Salmon River Inn Limited

The telephone rang on a Saturday afternoon, October 10 1992, as Fred Jones, 50% owner of Salmon River Inn Limited, was settling in front of the televised World Series game between the Braves and Blue Jays. The caller, his sister Eileen, who was the only other shareholder, sounded very upset. "I just had a call from our cook, Walter," she said. Me bank returned his payroll cheque because of insufficient funds." Fred was shocked. As a busy mechanical engineer operating a consulting practise in St John's, he had not had time to help his sister operate the Inn, which was located at Salmon River, almost two hundred kilometres from the city He realized, however, that the bank's action could adversely affect the reputation of the Inn, especially in the small community of Salmon River After some additional discussion, Fred agreed to meet Eileen at Salmon River the following morning.

Background Information

Eileen Timmons was a Registered Nurse living in Salmon River, Newfoundland. A single parent with two children in their late


This case was prepared by Professor Wayne King of the Faculty of Business Administration, Memorial University of Newfoundland for the Atlantic Entrepreneurial Institute as a basis for classroom discussion, and is not meant to illustrate either effective or ineffective management. Some elements of this case have been disguised.

Copyright 1993, the Atlantic Entrepreneurial Institute. Reproduction of this case is allowed without permission for educational purposes, but all such reproductions must acknowledge the copyright. This permission does not include publication.


teens, she found that in 1990 her income was significantly reduced when Provincial Government attempts to cut costs in the health care sector resulted in her employment status changing from full-time to part-time. As a result, she found it increasingly difficult to meet her living expenses. In order to supplement her income, Eileen had been considering the use of the proceeds of her late husband's insurance policy, $25,000, to start a small business, and had actively searched for the right opportunity. This opportunity seemed to present itself when, in early 1991, she learned that the local convent was for sale.

The Presentation Sisters of the Blessed Virgin Mary had been involved in the religious and educational aspects of life in Salmon Paver for over one hundred years. For most of this time approximately 15 members of the Order resided in the town, working as teachers in the local community school. With the introduction of regional schools, however, this service had been discontinued several years ago. As a result, the number of Presentation Sisters living in the community gradually decreased, until only three remained. The governing body of the Order decided that it was no longer feasible to operate the convent, which had been built about sixty years ago, so it was advertised locally for sale.

When Eileen learned of the former convent's availability, she immediately felt that it would be ideal for use as a tourist home. She also thought that, because of the building's age, it would need substantial upgrading and renovations. Accordingly, she contacted her brother Fred. After some discussion, they decided to form a limited company as equal shareholders to purchase the building. As a resident of the community, Eileen's role would be to supervise the day-to-day operations of the Inn. She would also continue her employment as a nurse. Fred's role would be to supervise one of his employees who would carry out an extensive examination of the building to determine the necessary improvements and modifications. He would also be responsible for raising the money to finance the purchase and renovations. Fred felt the Inn would qualify for funding under the Fisheries Alternative Program. This program, administered through the Atlantic Canada Opportunities Agency, would provide contributions toward approved capital costs of up to 65%. An equity contribution of 20% would normally be required from the project's owners, and the balance could then be financed through conventional lenders.

Fred was disappointed by the results of his survey of the property Although the building was sound structurally, he found that extensive external repairs were needed. Virtually all of the windows needed replacement and much of the siding had to be replaced. Inside, the building needed to be completely redecorated and improvements made to prepare it for this business. In addition, new furniture for the rooms and equipment for the restaurant would be required. At this point, Fred began to wonder whether the Inn would support the level of investment required. However, Eileen felt strongly that she could make it pay, and the Fisheries Alternative Program would contribute a major portion of the capital cost. The decision was made to proceed, and the funding was eventually approved; Exhibit I outlines the funding proposal.

By late October 1991, the company was ready to start the renovations. Almost immediately the project ran into problems. The local carpenters hued to complete the job seemed to take much longer than the original estimate, and many of the materials estimates were understated. Eileen also decided to hire an interior decorator to recommend draperies, wallpapers, and colour schemes which would preserve the original character of the building. As a result, the company incurred large cost overruns, and temporary financing had to be obtained from the bank. This was subsequently repaid from an additional investment by the shareholders and an additional term loan from the bank.

In May of 1992, the Inn was ready for business. Over the course of the summer there were several occasions when the company was unable to meet its obligations in a normal manner. Eileen found that she had to use part of her income from the hospital to pay some of the pressing bills. She felt that this was reasonable, however, because both of her children were now employed at the Inn, so the overall family income was higher. She was completely taken by surprise when the bank refused to honour the payroll cheque. As she commented to Fred during the telephone call, "I don't know what the bank expects of me. I'm already paying many of these bills personally What more can I do?"

The Problem

Fred arrived at Salmon River early on Sunday, October 11, and immediately met with Eileen. -Me first thing we must do is to determine our financial position," he told her. "I guess we can begin by reviewing the financial statements," she replied. I just received them on Friday." Fred examined the financial statements, which are attached as Exhibits 2 and 3. The following additional information came to light during the conversation:

  1. The capital improvement phase of the project was complete.
  2. The bank overdraft position was essentially unchanged since the financial statement date. However, the bank manager had recently asked Eileen to present a plan to retire this amount in an orderly manner Eileen felt she would need to have this plan ready within a week.
  3. The accounts payable amount included $28,625 due to the contractor. Eileen admitted that this should have been paid from the proceeds of the second term loan, but there were several pressing operating accounts which took precedence.
  4. Payroll deductions had not been remitted for two months and now totalled $5,137. Provincial sides tax was also unpaid and totalled $3,240. These were similar to the amounts included in the accounts payable figure on the Balance Sheet.
  5. After the Inn had opened for business, Eileen felt that she did riot have the time to supervise all of the day-to-day operations. Within the community, she was able to locate a lady who had had several years of experience in the hospitality industry. Eileen thought that the $7,000 salary paid this person was worthwhile, unfortunately, the lady had recently moved out of the community as her husband had been transferred.
  6. The revenues for both room rentals and restaurant sales were well below projections. There were eight rooms which rented at an average of $40 per night. Fred calculated that there had been 100 days between the Inn's opening and the end of August, a potential rental revenue of $32,000. On that basis, the occupancy rate appeared rather low Eileen felt, however, that the occupancy rate should have averaged about 60%, although she did not have any actual statistics to confirm this. She was also very disappointed by the restaurant sales. When the menu had been drawn up originally, all food purchases had been marked up by 150% to arrive at selling prices. She felt that about $5,000 of the amount disclosed as "purchases of food and supplies" related to non-food items. Even at that, however, the margin appeared too low.
  7. Wages and benefits were also a cause for concern. Fred felt that, even with the manager's salary deducted, this amount was excessive. Eileen became a little defensive, pointing out that her two children had been paid about $6,000 between them during the Inn's operating period. After further discussion, Eileen admitted that she had realized that there were too many employees. However, she felt that because of the poor fishery in the area a number of people in the community had not worked sufficient time to qualify for unemployment insurance benefits. In her opinion, employing these people for "a few weeks" was a good public relations gesture.
  8. Most of the other item on the list reflected normal operating costs for the year.

The Decision Options

Fred and Eileen agreed that the options open to the owners were as follows:

  1. Do nothing Because of the unpaid accounts and bank overdraft, the bank would likely place the company into receivership. All of the money they had already invested would then be lost.
  2. Look for another investor to participate in the company with them or sell the whole company to someone else.
  3. Invest an additional $70,000 to pay the outstanding accounts and repay the bank overdraft.

Both Fred and Eileen realized that in order to make an informed decision they needed additional information, particularly a set of forecasted financial statements. With this in mind, they prepared the following information:

  1. Between the peak occupancy season of mid-June to mid-September the rooms should operate at 70% capacity. During the rest of the year the occupancy rate would be about 40%
  2. Restaurant sales should approximate $100,000 for the year.
  3. Should the company operate over the next year, Fred and Eileen had agreed not to receive a salary from the Inn. Fred insisted that if this was the case, there be no official manager and that Eileen's children, at $10,000 each, and a cook at $20,000, be the only permanent employees. During the peak summer season, three additional employees could be added at the minimum wage of $4.75 per hour. Also, all employees would receive benefits at approximately 15%. per hour.

Summary

Both Fred and Eileen believed that the decision to be made was a critical one, and the importance of it could not be overstated. As Fred put it, "after all, raising an additional $70,000 will not be easy. Eileen will have to remortgage her home. I can find my share in my existing engineering business, but it will certainly reduce my flexibility in carrying out certain projects which I had planned for next year."


Exhibit 1

Approved Funding Proposal

Capital Costs
Land $10,000
Building purchase 50,000
Renovations 150,000
Furniture 25,000
Equipment 35,000
$270,000
Financing Package
Bank of Nova Scotia term loan $47,000
Shareholders' advances 54,000
Contribution under the Fisheries
Alternative Program 169,000
$270,000
Source: Company records

Exhibit 2

Salmon River Inn Limited
Balance Sheet
As of August 31, 1992

ASSETS
Fixed, at net book value
Land $10,000
Building 264,310
Furniture and equipment 94,462
368,772
Less: Contributions from ACOA 169,000
$199,772
LIABILITIES
Current
Bank overdraft (secured by personal
guarantees of owners) $ 9,957
Accounts payable 54,327
Current portion of long-term debt 9,500
73,784
Long-term debt
Bank of Nova Scotia, repayable over
10 years at prime plus 2% 84,985
Shareholders' advances, interest-free
with no repayment terms 99,998
258,767
SHAREHOLDERS' EQUITY
Share capital
Authorised: 1000 no par value shares
Issued: 100 shares 100
Retained earnings (deficit) (59,095)
(58,995)
$199,772
Source: Company records

Exhibit 3

Salmon River Inn Limited
Statement Of Loss and Deficit
For the Period Ended August 31, 1992

Revenues
Restaurant $ 34,647
Room rentals 9,695
44,342
Expenses
Food and supply purchases 25,610
Wages and benefits 33,315
Advertising and promotion 3,367
Utilities 7,712
Insurance 3,328
Interest and bank charges 7,112
Office supplies 1,246
Vehicle operating 997
Accounting 1,575
Other operating expenses 4,488
Municipal taxes and permits 1,440
Depreciation
- building 7,056
- furniture and equipment 6,191
103,437
Net loss for period and ending deficit $ 59,095
Note: Depreciation is calculated on a declining balance basis, net of ACOA contributions. Buildings are depreciated at 5%, equipment at 20%.

Source: Company records