CPSO Capsource Financial Inc (CE)

Notes to Unaudited Condensed Consolidated Financial Statements

(1) Nature of Operations CapSource Financial, Inc. (CapSource or the Company) is a U.S. corporation with its principal place of business in Boulder, Colorado. CapSource is a holding company that sells and leases dry van and refrigerated truck trailers through its wholly owned Mexican operating subsidiaries. In addition, on May 1, 2006, the Company acquired, and began operating, the truck trailer sales business of Prime Time Equipment, Inc., a California based authorized dealer for Hyundai Translead trailers. The Company now operates the acquired business through its wholly owned U.S. subsidiary, CapSource Equipment Company, Inc., d/b/a Prime Time Trailers. The Company operates in one business segment, the sale and lease of trailers, and conducts business in the United States and Mexico.

Prior to May 1, 2006, all of the Company’s sales were generated in Mexico. For the three months and nine months ended September 30, 2007 and 2006, the geographic distribution of the Company’s net sales was:

(2) Basis of presentation The accompanying unaudited condensed consolidated financial statements include the accounts of CapSource and its wholly owned subsidiaries. All intercompany balances have been eliminated in consolidation. In the opinion of Company management, the accompanying unaudited condensed, consolidated financial statements contain all adjustments (consisting of only normal recurring adjustments, except as noted elsewhere in the notes to the condensed consolidated financial statements) necessary to present fairly the financial position of the Company as of September 30, 2007, and the results of its operations and cash flows for the interim periods presented. These statements are condensed and, therefore, do not include all of the information and notes required by generally accepted accounting principles for complete financial statements. The statements should be read in conjunction with the consolidated financial statements and footnotes included in the Company’s annual report on Form 10-KSB for the year ended December 31, 2006. The results of operations for the three months and nine months ended September 30, 2007 and 2006 are not necessarily indicative of the results to be expected for the full year, or for any other future period.

The financial statements of the Company’s Mexican subsidiaries are reported in the local currency, the Mexican peso. However, as substantially all sales and leases are denominated in U.S. dollars, as well as generally all other activities, the functional currency is designated as the U.S. dollar. Any transactions denominated in the local currency are remeasured into the U.S. dollar, creating foreign exchange gains or losses that are included in other income (expense).

(3) Liquidity Since its inception, the Company has generated losses from operations, and as of September 30, 2007 had an accumulated deficit of $14,259,940 and working capital of $682,201.

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In conjunction with a private equity placement, the Company increased its equity by selling 5,000,000 shares of common stock for $2,000,000 on May 1, 2006, and an additional 750,000 shares of common stock for $300,000 on October 30, 2006. In addition, on May 1, 2006 the Company’s Chairman and largest stockholder converted $871,866 of debt owed to him by the Company, into 2,179,664 shares of Company common stock.

On May 1, 2006, in conjunction with the acquisition of the Prime Time Trailer business, the Company obtained a floor plan inventory credit line of approximately $3.0 million (increased to $3.5 million on May 1, 2007) from Navistar Financial Corporation to finance the purchase of new and used truck trailer inventory by the Company’s U.S. operations. The credit line was initially utilized in the assumption of $862,000 of acquisition debt. The floor plan notes, which bear interest at Prime rate plus 1.25% (9.0% as of September 30, 2007), are secured by specific trailer inventory and are paid as each financed trailer is sold by the Company (See Note 5).

On October 23, 2006, the Company obtained a floor plan inventory credit line of $3.6 million (increased to $5.0 on September 1, 2007) from Navistar Financial Corporation to finance the purchase and sale of new and used truck trailers by the Company’s Mexican operations. The floor plan notes, which bear interest at LIBOR plus 4.17% (currently 9.16%), are secured by specific trailer inventory and are paid as each financed trailer is sold by the Company (See Note 5).

On August 17, 2007, the Company obtained a short-term loan of 44.0 million Mexican pesos (equivalent to approximately $4.0 million on the date of the borrowing) from Pure Leasing, S.A. de C. V. of Mexico City, to finance the purchase of trailers by the Company’s Mexican operations, as well as for other working capital needs. Pure Leasing, S.A. de C. V. is a major customer of the Company’s Mexican operations. The term of the loan is for a period of 180 days, but requires repayment of 50% of the loan 30 days from the date of the borrowing, which the Company repaid on September 17, 2007. The loan bears interest at the Mexican Interbank Borrowing Rate plus 4.0% (currently 11.7%), and is secured by trailer inventory that is not otherwise pledged against borrowings.

To satisfy the Company’s liquidity needs Randy Pentel, the Company’s Chairman of the Board and majority stockholder, from time to time has made unsecured loans to the Company. During the nine months ended September 30, 2007, Mr. Pentel loaned the Company $530,673. As of September 30, 2007, the outstanding loans by him to the Company, classified as short-term debt payable to stockholder, totaled $1,997,636. Total interest expense on the Pentel loans was approximately $97,800 for the nine months ended September 30, 2007. As of September 30, 2007, total interest accrued on the Pentel loans was approximately $42,400. The Company repaid approximately $135,400 to Mr. Pentel in principal and interest on the loans during the nine months ended September 30, 2007. Subsequent to September 30, 2007 and as of November 14, 2007, Mr. Pentel loaned the Company an additional $175,000.

On August 10, 2007, the Company obtained additional term loans from two other major investors, totaling $300,000, to finance the Company’s working capital needs. The loans, which bear interest at 9.0%, are for a period of two years and are included as long-term debt on the Company’s balance sheet as of September 30, 2007. The Company’s Chairman of the Board, Randy Pentel, is personally guaranteeing the loans to the lenders.

Company management believes that the cash to be generated by operations and the floor plan financing arrangements, plus cash on hand at September 30, 2007, as well as additional funding expected from the Company’s Chairman and other major Company investors, will provide sufficient funds to satisfy obligations as they become due over the next twelve months. Over the long-term, management believes that the Company will need additional debt/equity funding, as well as successful growth in the Company’s U.S. operations, in order to satisfy long-term cash requirements.

The Company is seeking additional long-term debt and/or equity funding to continue operations. Should the Company be unsuccessful in growing U.S. operations, and should the Company’s Chairman or other major Company investors fail to provide additional funding, if needed, to sustain the Company’s working capital requirements, and/or should the Company be unsuccessful in obtaining funding from third parties, the Company could be forced to dramatically scale back its operations and activities.

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(4) Acquisition On May 1, 2006, the Company purchased substantially all of the assets and assumed certain liabilities of Prime Time Equipment, Inc. (a Fontana, California based authorized California dealer for Hyundai Translead trailers), for total consideration of approximately $1,970,000, of which $1,014,290 was paid in cash at closing, and the balance consisting of the assumption of certain liabilities that were paid in due course. The total purchase price consideration of $1,970,000 was allocated to the assets acquired, including identifiable intangible assets, based on the Company’s estimate of the respective fair values at the date of acquisition. Such estimates resulted in a valuation $498,390 for intangible assets, comprised of a non-compete agreement and the value of customer lists. The fair values of the intangible assets are subject to periodic reviews, at least annually, for possible impairment of their carrying values.

The Company acquired Prime Time in order to expand its operations into the California market as part of its strategic plan to provided equipment and services along the major transportation corridors to and from Mexico. In addition, the acquisition allows the Company to diversify its concentration in Mexico. The results of Prime Time’s operations have been included in the Company’s interim consolidated financial statements since May 1, 2006.

(5) Inventory, notes payable and credit line The Company funds the purchase of some of its inventory under floor plan credit lines from independent finance companies (unrelated to Hyundai Translead), that are secured by specific trailer inventory. As of September 30, 2007 and December 31, 2006, the Company had the following inventory balances, floor plan financing debt and other unsecured short term debt:

As presented in the Unaudited Condensed Consolidated Statements of Cash Flows, during the nine months ended September 30, 2007 and 2006, the Company received proceeds from notes payable, credit line and payable to stockholder of $20,103,377 and $4,662,242, respectively, which included $14,750,335 and $2,757,261, respectively, in conjunction with the floor plan lines of credit, and $4,000,000 and $0, respectively, in conjunction with the loan from Pure Leasing. During the nine months ended September 30, 2007 and 2006, the Company repaid debt of $12,774,990 and $3,393,028, respectively, which included repayments of $10,393,738 and $1,793,294, respectively, against the floor plan lines of credit, and $1,985,403 and $0, respectively, on the loan from Pure Leasing. In addition, during the nine months ended September 30, 2006, the Company’s majority stockholder converted Company debt of $871,866 into Company common stock.

(6) Accounts payable and accrued expenses The Company purchases the majority of its new trailer inventory from Hyundai Translead, which extends payment terms of at least 45 days. In certain cases, when specific inventory is committed for sale to particular customers, Hyundai Translead allows the Company to delay payment beyond 45 days until such time as the sales of the related inventory to the particular customers have been completed. The credit terms extended to the Company by Hyundai Translead are non-interest bearing and are not secured by inventory. However, effective July 1, 2007, Hyundai Translead will charge interest of 10.0% per annum on outstanding balances that exceed the 45 day payment terms. Following is a summary of the Company’s accounts payable and accrued expenses as of September 30, 2007 and December 31, 2006:

Other accounts payable and accrued expenses relate primarily to freight, customs/importation fees, and accrued employee termination costs as required under Mexican law.

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(7) Recognition of revenue from equipment sales Revenue generated by the sale of trailer and semi-trailer equipment is recorded at the time the equipment is delivered to the buyer, provided the Company has evidence of an arrangement, the sale price is fixed or determinable and collectibility is reasonably assured.

(8) Equipment leasing Statement of Financial Accounting Standards No. 13, Accounting for Leases, as amended, requires that a lessor account for each lease by either the direct financing or sales-type method (collectively capital leases), or the operating lease method. Capital leases are defined as those leases that transfer substantially all of the benefits and risks of ownership of the equipment to the lessee. The Company’s leases are classified as operating leases for all of its leases and for all lease activity as the lease contracts do not satisfy the criteria to be recognized as capital leases. For all types of leases, the determination of return on investment considers the estimated value of the equipment at lease termination, referred to as the residual value. Residual values are estimated at lease inception equal to the estimated value to be received from the equipment following termination of the initial lease (which in certain circumstances includes anticipated re-lease proceeds) as determined by the Company. In estimating such values, the Company considers all relevant information and circumstances regarding the equipment and the lessee. Actual results could differ significantly from initial estimates, which could in turn result in impairment or other charges in future periods.

The cost of equipment is recorded as equipment and is depreciated on a straight-line basis over the estimated useful life of the equipment. Leasing revenue consists principally of monthly rentals and related charges due from lessees. Leasing revenue is recognized over the related rental term. Deposits and advance rental payments are recorded as a liability until repaid or earned by us. Operating lease terms range from month-to-month rentals to five years. Initial direct costs (IDC) are capitalized and amortized over the lease term in proportion to the recognition of rental income. At September 30, 2007, the Company had no capitalized IDC. Depreciation expense and amortization of IDC are recorded as direct costs of trailers under operating leases in the accompanying consolidated statements of operations.

(9) Income Taxes Income taxes of $15,237 and $55,571 for the three months and nine months ended September 30, 2007, respectively, and $3,666 and $36,105 for the three months and nine months ended September 30, 2006, respectively, primarily represent an alternative tax on assets incurred by the Company’s Mexican operations. This tax is applicable to most Mexican corporations that have no taxable income. Income tax expense for the three months and nine months ended September 30, 2007, respectively, also includes $200 and $600, respectively, of income tax related to the Company’s U.S. operations.

(10) Comprehensive income (loss) Comprehensive income (loss) includes all changes in stockholders’ equity (net assets) from non-owner sources during the reporting period. Since inception, the Company’s comprehensive loss has been the same as its net loss.

(11) Common stock and warrant issuance For the nine months ended September 30, 2007 and 2006, the Company did not issue any stock or stock-based awards. Therefore, there is no stock-based compensation disclosure presented herein. All stock-based awards granted in previous periods and outstanding as of September 30, 2007 were fully vested as of the issuance date.

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( 12) Earnings per share The following summarizes the weighted-average common shares issued and outstanding for the three months and nine months ended September 30, 2007 and 2006:

Basic loss per share is computed by dividing net loss by the weighted average number of common shares outstanding. Diluted loss per share is computed by dividing net loss by the weighted average number of common shares outstanding increased for potentially dilutive common shares outstanding during the period. The dilutive effect of equity instruments is calculated using the treasury stock method.

Warrants to purchase 9,117,164 and 8,451,998 common shares as of September 30, 2007 and 2006, respectively, were excluded from the treasury stock calculation because they were anti-dilutive due to the Company’s net losses.

(13) Supplemental balance sheet information

Purchase Commitments:
As of September 30, 2007, the Company had committed to purchase additional trailers from Hyundai Translead, at a total purchase price of approximately $264,000, towards which the Company had not made any down payments. Under the terms of the commitment, the Company must pay Hyundai the total balance upon taking delivery of the trailers.

During the nine months ended September 30, 2007, the Company made trailer sales totaling approximately $8,726,000 to two customers, conditioned on the Company agreeing to repurchase some of the trailers in the future under certain circumstances. The two customers are leasing companies that buy trailers from the Company, which then are leased to their customers. Under the terms of the conditional repurchase agreements, the Company could be required to repurchase some of the trailers, if the customers’ lessees choose to return the trailers to the customers at lease termination and the customers choose not to release or sell the related trailers at that time.

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As of September 30, 2007, the Company could be obligated to one customer to repurchase up to 250 trailers, which currently have estimated market values totaling approximately $5,100,000, at repurchase prices totaling $4,850,000. The prices agreed upon in the conditional repurchase agreement decline over periods from one year to ten years following the dates of original sale, terminating in the year 2017. Based on the Company’s experience in the used trailer market, Company management estimates that the market value of the related used trailers will exceed the prices agreed upon in the repurchase agreement at any point in time over the period terminating in 2017. Thus, if the Company is required to repurchase any of the related trailers, it does not expect to incur loses on their subsequent sale or other disposition.

In addition, as of September 30, 2007, the Company could be obligated to a second customer to repurchase up to 96 trailers, which currently have estimated market values totaling approximately $1,900,000. The conditional repurchase period begins in the year 2010, terminating in 2014. Company management anticipates that the 96 related trailers will have estimated market values totaling approximately $1,600,000 as of July 1, 2010, the beginning of the repurchase period. As of that date, the repurchase prices agreed upon for the 96 trailers total $796,000. The prices in the conditional repurchase agreement decline over periods from three years to seven years following the dates of original sale in the year 2007. Based on the Company’s experience in the used trailer market, Company management estimates that the market value of the related used trailers will exceed the prices agreed upon in the repurchase agreement at any point in time over the period terminating in 2014. Thus, if the Company is required to repurchase any of the related trailers, it does not expect to incur loses on their subsequent sale or other disposition.

Registration Rights Obligation :
In conjunction with the private equity placement that took place on May 1, 2006, the Company was required to prepare and file with the Securities and Exchange Commission, a registration statement covering all the shares that were or could be issued as a result of this transaction. The Company complied with this requirement by filing the registration statement Form SB-2 (Registration Statement) on October 5, 2006. However, the Company also was obligated to have caused the Registration Statement to become effective within 180 days of May 1, 2006. Any delays in meeting the obligation to have the Registration Statement declared effective within 180 days of May 1, 2006 resulted in the Company being liable to the investors in an amount equal to one percent per month (or part thereof) of the purchase price paid for the shares, and, if exercised, the warrant shares, for the duration of any such delay.

As of August 13, 2007, the Registration Statement was declared effective. The Company is required to pay the investors the penalty fee of $23,000 for each month (or part thereof) that the effective date of the Registration Statement was delayed, unless the investors waive such fee. The registration rights agreement did not limit the amount of fee that would have to be paid if the effective date of the registration statement were delayed indefinitely. Thus, the annual fee obligation for such a delay would be approximately $276,000. Company management initially anticipated that the registration statement would become effective by May 15, 2007, resulting in an accrual of the penalty fee of $138,000. This estimated fee accrual was charged as a reduction of stockholders’ equity as reported in the Company’s Consolidated Balance Sheet as of December 31, 2006. In January 2007, the Company paid $23,000 of the estimated fee. Given that the Registration Statement was declared effective on August 13, 2007, approximately three months beyond the original anticipated effective date, the Company increased the penalty fee payable by $69,000 during the nine months ending September 30, 2007, with a related charge being reflected in the Company’s Consolidated Statement of Operations for the period then ended. The remaining estimated liability of $184,000 is included in accounts payable and accrued expenses as of September 30, 2007.

Effects of Recent Accounting Pronouncements :
In July 2006, the Financial Accounting Standards Board issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”, (Interpretation No. 48). Interpretation No. 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes.” Interpretation No. 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Interpretation No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The Company adopted the provisions of Interpretation No. 48 effective January 1, 2007. The adoption did not have any impact on the Company’s financial statements as of September 30, 2007 or for the nine-month period then ended. Company management currently is evaluating the possible impact of this Interpretation on its subsequent financial statements.

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In September 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements”, (SFAS No. 157). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. The provisions of this standard apply to other accounting pronouncements that require or permit fair value measurements. This Statement will be effective for the Company’s year ending December 31, 2008. Upon adoption, the provisions of SFAS No. 157 are to be applied prospectively with limited exceptions. Company management does not expect this Statement to have a significant impact on the Company’s financial statements.

In February 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of SFAS No. 115”, (SFAS No. 159). SFAS No. 159 permits entities to choose to measure financial instruments and certain other items fair value (the “fair value option”). Unrealized gains and losses on items for which the fair value option has been elected will be recognized in earnings at each subsequent reporting date. This Statement will be effective for the Company’s year ending December 31, 2008. Company management currently is evaluating the impact this Statement will have on its financial statements.

In June 2006, the Emerging Issues Task Force (EITF) reached a consensus on EITF Issue No. 06-03, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)”, (EITF No. 06-03”). EITF No. 06-03 provides that the presentation of taxes assessed by a governmental authority that are directly imposed on a revenue-producing transaction between a seller and a customer on either a gross basis (included in revenues and costs) or on a net basis (excluded from revenues) is an accounting policy decision that should be disclosed. The Company’s accounting policy is to present taxes collected from customers and remitted to governmental authorities on a net basis. The corresponding amounts recognized in the consolidated financial statements are not significant.

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