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.