-You have just been hired as a loan officer for Coastline Bank and Trust. Seaton Industries and Martin Company have both applied for $125,000 nine-month loans. It is the strict policy of the bank to have only $1,350,000 outstanding in unsecured loans at any point in time. Since the bank currently has $1,210,000 in unsecured loans outstanding it will be unable to grant loans to both companies. The bank president has given you the following selected information from the companies' loan applications.
Required: Assume that all account balances on the balance sheet are representative of the entire year. Based on this limited information, which company would you recommend to the bank president as the better risk for an unsecured loan? Support your answer with any relevant analysis, including examination of the current ratio, quick ratio, receivables turnover, and inventory turnover.

Question

-You have just been hired as a loan officer for Coastline Bank and Trust. Seaton Industries and Martin Company have both applied for $125,000 nine-month loans. It is the strict policy of the bank to have only $1,350,000 outstanding in unsecured loans at any point in time. Since the bank currently has $1,210,000 in unsecured loans outstanding it will be unable to grant loans to both companies. The bank president has given you the following selected information from the companies' loan applications.
  Required: Assume that all account balances on the balance sheet are representative of the entire year. Based on this limited information, which company would you recommend to the bank president as the better risk for an unsecured loan? Support your answer with any relevant analysis, including examination of the current ratio, quick ratio, receivables turnover, and inventory turnover.

Quizplus · Accepted Answer

The Answer is As a loan officer, there should be concern about the potential borrower's ability to meet its debts as they come due. Since both companies are requesting only nine-month loans, you should be interested in the potential borrowers' short-term solvency. Therefore, you would examine their current ratios and quick ratios. Further, you would consider the effect of the potential loan on these ratios. The current ratio is calculated as current assets divided by current liabilities.

As a loan officer, there should be concern about the potential borrower's ability to meet its debts as they come due. Since both companies are requesting only nine-month loans, you should be interested in the potential borrowers' short-term solvency. Therefore, you would examine their current ratios and quick ratios. Further, you would consider the effect of the potential loan on these ratios. The current ratio is calculated as current assets divided by current liabilities. It appears that both companies have more than sufficient current assets to meet their current obligations, including the new loan. However, some current assets, such as prepaid expenses and inventory, are not near-cash assets. Thus, a better measure of a potential borrower's ability to meet its current obligations is the quick ratio. This ratio is calculated as the sum of cash, marketable securities, and accounts receivable divided by current liabilities. Again, the effect of the new loan should be considered. Based on the quick ratio, Martin appears to be a much better risk than Seaton. Martin has approximately 2.5 times more near-cash assets available than Seaton to meet its current obligations. Therefore, Martin does not have to rely as heavily on converting other assets to cash as Seaton does to meet its obligations. The company that can most readily convert its inventory and receivables to cash might be the better risk. Two possible measures of a company's ability to generate cash from its receivables and inventory are the turnover and number-of-days ratios. Receivables turnover is calculated as net credit sales divided by average accounts receivable, and the number of days for receivables is calculated as 365 divided by the receivables turnover. Receivables turnover: Number of days: These ratios indicate that Seaton, on average, collects its receivables 27 days quicker than Martin. Therefore, Seaton can more easily convert its receivables to cash than Martin can. Inventory turnover is calculated as cost of goods sold divided by average inventory, and the number of days is calculated as 365 divided by inventory turnover. Inventory turnover: Number of days: These ratios bode well for Martin. Martin sells its inventory, on average, 73 days sooner than Seaton sells its inventory. This difference implies that Martin generates more sales which, in turn, implies that it generates more accounts receivable. Although Martin does not turn over its receivables as often as Seaton, it has a larger amount of receivables to turn over. Thus, Martin potentially has more assets that can easily be converted into cash than Seaton. Based upon Martin's superior quick ratio and potential ability to generate cash from its larger receivables base, the recommendation should be that the bank grants the loan to Martin. BT: AN

It appears that both companies have more than sufficient current assets to meet their current obligations, including the new loan. However, some current assets, such as prepaid expenses and inventory, are not near-cash assets. Thus, a better measure of a potential borrower's ability to meet its current obligations is the quick ratio. This ratio is calculated as the sum of cash, marketable securities, and accounts receivable divided by current liabilities. Again, the effect of the new loan should be considered.

Based on the quick ratio, Martin appears to be a much better risk than Seaton. Martin has approximately 2.5 times more near-cash assets available than Seaton to meet its current obligations. Therefore, Martin does not have to rely as heavily on converting other assets to cash as Seaton does to meet its obligations. The company that can most readily convert its inventory and receivables to cash might be the better risk. Two possible measures of a company's ability to generate cash from its receivables and inventory are the turnover and number-of-days ratios. Receivables turnover is calculated as net credit sales divided by average accounts receivable, and the number of days for receivables is calculated as 365 divided by the receivables turnover.
Receivables turnover:

Number of days:

These ratios indicate that Seaton, on average, collects its receivables 27 days quicker than Martin. Therefore, Seaton can more easily convert its receivables to cash than Martin can.
Inventory turnover is calculated as cost of goods sold divided by average inventory, and the number of days is calculated as 365 divided by inventory turnover.
Inventory turnover:

Number of days:

These ratios bode well for Martin. Martin sells its inventory, on average, 73 days sooner than Seaton sells its inventory. This difference implies that Martin generates more sales which, in turn, implies that it generates more accounts receivable. Although Martin does not turn over its receivables as often as Seaton, it has a larger amount of receivables to turn over. Thus, Martin potentially has more assets that can easily be converted into cash than Seaton.
Based upon Martin's superior quick ratio and potential ability to generate cash from its larger receivables base, the recommendation should be that the bank grants the loan to Martin.
BT: AN

-You Have Just Been Hired as a Loan Officer for Coastline