MT480 Loan Committee Memo-Unit 4 group project

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1 Loan Committee Memo Group 6 MT480 – Corporate Finance Professor Sandy McDonald December 5, 2023

2 Date: December 5, 2023 To: Charles Riddick, Loan Officer From: Loan Committee Lead Subject: Loan decision for Bob Smith, Inc. In the course of the original loan, as part of the loan documentation, the bank requirements include, Covenants, Conditions & Restrictions (CC&Rs), for Bob Smith, Inc., to maintain its credit facility with the bank. To remain in compliance, the following conditions need to be met: ● Maintain at least $70,000 in checking at all times ● Maintain a current ratio of at least 2:1 ● Maintain a quick ratio of at least 1:5 ● Do not increase officer salaries by more than 5% while the loan is outstanding ● Do not pay bonuses to officers without the bank’s explicit approval To evaluate Bob Smith Inc.’s loan request, a financial analysis was performed using the CS Balance Sheet and Statement of Cash Flows. The bank previously required Bob Smith, Inc. to increase its year-end 2016 cash balance to a minimum of $70,000 to qualify for the same interest rate on the original loan. However, the company’s balance did not meet the requirement, nor did it meet any of the conditions listed above. Management did not Comply with the CC&Rs The CC&Rs requirement that the company did not comply with, displays a cash balance of less than $34,000. The debt-to-equity raises concerns about the company’s financial health and failure to meet financial obligations. Cash flow management is the key to long-term business sustainability. More than just tracking expenses and income, this practice helps businesses plan for future investments and create strategies that facilitate success (Partnership Invoice Finance, 2023). Analysis was performed of the Accounts Receivable, Inventory, Accounts Payable, Wages Payable, Plant Property and Equipment, and Long-Term Debt. Current Ratio and Quick Ratio for CC&R Compliance The current ratio shows a company's liquidity and whether it can financially manage short-term loan obligations based on its asset-to-liability ratios. The quick snapshot of the company’s financials with their current ratio of 1.83; we can determine their liquidity is average. The company’s current assets stand at $758,686.00 which is less than the ideal 2:1 ratio of their liabilities, which are $413,848.00, showing they may not have issues paying back short-term loans, but would still be a higher risk. The company’s quick ratio of 0.81 shows that without their

3 inventory asset of $423,819.00 which is 15% of their assets, their liquidity is much less and shows more risk when granting loans. Bob Smith, Inc.’s failure to meet Cash Balance Requirements It is concluded that management needed to conduct a thorough analysis of the statement of cash flows to properly identify if the company met the minimum cash requirements set forth by the bank. Bob Smith, Inc.’s cash balance was less than $34,000.00 at the end of the period. This is substantially lower than the $70,000.00 bank requirement. Based on the financial data of Bob Smith, Inc., it appears that the company’s failure to meet the cash balance requirements is a direct result of management. Financial data suggests that management may have prioritized sales over cash, due to the increase in accounts receivable and inventory. The financial data also indicates that management may have been relying on debt financing instead of increasing cash flows which ultimately led to the inability to meet the cash balance requirements set forth. The Major Portion of the Company’s Working Capital Bob Smith, Inc.'s working capital appears to have been primarily allocated towards inventory and accounts receivable. This is evident from the financial data showing an increase in inventory from $352,740 in 2016 to $423,819 in 2017. Simultaneously, there was a decrease in accounts receivable from $318,678 to $260,205, suggesting a slower turnover in collecting receivables. This allocation of working capital towards increasing inventory levels and maintaining a higher accounts receivable balance indicates a focus on stocking up inventory, possibly at the expense of liquidity and cash flow efficiency. Using the 5 C's of Credit in the Loan Decision To properly assess the level of risk in providing another loan to Bob Smith, Inc. the loan committee used the 5 C’s (or characteristics) of credit commonly used in the industry to evaluate the creditworthiness of a firm. The 5 Cs are character, capacity, capital, conditions, and collateral. According to Protium (2023), character refers to the borrower’s reputation and credit history, capacity evaluates their ability to repay debt obligations by analyzing income and the economic conditions that they function within. Capital is evaluated by focusing on the overall financial strength of the company such as the liquidity of assets and how quickly real estate investments can be sold in case of loan default. Conditions further evaluate any external conditions that may negatively impact debt repayments, such as government policy changes, economic cycles, or advancements in technology. Lastly, collateral is any asset or real estate investment/property that can be used as a pledge to secure a loan.

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4 Using the 5 C’s of Credit Identifies All of the Correct Weaknesses The financial analysis for Bob Smith, Inc. suggests there are serious concerns that must be addressed before providing a new credit facility. Bob Smith, Inc.'s creditworthiness and reputation (character) are in question due to the failure to maintain $70,000 in the bank, outlined in the CC&Rs, and currently meet short-term debt obligations due to a decreased amount of cash on hand. Other violations are the increase in Wages Payable account by over 50%, which may include bonuses that were done without the bank’s explicit approval. The second factor is capacity and the potential inability to cover existing long-term debt along with an additional loan. External conditions suggest that the company’s inability to effectively recover A/Rs may suggest ineffective financing terms or a slowed economy. In analyzing capital and existing assets, Bob Smith, Inc. has an excessive amount of inventory(PP&E) that is currently 57.1% of total assets and suggests inefficient inventory management. This presents another issue as far as collateral; the majority of assets are non-liquid and cannot be converted into cash quickly prolonging repayment of the loan. Financial Analysis to Logically Support the Loan Committee’s Decision A thorough financial analysis logically supports the decision to not extend a loan to Bob Smith, Inc. Key concerns include the company's current ratio of 1.83 and quick ratio of 0.81, both indicating average to low liquidity. The low cash balance of $33,411, compared to the required $70,000, raises serious concerns about cash management capabilities. Additionally, the discrepancy between high net income and a minimal increase in cash (only $16,845) suggests inefficiencies in converting profits into cash. The heavy reliance on inventory (57.1% of total assets) and a notable increase in long-term debt further underscore potential risks in financial stability and cash flow management (Parrino et al., 2021) . Summary The decision-making process regarding the loan application of Bob Smith, Inc. is methodically organized and presented logically. The analysis begins with examining the allocation of working capital, highlighting inefficiencies in inventory and receivables management. It then transitions to a detailed financial analysis, scrutinizing liquidity ratios, cash flow, and balance sheet items, uncovering concerns about cash management and debt reliance. This leads to the application of the 5 C’s of Credit, which further elucidates the company's creditworthiness issues. The conclusion, drawn from this sequential and comprehensive evaluation, is a well-founded decision against extending a loan, aligning with prudent financial lending practices and risk mitigation. Thank you, loancommittegroup6@gmail.com

5 Attachments: Bob Smith, Inc. CS Balance Sheet and Statement of Cash Flows.

6 References Parrino, R., Kidwell, D.S., Bates, T., Gillan, S.L. (2021). Fundamentals of corporate finance. (5 th ed.). Wiley. https://purdueuniversityglobal.vitalsource.com/books/978-1-119-79538-4 Partnership Invoice Finance. (2023, June 28) The importance of a healthy and stable cash flow for business survival. LinkedIn. https://www.linkedin.com/pulse/importance-healthy-stable-cash-flow-business- survival Protium. (2023, January 4). 5 cs of credit: comprehending the underwriting process. LinkedIn. https://www.linkedin.com/pulse/5-cs-credit-comprehending- underwriting-process-protiumindia/

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