The telephone rang on 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 the 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. "The bank returned his payroll cheque because of insufficient funds." Fred was shocked. As a busy consulting engineer living 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, Newfoundland. 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 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.

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 Jones, a successful consulting engineer who lived in St. John's. 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 a survey of the property to determine the necessary improvements and modifications. The results, however, were disappointing and indicated that extensive work was necessary on the building, both externally and internally. None the less, the decision was made to proceed and the project was partially financed through a bank term loan.

By late October 1991, the company was ready to start the renovations. Almost immediately the project ran into problems. The local carpenters hired 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 by the time the renovations were complete, Fred and Eileen together had contributed $100,000 to the project.

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. "The first thing we must do is 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 Statement of Loss, which is attached as Exhibit 1.

Following some discussion on the operating results in general, Fred and Eileen prepared the following additional information:

1. All improvements and renovations were now complete.

2. At August 31, 1992, the Balance Sheet indicated the following:

• Accounts Payable amounted to $54,327 and, among other things, included:
• $28,625 - Due to the contractor;
• $5,137 -Unremitted payroll deductions;
• $3,240 - Unpaid Provincial sales tax.
• Bank overdraft was approximately $10,000.
• Term loan balance of $94,485.

Therefore, approximately $70,000 was needed to pay these debts and simply maintain operations.

3. After the Inn had opened for business, Eileen felt that she did not have the time to supervise all of the day-to-day operations. She hired a lady who had several years of experience in the hospitality industry and paid her a salary of $7,000.

4. The revenues for both room rentals and restaurant sales were both 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, giving an occupancy rate of 30%. He felt this was rather low. Eileen was also very disappointed by the restaurant sales because she felt a margin of 60% should be earned on these sales. About $5,000 of the amount disclosed as "purchases of food and supplies" related to non-food items, so it appeared they had earned only a 40% margin.

5. The next item on the Statement of Loss, Wages and benefits, was 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.

6. Most of the other items on the list reflected normal operating costs for a year.

The Decision Options

Fred summarized the options open to the owners as follows:

1. Do nothing. Both Fred and Eileen felt that because of the unpaid accounts and bank overdraft this would result in the bank placing the company into receivership. All of the money they had already invested would then be lost.
   
2. Look for another investor to participate with them or to purchase the company outright.
   
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 (92 days) 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. Food purchases cost approximately 40% of these sales; supplies would remain at the same amount as previously.
   
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 two 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 minimum wage ($4.75/hour). Also, all employees would receive benefits at approximately 15% of their salary.
   
4. Fred and Eileen have determined that interest and bank charges will amount to approximately $9,000 for the next year.

Summary

Both Fred and Eileen felt that the decision as to the best option was a critical one, and the importance of this decision 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 obtain my share from my existing engineering business, but it will certainly reduce my flexibility in carrying out certain projects which I had planned for next year."

Questions

Some specific questions that might be assigned include:

1. Identify some problems which led to the company's present crisis.
   
2. Prepare a financial forecast for the next operating year, using the same format as in Exhibit 1.
   
3. Evaluate each of the options presented in the case with regard to the company's future.
   
4. Has the company adequately promoted the Inn? What recommendations do you have for increasing sales volume?

Exhibit 1

Salmon River Inn Limited
Statement of Loss
For the Period Ended August 31, 1992