Question

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 (following), evaluate and recommend appropriate action on the loan request.

Creek Enterprises

Income Statement

for the Year Ended December 31, 2015

Sales revenue $30,000,000
Less: Cost of goods sold 21,000,000
Gross profit $9,000,000
Less: Operating expenses
Selling expense $3,000,000
General and administrative expenses 1,800,000
Lease expense 200,000
Depreciation expense 1,000,000
Total operating expenses $6,000,000
Operating profits $3,000,000
Less: Interest expense 1,000,000
Net profits before taxes $2,000,000
Less: Taxes (rate 5 40%) 800,000
Net profits after taxes $1,200,000
Less: Preferred stock dividends 100,0000
Earnings available for common stockholders $1,100,000

Creek Enterprises

Balance Sheet

December 31, 2015

Assets Liabilities and Stockholders' Equity
Cash $1,000,000 Accounts payable $8,000,000
Marketable securities 3,000,000 Notes payable 8,000,000
Accounts receivable 12,000,000 Accruals 500,000
Inventories 7,500,000
Total current assets $23,500,000 Total current liabilities $16,500,000
Furniture and fixtures 8,000,000 Long-term debt (includes financial leases)(b) $20,000,000
Machinery and equipment 20,500,000 Common stock (1 million shares at $5 par) 5,000,000
Land and buildings 11,000,000 Preferred stock (25,000 shares, $4 dividend) 2,500,000
Gross fixed assets (at cost)(a) $39,500,000 Paid-in capital in excess of par value 4,000,000
Less: Accumulated depreciation 13,000,000 Retained earnings 2,000,000
Net fixed assets 26,500,000 Total stockholders' equity $13,500,000
Total assets $50,000,000 Total liabilities and stockholders' equity $50,000,000

(a). The firm has a 4-year financial lease requiring annual beginning-of-year payments of $200,000.

Answer 1

To evaluate Creek Enterprises for a potential loan, the debt to equity ratio and times interest earned ratio are critical. Creek has a high debt to equity ratio of 2.7 and a times interest earned ratio of 3, suggesting moderate coverage of interest expenses. The bank should approach the loan with caution.

Step-by-step explanation:

The task is to assess Creek Enterprises' financial risk and leverage by analyzing their financial statements and comparing them to industry averages. Considering the provided income statement and balance sheet, we proceed with quantifying the company's debt ratios. One important metric is the debt to equity ratio, calculated by dividing total liabilities by total stockholders' equity. For Creek Enterprises, this ratio is calculated as ($16,500,000 + $20,000,000) / $13,500,000, resulting in a ratio of approximately 2.7, which indicates a high level of financial leverage. Another critical metric is the times interest earned ratio (TIE), which shows how many times a company can cover its interest expenses with its operating profits.

Creek's TIE is calculated by dividing the operating profits of $3,000,000 by the interest expenses of $1,000,000, resulting in a TIE of 3. This suggests that Creek Enterprises can cover its interest expenses but not by a wide margin.A high degree of leverage can lead to increased financial risk, especially if earnings are volatile. Given the high debt to equity ratio and moderate TIE, Springfield Bank should proceed with caution and perhaps require additional collateral or a higher interest rate to mitigate potential risks associated with the loan.