Financial policy in Tire City

Tire City is expanding its operations to incorporate a new warehouse. The new warehouse is expected to cost $2,400,000 and will help the company increase its capacity. The lender needs to decide whether or not to lend to Tire City, based on careful analysis of the company's financial statements.

Tire City's Financial Health

Tire City is in good financial condition. The company's most recent sales were $23.505 million and sales had increased at a compound annual rate exceeding 20%. Net income last year was $1.19 million. The company's capital structure is approximately 50/50, and long-term debt accounts for 19.3% of the firm's total capital structure. The company is solvent, with a current ratio of 2.03 and this figure has improved from the year previous. Retained earnings are rapidly growing, reflecting the company's profit position. Tire City has also improved its inventory turnover and fixed asset turnover, indicating that its cash conversion cycle is shorter now than it was in past years. This again indicates that the firm is of sound financial position and can very likely afford this expansion.

Covenants

If the loan came with a covenant that the company must maintain net working capital of at least $4 million, then it would meet this covenant for both 1996 and 1997. In 1996, Tire City had a net working capital (AR + Inv -- AP) of $4.2 million and in 1997, net working capital was $6.275 million.

Decision

As a lender, I would lend money to Tire City. There are three things I am looking for as a lender in this situation. The first is liquidity, the second is solvency and the third is growth. Liquidity is important because I would not want to lend to a company that was already highly leveraged. That is not the case with Tire City, as the company has only 19% of its capital structure in long-term debt and its debt/equity ratio is 0.39. Solvency is important because I need to know that in the short-term, the company can make its payments. Tire City has over $1 million in cash, has a strong current ratio and a low level of current maturities ($125,000).