Industrial sickness

Definition of sick industrial company:

The definition given under the provisions of the companys act 1956 and the definition given by RBI are as follows.

The companies Act, 1956

The companies act 1956 defined Sick industrial company and net worth as follows Section 2 (46AA) Sick industrial company means and industrial company which has: (A) The accumulated losses in any financial year equal to 50% or more of its average net worth during 4 years immediately preceding such financial year ,or (B) Failed to repay its debts with in any three consecutive quarters on demand made in writing for its repayment by creditors or creditors of such company. Section 2 (29A) Net worth means the sum total of the paid up capital and free reserves after deducting the provisions or expenses as may be prescribe. Explanation:- For the purpose of this clause free reserves means all reserves created out of the profit and share premium account but does not include reserves created out of revaluation of assets, write back of depreciation provision and amalgamation.

RBIs Definition
Sick industrial company- It is an industrial company (being a company registered for not less than 5 years) which has at the end of any financial year accumulated losses equal to or exceeding its entire net worth.

Potentially sick industrial company- If the accumulated losses of an industrial company as at the end of any financial year resulted in the erosion of 50% or more of its peak net worth during the immediately preceding four financial years. Weak unit- an industrial unit is define as weak if its accumulated losses at the end of any financial year resulted in the erosion of 50 % or more of its peak net worth in the immediately preceding 4 accounting years. Weak units has define above will, not only include those which fall under SICA (Industrial companies) but also other categories such as partnership firms, proprietary concerns etc.

Causes of industrial sickness

The following causes will generally lead to industrial sickness:

Internal causes: the following internal causes may lead to sickness of an industrial
unit. PLANNING AND IMPLEMENTATION STAGE Technical feasibility: (a) Inadequate technical know-how (b) Locational disadvantage (c) Out dated production process Economic viability: (a) High cost of inputs (b) Breakeven point too high (c) Uneconomic size of projects (d) Underestimation of financial requirement (e) Unduly large investment in fixed assets (f) Overestimation of demand (g) Cost over runs resulting from delays in getting licenses/sanctions etc. (h) Inadequate mobilization of finance

COMMERCIAL PRODUCTION STAGE Production management: (a) Inappropriate product mix (b) Poor quality control (c) Poor capacity utilization (d) High cost of production (e) Poor inventory management (f) Inadequate maintenance and replacement (g) Lack of timely and adequate modernization (h) High wastage Financial management: (a) Poor resources management and financial planning (b) Faulty costing (c) Liberal dividend policy (d) General financial indiscipline and application of funds for unauthorized purposes (e) Deficiency of funds (f) Over trading (g) Unfavorable gearing or keeping adverse debt equity ratio. (h) Inadequate working capital (i) Absence of cost consciousness (j) Lack of effective collection machinery Labour management: (a) Excessively high wage structure (b) Inefficient handling of labour problems (c) Excessive manpower (d) Poor labour productivity (e) Poor labour relations (f) Lack of trained /skilled labour

Marketing management (a) Dependence on a single customer or a limited no. of customer (b) Dependence on a single customer or a limited no. of products (c) Poor sales realization (d) Defective pricing policy (e) Booking of large order at fix prices in inflationary market (f) Weak market organization (g) Lack of market feedback And market research (h) Lack of knowledge of marking techniques (i) Unscrupulous sales /purchase practices Administrative management (a) Over centralization (b) Lack of professionalism (c) Lack of feedback to management (d) Lack of proper management information systems (e) Lack of controls (f) Lack of timely diversification (g) Excessive expenditure of R&D (h) Dividend loyalties (i) Incompetent management (j) Dishonest management

External causes
The external factors that cause industrial sickness are as given below Infrastructure Bottlenecks (a) Non availability of irregular supply of critical raw materials or other inputs (b) Chronic power shortage (c) Transport bottlenecks

Financial bottlenecks (a) Non availability of adequate finance at right times Government controls (a) Govt. price controls (b) Fiscal duties (c) Abrupt changes in govt. policies effecting costs/prices/imports/exports/licensing (d) Procedural delays on the part of the financial/licensing /other controlling or regulating authorities Market constraints (a) Market saturation (b) Technological obsolescence (c) Recession-fall in domestic/export demand Extraneous factors (a) Natural calamities (b) Political situation (c) Sympathetic strikes (d) Multiplicity of labour unions (e) War

REASONS FOR BUSINESS FAILURE

At One Level, A Company Either Ceases To Trade Because The Bank Or Creditors Stop It Or Voluntarily Ceases To Trade And Calls In The Receivers Or The Administrators. In Either Case, Action Is Taken Because The Firm Is Unable To Pay Its Debts Or Likely To Be Unable To Pay In The Near Future. Why Do Firms Get Into This Situation? The Accounts Of The Company Do Not Cause It To Go Broke. Rather Accounting Information Reveals What Has Gone Wrong and There Two Levels Of Cause (1) The Accounting Manifestation (2) The Root Problem.

Accounting Manifestation Of Failure

1. Too much working capital 2. Insufficient working capital 3. Too high interest charges 4. Too much debt 5. Over & high dividends 6. No cash & very poor profit margins 7. Making a trading loss 8. No growth & marginal profitability 9. Selling parts of the firm at a loss

ROOT PROBLEMS FOR FAILURE

1. Not selling enough 2. Not selling at the right prices 3. Not modernizing 4. Not product development or research 5. Buying useless assets 6. Failure to control costs& working capital 7. Reckless borrowing 8. Having a cavalier dividend policy
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DETECTION OF INCIPIENT SICKNESS

The Sickness Creeps Into The Industrial Unit In A Gradual And Slow Moving Process. If The Incipient Sickness Is To Not Detected In Its Early Stages, It Becomes Chronic Over A Period Of Time And Ultimately Ends-Up With Closure Of The Unit, In Terms Of Insolvency. The Management Is Required Recognize The Symptoms Of Sickness And SetRight Immediately To Avoid The Embracing Financial Situation In The Future, As Well As , Save The Unit From Permanent Closure. If Necessary The Management Should Engage The Services Of Special For Proper Diagnosis Of The Situation. A Planned Course Of Action With Coordination And Cooperation Of Functions And The Can Enable To Counter The Sickness. If Necessary, The Real Situation Should Be Put Before The Stakeholders Like Shareholders, Banks, Financial Institution, Government, Creditors Etc. To Bring The Operation To Smooth-Flow.

The Incipient Sickness Can Be Identified And Detected With Help Of Analyzing The Following Situation: 1. The Company Is Continuously Making Cash Losses Year After And The Trend Is Likely To Continue In Future. 2. The Working Capital Is Totally Insufficient To Carry The Day To Day Operations. 3. The Company Is Working Under The Situation Of Negative Working Capital. 4. The Operation Cycle And Cash Conversion Cycle Is Too Big Long, Affecting The Profitability Of The Organization. 5. The Company Is Working At Very Low Levels Of Capacity Utilization. 6. The Operation Costs Are Very High Compared To The Sales Revenue Realization. 7. Too Much Reliance On Outside Fund Increases The Interest Burden, As Well As Financial Risk. 8. There Is Gradual Deterioration Of Debt-Equity Ratio Over A Period Of Time. 9. There Is Gradual Deterioration Of Net Worth And The Situation Is Likely To Continue In Future. 10. The Working Capital Is Diverted To Purchase Capital Assets. 11. The Company Caught In A Situation Of Over Drafting I.E. The Working Capital Is Insufficient To Meet The Requirement Of Increased Level Of Sales Activity.

12. The Current Ratio, Quick Ratio, And Absolute Liquid Gives An Indication Of Technical Solvency Over A Period Of Time 13. The Managerial Incompetency Is Unable To Counter The Competitive Forces And Their Strategies. 14. Excess Capacity Created Leads Leads To Increase In Costs And Reduction In Profits In View Of the Grave Consequences Of Industrial Sickness, An Early Planned Programme Is Required To Remove The Incipient Sickness

Prediction of sickness Univariate models:

Beaver(1966) who tested groups of ratios covering cash flow, net income, gearing, liquidity and turnover. His research indicated that cashflow to total debt was the best predictor. In a later study beaver carried out a more detailed analysis of the liquidity ratio and their potential as predictors of business failure. on the basis of his study, he made the following generalizations about failing firms: 1.They generate less sales growth is less than that of non-failed firms. 2.They have less current assets but more current debt. 3.They have less inventory than non-failed firms. His data showed that the net working capital and quick asset ratios predicted better than the current asset ratio the cash ratio predicted best of all. Fitz patrik (1974) examined companies that failed in the 1920s and found the best ratio to be net profit to net worth Smith(1974) came up with working capital to total assets as the best indicator of failure. Merwine(19740) also found smiths ratio to be the best.

Multiple Discrimination Analysis

The computation and analysis of certain ratios on the information taken from financial statements allow the analysis to predict sickness or business failure. But tha ratios are considered independent of each other, will not permi to express the whole situation in a single measure. Therefore, it would be more useful if the important ratios are combined together to measure the probability of sickness or insolvency. To overcome this difficulty multiple discriminate analysis is used. Edward j. Altman (1968) developed z score model in order to detect the financial health of industrial units with a view to prevent the industrial sickness. The model was developed basing on empirical studies, to predict the sickness of a unit in advance. The model is also called as multiple discriminate analysis (mda). It is a linear analysis used to develop with five variables. The mda computes the discriminate coefficient while the independent variables are the actual values taken from the financial statements.

ALTMAN Z SCORE model is expressed as under:

Z = 1.2X1+1.4X2+3.3X3+.6X4+1.0X5
Where,

X1= working capital/ total assets X2= retained earnings/ total assets X3= earnings before interest and taxes/ total assets X4= market value of equity/ book value of total debt X5= sales/ total assets

Z score model can be analyzed as follows: 1. Sickness is predicted basing on value of Z 2. If Z score is more than 2.99 there is no danger of bankruptcy. 3. If Z score is below 1.81- there is definite failure 4. If Z score is between 1.81 and 2.99- it shows the grey area

ALTMAN developd a guideline for z score 1. If score is above 2.675 firms can be classified as financially sound. 2. If score is below 2.675 the firm is heading towards bankruptcy. Therefore, the lower the Z score , there is greater possibility of bankruptcy and vice versa. ALTMANSs model has established itself as the leading multivariate predictor model of corporate failure and it has been the subject of numbers tests around the world. It would be useful to employ the ALTMAN model in evaluating Indian firms and endeavour to establish the reliability of the model. It could be that the cut off point for the Z score should be altered from that established in the original study.

TAFFLER AND TISSHAW MODEL

R.J. Taffler and H.Tisshaw in their approach, developed two Z scales , one for quoted manufacturing enterprises and one for non-quoted manufacturing enterprises with turnover above million of u.k. companies for the sample of quoted manufacturing

enterprises, statistical analysis resulted in the following formula: Z = C0 + C1.R1 + C2.R2 + C3.R3 + C4.R4 Where, C0 to C4 are coefficients

R1 = profit before taxation / current liabilities

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R2 = current assets/ total liabilities R3 = current liabilities/ total assets R4 = immediate assets current liabilities / operating cost excluding depreciation

The above four ratios combine together various aspects of profitability and solvency to produce a Z score. When they turn to the unquoted manufacturing enterprises, the formula comprises not four but five ratios. Taffler and Tisshaw claim good results for their formula but, because of their proprietary interest, have not willing to publish the coefficients for their equations. It has not been possible for others working in the same area to test and comment on the particular models put forward.

ARGENTI SCORE BOARD

The following theories attempt to explain the reasons for failure. Argenti 1976 after analyzing the factor associated with the collapse of Rolls Royce, gave six causes of failure which are as follows: (a) Bad management structure (b) Lake of accountancy information (c) Not responding appropriately to change (d) Overtrading (e) Involvement with a big project (f) High gearing Argenti has stressed on non-financial indicators for assessment of symptoms of failure. According to him we must have an intimate knowledge of the company and especially its top management. The failure of business organization is seen as the culmination of sequence starting with management defects that bring mistakes, which in turn produce symptoms.

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PRINCIPLES TO AVOID FAILURE

Ross and Kami (1973) after an extensive analysis of a large number of American companies, both successful and unsuccessful, came up with a list of ten basic principles of management which, if followed, should avoid failure. The ten principles are as follows: (a) Develop and communicate a strategy (b) A unified sense of direction to which all members of the organization relate (c) If you want to achieve plans, programs and policies, then overall controls and cost controls must be established (d) Exercise care in the selection of a board of directors and require that they actively participate in management (e) Avoid one-man rule (f) Provide management depth (g) Keep informed of change and react to change (h) Dont overlook the customer and the customers new power (i) Use but dont misuse computers (j) Do not engage in accounting manipulation (k) Provide for an organizational structure that meets the needs of people

DIAGNOSTIC STUDY IN REVIVAL OF SICK UNIT

Any successful scheme for revival will start with a diagnostic study or preparation of revival scheme. This involves identifying four Rs reasons, rationale , risks and requirements. This are briefly discussed as under: Reasons for sickness- the real reason should be identified first. Very often, one may be guided by appear reasons and real reasons. Just as a wrong diagnosis does not help during disease of a man it may not serve any purpose in reviving the industrial health.Thus, misdirected efforts and reasoarses arising from wrong diagnosis should be avoided. Rationale for revival- what is rationale for revival? Establishing justification for revival is very important. This will help identification of viable and non-viable units. In reality, the number of viable units would be very low (5% to 10% of the sick units).
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Risk- the risk inherent in the revival should be evaluated. It may be emphasized that reviving a sick unit is more risky then launching a new project. Revival operation of a sick unit, even if found to be potentially viable, is an onerous task. Requirements- the requirements in terms of resources, technology, government help, management efficiency, productivity etc. should be listed down. In spite of potential viability, a revival scheme may fail if there is any mismatch between requirements and their availability. After the diagnostic study, one should prioritize the thrust areas, as well as, management skills and approaches needed for successful revival operations.

Turnaround management
The term turnaround management refers to the management measures which reverse the negative trends in the performance indicators of an industrial unit. In other words, turnaround management refers to the management measures which turn a sick unit back to a healthy one or those measures which reverse the deteriorating trends of the performance indicators such as falling market share, sales(in constant rupee), and profitability and worsening debt-equity ratio. The exact nature of the turnaround management and the relative importance of different factors may vary from company to company. It has been identified ten elements as the basic components of successful turnaround strategy as: (a) Change in the top management (b)Initial credibility building pressures (a) Neutralizing external pressures (a) Initial control (b) Identifying quick payoff (c) Quick cost reduction (d) Revenue generation (e) Asset liquidation for generating cash (f) Mobilization of the organization (g) Better internal coordination
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Turnaround strategies are accurate diagnoses of distressed companys situation and are decisive action resolve the problem in the corporate. The various factors that influence the turnaround strategy are the management, human resource, production, finance, product mix, modification, marketing and others.

Securitization and reconstruction of financial assets

To felicitate quick and efficacious recovery of debts due to bank and financial institutions, the parliament has enacted the securitization and reconstruction of financial assets and enforcement of security interest act, 2002. (SARFAESI Act)

Securitization of Financial Assets

Securitization means acquisition of financial assets by any securitization company or Reconstruction company from the bank and financial institutions. The financial assets means debt/receivable, secure by mortgage charge or pledge of immovable or moveable property. Any claim any right, any beneficial interest in property or any financial assistant is also considered as financial assets. On acquiring financial assets from bank and financial institution the securitization company will raise funds from qualified institutional buyers by issues of securities receipt representing undivided interest in such financial assets. Registration is not required for such security receipt. The Act proposes to establish a center registry, with its own seal for the purpose of registration of transactions of securitization of financial assets and creation of security interest. Enforcement of security interest The security interest created in favor of any secure creditors may be enforcing by creditor without intervention of any court or tribunal, after giving a 60days notice. If the borrower does not pay the principal and interest as specify in the notice within 60 days, the secure creditors can take possession of assets, take over management of assets, and appoint any person to manage the assets. The secured creditors can exercise the aforesaid power only if the asset is a nonperforming assets as per the guideline prescribed by RBI.NPA means that the interest or installment is overdue for period exceeding 180 days. The borrower shall be entitled to compensation for any wrongful dispossession of assets by secured creditor.

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Special features of securities receipts

The security receipts issued by the Securitization Company or reconstruction company, which is register with RBI under the SARFAESI Act. Such SRs are predominantly backed by impaired assets. These SRs have the following as compared to other type of securities issued on normal assets. (a) SRs cannot be strictly characterized as debt instruments since they combine the features of both equity and debt. However these are recognized as securities contracts act, 1956. (b) The case flow from the underlying assets cannot be predicted in terms of value and intervals. (c) The investment in SRs is restricted to QIBs only. (d) These instruments when rated would generally be below investment grade. These instruments are generally privately placed and presently not listed. (e) In the event of non-realization of financial assets, the SR holders representing 75% of the total value of SRs issued by the SC/Rc can call for a meeting of all the SR holders in a particular scheme and every resolution passed in such meeting shall be binding on the SC/Rc. The SC/Rc should declare net assets value of the SRs issued by it at periodical intervals, in order to enable qualified institutional buyers to know the value of there investment in SRs issued by SC/RC. The SC/RC should obtain rating from SEBI registered rating agencies and SC/RC should supply necessary information to the rating agencies. The initial rating/grading would be assigned within one year from acquisition of assets by SC/RC or finalization of resolution strategy, whichwver is earlier. Thereafter, rating/grading shall be reviewed at half-yearly intervals i.e. on June 30 and December 31 every year. The SC/RC should declare NAV within two month from the date of half yearly review i.e. by August 31 and February 28 respectively.

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Nonperforming Assets
An asset, including a leased asset, becomes non performing when it ceasesto generate income for the bank.NPA was defined as a credit facility in respect of which the interest and/or instalment of principal has remained past due for a specified period of time.A non performing asset (NPA) is a loan or an advance where; i. interest and/ or instalment of principal remain overdue for a period of morethan 90 days in respect of a term loan, ii. the account remains out of order as indicated at paragraph 2.2 below, inrespect of an Overdraft/Cash Credit (OD/CC), iii. the bill remains overdue for a period of more than 90 days in the case ofbills purchased and discounted, iv. the instalment of principal or interest thereon remains overdue for twocrop seasons for short duration crops, v. the instalment of principal or interest thereon remains overdue for onecrop season for long duration crops, vi. the amount of liquidity facility remains outstanding for more than 90 days,in respect of a securitisation transaction undertaken in terms of guidelineson securitisation dated February 1, 2006. vii. in respect of derivative transactions, the overdue receivables representingpositive mark-to-market value of a derivative contract, if these remainunpaid for a period of 90 days from the specified due date for payment.Banks should, classify an account as NPA only if the interest due andcharged during any quarter is not serviced fully within 90 days from the end of the quarter. Out of Order status An account should be treated as 'out of order' if the outstanding balance remainscontinuously in excess of the sanctioned limit/drawing power. In cases where the outstanding balance in the principal operating account is less than the

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sanctionedlimit/drawing power, but there are no credits continuously for 90 days as on the date of Balance Sheet or credits are not enough to cover the interest debited during the sameperiod, these accounts should be treated as 'out of order'. Overdue Any amount due to the bank under any credit facility is overdue if it is not paid on the due date fixed by the bank

RBIs Classification of NPAs

Banks are required to classify nonperforming assets further into the following threecategories based on the period for which the asset has remained nonperforming and the realisability of the dues: i. Substandard Assets ii. Doubtful Assets iii. Loss Assets

1. Substandard Assets

With effect from 31 March 2005, a substandard asset would be one, which hasRemained NPA for a period less than or equal to 12 months. In such cases, theCurrent net worth of the borrower/ guarantor or the current market value of theSecurity charged is not enough to ensure recovery of the dues to the banks in full. Inother words, such an asset will have well defined credit weaknesses that jeopardisethe liquidation of the debt and characterised are the distinct possibility that theBanks will sustain some loss, if deficiencies are not corrected. 2. Doubtful Assets.

With effect from March 31, 2005, an asset would be classified as doubtful if it hasRemained in the substandard category for a period of 12 months. A loan classifiedas
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doubtful has all the weaknesses inherent in assets that were classified as substandard,with the added characteristic that the weaknesses make collection orLiquidation in full, on the basis of currently known facts, conditions and values highly questionable and improbable.

3. Loss Assets

A loss asset is one where loss has been identified by the bank or internal or external auditors or the RBI inspection but the amount has not been written off wholly. In other words, such an asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted although there may be some salvage or recovery value.

Working capital management in sick Industries

The industrial sickness is caused due to numerous internal and external factors. But the sickness caused may also be attributed to the poor working capital management like: (a) Poor financial planning (b) Poor resources management (c) Faulty costing (d) Use of working capital fund for purpose of capital expenditure (e) Overtrading, over capitalization or under capitalization (f) Inadequate working capital (g) Prolonged operating cycle (h) Inefficiency in collection of receivables (i) Lack of effective collection machinery (j) Excessive holding of stocks (k) Stoppage of production due to stock-outs (l) Excessive reliance on trade-credit (m) Bank finance not available

The planning and control of working capital in sick industries need special attention. A thorough analysis of cause for sickness is required for wc management in sick industry. The finance manager required to take steps to restructure the wc requirement and the
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banks may be approached for need based finance instead of operating on the basis of predetermined credit limits given by the bank. The efforts to be made for improvement of current ratio and quick ratio,by reducing the levels of investment in stocks and receivable. The financial restructuring to be made to improve the leverage ratio.

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