Should Druthers Forming Limited Be Given The Loan?

DRUTHERS FORMING LIMITED

Should Druthers Forming Limited be given the loan?

Druthers Forming Limited that was founded in 1987 by Mr. Garrett and Norm Sheppard have requested on July 30, 2007 an amount of $350,000 loan from Mr. Brad Mac Dougall, account manager at the Canadian Commercial Bank (CCB). To know whether or not this amount needs to be passed depends on several factors thus for this purpose there are several questions that are needed to be answered before this decision can be made, thus in this report we will find out the answers to Mr. Brad’s questions.

To make any decision we first need to assess the past financial performance using the statement of cash flow and ratio analysis.

If we take a look at the cash flow statement 2007 for the first thing that we can notice is the Net Income which for this year was $-12,100. This means that Druthers Forming Limited for that year have made a loss which is not good for any kind of bank that is giving a loan worth $350,000, even so if we take a look at the Net Cash Flow from Operations we can see that even with a loss the company can easily cover it with cash. In terms of Financial Activities the net cash flow is $-15,212 which again means that the company already has long term loan and is already affecting the cash flow in a negative way.

If we go further to Investing Activities we can clearly see again that the net cash flow for this as well is $-68,204 which again is impacting the cash flow in a negative way but the cause for this is that they have a lot of money invested in land and construction, which in due course could come in a form of return and thus will boast the cash flow. The net cash flow after calculation is only $45,974 and with an addition of beginning cash the ending cash is only $118,550 but as mentioned before there is a possibility that some of the negative net cash flow could turn to positive cash flow.

The cash flow has given us an idea of the situation of the cash in the company but now we need to go even deeper with finding out what affect the company has on its ratios. The first and the most important ratios for any company is the Liquidity Ratios which include Current Ratio, Acid Test/Quick Ratio and Cash Ratio. To begin with let’s look at the Current Ratio which for 2007 is 3.14:1 and for any bank this is good as this assures that the company will easily is able to pay the loan but in term of the company itself it may not be a good sign as this means that they have more than 3 times the current asset to their current liability which will for sure affect the companies interests and thus will affect the Income Statement at a future stage.

If we look at the Acid Test Ratio which for 2007 is 3.01:1 we can come to the same conclusion as before with the Current Ration that it is really good for a bank to offer loan to this company. As for Cash Ratio for 2007 it is 1.38:1 which is really good for any company to have a ratio above 1 is very good and this means that they are managing their cash well and will for sure help them to get their loans easily as this assures banks that they will have enough funds to pay the loan in the future. Another ratio that will help us to understand the situation is the Total Debt Ratio which is total asset minus total equity upon total asset. For the year 2007 the total asset was $423,504 and total equity is $302,115 which is equal to 28.6%. This is not bad for any company but considering the Banks point of view it would be a lot better if it was higher that 30%.

The second question requests us to project two years financial statements which are the Statement of Income and Balance Sheet for the year 2008 and 2009. This has been shown in the tables below:

The next question that was presented is to consider the working capital requirements, including performing a sensitivity analysis on the days of accounts receivable, inventory and/or accounts payable.

As given in the working capital for the year 2007 is $183,129 which compared to previous years has fallen drastically. This means that the financial health of the company is deteriorating and this will keep on happening until the company improves it working capital. In terms of Accounts Receivable, Inventory and/or Accounts Payable the age period is 157 days, 12 days and 57 days respectively. The best way to calculate this is to use ratios and for this purpose we will first look into the Days Sales in Inventory which is 365 / Inventory Turnover which is given as 12 days. This means that the company will receive their inventory 30.4 times in 365 days which is very good for the company’s cash flow and will thus benefit the bank as well.

As for Accounts Receivable we need to take a look at the ratio called Days Sales in Receivables which is 365 / Receivables Turnover. This is also given to us as 157 days which means that it will take 2.32 times for the company to cover its accounts receivable and in comparison if we look at Accounts Payable the number of days mentioned is only 57 days to 150 days because 85% of the yearly purchase were made from May to September which means that the accounts are payable 2.63 times. We can clearly see in the earlier mentioned figures that the company receives the payment much slower that the number of times it pays which is not the best choice for any company as every company should try and keep its accounts receivable and payable as equal as they can. For example if Druthers Forming Limited changed their receiving period from 157 days to 120 days this will increase the receivable time period to 3.04 times which is a lot better and on the other hand if they try to increase the payable period to 70 days this will mean that the company will need to pay only 2.1 times which is much closer than to their actual state. To be a lot serious the better option for the company is to try to reduce the receivable period to 60 days and increase their payable period to 90 days this will mean that it will take 6.08 times and 4.05 times for the company to receive and pay respectively. This would be the best situation for the company as this means that they will receive cash a lot sooner that paying it.

In terms of Inventory that was discussed previously we could consider that 12 days in 365 days is not bad but what if the inventory turnover is changed to 20 days. In this case the company will be selling its inventory 18.3 times a year which will impact the cash flow and the balance sheet thus we can come to a conclusion that it would be better to try and keep the inventory turnover to 12 days and if possible to try to reduce it a little if possible. Thus we could say that due to the difference in receivables to the payables the working capital will keep on decreasing until some changes are done.

The next question that is put in front of us is to determine the loan amount needed, and decide on the type and terms of the loan.

For this purpose we will consider that the loan has been given and we take it as $350,000 as the amount that will be given as loan. There are mainly two types of loan these are secured and non-secured loans. Secured loans is when a bank gives a loan based on an asset as a guarantee and non secured asset is when there is no asset taken as a guarantee but instead it is given based on the bank balance. In this case the type of loan that we will consider is secure loan and thus the terms of the loan will be based on that the building purchased will be considered as a guarantee for it. The other terms will be that the repayment period for the loan will not exceed 10 years and the interest on the loan every year shall be 5.8%. In case of failure to pay the bank will be eligible to claim the property. The loan will be distributed equally through the 10 year span and the interest every year would be $20300.

The question that we then need to consider next is the analysis the risk associated with the loan using the four C’s of credit.

To begin with this we first need to know what are the four C’s of credit which are character, capacity, capital and collateral. Character refers to the financial history of the borrower (Murray(a)); this means that we need to access the financial data of the company. Druthers Forming Limited gets between 30% and 70% of their sales from Sheppard Homes which is basically one of their family businesses. Due to this reason most of the other builders in the market are very reluctant to give the company any business. Most of Druthers suppliers offered them 30 to 60 day credit term and they did the same as well but the problem with this as mentioned before in the earlier section is that they still ended up paying their creditors before the received any cash from the debtors. This also means that the company has always paid their creditors and even if we take a look at the long term debt of the company they have been paying their debts at a consistent pace.

Capacity refers to the ability of the business to generate revenues in order to pay back the loan (Murray(b)). As mentioned before the company did make a loss in the year 2007 and the sales of the company has fallen drastically in a span of three years. This is not the only problem they are having as the cash flow is also not doing very well and unless some changes are done they will keep on having bad cash flow.

Capital refers to the capital assets of the business such as machinery and equipment, etc. (Murray(c)) If we look at the balance sheet for the year 2007, we can see that the fixed asset consists of only land and construction in progress which is not much compared to what normally the company’s fixed assets tend to be.

Collateral is the cash and assets a business owner pledges owner pledges to secure a loan (Murray(d)). As mentioned before the company has not much fixed assets and this means that they do not have any asset to give as security for the loan but as we already know that the company needs the money to purchase a building we can consider it as a guarantee for the loan.

Now we need to evaluate several options (deny the loan, grant the request or defer the request) available to the lender to determine which option is the best for this decision.

As mentioned in the question we need to consider three options the first option is to deny the loan which considering the companies past would be a better choice as the company has made a loss in 2007, in addition they do not have a good cash flow and last but not the least they have no assets to offer as security which is imposible for a bank to give a loan without a security. The second option to grant the request as mentioned would not be wise but there is some hope in terms of this as we could consider the building that will be purchased as security so that in case of any failure to pay, we could consider the building as payment for the loan but by the looks of things the company has never really failed to pay their long term loans and this is a good sign for any bank. The last option to defer the loan and this may actually be the best option as the company does not have enough funds to pay the bank plus they have no security to properly cover the loan. The best thing would be either to wait for another six months to a year to see the status of the company’s finance and then the company could put in another request.

The last question that was asked to us was as Mac Dougall, to decide whether to lend funds and to provide supporting rationale for this decision.

After giving a lot of thinking to this it seems that it would be better that instead of actually giving the whole amount we can come to an agreement that the bank will give a loan of $200,000 for the first year with an interest of 5.8% per year which is $11,600 per year for a span of 10 years and in case the situation of the company is better after six months or a year, we could offer another $150,000 with the same conditions as above but the company will need to give 60% of the ownership of the building to the bank as security for this loan incase of failure to pay. This may not be the best option for Druthers Forming Limited but considering their week cash flow and balance sheet it would be difficult for any bank to offer the total amount of loan without being fully sure that the company can pay the loan and interest.

Bibliography

Murray, J. (n.d.). The 4 C’s of Credit for Business Loan. Retrieved August 8, 2010, from About.com: http://biztaxlaw.about.com/od/financingyourstartup/a/4csofcredit.htm

Murray, J. (n.d.). The 4 C’s of Credit for Business Loan. Retrieved August 8, 2010, from About.com: http://biztaxlaw.about.com/od/financingyourstartup/a/4csofcredit.htm

Murray, J. (n.d.). The 4 C’s of Credit for Business Loans. Retrieved August 8, 2010, from About.com: http://biztaxlaw.about.com/od/financingyourstartup/a/4csofcredit.htm

Murray, J. (n.d.). The 4 C’s of Credit for Business Loans . Retrieved August 8, 2010, from About.com: http://biztaxlaw.about.com/od/financingyourstartup/a/4csofcredit.htm