I\'m having trouble with question 18P of Chapter 3 in Principals of Managerial F
ID: 2727351 • Letter: I
Question
I'm having trouble with question 18P of Chapter 3 in Principals of Managerial Finance, 14th edition. Can you please help me? Thank you
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
1. Debt Ratio: This ratio indicates the relationship between debt and total assets. This ratio indicates the financial leverage and financial risk, the desirble ratio is 0.5. hence, debt should be half of the assets of the comapany. Creek enterprizes debt ratio is as follows:
Debt Ratio = Total Debt/Total assets
Total debt = Total current liabilities - Accounts Payable = $16,500,000
Total Assets = $50,000,000
Debt Ratio = 16,500,000/50,000,000 = 0.33
Comment : Creek's Debt ratop is 0.33, it is less than industry average i.e 0.51, it involves less financial risk, but the company will lose advantages of debt.
2. Times interest earned ratio or Interest coverage ratio : This ratio indicates the relationship between Company's earnings before interest and taxes (EBIT) and interest expense. Higher ratio is preferable. this ratio, generally applied by the lenders to know the ability of borrower to pay interest out of its profits
Times interest earned ratio = EBIT/interest expense
EBIT = 3,000,000/1,000,000 = 3 times: this means company profits are 3 times to interest expenses,
Comment: Creek's times interest earned ratio 3 is lower than industry average i.e 7.30;
3. Fixed payment coverage ratio: The ratio indicates the ability of the company to meet its fixed charge obligations like interest and lease payments;
Fixed payment coverage ratio = EBIT + Fixed charge before tax/Fixed charge before tax + interest
EBIT + Fixed charge before tax = 3,000,000 + Lease payment $200,000
Fixed charge before tax = Interest 1,000,000 + Lease payment 200,000 + Leae principal payment 800,000+Preferred stock dividend 1,000,000 = 3,000,000
Fixed payment coverage ratio = 3,200,000/3,000,000 = 1.067 times
Comment : Creek's Fixed payment coverage ratio is 1.067, but the industry average is 1.85;
Openion: Creek's debt ratio is 0.33; Interest coverage ratio is 3 and Fixed payment coverage ratio is 1.067; All these ratios are lower than industry average. As regards with debt ratio it is lower than industry average, and also better to have lower debt; Times interest earned ratio is 3, means company profits are three times larger than its interest payment, it is also bertter and the fixed payment coverage ratio is 1.067, means company's profits are just sufficient to meet fixed charge obligations. Bank may sanctions loan, but it shoud monitor the payment schedules carefully.
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