Baker & Co. has applied for a loan from the Trust Us Bank to invest in several potential opportunities

Baker & Co. has applied for a loan from the Trust Us Bank to invest in several potential opportunities. To evaluate the firm as a potential debtor, the bank would like to compare Baker & Co. to the industry. The following are the financial statements given to Trust Us Bank:

Balance Sheet                                           12/31/13                12/31/14

Cash                                                             $305                         270

Accounts receivable                                  275                         290

Inventory                                                      600                         580

Current assets                                          1,180                      1,140

Plant and equipment                             1,700                      1,940

Less: acc depr                                           (500)                       (600)

Net plant and equipment                     1,200                      1,340

Total assets                                             $2,380                    $2,480

Liabilities and Owners' Equity

Accounts payable                                    $150                       $200

Notes payable                                             125                              0

Current liabilities                                       275                         200

Bonds                                                             500                         500

Owners' equity

Common stock                                            165                         305

Paid-in-capital                                            775                         775

Retained earnings                                      665                         700

Total owners' equity                              1,605                      1,780

Total liabilities and owners' equity $2,380                   $2,480

Income Statement

Sales (100% credit)                               $1,100                    $1,330

Cost of goods sold                                      600                         760

Gross profit                                                  500                         570

Operating expenses                                     20                            30

Depreciation                                                160                         200

Net operating income                               320                         340

Interest expense                                            64                            57

Net income before taxes                           256                         283

Taxes                                                                87                            96

Net income                                                $169                       $187

a. What are the firm's financial strengths and weaknesses?

b. Should the bank make the loan? Why or why not?

Answer: 

a. The firm's liquidity has improved significantly, as indicated by the current ratio and the acid test ratio. However, the current ratio is a bit deceiving since it relies on inventory in part for liquidity. Since the inventory is not particularly liquid (low inventory turnover), the quick ratio is a better measure of liquidity, which is still below the industry norm. Management has done a less-than-average job of generating operating profits on its assets (low operating income return on investment). The cause for the low OIROI is the inefficient use of assets (low asset turnover), especially inventory (low inventory turnover). However, this ineffectiveness is countered by efficiencies in keeping operating expenses low (high operating profit margin). From a balance sheet perspective, the company has less financial risk than the average firm in the industry (slightly lower debt ratio). However, owing to the firm's lower profitability, it is not covering its interest charges as well as the average firm in the industry (low times interest earned). Owing to the low return on investment, the firm's return on assets and return on equity are low relative to its competition.

b. The answer is not an easy one. The firm has improved its liquidity, but it is still having problems at effectively managing its inventory. It may be that the loan is not needed to the extent thought, but rather management should work at reducing its investment in inventories. The bank would also want to know why the operating profit margin, which is still high, is falling. Nevertheless, the loan decision could go either way.