Capstan Autos operated an East Coast dealership for a major Japanese car manufacturer. Capstans owner, Sidney Capstan, attributed much of the businesss success to its no-frills policy of competitive pricing and immediate cash payment. The business was basically a simple onethe firm imported cars at the beginning of each quarter and paid the manufacturer at the end of the quarter. The revenues from the sale of these cars covered the payment to the manufacturer and the expenses of running the business, as well as providing Sidney with a good return on his equity investment. By the fourth quarter of 2015, sales were running at 250 cars a quarter. Since the average sale price of each car was about $20,000, this translated into quarterly revenues of 250 $20,000 = $5 million. The average cost to Capstan of each imported car was $18,000. After paying wages, rent, and other recurring costs of $200,000 per quarter and deducting depreciation of $80,000, the company was left with earnings before interest and taxes (EBIT) of $220,000 a quarter and net profits of $140,000. The year 2016 was not a happy one for car importers in Canada. Recession led to a general decline in auto sales, while the fall in the value of the dollar shaved profit margins for many dealers in imported cars. Capstan, more than most firms, foresaw the difficulties ahead and reacted at once by offering 6 months free credit while holding the sale price of its cars constant. Wages and other costs were pared by 25% to $150,000 a quarter and the company effectively eliminated all capital expenditures. The policy seemed successful. Unit sales fell by 20% to 200 units a quarter, but the company continued to operate at a satisfactory profit (see table). The slump in sales lasted 6 months, but as consumer confidence began to return, auto sales began to recover. The companys new policy of 6 months free credit was proving sufficiently popular that Sidney Capstan decided to maintain the policy. In the third quarter of 2016, sales had recovered to 225 units; by the fourth quarter they were 250 units; and by the first quarter of the next year they had reached 275 units. It looked as if the company could expect to sell 300 cars by the second quarter of 2009. Earnings before interest and tax were already in excess of their previous high and Sidney was able to congratulate himself on weathering what looked to be a tricky period. Over the 18-month period, the firm had earned net profits of over half a million dollars, and the equity had grown from just under $1 million to about $2 million. Sidney was first and foremost a superb salesperson and always left the financial aspects of the business to his financial manager. However, one feature of the financial statements disturbed him: the mounting level of debt, which had reached $9.7 million by the end of the first quarter of 2014. This unease turned to alarm when the financial manager phoned to say that the bank was reluctant to extend further credit, and was even questioning its current level of exposure to the company. Sidney found it impossible to understand how such a successful year could have landed the company in financial difficulties. The company had always had good relationships with its bank, and the interest rate on its bank loans was a reasonable 8% per year (or about 2% per quarter). Surely, he reasoned, when the bank saw the projected sales growth for the rest of 2014, it would realize that there were plenty of profits to enable the company to start repaying its loans. Questions: 1. Is Capstan Autos in trouble? 2. Is the bank correct to withhold further credit? 3. Why is Capstans indebtedness increasing if its profits are higher Summary Income Statement Year 2012 Year 2013 Year 2014 Quarter 4 1 2 3 4 1 1 Number of Cars Sold 250 200 200 225 250 275 2 Unit Price 20 20 20 20 20 20 3 Unit Cost 18 18 18 18 18 18 4 Revenue (1*2) 5000 4000 4000 4500 5000 5500 5 COGS (1*3) 4500 3600 3600 4050 4500 4950 6 Wages & Other Costs 200 150 150 150 150 150 7 Depreciation 80 80 80 80 80 80 8 EBIT (4-5-6-7) 220 170 170 220 270 320 9 Net Interest 4 0 76 153 161 178 10 Pre Tax Profit (8-9) 216 170 94 67 109 142 11 Tax (.35*10) 76 60 33 23 38 50 12 Net Profit (10-11) 140 110 61 44 71 92 Summary Balance Sheets (4000s) End of 3rd Quarter 2012 End of 1st Quarter 2013 Cash 10 10 Receivables 0 10500 Inventory 4500 5400 Total Current Assets 4510 15910 Fixed Assets Net 1760 1280 Total Assets 6270 17190 Bank Loan 230 9731 Payables 4500 5400 Total Current Liabilities 4730 15131 Share Holders Equity 1540 2059 Total Liabilities 6270 17190