You have taken the following information from a firm’s financial statements. As

Question

You have taken the following information from a firm’s financial statements. As an investor in the firm’s debt instruments, you are concerned with its liquidity position and its use of financial leverage. What conclusions can you draw from this information?

2010 2009 2008 Sales $          1,700,000 $          1,500,000 $          1,000,000 Cash                     18,000                       7,000                       5,000 Accounts Receivable                  152,000                  130,000                  125,000 Inventory                  200,000                  190,000                  200,000 Current Liabilities                  225,000                  210,000                  175,000 Operating Income                  170,000                  145,000                     90,000 Interest expense                     27,000                     23,000                     20,000 Taxes                     53,000                     45,000                     25,000 Net income                     90,000                     77,000                     45,000 Debt                  260,000                  250,000                  200,000 Equity                  330,000                  300,000                  200,000

Explanation / Answer

I am making the calculations for the 'latest year'; you can make similar calculations for earlier years. You can make a trend analysis of the these ratios to sees whether the ratios are improving or deteriorating.

I. Debt Equity Ratio:

Debt 260,000 / Equity 330,000 = 0.79 : 1

This Ratio is OK

ii. Interest Service Coverage Ratio:

(Net Income + Non-cash debits + Interest + Tax) / Interest

=(Net income 90,000 + Interest expense 27,000 + Tax 53,000) / Interest expense 27,000

= 145,700 / 27,000 = 5.4 times.

Interest is covered by 5.4 times, which is a comfortable position.

iii. Debt-Service Coverage Ratio:

(Net Income + Non-cash debits + Interest + Tax) / (Debt Repayments + Interest)

In the absence of information about debt repayments, it is not possible to calculate this ratio.

iii. Current Ratio:

(Cash 18,000 + A/R 152,000 + Inventory 200,000) / Current liabilities 225,000 = 370,000/ 225,000 = 1.64

1.64 is a very good current ratio.

3. Conclusion: For 2010, the liquidity position of the company is comfortable.

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