Tootsie Roll Industries: Ratio Analysis for Loan Assessment

Introduction

In order to grow, firms need to make investments. Investment takes capital, which will often involve raising funds through borrowing. The investment being made must be assessed to ensure that it is viable and will create value. However, one of the most important considerations for any potential lender is the ability of the firm to repay the debt (Howells and Bain, 2007). The firm's financial position must be assessed to determine whether it can repay the loan and to evaluate the risk associated with that loan. The assessment of assets is also important for determining the potential level of security available — particularly relevant when the lender may require some type of charge, such as a floating charge (Libby et al., 2010). To assess the position of the firm and determine whether a 10% increase in total liabilities is viable, a ratio analysis is conducted covering liquidity, solvency, and profitability.

Liquidity is an important consideration, as it refers to the ability of the firm to pay its current debts — generally defined as payments due within the next twelve months (Libby et al., 2010) — out of its current assets. The current ratio is calculated by dividing current assets by current liabilities. The result shows how many times the current assets of the firm cover its current liabilities (Libby et al., 2010).

Table 1: Current Ratio for Tootsie Roll Industries Inc.

Liquidity Analysis

Current ratio | 2006 | 2007
Current assets (a) | 190,917 | 199,726
Current liabilities (b) | 62,211 | 57,972
Ratio (a/b) | 3.07 | 3.45

From this it is apparent that the firm is liquid, with current assets able to cover current liabilities 3.45 times. Furthermore, the ratio has improved from the previous year, so there is no indication of a negative trend. This is a favorable result for a potential lender. However, there is an assumption that current assets could be liquidated at book value; if current assets needed to be sold quickly, they might not realize their full value — this is particularly true for inventory (Libby et al., 2010). For this reason, in addition to the current ratio, the quick ratio is also calculated. The quick ratio uses the same formula but excludes inventory from total current assets.

Table 2: Quick Ratio for Tootsie Roll Industries Inc.

Quick ratio | 2006 | 2007
Current assets (a) | 190,917 | 199,726
Inventories (b) | 63,957 | 57,402
Net current assets (a − b) (c) | 126,960 | 142,324
Current liabilities (d) | 62,211 | 57,972
Quick ratio (c/d) | 2.04 | 2.46

Even after excluding inventory, the firm appears liquid, with a quick ratio of 2.46. On the basis of these liquidity measures, the firm looks to be a strong candidate for a loan.

Solvency Analysis

The current and quick ratios assess a firm's short-term ability to meet its obligations. A lender will also want to evaluate the longer-term position and the firm's ability to repay the entire debt plus interest and fees (Libby et al., 2010). The solvency ratio measures the level of cash generated in a year as a percentage of total debt. Cash generated is calculated by taking net profit after tax and adding back depreciation. Total liabilities are calculated by summing current and non-current (long-term) liabilities.

Table 3: Solvency Ratio for Tootsie Roll Industries Inc.

| 2006 | 2007
Net profit after tax (a) | 65,919 | 51,625
Depreciation (b) | 15,816 | 15,859
Adjusted net profit (a + b) (c) | 81,735 | 67,484
Current liabilities (d) | 62,211 | 57,972
Non-current liabilities (e) | 98,747 | 116,523
Total liabilities (d + e) (f) | 160,958 | 174,495
Solvency ratio (c/f) | 50.78% | 38.67%

The solvency ratio declined from 50.78% in 2006 to 38.67% in 2007, indicating that cash generated as a percentage of total indebtedness is falling. This may be a concern and could signal some inefficiency within the firm. However, it is generally accepted that a ratio below 20% signals financial difficulty. Tootsie Roll is well above this danger threshold, though a lender may wish to investigate the reasons behind the decline further in order to fully assess risk.

Conclusion

Table 4: Operating Profit Margin for Tootsie Roll Industries Inc.

Operating profit margin | 2006 | 2007
Total revenue (a) | 501,150 | 497,717
Operating profit (b) | 87,529 | 70,852
Operating profit margin (b/a) | 17.47% | 14.24%

Table 5: Net Profit Margin for Tootsie Roll Industries Inc.

Net profit margin | 2006 | 2007
Total revenue (a) | 501,150 | 497,717
Net profit after tax (b) | 65,919 | 51,625
Net profit margin (b/a) | 13.15% | 10.37%

In both cases, the firm shows a degree of decline; however, profit margins remain positive and appear to be within acceptable stakeholder expectations. This decline may also help explain why the firm is seeking additional investment.

Overall, the firm shows some indicators of declining performance, but at the current time it appears that a 10% increase in liabilities is affordable. Such an increase may, in fact, be necessary if the intended investment helps to restore and improve financial performance. Based on the ratio analysis conducted, Tootsie Roll Industries Inc. presents an acceptable risk profile for a lender, provided that the reasons behind the declining solvency and profit margins are explored more thoroughly during the credit assessment process.

Paper is based on a case supplied by the student.

Howells, P.G.A. and Bain, K. (2007). Financial Institutions and Markets. London: Longman.

Libby, R., Libby, P. and Short, D. (2010). Financial Accounting. McGraw-Hill.