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Reluctance of bank to extend credit

Sidney Capstan attributed much of the business' success to its no-frills policy of competitive pricing and immediate cash payment. The business was basically a simple one--the 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 Capstan with a good return on equity investment.

By the fourth quarter of 2006 sales were running at 250 cars a quarter. Since the average sale of each car was $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 2007 was not a happy year for car importers in the United States. 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 sales of its cars constant. Wages and other costs were pared by 25 percent to $150,000 a quarter and the company effectively eliminated all capital expenditures. The policy appeared successful. Unit sales fell by 20 percent to 200 units a quarter, and the company continued to operate at a satisfactory profit (see table).

The slump 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 Sidney Capstan decided to maintain the policy. In the third quarter of 2007 sales had recovered to 225 units; by the fourth quarter they were 250 unites; and by the first quarter of the next year they had reached 275 units. It looked as if by the second quarter of 2008 that the company could expect to sell 300 cars. Earnings before interest were already in excess of their previous high and Sidney Capstan 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, the equity had grown from just over $1.5 million to about $2 million.

Sidney Capstan 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 Sidney Capstan-the mounting level of debt, which by the end of the first quarter of 2008 had reached $9.7 million. This unease further increased 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.

Capstan found it impossible to understand how such a successful year could have landed the company in financial difficulties. The company had always had a good relationship with its bank, and the interest rate on its bank loans was a reasonable 8 percent a year (or about 2 percent per a quarter). Surely, Capstan reasoned, when the bank saw the projected sales growth for the rest of 2008, it would realized that there were plenty of profits to enable the company to start repaying its loans.

**1) I need to summarize the case.

**2) Prepare a detailed response to Mr. Capstan from the bank in which you explain why the bank would be reluctant to extend further credit to his organization even though his organization appears to be projecting sales growth.

(all figures except unit sales in thousands of dollars)
Year: 2009 2010 2010 2010 2011
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. Revenues (1 × 2) 5,000 4,000 4,000 4,500 5,000 5,500

5. Cost of goods sold 4,500 3,600 3,600 4,050 4,500 4,950

6. Wages and 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. Pretax 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

(figures in thousands of dollars)

End of 3rd Quarter End of 1st Quarter
2009 2011
Cash 10 10
Receivables 0 10,500
Inventory 4,500 5,400
Total current assets 4,510 15,910
Fixed assets, net 1,760 1,280
Total assets 6,270 17,190
Bank loan 230 9,731
Payables 4,500 5,400
Totalcurrent liabilities4,730 15,131
Shareholders' equity 1,540 2,059
Total liabilities 6,270 17,190

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Summary of the case:

The case presents a business scenario, wherein a company tries to overcome recession in the business via adopting innovate strategies. In this scenario, the company uses credit as a tool to attract customers. In the event, company seriously hampers its capital structure and takes too much, resulting in high financing costs and lopsided capital structure with a unfavorable debt to equity ratio. This ...

Solution Summary

Reluctance of bank to extend credit