Joseph Berio is a loan officer with the First Bank of Tennessee. Red Brick, Incorporated, a major producer of masonry products, has applied for a short-term loan. Red Brick supplies building material throughout the southern states, with brick plants located in Tennessee, Alabama, Georgia, and Indiana.

Mr. Berio knows that brick production is affected by two factors: the cost of energy and the state of the building industry. First, manufacturing bricks uses a significant amount of energy. Red Brick, Inc. has recently converted many oil-fired kilns to coal kilns, which are cheaper to operate.

To finance these conversions, the company has recently issued a substantial amount of long-term debt that must be retired over the next 25 years.

Second, brick sales are very sensitive to activity in the building in dustry, especially new housing starts. The industry frequently follows a pattern of boom and bust, with sales and earnings responding to changes in the demand for building products.

Currently the economy is experiencing a severe recession, and housing starts have fallen more than 40 percent from the previous year. While the south and southwest have not experienced such a severe decline, housing starts there have declined 25 percent.

Red Brick, Inc. has not been immune to the economic environment.

Sales have declined, and although the firm has reduced production, inventory has increased. The firm needs the short-term loan to finance its inventory. Mr. Berio must decide whether to grant or deny the loan.

Such loans have been made to Red Brick in the past and have always been repaid when the economic picture improved.

The firm's income statement and balance sheet are given in Exhibit 1.

Exhibit 2 presents both a ratio analysis of Red Brick's previous year's financial statements and the industry averages of the ratios.

To help decide whether to grant the loan, Mr. Berio computes several ratios and compares the results with the ratios given in Exhibit 2.

a. What strengths and weaknesses are indicated by this analysis?

b. What may explain why the debt ratio exceeds the industry average? Is that necessarily a weakness in this case?

c. As a banker, is Mr. Berio more concerned with the firm's liquidity or its return on equity?

d. Based on the above analysis, should Mr. Berio grant the loan? Justify your position.

EXHIBIT 1

E X H I B I T 2

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Red Brick Income Statement (for the period ending December 12/31/20X1) Sales Cost of goods sold Administrative expenses Operating income Interest expense $210,000,000 170,000,000 26,000,000 S14,000,000 13,000,000 400,000 $ 600,000 Net income Red Brick Balance Sheet as of 12/31/20X2 Liabilities and Stockholders' Equity Assets Cash Accounts receivable Inventory Plant and equipment $600,000 Accounts payable 39,000,000 11,000,000 45,000,000 132,000,000 Stockholders' equity 146,000,000 $241,000,000 33,000,000* Notes payable 75,400,000t Long-term debt $241,000,000 Company's Ratios (Previous Year) Current ratio Quick ratic Inventory turnover Average collection period Debt ratio (debt/total assets) Times-interest-earned Return on equity Return on assets Operating profit margin Net profit margin 4.7X 39 days 39% 4.1 13.8% 8.2% 14.1% 8.8% Industry Average 2.21 0.8:1 4.6X 49 days 30% 3.7 14.1% 10.2% 15.2% 8.8%