Question

Angel Martin is a young entrepreneur who operates Martin Music Services, offering singing lessons and instruction on musical instruments. Martin wishes to expand but needs a \(30,000 loan. The bank requests that Martin prepare a balance sheet and key financial ratios. Martin has not kept formal records but is able to provide the following accounts and their amounts as of December 31, 2017.

Cash………………..…..\) 3,600 Accounts Receivable……………… \( 9,600

Prepaid Insurance…... \) 1,500 Prepaid Rent.…………………………. 9,400

Store Supplies…………. 6,600 Equipment.…………………………… 50,000

Accounts Payable……… 2,200 Unearned Lesson Fees……………. 15,600

Total Equity*…………… 62,900

Annual net income….... 40,000

*The total equity amount reflects all owner investments, dividends, revenues, and expenses as of December 31, 2017.

Required

1. Prepare a balance sheet as of December 31, 2017, for Martin Music Services. (Report only the total equity amount on the balance sheet.)

2. Compute Martin’s debt ratio and its return on assets (the latter ratio is defined in Chapter 1). Assume average assets equal its ending balance.

3. Do you believe the prospects of a $30,000 bank loan are good? Why or why not?

Short answer

The balance sheet matches at $80,700 and the debt ratio and ROA come out to be 0.22 and 49.6%. In this scenario, the loan should not be taken.

Step-by-step solution

Balance sheet as on Dec 31, 2017

Martin Music Services
Balance sheet
As on December 31, 2017
Assets	Amount	Liabilities & Equity	Amount
Cash	$3,600
Prepaid Rent	9,400	Accounts Payable	2,200
Accounts receivables	9,600	Unearned lesson fees	15,600
		Total Liabilities	$17,800
Store supplies	6,600	Total Equity	62,900
Prepaid Insurance	1,500
Equipment	50,000
Total Assets	$80,700	Total liabilities and equity	$80,700

Debt ratio and ROA

$\begin{array}{c}\mathbf{Debt}\mathbf{}\mathbf{ratio}\mathbf{=}\frac{\mathbf{Total}\mathbf{}\mathbf{Liabilities}}{\mathbf{Total}\mathbf{}\mathbf{Assets}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{17}\mathbf{,}\mathbf{800}}{\mathbf{\$}\mathbf{80}\mathbf{,}\mathbf{700}}\\ \mathbf{=}\mathbf{0}\mathbf{.}\mathbf{22}\end{array}$

$\begin{array}{c}\mathbf{ROA}\mathbf{=}\frac{\mathbf{Annual}\mathbf{}\mathbf{netincome}}{\mathbf{Total}\mathbf{}\mathbf{Assets}}\mathbf{\times }\mathbf{100}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{40}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{80}\mathbf{,}\mathbf{700}}\mathbf{\times }\mathbf{100}\\ \mathbf{=}\mathbf{49}\mathbf{.}\mathbf{6}\mathbf{\%}\end{array}$

Assessment of bank loan

In the given case, the debt ratio of the company is 22% and the ROA is 49%. So, any loan taken would increase the debt ratio and the risk-return relationship would be deteriorated due to this loan.

So, based on the given scenario, the company should not opt for a loan and instead should try to obtain new investments.