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why has the bank withheld further credit

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Case Study Analysis: Mini Case - Capstan Autos

a. Briefly summarize the case.

b. Prepare a 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.
Provide anwsers to following questions:

Mr. Capstan kept on coming back to three questions:

1. Was his company really in trouble?

2. Could the bank be right in its decision to withhold further credit?

3. And why was the company's indebtedness increasing when its profits were higher than ever?

Please back up answers with ratios if necessary.

Capstan Autos operated an East Coast dealership for a major
Japanese car manufacturer. Capstan's owner, Sidney Capstan, 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 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 his equity
investment.

By the fourth quarter of 2009 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 2010 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 sale price 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, but 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 2010 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 by the second quarter of
2011 the company could expect to sell 300 cars. Earnings before
interest and tax 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, and 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 2011 had reached $9.7 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 exposure to the
company.

Mr. Capstan 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 percent a
year (or about 2 percent a quarter). Surely, Mr. Capstan reasoned,
when the bank saw the projected sales growth for the rest of 2011,
it would realize that there were plenty of profits to enable the company
to start repaying its loans.

Mr. Capstan kept coming back to three questions:Was his company
really in trouble? Could the bank be right in its decision to
withhold further credit? And why was the company's indebtedness
increasing when its profits were higher than ever?

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https://brainmass.com/business/credit-management-credit-policy-analysis-and-risk/why-has-the-bank-withheld-further-credit-272501

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Case Summary:

The case revolves around a car dealership called Capstan Autos that dealt in imported cars of a major Japanese manufacturer. The dealership has enjoyed good success and has established a reputation for offering competitive pricing on its products. However, during recessionary times, the car sales declined as consumers cut their spending on cars and thus, in order to maintain sales levels, extended 6 month credit to its customers without any price increase on the cars. The policy proved to be successful for the company in terms of maintaining the sales levels during such recessionary times, but bought other troubles for the company.

The company actually financed this credit via bank loan and the owner did not pump in more equity in the company. Therefore, the level of debt in the books of the company increased considerably and the interest burden also rose significantly. The debt to equity ratio became poor. Therefore, even though the company was able to achieve high sales during recessionary times and earned decent profit, the net profit figures significantly declined due to huge interest burden in the books of the company. Further, the inability of the company to make the collections procedures efficient resulted in alarming rise in the receivables component in the balance sheet of the company.

These financial difficulties led the bank/lender of the company to withhold further credit to the company as the bank was skeptical about the ability of the company to repay its debt and meet interest payment obligations in such tough times. Further, the poor mix of cash versus credit sales and the inability of the company to collect its extended credit in an efficient manner made the matters even worse as banks were really skeptical about the cash inflow of the company due to such poor financial policies. Therefore, the bank was hesitant to extend credit even with such increase in sales ...

Solution Summary

Prepare a 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.

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