Question

Springfield Bank is evaluating Creek​ Enterprises, which has requested a $ 3,720,000 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 and​ Creek's recent financial​ statements, evaluate and recommend appropriate action on the loan request.

Industry averages
Debt ratio	0.47

Times interest earned ratio	7.29

​Fixed-payment coverage ratio                                                                                                            2.03

Creek Enterprises Income​ Statement:

Creek Enterprises Income Statement for the Year Ended December 31, 2019          
Sales revenue        $30,045,000  
Less: Cost of goods sold       20,995,000  
Gross profits        $9,050,000  
Less: Operating expenses          
Selling expense    $2,968,000      
General and administrative expenses    1,832,000      
Lease expense    237,000      
Depreciation expense   999,000      
Total operating expense       6,036,000  
Operating profits        $3,014,000  
Less: Interest expense       1,002,000  
Net profits before taxes        $2,012,000  
Less: Taxes (rate=21%)       422,520  
Net profits after taxes        $1,589,480  
Less: Preferred stock dividends       103,700  
Earnings available for common stockholders        $1,485,780   

Creek Enterprises Balance​ Sheet:

Creek Enterprises Balance Sheet December 31, 2019                  
Assets           Liabilities and Stockholders' Equity      
Current assets            Current liabilities      
Cash    $952,000       Accounts payable    $7,969,000  
Marketable securities    3,018,000       Notes payable    7,991,000  
Accounts receivable    11,962,000       Accruals    539,000  
Inventories    7,543,000       Total current liabilities    $16,499,000  
Total current assets    $23,475,000       Long-term debt (includes      
           financial leases)**   $19,493,500  
Gross fixed assets (at cost)*            Stockholders' equity      
Land and buildings    $10,997,000       Preferred stock (24,400      
               shares, $4.25 dividend)    $2,462,000  
Machinery and equipment    20,516,000       Common stock (1.07 million      
Furniture and fixtures    8,043,000           shares at $5.25 par)    5,617,500  
Gross fixed assets    $39,556,000       Paid-in capital in excess of      
               par value    3,968,000  
Less: Accumulated depreciation    13,005,000       Retained earnings    1,986,000  
Net fixed assets    $26,551,000       Total stockholders' equity    $14,033,500  
          Total liabilities and      
Total assets    50,026,000           stockholders' equity   $50,026,000  
*The firm has a 4-year financial lease requiring annual beginning-of-year payments of $237,000. Three years of the lease have yet to run.                  
**Required annual principal payments are $807,000.                   

Answer 1

We will calculate the financial leverage ratios for Creek enterprises

Debt ratio tells us the proportion of assets which are financed by debt, a higher ratio implies higher leverage for the company and so higher risk

Formula to calculate Debt ratio

Debt Ratio = Debt/Total assets

Calculation of debt ratio

Debt ratio = (16,499,000+19,493,500)/50,026,000

Debt ratio = 35,992,500/50,026,000

Debt ratio = 0.72

Debt ratio of the company is 0.72

Times interest earned ratio tells us the ability of the company to pay its debt obligation from the net income of the company

Formula to calculate times interest earned ratio

Times interest earned ratio = EBIT/Interest

Calculation of times interest earned ratio

Times interest earned ratio = 3,014,000/1,002,000

Times interest earned ratio =

3.01

Times interest earned ratio of the company is 3.01

Fixed payment coverage ratio tells the company's ability to make payment of fixed obligation in a year

Formula to calculate fixed payment coverage ratio

Fixed payment coverage ratio = EBIT + Lease payments/Interest + Lease payments + [[Principal + Preferred stock]*(1/(1-t))]

Calculation of fixed payment coverage ratio

Fixed payment coverage ratio

3,014,000 + 237,000/1,002,000 + 237,000 + [[807,000 + 103,700]*(1/1-0.21))]

3,251,000/(1,002,000+237,000+1,152,785)

1.36

Fixed payment coverage ratio is 1.36

Ratio

Creek

Industry

Debt ratio

0.72

0.47

Times interest earned ratio

3.01

7.29

Fixed payment coverage ratio

1.36

2.03

Creek enterprises has higher debt proportion and much lower ability to make payment of debt obligations than the average firm in the industry

Hence, the loan should be rejected