Question

As a loan analyst for Utrillo Bank, you have been presented with the following information.

	Toulouse Co.	Lautrec Co.
Assets
Cash	\(120,000	\) 320,000
Receivables	220,000	302,000
Inventories	570,000	518,000
Total current assets	910,000	1,140,000
Other assets	500,000	612,000
Total assets	\(1,410,000	\)1,752,000
Liabilities and Stockholders’ Equity
Current liabilities	\( 305,000	\) 350,000
Long-term liabilities	400,000	500,000
Capital stock and retained earnings	705,000	902,000
Total liabilities and stockholders’ equity	\(1,410,000	\)1,752,000
Annual sales	\(930,000	\)1,500,000
Rate of gross profit t on sales	30%	40%

Each of these companies has requested a loan of $50,000 for 6 months with no collateral offered. Because your bank has reached its quota for loans of this type, only one of these requests is to be granted.

Instructions

Which of the two companies, as judged by the information given above, would you recommend as the better risk and why? Assume that the ending account balances are representative of the entire year.

Short answer

Lautrec Co. appears to be a better short-term credit risk than Toulouse Co.

Step-by-step solution

Meaning of Ratio Analysis

Ratio analysis may be a quantitative strategy of picking up knowledge about a company's liquidity, operational proficiency, and productivity by examining its financial statements, such as the balance sheet and income statement.

Judging between two companies that can bear risk

Computations are given below, which furnish some basis of comparison of the two companies:

	Toulouse Co.	Lautrec Co.
Composition of current assets
Cash	13%	28%
Receivables	24%	27%
Inventories	63%	45%
	100	100
Computation of various ratios
Current ratio	2.8:1	3.26:1
Acid-test ratio	1.11:1	1.78:1
Accounts receivable turnover	4.23 times	4.97 times
Inventory turnover	1.14 times	1.74 times
Cash to current liabilities	0.39:1	0.91:1

Working Notes:

Computation of Current ratio of Toulouse Co.

$\begin{array}{rcl}\mathrm{Current}\mathrm{ratio}& =& \frac{\mathrm{Current}\mathrm{assets}}{\mathrm{Current}\mathrm{liabilities}}\\ & =& \frac{\$910,000}{\$305,000}\\ & =& 2.8:1\end{array}$

Computation of Current ratio of Lautrec Co.

$\begin{array}{rcl}\mathrm{Current}\mathrm{ratio}& =& \frac{\mathrm{Current}\mathrm{assets}}{\mathrm{Current}\mathrm{liabilities}}\\ & =& \frac{\$1,140,000}{\$350,000}\\ & =& 3.26:1\end{array}$

Computation of acid-test ratio of Toulouse Co.

$\begin{array}{rcl}\mathrm{Acid}\mathrm{test}\mathrm{ratio}& =& \frac{\mathrm{Cash}+\mathrm{receivables}}{\mathrm{Current}\mathrm{liabilities}}\\ & =& \frac{\$120,000+\$220,000}{\$305,000}\\ & =& \frac{\$340,000}{\$305,000}\\ & =& 1.11:1\end{array}$

Computation of acid-test ratio of Lautrec Co.

$\begin{array}{rcl}\mathrm{Acid}\mathrm{test}\mathrm{ratio}& =& \frac{\mathrm{Cash}+\mathrm{receivables}}{\mathrm{Current}\mathrm{liabilities}}\\ & =& \frac{\$320,000+\$302,000}{\$305,000}\\ & =& \frac{\$622,000}{\$350,000}\\ & =& 1.78:1\end{array}$

Computation of accounts receivable turnover of Toulouse Co.

$\begin{array}{rcl}\mathrm{Account}\mathrm{receivable}\mathrm{turnover}& =& \frac{\mathrm{Annual}\mathrm{sales}}{\mathrm{Current}\mathrm{liabilities}}\\ & =& \frac{\$930,000}{\$305,000}\\ & =& 4.23\mathrm{times}\end{array}$

Computation of accounts receivable turnover of Lautrec Co.

$\begin{array}{rcl}\mathrm{Account}\mathrm{receivable}\mathrm{turnover}& =& \frac{\mathrm{Annual}\mathrm{sales}}{\mathrm{Current}\mathrm{liabilities}}\\ & =& \frac{\$1,500,000}{\$350,000}\\ & =& 4.97\mathrm{times}\end{array}$

Computation of accounts inventory turnover of Toulouse Co.

$\begin{array}{rcl}\mathrm{Inventory}\mathrm{turnover}& =& \frac{\mathrm{Annual}\mathrm{sales}\times \mathrm{Unit}\mathrm{selling}\mathrm{price}}{\mathrm{Inventories}}\\ & =& \frac{\$930,000\times 0.70}{\$570,000}\\ & =& 1.14\mathrm{times}\end{array}$

Computation of accounts inventory turnover of Lautrec Co.

$\begin{array}{rcl}\mathrm{Inventory}\mathrm{turnover}& =& \frac{\mathrm{Annual}\mathrm{sales}\times \mathrm{Unit}\mathrm{selling}\mathrm{price}}{\mathrm{Inventories}}\\ & =& \frac{\$1,500,000\times 0.60}{\$518,000}\\ & =& 1.74\mathrm{times}\end{array}$

Computation of cash to current liabilities of Toulouse Co.

$\begin{array}{rcl}\mathrm{Cash}\mathrm{to}\mathrm{current}\mathrm{liabilities}& =& \frac{\mathrm{Cash}}{\mathrm{Current}\mathrm{liabilities}}\\ & =& \frac{\$120,000}{\$305,000}\\ & =& 0.39:1\end{array}$

Computation of cash to current liabilities of Lautrec Co.

$\begin{array}{rcl}\mathrm{Cash}\mathrm{to}\mathrm{current}\mathrm{liabilities}& =& \frac{\mathrm{Cash}}{\mathrm{Current}\mathrm{liabilities}}\\ & =& \frac{\$320,000}{\$350,000}\\ & =& 0.91:1\end{array}$

Investigation of different liquidity ratios illustrates that Lautrec Co. is more grounded financially, all other variables being equal, within the short term. The comparative risk may well be judged superior in the event that extra information was accessible relating to such things as net income, the reason for the loan, the due date of current and long-term liabilities, future prospects, etc.