Indiana Building Supplies Essay

1137 Words Nov 24th, 2012 5 Pages
Indiana Building Supplies - Comment

An analysis of these ratios shows that both Clemens and Willis are right. All of the profitability ratios for IBS are higher than the industry average. Thus, IBS seems to have done well. And indeed, it was done well for its shareholders in 2005. Note, however, that the current and quick ratios have generally been trending downward and are significantly lower than the industry averages as well as the stipulations in the loan covenants. Thus, liquidity is poor. Moreover, inventory is turning over very slowly and the average collection period has increased significantly. These figures are manifestations of IBS’s policy of raising prices and focusing almost exclusively on Indiana customers who are
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If IBS is successful in selling off all that it produces (i.e., if the Indiana customers exhibit sufficiently high demand), then all of the extra profits go to IBS. On the other hand, if demand is poor and IBS cannot unload its finished goods inventory, the bank may not be repaid and could be left holding a mix of finished goods, work-in-progress and raw materials inventory. So, the bank absorbs much of the risk associated with IBS’s pricing strategy. This is a classic example of moral hazard related to risky debt.

Note also that IBS’s debt ratio has been increasing since 2000, and now it is well above the industry average as well as what is permitted in the loan covenants. This also hurts IBS’s creditors since their risk exposure is increased. Moreover, as we saw in our discussion of capital in this chapter, a decline in equity capital relative to total assets increases the firm’s incentive to take more risk at the creditors’ expense. So, Clemens’ willingness to go along with Klinghoffer’s suggestion now is not that surprising. Note that the benefits of increased profitability are skewed more in favor of IBS’s shareholders; for 2005 the return on the net worth of IBS is 299 basis points above the industry average, whereas its return on total assets is 70 basis points above the industry average.

Let us now see if IBS could generate enough cash internally to repay FNBB its old loan as well as the new loan. As we

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