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long-term debt ratio

1 Nothing will happen to the long-term debt ratio computed using book values, since the face values of the old and new debt are equal. However, times interest earned and cash coverage will increase since the firm will reduce its interest expense.

2 a. The current ratio starts at 1.2/1.0 = 1.2. The transaction will reduce current assets to $.7 million and current liabilities to $.5 million. The current ratio increases to .7/.5 = 1.4. Net working capital is unaffected: current assets and current liabilities fall by equal amounts.

b. The current ratio is unaffected, since the firm merely exchanges one current asset (cash) for another (inventories). However, the quick ratio will fall since inventories are not included among the most liquid assets.

3 Average daily expenses are (9,330 + 8,912 + 291)/365 = $50.8 million. Average accounts payable are (3,870 + 3,617)/2 = 3,743.5 million. The average payment delay is therefore 3,743.5/50.8 = 73.7 days.

4 a. The firm must compensate for its below-average profit margin with an above-average turnover ratio. Remember that ROA is the product of margin turnover.

b. If ROA equals the industry average but ROE exceeds the industry average, the firm must have above-average leverage. As long as ROA exceeds the borrowing rate, leverage will increase ROE.

5 Retailers maintain large inventories of goods, specifically the products they stock in their stores. This shows up in the high net working capital ratio. Their profit margin on sales is relatively low, but they make up for that low margin by turning over goods rapidly. The high asset turnover allows retailers to earn an adequate return on assets even with a low profit margin, and competition prevents them from increasing prices and margins to a level that would provide a better ROA. In contrast, manufacturing firms have low turnover, and therefore need higher profit margins to remain viable.

Burchetts Green had enjoyed the bank training course, but it was good to be starting his first real job in the corporate lending group. Earlier that morning the boss had handed him a set of financial statements for The Hobby Horse Company, Inc. (HH). ¬Hobby Horse, ­ she said, ¬has got a $45 million loan from us due at the end of September and it is likely to ask us to roll it over.

The company seems to have run into some rough weather recently and I have asked Furze Platt to go down there this afternoon and see what is happening. It might do you good to go along with her. Before you go, take a look at these financial statements and see what you think the problems are. Here`s a chance for you to use some of that stuff they taught you in the training course. ­

Burchetts was familiar with the HH story. Founded in 1990, it had rapidly built up a chain of discount stores selling materials for crafts and hobbies. However, last year a number of new store openings coinciding with a poor Christmas season had pushed the company into loss. Management had halted all new construction and put 15 of its existing stores up for sale.

Burchetts decided to start with the 6-year summary of HH`s balance sheet and income statement (Table A.18). Then he turned to examine in more detail the latest position (Tables A.19 and A.20).