The chief executive officer of Ginny’s Fashions has included the following finan
ID: 2445774 • Letter: T
Question
The chief executive officer of Ginny’s Fashions has included the following financial statements in a loan application submitted to Priority Bank. The company intends to acquire additional equipment and wishes to finance the purchase with a long-term note.
2015
2014
Balance Sheet
Current Assets
$21,000
$14,000
Long-term Assets
52,000
50,000
Current Liabilities
9,000
7,000
Long-term Liabilities
24,000
26,000
Contributed Capital
25,000
25,000
Retained Earnings
15,000
6,000
2015
2014
Income Statement
Revenues
$74,000
$70,000
Expenses
56,000
53,000
Statement of Cash Flows
Net cash from operating activities
$9,000
$15,000
Net cash from investing activities
(12,000)
(14,000)
Net cash from financing activities
5,000
7,000
Change in cash balance
--------à$2,000
-----------à$8,000
Beginning cash balance
9,000
1,000
Ending cash balance
--------à$11,000
------------à9,000
Assume that you, a bank loan officer, review the financial statements, and recommend whether Ginny’s Fashions should be considered for a loan. Support your recommendation with financial ratios. Assume a tax rate of 30 percent. Interest expense is $2,000 in 2015 and $2,000 in 2014.
2015
2014
Balance Sheet
Current Assets
$21,000
$14,000
Long-term Assets
52,000
50,000
Current Liabilities
9,000
7,000
Long-term Liabilities
24,000
26,000
Contributed Capital
25,000
25,000
Retained Earnings
15,000
6,000
Explanation / Answer
I would analyze the following ratios:
1. Profitability ratio = [(Revenue - Expenses) x (1 - tax rate)] / Revenues x 100 [Profitability]
2. Debt/Equity ratio = Long term liabilities / Contributed capital [Leverage]
3. Interest coverage ratio = (Revenues - Expenses) / Interest expense [Debt-Servicing ability]
4. Current ratio = Current assets / Current liabilities [Solvency]
5. (Net Cash Flow from Operations / Revenue) ratio [Cash flow adequacy]
2014
Profitability = $[(70,000 - 53,000) x (1 - 0.30) / $70,000] x 100 = 17%
Debt/Equity = $26,000 / $25,000 = 1.04
Interest coverage = $(70,000 - 53,000) / $2,000 = 8.50
Current ratio = $14,000 / $7,000 = 2.0
Net Cash Flow from Operations / Revenue = $15,000 / $70,000 = 0.21
2015
Profitability = $[(74,000 - 56,000) x (1 - 0.30) / $74,000] x 100 = 17%
Debt/Equity = $24,000 / $25,000 = 0.96
Interest coverage = $(740,000 - 56,000) / $2,000 = 9
Current ratio = $21,000 / $9,000 = 2.3
Net Cash Flow from Operations / Revenue = $9,000 / $74,000 = 0.12
Analysis
Profitability has remained unchanged across both years. Current ratio has improved from 2.0 to 2.3, indicating higher ability to settle current liabilities from current assets. Debt equity ratio has reduced from 1.04 to 0.96, indicating lower reliance on debt. Interest coverage has increased from 8.5 to 0, indicating higher ability to repay interests from Earning Before Interest & Tax (EBIT). However, ratio of net cash flow from operations to Revenue has considerably decreased, but considering the other primary indicators of the firm's financial health, we cannot come to a negative conclusion since we don't have the break-up of cash flow from operating activities.
Summarizing, the firm is healthy and I would recommend sanction of the loan.
Tutor's Note: It was assumed that Expenses exclude interest expense, but even if this assumption is relaxed, none of the ratios and the conclusion will change.
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