Evaluative Credit Analysis of Creative Activities of Pty Ltd - Case Study Example

Supervisor An evaluative Credit analysis of Creative Activities Pty Ltd– The Bank’s Decision By: October, 2008 Table of Contents 1.1 Introduction 1.2 Presentation of Financial Ratio of Creative Activities Pty Ltd 1.3 Explanation of Financial Ratio and influence on Banks manager Decision 1.4 Creative Activities Pty Ltd ability to service the Debt 2.0 Lease Finance 2.1 Advantages of Lease Finance 3.0 Rental Finance 3.1 Advantages of Rental Finance 4.0 Conclusion 1.0 Introduction Today, bankers are increasingly becoming conscious about recent developments in their respective markets and have resorted into various method of managing credit risk in bank. Risk management appears to have improved in most sub-regions as a result of the introduction of new approaches to the allocation of credit as well as better measurement and pricing of the various risks (BIS Paper No 33, 2005, Moreno, 2006) The risk that a debt issuer will default is known as credit risk; this is typically the most important form of risk for commercial banks (Shapiro, 2003; Buckley, 1996; Muller and Verschoor, 2005; Solt and Wayne, 2001). Solt & Wayne (2001) argues that, in assessing credit risk, an institution needs to consider three issues: default probabilities over the horizon of the obligation, credit exposure (ie how large the obligation is when the default occurs) and the recovery rate (ie what part of the exposure may be recovered through bankruptcy proceedings or some other form of settlement) (Solt and Wayne, 2001). Credit risk is often difficult to assess due to the lack of information on the credit history and financial position of borrowers, inadequate accounting practices and standards that make it difficult to evaluate credit exposures. Today, banks have to study the financial position of a credit applicant to grant a facility. Having said this, in the section that follows, using the information for the client, I will calculate relevant financial ratios, to assess the credit worthiness, using the ratios, I will pass my judgement on whether the credit should be granted or not. Finaly, I will present the advantages of leasing and rental form of financing. The last section of the paper presents a brief summary in the form of a conclusion. 1.2 Presentation of Financial Ratio of Creative Activities Pty Ltd The table below provides a summary of relevant financial ratios of Creative Activities Pty Ltd that will help us pass relevant judgement as to the outcome of the facility requested. Year 2007 2008 Return on Asset 29.33 % 29.31 % Return on Owners Equity 34.71 % 34.70 % Gross Profit Margin 57.93 % 57.53 % Net Profit Margin 14.89 % 14.80 % Average Inventory Turnover 106.73 Days 104.34 Days Average Settlement Period for Debtors 51.53 Days 50.01 Days Current Ratio 3.91 Times 4.07 Times Quick (Acid) Ratio 2.21 Times 2.43 Times Gearing Ratio 2.54 % 2.36 % 1.3 Explanation of Financial Ratio and influence on Banks manager Decision Gross profit percentage measures what remains from sales after the company must have paid out the cost of goods sold expressed as a percentage. An increase in sales and a fall in the cost of goods sold will obviously increase gross profit percentage all things being equal. From the analysis, though the company under case study Creative Activities Pty LtD made positive gross profit percentage for the two periods, the situation for 2008 when compared to 2007 is worse off. That is 57.93% in 2007 when compared to 57.53% in 2008. The ratio tells us that, despite fall total revenue received in the period of 2008 when compared to 2007, cost of goods sold also had a increase. Thus, management is getting more inefficient and ineffective. Management must try to cut down ordering and other sales related cost. The same situation holds true for net profit margin, return on equity and return on assets whose values decreased in 2008 when compared to 2009. According to Artrill &Elliot (2005), Net profit measures the amount of revenue outstanding after all the company related expenses for the period must have been paid. In other words, Net profit percentage finds out if the average markup on goods covers the expenses, and therefore results in a profit? From the ratio, Creative Activity Inc again did better in 2007 when compared to 2008. The company needs to be on the lookout for downward trends in the gross profit rate. The fact that, the figure here falls short of the industry benchmark is not indication of bad performance when 2007 is compared to 2008. The year 2007 is better than 2008. The company should try and reduce the costs associated with its other activities. Cut down on General and administrative expenses. Return on capital employed measures the dollar earn by each dollar contributed by the capital of the organisation, while Return on equity measures the dollar earn by each dollar of shareholders fund. Return on capital employed (ROCE) is the rate of return a business is making on the total capital employed in the business (Penman 2003, Berlin, W.J., & Lexa 2005). Capital will include all sources of funding. The company has again fallen short of the industry benchmark figures for both ROCE and ROE. However, the fact that 2007 is better when compared to 2008 shows sign of falling trends. The current ratios have also witnessed improvements from 2008 when compared with 2007. The current ratio and Acid test ratio and cash ratio show that Creative Activities has enough current assets to cover its short-term liabilities without facing business risk that is the risk that it might not meet its short-term commitments. Current ratio increased from 3.91in 2007 to 4.07 in 2008. Creative Activity as seen from the inventory turnover uses more than 100days to turn over its stocks. This is not good indication. The number of days offered to the company’s debtors to pay their debt is questionable. That is 50.01 days in 2008 when compared to 51.23 days in 2007. How ever, this is due to a favorable credit terms given to client to encourage purchase. However, what I will recommend here is for the company should try and tie the debtor’s collection period and creditor’s payment period to fall within the same band payment band. 1.4Creative Activities Pty Ltd ability to service the Debt The company has a good financial standing, good working capital ratio with cash able to service it short term liabilities more than two times. There is no doubt as to whether Creative Activity will be able to service the debt since the company has a good financial standing. Creative Activities should however, adjust its own credit policy with respect to its creditors. 2.0 Finance versus Rental Lease A lease arrangement is a contract by which one party-the lessor gives another – the lessee the use and possession of equipment for a specified time and for fixed payments (Atrill & Eliot 2005).According to Atrill, & Elliot (2005), finance lease is based on rental contract. Here, the researchers use finance lease to mean neither to lend nor to borrow equipment fund, but to lease equipment itself (Atrill & Elliot 2005). Atrill & Eliot went forward to show how five qualities are essential for a finance lease. These qualities include-the transfer of ownership of leased property to lessees with a bargain purchase option included. This method of financing has been largely applauded because of the following advantages It provides 100% financing Leasing preserves credit line It is an approach used for balancing usage and cost Most Lessees uses Leasing to increase their purchasing power It is noted for convenience and it preserves working capital It is hedged against inflation with flexible payments Unlike lease financing, Atrill & Eliot (2005) stated that, in a rental financing, the risk remains with the Leasors while the benefit moves to the Leasees. In most of rental financing, Lessors possess real estate and personal estate that are subject to contract. After the renting and hiring term, the contract can be renewed on the same or new conditions, Lessees can claim a reduction in rent and cancel the contract.Leassors take property’s warranty and is under obligation to repair properties. References Atrill, P. & Elliot J., (2005). Financial Accounting for non specialists. 3rd Edition. Prentice Hall: London Berlin, W.J., & Lexa, J. F., (2005).Financial modeling in medicine: Cash flow, basic metrics, the time value of money, discount rates, and internal rate of return. Journal of American college of Radiology. Vol.2 Issue3, Pp. 225-231 Moreno, R (2006): “The changing nature of risks facing banks”, BIS Papers, No. 28, August. Mohanty, M, G Schnabel and P Garcia-Luna (2006): “Banks and aggregate credit: what is new?” BIS Paper No. 28, August. Shapiro A.C. (2003). Multinational Financial Management. Seventh Edition. Wiley and Sons Inc. Solt M. E., Wayne L. Y. (2001). Economic exposure and hysteresis Evidence from German, Japanese, and U.S. stock returns Global Finance Journal. Pp 217-235 Vachani S. (2005). Problems of foreign subsidiaries of SMEs compared with large companies. International Business Review, vol. 14, pp. 415-439. Muller A., Verschoor W. F.C. (2005) Foreign exchange risk exposure: Survey and suggestions. Journal of Multinational Financial Management. Read More