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Revised 01/02/01

AlberCan Drilling Supply Company (A)


In the spring of 1998, 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. MacDonalds 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 1983 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 1994. 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 ADSs 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 ADSs 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. ADSs 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.

_________________________ This case was prepared by Neil C. Churchill as an aid in understanding the theory and practice of management rather than to illustrate either the effective or ineffective handling of a management situation. Copyright 1999 by Neil C. Churchill

ADS (A)

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 ADSs inventory of both of these products rose steadily throughout the 1990s in response to the increase in sales realized by the firm. See Exhibit 1 for the firm's financial statements for 1995-1998. 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 1990's, with revenues growing from $2,286,000 in 1995 to $3,512,000 in 1997 (see the Operating Statement on Exhibit 2). Mr. MacDonald expressed optimism that revenues would increase to $4,400,000 in 1998, with a proportional rise in earnings, and up again in 1999 with an additional increase of 25% of 1998 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 terms 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 1 during the latter 1990's (see the comparative Balance Sheets on Exhbit 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.

Terms in the industry were 2% in 10 days net 30. Suppliers would never let a customer go beyond 60 days, would start threatening at 45 to 60 days, and were not gonna like you beyond 35-45 days. In this situation, they would also turn these delinquent accounts payable into interest-bearing trade notes payable. A situation that just proceeded putting the customer on COD (collect on delivery).
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ADS (A)

The Loan
After receiving the investigator's report on ADS, Mr. Louis-Jacques Rocquet, ADSs 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 1996, by increasing other liabilities and delaying personal drawings, Mr. MacDonald had been able to reduce the outstanding loan balance to zero. Since that time, the loan had not been paid down to zero although Mr. MacDonald had expressed optimism to the bank's investigator 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 with 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 5% above prime (this would equal a 12% rate under conditions existing in the Spring of 1998); 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. MacDonalds 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 1998 and for 1999. 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. Roquets granting him an in increase in his line of credit of $200,000. When Andy said, Thats great Ian! Ian replied: I guess so but Im 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 1998 and an additional 25% increase to $5,500,000 in 1999. While I may need this loan to make these projections, I wonder if Banks loan restrictions will keep me from making my goals. The market is there, our facilities can handle the volume, but I am concerned.

ADS (A)

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 98 and99. Andy thought for a moment and than said: OK 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: Weve been doing pretty well these past two to three years. Do the forecasts with things remaining basically the same. OK? Andy thought over the last point and said: OK, Ill use our sales projections and keep all the operating and financial ratios basically the same as they have been with three exceptions: accounts payable have to be reduced, the way you suggested to 45 days; accrued expenses will stay at $80,000; and interest expense will go up. Also, Ill pull interest expense out of Operating Expenses and make it a line item and that will help us 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 1998 and 1999 in order to determine cash requirements. (Note, that Notes Payable-Trade 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?

ADS (A)

Exhibit 1

AlberCan Drilling Supply Company Comparative Balance Sheets


( figures in thousands of Candian dollars)

December 31 1995 ASSETS Cash Accounts receivable (net) Inventory Total current assets Plant and equiment (net) TOTAL ASSETS 198 242 202 642 162 804 88 354 474 916 184 1,100 36 508 662 1,206 200 1,406 1996 1997

March 31 1998 34 566 774 1,374 218 1,592

EQUITIES Notes payable - Bank Notes payable - Trade Accounts payable Accrued expenses LT Debt -- Current Total current liabilities LT Debt -- Non-current Total liabilities Owners' equitiy TOTAL EQUITIES 164 168 8 340 100 440 364 804 232 238 80 8 558 92 650 450 1,100 322 384 80 8 794 84 878 528 1,406 294 222 310 80 8 914 76 990 602 1,592

ADS (A)

Exhibit 2

AlberCan Drilling Supply Company Operating Statements


( figures in thousands of Candian dollars)

For the Year Ended December 31 1995 Net sales / turnover Cost of goods sold Beginning inventory Purchases Merchandise available for sale Less ending inventory Cost of goods sold Gross profit Operating expenses * Net Profit Before Taxes ** Drawings by the proprietor Earnings Retained in the Business Owners Equity at beginning of period Owners Equity at End of Period 158 1,722 1,880 (202) 1,678 608 506 102 (124) (22) 386 364 202 2,286 2,488 (474) 2,014 888 652 236 (150) 86 364 450 474 2,660 3,134 (662) 2,472 1,040 748 292 (214) 78 450 528 2,286 1996 2,902 1997 3,512

Qtr Ended March 31 1998 992 662 764 1,426 (774) 652 340 224 116 (42) 74 528 602

* No allowance for owner's salary or for income taxes is included in any of these items. firm is a sole proprietorship (not a limited liability company) for legal and tax purposes. ** In the first quarter of 1997: Net sales (turnover) Net profit before taxes 828 72

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