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Debt & Ratio analysis

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P2-12
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 and Creek's recent financial statements (on the facing page), evaluate and recommend appropriate action on the loan request.

P2-13
1). Common-size statement analysis A common-size income statement for Creek
Enterprises' 2005 operations follows. Using the firm's 2006 income statement
presented in Problem 2-12, develop the 2006 common-size income statement
and compare it to the 2005 statement. Which areas require further analysis and
investigation?
LG5
BASIC
Creek Enterprises
Common-Size Income Statement
for the Year Ended December 31, 2005

Sales revenue ($35,000,000) 100.0%
Less: Cost of goods sold 65.9%
Gross profits 34.1%
Less: Operating expenses
Selling expense 12.7%
General and administrative expenses 6.3
Lease expense 0.6
Depreciation expense 3.6
Total operating expense 23.2
Operating profits 10.9%
Less: Interest expense 1.5
Net profits before taxes 9.4%
Less: Taxes (rate _ 40%) 3.8
Net profits after taxes 5.6%
Less: Preferred stock dividends 0.1
Earnings available for common stockholders 5.5%

P2-15

2). Cross-sectional ratio analysis Use the financial statements below and on
page 84 for Fox Manufacturing Company for the year ended December 31,
2006, along with the industry average ratios also given in what follows, to:
a. Prepare and interpret a complete ratio analysis of the firm's 2006 operations.
b. Summarize your findings and make recommendations.
LG6
CHAPTER 2 Financial Statements and Analysis 83

Fox Manufacturing Company
Income Statement
for the Year Ended December 31, 2006

Sales revenue $600,000
Less: Cost of goods sold 460,000
Gross profits $140,000
Less: Operating expenses
General and administrative expenses $30,000
Depreciation expense 30,000
Total operating expense 60,000
Operating profits $ 80,000
Less: Interest expense 10,000
Net profits before taxes $ 70,000
Less: Taxes 27,000
Net profits after taxes (earnings available
for common stockholders)
$42,900
Earnings per share (EPS) $2.15

Fox Manufacturing Company
Balance Sheet
December 31, 2006
Assets

Cash $ 15,000
Marketable securities 7,200
Accounts receivable 34,100
Inventories 82,000
Total current assets $138,300
Net fixed assets 270,000
Total assets $408,300

Liabilities and Stockholders' Equity

Accounts payable $ 57,000
Notes payable 13,000
Accruals 5,000 Total current liabilities $ 75,000
Long-term debt $150,000
Stockholders' equity
Common stock equity (20,000 shares outstanding) $110,200
Retained earnings 73,100
Total stockholders' equity $183, 300
Total liabilities and stockholders' equity $408,300

Ratio Industry average, 2006

Current ratio 2.35
Quick ratio 0.87
Inventory turnovera 4.55
Average collection perioda 35.8 days
Total asset turnover 1.09
Debt ratio 0.300
Times interest earned ratio 12.3
Gross profit margin 0.202
Operating profit margin 0.135
Net profit margin 0.091
Return on total assets (ROA) 0.099
Return on common equity (ROE) 0.167
Earnings per share (EPS) $3.10

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P2-12
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 and Creek's recent financial statements (on the facing page), evaluate and recommend appropriate action on the loan request.

We calculate the three ratios given and compare with the industry.
Debt ratio = Total debt/Total assets = 36,500,000/50,000,000 = 0.73
Times interest earned = EBIT/Interest = 3,000,000/1,000,000 = 3 times
Fixed Payment coverage ratio = (EBIT+ Lease Payment)/(Interest + Lease Payments + ((Principal + Preferred Dividends)X(1/(1-t)))
Fixed Payment coverage ratio = (3,000,000+200,000)/(1,000,000+200,000+((800,000+100,000)X(1/(1-0.4)))
= 1.19 times
We put the ratios as a table
Creek Industry
Debt ratio 0.73 0.51
Times interest earned 3x 7.3x
Fixed payment coverage ratio 1.19x 1.85x

From a comparison, Creek has a much higher debt and lower ability to service the debt. The loan should not be granted.

P2-13
1). Common-size statement analysis A common-size income statement for Creek
Enterprises' 2005 operations follows. Using the firm's 2006 income statement
presented in Problem 2-12, develop the 2006 common-size income statement
and compare it to the 2005 statement. Which areas require further analysis and
investigation?
LG5
BASIC
Creek Enterprises
Common-Size Income Statement
for the Year Ended December 31, 2005
Sales revenue ($35,000,000) 100.0%
Less: Cost of goods sold 65.9%
Gross profits 34.1%
Less: Operating expenses

Selling expense 12.7%
General and administrative expenses 6.3
Lease expense ...

Solution Summary

The solution has common size and ratio analysis for the two companies - Creek Enterprises and Fox Manufacturing

$2.19