Executive Summary
Tire City, Inc. has petitioned MidBank for a loan in order to expand their business, and build a new warehouse. Through the financial statement reporting and the numbers that have been presented to me, I believe that this is a sound investment. The growth percentage of 20 percent per year is conceivable, if business stays as it currently is. The amount of debt that would need to be financed for this expansion is palatable, and well within the normal ranges for these sort of projects. Moreover, the company has very solid net working capital and leverage ratios. All of these factors lead me to believe that this will be a profitable investment for the bank. The one issue that I had was in 1996 when Tire City capped their inventory, and it caused a large cash inflow on their financial statements because of the positive change. This could be due to many different factors, but this bears monitoring and questioning when the bank is doing their due diligence with Tire City. I have scheduled a meeting with Mr. Martin in order to inquire about why this inventory anomaly has occurred. I will report back as soon as possible.
Analyzing Tire City, Inc.’s Financial Health
Profitability
At first glance, Tire City, Inc. seems to be doing very well for itself. The historical average of return on sales indicates that for every dollar they take in, that approximately five percent of that dollar is profit. That is not a number that will blow investors away, but it is also not decreasing so this indicates that the company is becoming more efficient. Likewise, the return on invested capital is increasing. This shows us that the company is earning 20 percent on their investments where their cost of capital is only 10 percent through financing activities. Tire City’s return on equity is very high throughout this period, which indicates that the company is generating between 23 and 24 cents per dollar that a shareholder invests. That is an outstanding return to the shareholders.
Liquidity
The current ratio of two shows that Tire City is not in danger of defaulting on any debts at this point, but the quick ratio tells a little bit of a different story. The quick ratio generally is hovering around 1.3, which means that for every dollar of liability the company has an excess of 30 cents. While that is still above water, per se, that number definitely bears watching in the coming years.
Leverage
The capital to debt ratio for Tire City indicates that they finance projects with 26 percent capital in 1993, but this figure falls to 20 percent in 1994 and 15 in 1995. Tire City’s financial strength is adequate based upon this measure. Tire City’s interest coverage ratio is over the industry benchmark of 1.5, so they should not have any problems paying out on the interest that is owed. Tire City’s asset to equity ratio suggests that Tire City outright owns more of their assets than the shareholders do, so in the event of the need to liquidate Tire City will be in a better position to satisfy debts.
Activity
The asset turnover ratio suggests that Tire City’s assets turnover in the range of 2.47 – 2.62 times per period, in this case years. This indicates that the company is being efficient with their assets in generating sales. The days’ receivable ranges from 55.50 to 57.24, which indicates that every two months the receivables are being collected. This is a number that could bear watching, as it tells how efficiently Tire City is at collecting upon their debts. Similarly, the days inventory ratio tells us that it takes Tire City from 56.39 days to 63.09 days to take raw materials and turn them into sales. This figure seems to fall in line with their other numbers and seems a little on the high side. The days’ payable ratio is lower than the other two.
The payables get paid in a range of 38.61 – 40.65 days. This indicates that Tire City is the most efficient at paying their debts. This number is moving in the correct direction. However, it is important to note that the average for these numbers vary from industry to industry and due diligence should be done in order to get a good grasp of the industry standard.
Analyzing Tire City, Inc.’s Future Financial Health
Tire City, from the projections, seems to be headed in the correct direction. In the fiscal year 1996, even with increasing debt by 351 thousand dollars, Tire City turned a profit. The expansionary vision that has been given seems to project to more revenue, which increases from 23,505 to 28,206, and a healthy growth rate that can be viewed as sustainable. One precaution to this is the anomaly that takes place in the inventory in 1996. This should be monitored closely and inquired about the reasoning of capping the inventory at 1625 for that year. The total assets of the company is still greater than the liabilities, which leads me to believe that they are structured correctly and have taken the necessary precautions in their capital structure.
Impact on External Funding – 1996
Inventory Variable
If the inventory variable is independent, then we see that as the inventory goes up, the bank debt follows suit. This could be because the firm cannot finance extra inventory, or it could be that they have no capacity to store that inventory.
Accrued Expenses Variable
When assuming that Accrued Expenses grows less than anticipated, we see that bank debt has an inverse relationship. This could be because of many factors, but my main suspicion is that the company utilizes this expense as a sort of short term financing. Accrued Expenses are expenses that have not been billed yet, E.G.: unpaid contract work for plumbing, so if they are not billed then they are not taken out of the cash flows yet. Impact on External Funding – 1997
Depreciation Variable
If Tire City was allowed to depreciate more than the allotted 5 percent, we see bank debt go down. This could be because of the implicated tax benefits to depreciating more of the building at the outset of the loan. This will imply that the firm will require less financing in the second year of the project. Sales Growth Variable
If sales growth increases, we also see an increase in bank debt financed. This will take place because inventory goes up in this case. If inventories are going up, then more raw materials will need to be purchased in order to keep manufacturing going. If the company does not have the requisite funds to pay for those materials, more financing will be needed.
Payable/Receivable Variable
Changing the days payable to 45 days instead of the 40 days and changing the accounts receivable to 45 days have a lessening influence on bank debt. This can be attributed to collecting money more quickly from customers, which increases cash reserves, and paying a little bit later on debts, which also increases cash reserves.
Covenant Assessment
According to the covenant, Tire City must maintain a net working capital of over 4000 in order to not violate. Tire City, according to the numbers, will maintain the covenant in the years 1996 and 1997. In 1996, accounts receivable plus inventory minus accounts payable is 4198.05 and in 1997 the same equation results in a net working capital of 6217.96. It is likely that they will meet this covenant.
Cash Flow Statement
The statement of cash flows is prepared and attached to the back of this report. Please refer to that statement for this section. Also attached is a pro forma statement that addresses the possibility of utilizing the current years’ bank debt for calculating interest expense.
Conclusion
From the numbers that have been presented, I believe I would recommend loaning Tire City the funds to expand due to the fact that their numbers are solid. The one ratio I take issue with is the quick ratio that is forecasted for the year 1997. At 1.11, that number draws a bit of concern because if a firm drops below one that means that they may have a hard time paying off liabilities. The growth of the firm, if everything goes as projected, should be enough to merit consideration. The company has solid net working capital, and is growing at what can be conceived as a sustainable rate. The one number that really jumps off of the page is the inventory in 1996. I advise that this number be investigated thoroughly before any final decision is made for this loan.
