Macdonald Flooring Company

MACDONALD FLOORING COMPANY

On July 10, 1989 George London, commercial lending officer of Maritime Bank, Sydney, Nova Scotia sat down and gathered his notes on the meeting he had just attended with Cathy Palmer, the Bank's lawyer, and John MacDonald, owner of MacDonald Flooring Company. George had called the meeting to advise John that the Bank was concerned about the deteriorating financial state of MacDonald Flooring.

As the Company's banker, George London had to assess the Company's prospects and determine whether and how it could be turned around, or if the Bank should call its loans and place MacDonald Flooring into receivership.

After John had left, Cathy stayed to discuss the Bank's position. She advised that if bankruptcy and receivership proceedings were to be initiated, the process should start as soon as possible. George noted her advice, and assured her that he would call her in a few days.

Company History

MacDonald Flooring Company was established in 1981 by John MacDonald in Sydney, Nova Scotia (Cape Breton). John was an experienced flooring supervisor. The business installed flooring, and expanded rapidly during the early 1980s. In 1984 the business was relocated to a larger warehouse in the same area. Sales continued to grow rapidly, from $863,000 in 1985 to $1.7 million in 1987 (see Exhibits 1 and 2). Fixed assets were increased, and a retail outlet was opened in 1987. The retail outlet was a ceramic tile and bath boutique for which new premises were leased.

Despite the fast sales growth, George London was concerned by the Company's rapid changes, its frequent overextension on its line of credit and an unfulfilled debenture covenant requiring audited quarterly financial statements. The overextensions had so concerned him that he had placed the Company on the Bank's watch list until February 1988; at that time the account had seemed to

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This case was prepared by Gordon S. Roberts, Bank of Montreal Professor of Finance and Linda P. Hendry, Finance Lecturer at Dalhousie University for the Atlantic Entrepreneurial Institute as a basis for classroom discussion, and is not meant to illustrate either effective or ineffective management.

Copyright 1991, the Atlantic Entrepreneurial Institute. Reproduction of this case is allowed without permission for educational purposes, but all such reproduction must acknowledge the copyright. This permission does not include publication. be stabilizing. However, financial statements continued to be unaudited, provided only semi- annually, and reached the Bank several months after the statement date.

In 1988 the Company suffered its first loss, one of $7,000. A significant loss of $97,000 resulted during the first six months of 1989 (up to the end of March). Current Business Activities

The Company's market was mainly in industrial Cape Breton. A close look at the receivables listings revealed generally good quality accounts. Several large accounts were with reputable firms and government organizations. Organizations with this type of account normally took advantage of a strong market position to extend payables beyond due dates. As a result, the Company's average collection period was long -- 87 days in 1986, 89 days in 1987 and 62 days in 1988. The credit terms given were net 30 days with 60 to 90 days on large accounts. As of May 1989 the ages of accounts receivables were as follows:

CURRENT 30-59 DAYS 60-89 DAYS 90 DAYS + WITHIN TERMS PAST DUE PAST DUE PAST DUE 67% 19% 2% 12%

The Principal in the Company

Although John MacDonald was a good estimator and foreman, George London felt he lacked an adequate financial background and knowledge of the controls and systems needed to run his expanded business. John's main function was to cost jobs and supervise their completion; he placed total reliance on his staff and the Company's chartered accounting firm to carry out the tasks needed to control operations. John did not even verify that these tasks were carried out properly, or at all. It was not until an accountant was hired in mid-1988 that the Company had the internal means to properly account for each operation and to obtain financial information to make decisions.

During 1988 there was a $42,000 increase in the amount John MacDonald owed to the current asset account "Due from shareholder." This increase was due mainly to a separation settlement with his common-law wife and former shareholder. To assist in reducing the shareholder receivable, John transferred personal property (land and a building) to the Company. The building was rented to an unrelated company at $1,800 per month with a three year lease.

2 Company Facilities

MacDonald Flooring Company paid $1,000 per month rent for the warehouse that housed its flooring installation operation. Its new premises, for the ceramic tile and bath boutique, included a large retail showroom, warehouse, and office space. The lease agreement was for $2,667 per month and expired in 1991 with an option to renew for an additional five years at renegotiated rates. George London viewed the facilities in May 1989, and he considered them adequate for the operations of the Company.

The Banker's Risk Assessment of the Company in April 1989

The Company financial statements were unaudited and semi-annual, which violated debenture covenants requiring audited quarterly financial statements. Another covenant required capital expenditures to be less than $25,000; this amount was exceeded without prior approval from the Bank when the Company opened the ceramic tile and bath boutique. Considering the Company's apparent lack of internal financial controls and problematic information systems, George identified financial reporting as a significant risk for 1987 (and prior years).

Partly in response to George's concerns, in 1988 the Company hired Eva Levesque a CA student, to provide day-to-day accounting for operations. She discovered that the Company was not remitting sales tax on purchases. Major suppliers were not adding sales tax to delivery invoices, leaving the responsibility to MacDonald Flooring, as purchaser, to remit the tax. For example, on a $1,000 invoice, sales tax of $100 (10%) should have been remitted directly to the provincial government. These taxes were neither being remitted, nor recorded by the accounting procedures. When Eva brought this oversight to John's attention, he called in the Provincial Tax Commission, who discovered unrecorded sales tax amounting to at least $175,000.

Several other factors contributed to the 1988 loss. Sales declined significantly, and would have been even lower were it not for the ceramic tile and bath boutique. The only reason John could give for the decline was the delay of several large projects until late 1988. Operating expenses were up by $129,000 from 1987. These expenses included costs associated with the property previously owned by John and transferred in 1988 to the Company. Inventory, fixed costs and capital expenditures required for the ceramic tile and bath boutique also contributed to increased 1988 operating costs.

3 The Sales Tax Liability

The Provincial Tax Commission did a four year audit which revealed $140,000 in unremitted sales tax for the years 1985 to 1989. The Company was also assessed an interest penalty of $35,000. The full amount of the sales tax owing was to be paid by December 31, 1989. The interest portion would be forgiven if full payment was made by the end of the year; this arrangement would give MacDonald Flooring about six months to find the money.

Eva restated the Financial Statements for 1987 and 1988 and the remaining amount, $38,544 for the years 1985 and 1986, was charged as a prior period adjustment to retained earnings on the 1988 statement. Of the total adjustments made, $35,276 was applicable to 1987, $86,304 to 1988 and $14,902 to 1989; according to Eva, these amounts should have been charged to income for the respective years. Other effects of the restatement were to increase income tax receivable by $8,819 in 1987 and $6,835 in 1988; and to increase the accrued liabilities by the lost retained earnings (see Exhibits 3 and 4). She sent the revised statements to the Bank with her explanation and a copy of the Provincial Tax Commission report.

Because the adjustments were made directly to revenue and net profit, George found it difficult to determine if gross profit was accurate. Gross profit, although improved in 1988, was well below 1985 and 1986 levels. George felt that the sales tax should be included in material costs and gross profit adjusted accordingly.

Banker's Investigation of Company Receivables and Inventory

John assured George that there were more than adequate assets in the form of receivables and inventory (including work in progress and contracts in hand, if completed) to liquidate the debt owed to the Bank. To validate this important statement, George examined the contracts on hand, and evaluated each one based on discussions with John or other employees of MacDonald Flooring. A detailed analysis of three typical contracts appears in Exhibit 5.

Inventory consisted of ceramic tiles, marble products, retail and commercial vinyls and carpeting. The inventory was of good quality, with limited evidence of obsolescence. Approximately 25-30 percent of inventory held at any time was related to specific contracts; the balance was primarily made up of retail products, with a small amount held for commercial repair jobs.

Since only the retail inventory would have been available to cover the bank debt -- commercial inventory would have been used in contract completion -- George was concerned that its resale value would be low because it was in small lots. When he checked the file of another retail ceramic tile company that had gone into receivership the year before, George found that the receivers had contacted two competitors. After receiving inventory listings and tours of the premises, the competitors had offered around $10,000 for inventory costing $30,000. Not satisfied with realizing

4 30 cents on the dollar, the receiver had next invited proposals from liquidators to auction the inventory to the public. A representative response is reproduced in part in Exhibit 6.

Economic Forecast

George consulted the economic forecasts regularly prepared by the Bank's Economics Department. George began with a survey of leading economic indicators which showed that the Canadian economy was beginning to slow down. The Bank's economists believed that interest rates would remain high as long as Governor Crow of the Bank of Canada remained concerned about inflationary pressures; these did not seem to be easing.

The economists believed that as a result of Canada's high interest rates and the unusually wide spread between US and Canadian interest rates, the Canadian dollar was overvalued with respect to the US dollar. The Canadian dollar was expected to fall by year end to around 81 cents US from its current value of 84 cents.

An economic slowdown was forecast in the Atlantic region as well. Traditionally, Cape Breton was economically depressed by comparison with Halifax and other parts of the province. By creating additional record-keeping costs, the Goods and Services Tax (GST) to take effect in January 1991, was expected to have a negative impact on the construction industry. MacDonald Flooring expected a greater impact on its ceramic tile and bath boutique than on its flooring installation business because of the greater number of transactions in the retail operation.

Industry Scan

Although there was no real competition in the immediate area, there was stiff competition from Halifax. As a Cape Breton company, MacDonald Flooring had an advantage in bidding on government contracts in Cape Breton. However, costs and quality control had to be maintained carefully on commercial contracts, because reputation was important to specification writers who influenced selection of contractors on these jobs. Specification writers for commercial and government contracts detailed materials requirements such as ability to meet standards, ease of application, and pricing (including freight costs). They also often recommended specific contractors whose work was known to meet their needs.

The Alternatives for Management and the Bank

Receivership

At the meeting with George London and Cathy Palmer, John MacDonald was advised that the Bank was unhappy with the Company's financial situation, particularly in view of the sales tax liability.

5 One option was for the Bank to issue letters of demand for the two loans outstanding in the Company's name (one operating and one term) as well as a letter requiring John to cover his $150,000 personal guarantee in favour of the Company. John did not appear to be overly surprised, and said that he was not able to generate enough money to pay the Bank out immediately.

The operating demand loan was a revolving line of credit up to $275,000 at prime plus 3.5%. As of March 31 the loan was over overextended to $350,000. The term loan, also demand but non- revolving, was granted in 1988 for $50,000 to replace working capital used for leasehold improvements, equipment, start-up costs of the retail outlet and cost of its inventory. This loan was to be repaid over 36 months at $1,400 per month plus interest at prime plus 2.75%. The outstanding amount at March 31 was $40,200. The margin formula was 75% of the account manager's estimation of assigned receivables worth after deducting accounts aged 60 days or more, accounts in dispute and 50% of inventory at cost. The maximum available under inventory was $125,000, with inventory to be verified quarterly by in-house financial statements. The margin formula was applied to both loans.

The Bank's security on these loans was a general assignment of accounts receivable and a section 178 security on inventory as well as the $150,000 limited personal guarantee.

Injection of New Capital

John said that a possibility existed for him to have another investor put cash into the Company. He asked how much cash the Bank thought he should have in order for the Bank to continue its loans to his company, George said the Bank was not prepared to continue, but that a cash injection of at least $150,000 would be needed to offset the provincial sales tax liability. John left the meeting indicating that he was going to discuss the situation with his lawyer.

6 Implications for the Bank

Cathy told George that bankruptcy would have to be initiated in order for the Bank's security position to take priority over the sales tax liability to the Province. Under Nova Scotia law, this meant that, should bankruptcy be initiated, a receiver and a separate trustee in bankruptcy would have to be appointed. Their fees would reduce the amount the Bank would receive.

George recalled only too well how time consuming receivership and liquidation could be. There was always the possibility that either the customer or the Bank would initiate legal action requiring long and costly conferences with the Bank's lawyers, and days in court. Also, receivers would need to consult with the Bank on liquidation negotiations which are often quite complicated.

Placing a Company into receivership could also create negative public relations for the Bank. Last year, the decision to put a receiver into another Cape Breton company had triggered a phone call from a Maritime Bank director who lived in Cape Breton. The director had received a letter from his riding MP stating that "in his view the Bank had moved precipitously against the Company." The MP had asked the Bank director to take corrective action.

Implications for the Company Principal

George knew that John MacDonald would be under severe strain with either alternative. Should his Company be forced into receivership, John would also be forced into personal bankruptcy. If he found another investor to inject cash, the investor would want some responsibility for Company operations; John would thus lose some of the control he had enjoyed to date. Should the Company continue, the Bank would also be likely to exert considerable control over operations.

George realized that he had to quickly decide what to do. He knew that Cathy was right; if bankruptcy and receivership proceedings were to be initiated, the process had to be started as soon as possible.

7 Exhibit 1 Macdonald Flooring Company Unaudited Balance Sheet ($ 000s) Year Ended September 30

1 Year ended March 31.

8 Source: Bank Files and Company Records

9 Exhibit 2 Macdonald Flooring Company Unaudited Income Statement ($ 000s) Year Ended September 30

1 Year ended March 31. 2 Selling, General and Administrative expense. 3 Recovered.

Source: Bank Files and Company Records

10 Exhibit 3 Macdonald Flooring Company Restated Balance Sheet ($ 000s) Year Ended September 30

11 1 Year ended March 31. 2 Figures as restated in the 1988 F/S and March 31, 1989 interim F/S.

Source: Bank files and company records.

12 Exhibit 4 Macdonald Flooring Company Restated Income Statement ($ 000s) Year Ended September 30

1 Year ended March 31. 2 Figures as restated in the 1988 F/S and March 31, 1989 interim F/S. 3 Selling, General and Administrative expense. 4 Recovered.

Source: Bank files and company records.

13 Exhibit 5 Detailed Analysis Of Selected Accounts Receivable

Source: Company files and interviews.

14 Exhibit 6 Liquidation Sale (from comparable file)

XXXXXX XXXXXX XXXXXX XXX XX 19XX XXXXXX XXXXXX XXXXXX

Dear Mr London:

RE: LIQUIDATION SALE

Our firm has discussed the possiblity of a liquidation sale, on your behalf, of the above estate, and have decided it is not a contract we wish to enter into.

We have met with people in the trade and the consensus is the quantities are too small, for example, 3 boxes of one type of product or 10 boxes of another, generally not enough to warrant purchase and storage.

To conduct a liquidation sale to the general public would be suicide with every little old lady coming in with a sketch of her kitchen or bath.

The writer feels, if you have an offer in hand for somewhere around $120,000 to $150,000 [20-25% of cost], I strongly recommend you accept.

Thank you for contacting us at this time and looking forward to being of service to you in the future.

Regards,

XXXXXXXXXX

Source: Bank File