Case Analysis: Financial Condition of AlberCan Drilling Supply Company

Case Analysis:

In the spring of 2008, Ian MacDonald was concerned about the financial condition of the AlberCan Drilling Supply Company.  In spite of steadily increasing sales and earnings during the past few years, the firm was experiencing a shortage of cash.  As the firm's president, Mr. MacDonald decided to ask the First Mountain Bank to increase the amount of his loan with them.  Prior to acting on Mr. MacDonald’s request, the bank began a routine credit investigation of the company.
The Company
The bank's investigator found that Mr. MacDonald founded the ADS Company in 1993 in partnership with a friend, Mr. Patrick Kelly.  The two men had grown up near areas of oil drilling activity in Alberta, Canada and decided to operate a business related to that industry.
However, personal reasons caused Mr. Kelly to sell his interest in the company to Mr. MacDonald in 2004.  Mr. Kelly accepted a $130,000 note in payment.  Mr. MacDonald paid off the note one year later from proceeds of a $108,000 mortgage loan from the First Mountain Bank and from his personal assets.  The mortgage loan required annual payments of $8,000 for 10 years, a "balloon" payment of $28,000 at the end of the ten years, plus interest at a 10% rate.
ADS was located in a small city in Alberta around which there was significant drilling activity.  The firm owned several acres of land with two storage buildings, several trucks for delivery service, and a small office.  The company's sole business was the sale of drill pipe and collars to drilling contractors in the local area.  Most customers operated within a 250 kilometre radius of the firm's location.
About two-thirds of ADS’s sales were to small drilling contractors who purchased almost their entire drill pipe and drill collar needs from suppliers such as ADS on an as-needed basis.  The remainder of ADS’s sales were made to much larger companies who normally bought large quantities of drill pipes and drill collars directly from the manufacturers.  These firms bought from ADS and other small suppliers when their stocks unexpectedly ran out or an unusual size or grade of pipe or collar was required.
ADS’s inventory included drill pipe and drill collars.  Drill pipe was used to transmit turning motion at the surface of a well to the drill bit at the bottom.  The pipe normally was manufactured in lengths of about 10 meters.  It was usually required by customers in sizes of 10, 12, or 14 centimetres in diameter.  ADS stocked large quantities of these sizes in a number of grades.  It also stocked a limited quantity of the less common sizes and grades of pipe.
A drill collar was a heavy walled pipe that connected the drill pipe and the bit.  It was used to supply vertical penetration and weight to the bit.  ADS also stocked these in a variety of sizes and grades.
The value of ADS’s inventory of both of these products rose steadily throughout the 2000s in response to the increase in sales realized by the firm.  See Exhibit 1 for the firm's financial statements for 2005-2008.
ADS advertised occasionally in various oil industry publications, but relied primarily on its reputation for good service and on word-of-mouth advertising to generate sales.  The large majority of orders were received over the telephone, but occasionally a customer appeared personally at the firm's location with a rush order.  ADS's ability to respond quickly to these needs was a prime reason for its success and good reputation among its customers.
Ian MacDonald personally managed all activities in the firm.  He was a young and energetic man, and he maintained a good relationship with his customers and the manufacturers of his inventory.  He employed twelve yardmen who handled and delivered the pipe and one assistant who helped with office duties.
AlberCan Drilling's Financial Condition
The investigator observed that sales and earnings of the firm had risen steadily during the late 1990s, with revenues growing from $2,286,000 in 2005 to $3,512,000 in 2007 (see the Operating Statement on Exhibit 2).  Mr. MacDonald expressed optimism that revenues would increase to $4,400,000 in 2008 with a proportional rise in earnings, and rise again in 2009 with an additional increase of 25% of 2008 sales.  The increased level of drilling activity in the area around ADS was expected to provide this increased demand for the firm's inventory.  The investigator also learned from Mr. MacDonald that he expected most of his customers to continue utilizing the normal payment term of 30 days with a few delaying payments for up to 90 days.
According to the firm's financial statements, ADS's financial structure depended increasingly on bank loans and trade credit  during the latter 2000s (see the comparative Balance Sheets on Exhibit 1).  The amount of bank borrowings had increased to a point where the firm's existing credit limit of $300,000 could easily become a problem during the near term future.  Mr. MacDonald fully expected that increasing levels of inventory would be necessary to support the sales trends he expected to develop during the remainder of the year.  He also realized he would need to continue drawing funds from the business to cover his personal expenses, as well as to pay income tax.  (See the reconciliation of earnings and owners’ equity for each financial period at the end of the Operating Statement in Exhibit 2.)
The Loan
After receiving the investigator's report on ADS, Mr. Louis-Jacques Rocquet, ADS’s loan officer at First Mountain Bank, reviewed ADS's history of payment on the existing loan.  In early 1995, the firm had paid down the loan balance to zero.  Again in February of 2006, by increasing other liabilities and delaying personal drawings, Mr. MacDonald had been able to reduce the outstanding loan balance to zero.  Since then, the loan had not been paid down to zero, although Mr. MacDonald was optimistic that the firm would continue to perform successfully.  Throughout this period, ADS continued to pay down, on schedule, the mortgage loan stemming from the buyout of Mr. Kelly's interest in the business.
After much consideration, Mr. Rocquet decided to extend an additional $200,000 credit to ADS but decided to implement a fixed schedule of repayment before additional borrowing could be extended.  He called Mr. MacDonald in and explained the terms of the loan increase:
•    $200,000 would be loaned at an interest rate 6% above prime (this would equal a 12% rate under conditions existing in the Spring of 2008);
•    20% of the principal balance would be due on October 1 of each year; the interest payments would be semi-annual, due on January 1 and July 1;
•    ADS could take on no additional short-term debt from any other financial institution until this loan was paid off;
•    The bank would have the right of approval on fixed asset purchases over $200,000;
•    The bank could limit Mr. MacDonald’s personal withdrawals of funds from the business to $200,000 in any single year; and
•    ADS would have to maintain a specific level of net working capital.
Mr. MacDonald was disappointed in the terms of the loan.  Aside from the high interest rate, the provisions of the loan seemed restrictive and might not allow the company to continue growing at the pace he desired.
The Forecasts
Upon returning to AlberCan from the bank, Ian MacDonald went straight to his office where he did two things.  First, he opened this file drawer and got out his sales projections for the rest of 2008 and for 2009.  Then he called his accountant Andy Maxwell and asked him to come down to his office.
When Andy got there, Ian told him of his meeting at the bank and Mr. Roquet’s granting him an in increase in his line of credit of $200,000.  When Andy said, “That’s great, Ian!”  Ian replied:
I guess so, but I’m concerned about all those restrictions and covenants and what they will do to our planned rate of growth.  Our expectations are for sales of $4,400,000 in 2008 and an additional 25% increase to $5,500,000 in 2009.  While I may need this loan to make these projections, I wonder if the bank’s loan restrictions will keep me from meeting my goals.  The market is there, our facilities can handle the volume, but I am concerned.
Andy, could you take a look at our numbers, factor in these restrictions and the growth rate I showed you, and give me a set of financial projections for ’08 and’09.
Andy thought for a moment and than said:
Okay, Ian, but what assumptions should I make about operations, your drawing account, receivables, inventory, operating expenses, and the like?  And what about accounts payable?  We have to get them down to 45 days or less or our suppliers will shut us down.
Ian replied:
We’ve been doing pretty well these past two to three years.  Complete the forecasts assuming that things will remain basically the same.  Okay?
Andy thought over the last point and said:
Okay, I’ll use our sales projections and keep all of the operating and financial ratios basically the same as they have been with three exceptions: accounts payable have to be reduced to 45 days, accrued expenses will stay at $80,000 and interest expense will go up.  Also, I’ll pull interest expense out of our operating expenses and make it a line item. That will help us to see what the economy, on the one hand, and the banks, on the other, will do to us.
“Great,” said Ian, “Get back to me tomorrow.  And remember, the money I withdraw from the company each month has to pay my living expenses and my 40% personal tax on the company profits.”

Assignment:
1.    Why does Mr. MacDonald have to borrow to support his profitable business?  What is the source of his problem?  What alternative solutions does he have?
2.    Based upon what Ian and Andy agreed upon, prepare projected profit and loss and balance sheets for 2008 and 2009 in order to determine cash requirements.  (Note that “notes payable-rrade” means that his suppliers are both charging interest and are no longer willing to support account payable balances over 45 days.)
Hint:  You might wish to split the bank loan into two accounts, the old loan of up to $300,000 and the new loan of up to $200,000, in order to show the additional borrowing more sharply.
3.    Given the results of your calculations:
a.    As the banker, would you grant MacDonald the additional $200,000 credit under the same or similar conditions as proposed?
b.      As MacDonald, would you (should you) take out the loan?

Company History

Businesses find themselves in need of extra capital even if they are making profits. There are two major ways through which these businesses can raise additional capital for their businesses. These methods include equity and debt capital. Equity capital is where a company divides its ownership into small units called shares (Ahuja, Narender). These shares are sold to various people at a predetermined fixed share price in order to raise capital for the business. The shareholders own a percentage of the company and they have various rights as outlined in the companies act. They benefit from the companies` dividends when a company makes profits. Another method of raising capital for businesses is the debt capital financing. This is where a company or organization borrows funds from a financial institution or an individual and repays it later at an interest. Debt financing is used by most companies as most of them do not want to lose control of their ventures by sharing ownership (Mullins, John).There are various advantages and disadvantages of using either of the methods. This paper analyzes the reasons why MacDonald needs to borrow to support his growing business. The problem that MacDonald is facing in this case is mainly due to overstocking hence leading to cash flow problems for the company. MacDonald has a variety of other options that he can exploit in order to raise capital. One of them as stated above is seeking to sell shares or by selling debentures (Bilgin, Mehmet , Hakan Danis, Ender Demir, and Ugur Can).Also contained in this paper are projected financial reports for Albercan drilling and a detailed analysis of the same.

The major reason why McDonald needs to borrow in order to finance Albercan drilling despite the company making good profits is so that the company can solve its cash flow problems. The company has fallen into cash flow problems because of its decision to increase its inventory by a very large margin. This decision has resulted in the companies` cash outflows exceeding cash inflows (Kim, Joon Ho). These cash flow problems for the company were brought about by the decision of McDonald to buy the share ownership of Mr.Kelly who decided to exit the business. Due to this reason, it is vital that ADS seeks additional investment so as to be able to run the operations of the company smoothly.

Another reason why ADC needs to borrow despite making reasonable profits is that the company has a growth plan and vision. In order to achieve this vision, it is important that the company borrows money in order to facilitate its growth and expansion plans. The company has been growing at a consistent rate over the previous 10 years and the profits have been increasing persistently. This growth however is threatened by the reduction in cash from the business as a result of acquiring the stake belonging to Mr Kelly. If the company’s growth projections are met, it will be easy for the company to repay the loans and consequently increase its profits. The investment from the loan from the bank will generate enough cash to cover the cost of borrowing. The company can increase its product portfolio and increase its stock to more diverse and modern drilling equipment.