Line of Credit Review at Harbor Light Outfitters
Harbor Light Outfitters, a paddleboard and outdoor-gear retailer, has applied to its bank for a $150,000 line of credit. The loan officer received statements dated March 31, the end of the company's slowest quarter and the start of its spring buying season. Current assets are $310,000: cash $37,000, accounts receivable $78,000, and inventory $195,000. Current liabilities are $185,000, mostly trade payables plus a $60,000 line-of-credit balance. Annual sales are $1,240,000, up 8% from $1,148,000; cost of goods sold is $806,000; net income is $41,000. Total assets are $620,000, total liabilities $430,000, and equity $190,000. Last year's ending inventory was $160,000, and it peaked at $205,000 in May. Industry medians for similar retailers are: current ratio 2.0, quick ratio 1.1, inventory turnover 6.5 times, debt-to-equity 1.2, net profit margin 4.5%.
1. Compute the current ratio, quick ratio, inventory turnover, days in inventory, debt-to-equity, and net profit margin. Compare each to the industry median and identify the company's central financial weakness.
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Current ratio = 310,000 ÷ 185,000 = 1.68 (median 2.0 - below).
Quick ratio = (310,000 − 195,000) ÷ 185,000 = 115,000 ÷ 185,000 = 0.62 (median 1.1 - far below).
Inventory turnover = 806,000 ÷ average inventory of 177,500 = 4.54 times (median 6.5 - well below).
Days in inventory = 365 ÷ 4.54 = 80.4 days (median implies 365 ÷ 6.5 = 56.2 days).
Debt-to-equity = 430,000 ÷ 190,000 = 2.26 (median 1.2 - nearly double).
Net profit margin = 41,000 ÷ 1,240,000 = 3.3% (median 4.5% - below).
Also worth computing: days sales outstanding = 78,000 ÷ (1,240,000 ÷ 365 = 3,397) = 23 days, which is healthy. The receivables are not the problem.
Central weakness. The company is inventory-heavy and thin on liquid assets. Roughly 63% of current assets sit in stock that turns in 80 days instead of 56, and the balance sheet is financed mostly by debt. The quick ratio of 0.62 means that without selling inventory, Harbor Light cannot cover current liabilities - the exact condition a line of credit is meant to bridge, which makes the bank's question less about whether to lend and more about how much and on what terms.
2. The owner argues that a positive net income of $41,000 and 8% sales growth prove the business is healthy and the March 31 balance sheet is misleading. How much of that argument is correct, and what is actually consuming cash?
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What is correct. March 31 is genuinely a seasonal low point, and the company builds stock for spring. Inventory reached $205,000 in May last year, so the $195,000 figure is not a permanent overstock - it is a seasonal position. A bank that reads one quarter in isolation will misjudge the business, and the right response is to request monthly statements and a peak-season projection rather than to deny.
What is not correct. Seasonality explains the timing, not the trend. Inventory grew from $160,000 to $195,000, a $35,000 increase that absorbed cash, while sales grew only 8%. If inventory had grown at the sales rate, it would be about $173,000; the extra $22,000 is a genuine build. The structural measure is days in inventory: at 80 days versus the 56-day benchmark, the company carries excess inventory of roughly (806,000 ÷ 365) × (80.4 − 56.2) = 2,208 × 24.2 ≈ $53,000 at cost, even allowing for seasonality.
Cash flow logic to state. Profit is an accounting measure; cash is affected by working-capital growth. Here, cash was consumed by a $35,000 inventory build funded largely by payables and the existing line, which is why current liabilities are high and the quick ratio is weak. Growth itself is part of the problem: an 8% sales increase finances more receivables and stock before the cash comes back. The owner's argument is half right - the date is misleading, but the inventory discipline and leverage are real issues.
3. Recommend a lending decision and the structure you would propose. Justify why a straight approval or a straight denial would both be poor answers.
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Recommendation: approve a smaller, structured, monitored facility rather than the full request. For example, a $100,000 line with a borrowing base tied to eligible inventory and receivables, a covenant requiring the current ratio to stay above 1.5, monthly borrowing-base certificates, a personal guarantee, and a written plan to reduce inventory by roughly $50,000 by the end of July.
Why a straight denial is wrong. The company is profitable, growing 8%, and collecting receivables in 23 days. It has positive equity of $190,000 and a real seasonal need: buying inventory before the selling season is exactly what a line of credit is for, and denying it would push the owner toward worse financing or lost sales.
Why a straight approval of $150,000 is also wrong. The requested amount is larger than the demonstrated working-capital need, and the bank would be funding a leverage position (debt-to-equity 2.26) and 80-day inventory turns without a mechanism to ensure repayment. Lending the full amount against a seasonal peak without covenants rewards the behavior that created the problem.
Conditions and questions to raise. Request trailing twelve-month and monthly statements to verify the May peak; confirm whether the $60,000 line balance is seasonal or permanent; secure a first lien on inventory and receivables; set a clean-up period (for example, 30 consecutive days at zero balance) so the line is genuinely seasonal; and require the inventory reduction plan with reporting. The reasoning to make explicit is that structure, not the yes/no answer, is how a lender controls working-capital risk.