Case Study.

Answer the questions only.

AD Auto operated a second-hand imported car dealership for a major Japanese distributor. AD Auto's owner, Mr. Adam Daniel, attributed much of the business's success to its no-frills policy of competitive pricing and immediate cash payment. The business was basically a simple one - the firm imported these second-hand cars at the beginning of each quarter and paid the Japanese distributor at the end of each quarter. The revenues from the sale of these cars covered the payment to the distributor and the expenses of running the business, as well as providing Mr. Adam with a good return on his equity investment. By the fourth quarter of 2010, sales were running at 150 cars a quarter. Since average sale price of each car was about RM60,000, this translated into quarterly revenues of 150 x RM60,000 = RM9 million. The average cost of each imported car was RM500,000. After paying wages, rent, and other recurring costs of RM50,000 per quarter and deducting

depreciation of RM200,000, the company was left with earnings before interest and taxes (EBIT) of RM800,000 a quarter and net profits of RM577,000.

This year 2011 was not a happy year for car importers in the country. The new automotive

policy had led to a general decline in auto sales, while the fall in the value of ringgit to Japanese Yen shaved profit margins for many dealers in Japanese imported cars. AD Auto, 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 cut by 25 percent to RM375,000 a quarter and the company effectively eliminated capital expenditures. This rearrangement appeared successful. Even though unit sales fell by 20 percent to 120 units a quarter, the company continued to operate in a satisfactory profit (see Exhibit 1).

The decline in sales lasted for 6 months, but as consumer confidence began to return, auto sales began to recover. The company's new policy of 6 months' free credit was proving sufficiently popular that Mr. Adam decided to maintain the policy. In the third quarter of 2011, sales had recovered to 135 units; by the fourth quarter they were back to 150 units; and by the first quarter of 2012, they had reached 175 units. It looked as if by the second quarter of 2012 that company could expect to sell 200 cars. Earnings before interest and tax (EBIT) were already in excess of their previous high and Mr. Adam was able to congratulate himself on weathering what looked to be a tricky period. Over the last 12-month period, AD Auto had earned a net profits of over RM1.7 million, and the equity had grown from just under RM2 million to about RM3.4 million.

Mr. Adam Daniel was first and foremost a superb salesman and always left the financial

aspects of the business to his financial manager. However, there was one feature of the financial statements that disturbed Adam - the mounting level of debt, which by the end of the first quarter of 2012 had reached RM19 million. 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 risk exposure to the company.

Adam found it impossible to understand how such 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 percent a year (or about 2 percent a quarter). Surely, Adam reasoned, when the bank saw the projected sales growth for the rest of 2012, it would realize that there were plenty of profits to enable to start repaying its loans.

EXHIBIT 1

SUMMARY OF INCOME STATEMENT

(all figures except unit sales in thousands)

Year: 2010 2011 2012

Quarter: Fourth First, 2nd, 3rd, 4th 1st

Number of cars sold 150 120 120 135 150 175

Unit price 60 60 60 60 60 60

Unit cost 50 50 50 50 50 50

Revenues 9,000 7,200 7,200 8,100 9,000 10,500

Cost of Goods sold 7,500 6,000 6,000 6,750 7,500 8,750

Wages and other costs 500 375 375 375 375 375

Depreciation 200 200 200 200 200 200

EBIT 800 625 625 775 925 1,175

Net Interest 20 0 150 300 361 380

Pretax profit 780 625 475 475 564 795

Tax(26%) 203 163 124 124 147 207

Net Profit 577 462 351 351 417 588

EXHIBIT 2

SUMMARY OF BALANCE SHEET

(all figures except unit sales in thousands)

End of Quarter End of Quarter

2011 2012

Cash 80 80

Receivables 0 19,500

Inventory 4,500 5,400

Total Current Assets 4,580 24,980

Fixed Assets, net 3,690 2,690

TOTAL ASSETS 7,270 27,670

Bank loans 1,000 19,000

Payables 4,500 5,200

Total Current Liabilities 5,500 24,200

Shareholders' equity 1,770 3,470

TOTAL LIABILITIES 7 EQUITY 7,270 27,670

Questions

1. Is the bank correct to withhold further credit to AD Auto? Why?
2. Why is AD Auto's indebtedness increasing if its profits are higher than ever?

3. Although financial statement can provide useful information about a company's operationsand financial condition, what are some of the problems and limitations, based on this case?