Question
Springfield Bank is evaluating Creek Enterprises, which has requested a $4,000,000 loan, to assess the firms 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 Creeks 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
aThe 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.
bRequired 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
Answer: In the books of Springfield bank
1.Financial Leverage = Operating Profits / Net profits before Tax
Hence, Financial Leverage of the firm = 1.5 (3,000,000 / 2,000,000)
2. Debt Ratio = Total Liabilities / Total Assets here. total liabilities do not contain shareholders equity and retained earnings,
Hence Debt ratio = 36,500,000/50,000,000 (Liabilities = Total current liabilities + Long term Debt)
Hence Debt Ratio = 0.73
3.Time Interest Earned ratio = Operating profits / Interest expense
Hence Time Interest Earned Ratio = 3,000,000 / 1,000,000
Therefore, time Interest Earned Ratio = 3
4. Fixed payment coverage ratio. it is (Earnings before interest and taxes + Lease payments) / {(Interest +Leases Payments) +(Principal payments + Preferred stock dividends) x [1/(1-T)]}
Hence, Fixed Payment Coverage Ratio = (3,000,000 + 200,000) /{(1000,000 + 200,000) +(800,000 + 100,000) x [1/(1-40%)]}
Therefore, Fixed Payment Coverage Ratio = 1.19
Based On this and the industry Ratios
Hence the bank should not avail the loan as the firm is high on risk and is severely leveraged.
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