Question

Read below and answer, Why does a business that has profit of $30,000 per year need a bank loan?

Jones Electrical Distribution After several years of rapid growth, in the spring of 2007 Jones Electrical Distribution anticipated a further substantial increase in sales. Despite good profits, the company had experienced a shortage of cash and had found it necessary to increase its borrowing from Metropolitan Bank-a local one- branch bank-to $250,000 in 2006. The maximum loan that Metropolitan would make to any one borrower was $250,000, and Jones had been able to stay within the limit only by relying very heavily on trade credit from the manufacturers from whom Jones purchased the electrical products it sold to its customers. Nelson Jones, sole owner and president of the company, was therefore looking elsewhere for a new banking relationship that would allow him to negotiate a larger loan. Jim Lyons, a homebuilder who was a friend of Jones, introduced Jones to Rachel Montrose, Lyons's relationship officer at the local branch of Southern Bank & Trust-a large, regional bank. Southern had a 7-year relationship with Lyons, including a current loan balance of over $3 million. Jones and Montrose tentatively discussed the possibility that Southern might extend a line of credit to Jones up to a maximum amount of $350,000. Jones thought that a loan of this size would more than meet his needs for at least the next year, and he was eager for the flexibility that a line of credit of this size would provide. After discussion, Montrose had arranged for the credit department of Southern Bank & Trust to investigate Nelson Jones and his company. Background of Jones Electrical Distribution Jones Electrical Distribution was founded in 1999 as a partnership between Nelson Jones and his college roommate, Dave Verden. In 2003, Jones and Verden had a disagreement on how aggressively they should grow the business, and Jones ultimately bought Verden out for $250,000. They agreed that Jones would pay Verden the $250,000 in installments of $2,000 per month plus interest of 8% per year.

Answer 1

	Particulars	2004	2005	2006	2007 (1st Qtr)
a	Current Assets	475	562	666	755
b	Current Liabilities	222	294	407	489
(a/b)	Current Ratio	2.14	1.91	1.64	1.54
a	Liquid Assets	232	284	287	323
b	Current Liabilities	222	294	407	489
(a/b)	Liquid Ratio	1.05	0.97	0.71	0.66

Reason for Loan requirement is justified from above table. One can see decreasing trend in current ratio meaning weakening short term financial position thereby putting pressure on working capital. But one say that current assets are still enough to meet short term commitments.

So, to further test the liquidity of firm, we calculated liquid ratio or quick asset ratio. In this we replaced liquid assets with current assets,i.e., excluded inventory from current assets to arrive at liquid assets as stock cannot be easily liquidated. Declining pattern is also observed in this ratio. However, it clear out the picture that firm does not have enough liquid funds to meet its short term obligations.

This analysis justifies firm's need for bank loan.