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.

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

Explanation / Answer

Net cash accruals = Earning available for common stockholders + Depreciation expense

= $1,100,000 + $1,000,000

= $2,100,000 which should cover the annual debt repayment

Interest coverage ratio = Operating profit / Interest expense

= $3,000,000 / $1,000,000

= 3 which is comfortable at present

Further analysis would require information about the existing debt level, debt repayment schedule and the paid up equity capital. However, given the above information, lending the loan of $4,000,000 seems to be a comfortable option.

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