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 2018 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 mil- lion. 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 2019 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% to $150,000 a quarter, and the company effectively eliminated all capital expenditures. The policy appeared 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 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 2019 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 2020 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 2020 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% a year (or about 2% a quarter). Surely, Mr. Capstan reasoned, when the bank saw the projected sales growth for the rest of 2020, 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?

Using Excel and showing calculations calculate the following ratios

1. Debt equity ratio

2. Debt asset ratio

SUMMARY INCOME STATEMENT

(all figures except unit sales in thousands of dollars)

Year: 2018 2019 2020

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 (1 × 3) 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

SUMMARY BALANCE SHEETS

(figures in thousands of dollars)

End of 3rd Quarter 2018 End of 1st Quarter 2020

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

Total current liabilities 4,730 15,131

Shareholders' equity 1,540 2,059

Total liabilities plus equity 6,270 17,190

Question

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 2018 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 mil- lion. 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 2019 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% to $150,000 a quarter, and the company effectively eliminated all capital expenditures. The policy appeared 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 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 2019 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 2020 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 2020 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% a year (or about 2% a quarter). Surely, Mr. Capstan reasoned, when the bank saw the projected sales growth for the rest of 2020, 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?

Using Excel and showing calculations calculate the following ratios

1. Debt equity ratio

2. Debt asset ratio

SUMMARY INCOME STATEMENT
(all figures except unit sales in thousands of dollars)
	Year:	2018	2019	2020
	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 (1 × 3)		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



SUMMARY BALANCE SHEETS
(figures in thousands of dollars)
	End of 3rd Quarter 2018	End of 1st Quarter 2020
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
Total current liabilities	4,730	15,131
Shareholders' equity	1,540	2,059
Total liabilities plus equity	6,270	17,190

Accepted Answer

SUMMARY INCOME STATEMENT

(all figures except unit sales in thousands of dollars)

Year:
2018…