Financial Distress

Chapter 30 Financial Distress 828
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Chapter
30 Fi nanci al
Di stress
KEY NOTATIONS
APR Absolute Priority rule
CVA Company voluntary
agreement
DIP Debtor in possession
(debt)
Z Index of bankruptcy
If there is one thing that has characterized recent times, it is that many rms
have become nancially distressed. Because of the global credit crunch, which
led to the worldwide recession in 2009, corporations have never been in such
difculty. In most industries demand for services and goods has plummeted,
and at the time of writing the International Monetary Fund has predicted
that global economic growth will be only 0.5 per cent in 2009. This is the
worst economic performance since World War Two.
A rm that does not generate enough cash ow to make a contractually
required payment, such as an interest payment, will experience nancial
distress. A rm that defaults on a required payment may be forced to liquidate its assets. More often, a
defaulting rm will reorganize its nancial structure. Financial restructuring involves replacing old
nancial claims with new ones, and takes place with private workouts or legal bankruptcy. Private workouts
are voluntary arrangements to restructure a companys debt, such as postponing a payment or reducing
the size of the payment. If a private workout is not possible, formal bankruptcy is usually required.
30.1 What Is Financial Distress?
Financial distress is surprisingly hard to dene precisely. This is true partly because of the variety of events
befalling rms under nancial distress. The list of events is almost endless, but here are some examples:
Dividend reductions
Plant closings
Losses
Layoffs
CEO resignations
Plummeting share prices
Financial distress is a situation where a rms operating cash ows are not sufcient to satisfy current
obligations (such as trade credits or interest expenses), and the rm is forced to take corrective action.
1

Financial distress may lead a rm to default on a contract, and it may involve nancial restructuring
between the rm, its creditors, and its equity investors. Usually the rm is forced to take actions that
it would not have taken if it had sufcient cash ow.
Our denition of nancial distress can be expanded somewhat by linking it to insolvency. Insolvency
is dened in Blacks Law Dictionary as
2
Inability to pay ones debts; lack of means of paying ones debts. Such a condition of a womans
(or mans) assets and liability that the former made immediately available would be insufcient
to discharge the latter.
P
A
R
T

e
I
g
h
T

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What happens in Financial Distress? 829
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This denition has two general themes: value and ows.
3
These two ways of thinking about
insolvency are depicted in Fig. 30.1. Value-based insolvency occurs when a rm has negative
net worth, so the value of assets is less than the value of its debts. Flow-based insolvency
occurs when operating cash ow is insufcient to meet current obligations. Flow-based
insolvency refers to the inability to pay ones debts.
30.2 What happens in Financial Distress?
There are many responses to nancial distress that a rm can make. These include one or
more of the following turnaround strategies.
Asset expansion policies 1
Operational contraction policies 2
Financial policies 3
External control activity 4
Changes in managerial control 5
Wind up company 6
Asset expansion Policies
If a rm nds itself in difculty, it may try to reduce the risk of its operations by increasing
the size of its business or assets. Asset expansion policies include the full acquisition of another
rm, a partial acquisition, setting up a new joint venture, increasing capital expenditure, higher
levels of production, or expansion of existing facilities.
The joint venture between Fiat and Chrysler is a good example of an asset expansion policy.
In 2009 carmakers were facing a bleak prospect, with sales down across the world. The US and
British governments had already bailed out their own automobile industries, and many carmakers
had reduced production to only part of the year. By entering into a joint venture, Fiat and
Chrysler were able to expand their sales revenue at a time when they needed it the most.
Table 30.1 Large corporate bankruptcies since 2001
TABL E
30.1
Company Country Year
Ssangyong Motor Company South Korea 2009
Nortel Networks United States 2009
Washington Mutual United States 2008
Sterling Airlines Denmark 2008
Sanlu group China 2008
Lehman Brothers holdings Inc. United States 2008
Kaupthing Bank Iceland 2008
hypo Real estate germany 2008
Yukos Russia 2006
Mg Rover United Kingdom 2005
Delta Air Lines, Inc. United States 2005
Parmalat Italy 2004
Worldcom Inc. United States 2002
Sabena Belgium 2001
enron Corp. United States 2001
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Operational Contraction Policies
The opposite of expansion is contraction, and many rms choose to focus on their most protable
businesses during a downturn. Operational contraction policies include asset sales, spin-offs and
divestitures (see Chapter 29). Plants may also be closed, production can be cut, and employees made
redundant. Redundancies are politically very sensitive, and many countries have very strong trade
unions that can dramatically constrain the exibility of rms when dealing with their own workforce.
Honda is a good example of following a contraction policy. First quarter results for 2009
were absolutely dire. Car sales had dropped by 10 per cent, and 400,000 fewer cars were sold
than the same period in 2008. There was also the very strong possibility that the company
would make an annual loss for the rst time since it was founded in 1948. In response, Honda
cut global production by 420,000 units and closed its UK plant for four months in order to
reduce inventory levels. The employees of the British plant were still paid during this period
and, as a result, no redundancies were made.
Financial Policies
Financially distressed rms will denitely face some type of cash liquidity problem. Several
remedies are available. One, the company can reduce its annual dividend. Another option is
to restructure existing debt facilities so that less interest is paid. The equity and debt markets
may also be tapped to raise further funding.
F I GUR E
30.1
Figure 30.1 Insolvency
Solvent firm Insolvent firm
Negative
equity
Contractual
obligations
Firm cash flow
Cash flow
shortfall
Insolvency
Value-based insolvency occurs when the value of the assets of a firm is less than the value
of the debts. This implies negative equity. Flow-based insolvency occurs when firm cash
flows are insufficient to cover contractually required payments.
Debt
Equity
Value
A
s
s
e
t
s
A. Value-based insolvency
B. Flow-based insolvency
D
e
b
t
A
s
s
e
t
s
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Bankruptcy Liquidation and Reorganization 831
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During the global credit crunch many banks had to be bailed out by their governments
with loan guarantees and equity share issues. In addition, almost every bank slashed its
dividends to zero.
external Control Activity
External control activity means that the rm has been taken over, or an outside investor takes
a signicant stake in the rm. A change in external control means that one or more major
shareholders sell their shares to another investor with a larger capital base and greater access
to capital.
The European football industry has seen many deals of this type. One notable example
is Glasgow Celtic, which was days away from bankruptcy when investor Fergus McCann
purchased the shares of the club, imposed a very strict turnaround strategy, and reduced debt
to almost zero. The team subsequently went on to dominate Scottish football, reached the
UEFA cup nal in 2003, and was one of only a few major British clubs to make a prot during
the economic recession.
Changes in Managerial Control
The ultimate penalty for poor performance is losing your job, and many rms opt to remove their
chairman, chief executive or other directors when they are in nancial distress. This will normally
go hand in hand with other forms of restructuring. Examples include Fred Goodwin, the former
chief executive of Royal Bank of Scotland, who had to step down after the bank found itself in
serious nancial difculty as a result of the acquisition of Dutch bank ABN AMRO in 2007.
Wind up Company
The nal and least desirable strategy a nancially distressed rm will follow is to wind up its
operations and go into some form of bankruptcy. Bankruptcy laws differ on a country-by-
country basis, and even within the United Kingdom bankruptcy law is different in Scotland
from the rest of the country. At the time of writing (2009), growth in corporate bankruptcies
had rocketed as a result of the harsh economic conditions facing businesses. Bankruptcy may
not always end in the disappearance of a company, and rms may be split up, sold on to a
new buyer, or restructured during the process.
Figure 30.2 shows how large public rms move through nancial distress in the US.
Approximately half of the nancial restructurings have been effected via private workouts.
Most large public rms (approximately 70 per cent) that le for bankruptcy are able to
reorganize and continue to do business.
5
Firms in Europe follow a very similar process when they are nancially distressed. For
example, Table 30.2 presents the turnaround strategies of British rms that faced nancial
distress during the 1990s. The majority of rms reduced their scope of operations and under-
went some form of nancial restructuring.
Financial distress can serve as a rms early warning system for trouble. Firms with
more debt will experience nancial distress earlier than rms with less debt. However,
rms that experience nancial distress earlier will have more time for private workouts
and reorganization. Firms with low leverage will experience nancial distress later and, in
many instances, be forced to liquidate.
30.3 Bankruptcy Liquidation and Reorganization
Firms that cannot or choose not to make contractually required payments to creditors have
two basic options: liquidation or reorganization.
Liquidation means termination of the rm as a going concern; it involves selling the
assets of the rm for salvage value. The proceeds, net of transactions costs, are distributed to
creditors in order of established priority.
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Reorganization is the option of keeping the rm a going concern; it sometimes involves
issuing new securities to replace old securities.
Liquidation and formal reorganization may be done by bankruptcy. Bankruptcy is a legal
proceeding, and can be done voluntarily, with the corporation ling the petition, or involun-
tarily, with the creditors ling the petition.
Bankruptcy Law
Bankruptcy law across the world is converging to a similar process. However, there are important
country-level differences. The European Union introduced its bankruptcy regulation in 2002,
Regulation on Insolvency Proceedings, which is followed by all EU countries, with the excep-
tion of Denmark. As European bankruptcy law is very similar, the regulations facing British
bankruptcy will be discussed in detail, followed by an overview of the salient differences in
other countries.
Financially distressed rms in the UK can be voluntarily or compulsorily dissolved or liquidated.
Liquidation means that the rms assets are sold to allow payment of the outstanding liabilities
of the rm. However, this is the very last and least desirable option, and it will be considered only
when all other strategies have been exhausted. An alternative is to appoint an administrator,
who will attempt to restructure the rms outstanding claims, introduce a viable business model,
or look for a potential buyer. It is important to note that when a rm is in administration, it
will continue business until a solution (which may be liquidation) is found.
F I GUR E
30.2
Source: K.H. Wruck, Financial distress: reorganization and organizational efciency,
Journal of Financial Economics, vol. 27 (1990), Figure 2. See also S.C. Gilson, K. John and
L.N.P. Lang, Troubled debt restructuring: an empirical study of private reorganization of
rms in defaults, Journal of Financial Economics, vol. 27 (1990); and L.A. Weiss, Bankruptcy
resolution: direct costs and violation of priority of claims, Journal of Financial Economics,
vol. 27 (1990).
Figure 30.2 What happens in nancial distress
Reorganize and
emerge
83%
10%
7%
Private
workout
Financial
restructuring
No financial
restructuring
5
3
%
5
1
%
Merge with
another firm
Legal bankruptcy
Chapter 11
Liquidation
Financial
distress
4
9
%
4
7
%
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Liquidation For a rm to be liquidated or made insolvent, a creditor, the directors, or share-
holders must petition a court for a winding-up order. If a judge decides that there is a case
for liquidation, an ofcial receiver will be appointed, who liquidates the assets of the rm
and distributes the proceeds to all creditors. Normally, creditors will not be paid all that
they are due, because of direct bankruptcy costs from legal and administration fees.
Priority of Claims Once a corporation is determined to be bankrupt, liquidation takes place.
The distribution of the proceeds of the liquidation occurs according to the following general
priority:
Table 30.2 Turnaround strategies of nancially distressed UK rms 19921998
TABL E
30.2
Reported action Percentage of rms
Asset expansion policies
Full acquisition 32.46
Partial acquisition 4.55
Joint venture 8.44
Increase investment expenditures 0.65
Increase output / expand production facilities 2.60
Total 40.26
Asset contraction policies
Asset sale / spin-off / divestiture 29.87
Plant closure 1.30
Withdrawal from line of business 7.14
Unspecied cost-cutting programme 16.23
Cut in employment 13.64
Total 65.58
Financial policies
Cut dividend 45.45
Debt restructuring / renegotiation 1.95
Issue debt 4.55
Rights issue 3.90
Placing 6.49
Total 54.55
External control activity
Non-nancial block purchase 0.65
Negotiations 4.55
Unsuccessful offer 0
Total 4.55
Change in managerial control
Ceo turnover 20.78
Forced ceo turnover 8.44
Total 20.78
Source: D. Hillier and P. McColgan, Managerial discipline and rm responses to a decline in
operating performance, Working Paper (2007).
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Administration expenses associated with liquidating the bankrupts assets 1
Unsecured claims arising after the ling of an involuntary bankruptcy petition 2
Wages, salaries, and commissions 3
Contributions to employee benet plans arising within a set period before the ling date 4
Consumer claims 5
Tax claims 6
Secured and unsecured creditors claims 7
Preference shareholder claims 8
Ordinary shareholder claims 9
The priority rule in liquidation is known as the absolute priority rule (APR).
One qualication to this list concerns secured creditors. Liens on property are outside APR
ordering. However, if the secured property is liquidated and provides cash insufcient to cover
the amount owed them, the secured creditors join with unsecured creditors in dividing the
remaining liquidating value. In contrast, if the secured property is liquidated for proceeds greater
than the secured claim, the net proceeds are used to pay unsecured creditors and others.
EXAMPLE
30.1
APR
The B.O. Deodorant Company is to be liquidated. Its liquidating value is 2.7 million.
Bonds worth 1.5 million are secured by a mortgage on the B.O. Deodorant Company
corporate headquarters building, which is sold for 1 million; 200,000 is used to cover
administrative costs and other claims (including unpaid wages, pension benets, consumer claims, and
taxes). After paying 200,000 to the administrative priority claims, the amount available to pay secured
and unsecured creditors is 2.5 million. This is less than the amount of unpaid debt of 4 million.
Under APR, all creditors must be paid before shareholders, and the mortgage bondholders have rst
claim on the 1 million obtained from the sale of the headquarters building.
The trustee has proposed the following distribution:
Type of claim
Prior claim
()
Cash received
under liquidation
()
Bonds (secured by mortgage) 1,500,000 1,500,000
Subordinated debentures 2,500,000 1,000,000
Ordinary shareholders 10,000,000 0
Total 14,000,000 2,500,000
Calculation of the distribution ()
Cash received from sale of assets available for distribution 2,500,000
Cash paid to secured bondholders on sale of mortgaged property 1,000,000
Available to bond and debenture holders 1,500,000
Total claims remaining (4,000,000 less payment of 1,000,000 on secured bonds) 3,000,000
Distribution of remaining 1,500,000 to cover total remaining claims of 3,000,000
Type of claim remaining
Claim on
liquidation
proceeds ()
Cash received
()
Bonds 500,000 500,000
Debentures 2,500,000 1,000,000
Total 3,000,000 1,500,000
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Administration When a company enters administration, the administrator will attempt to
restructure the companys liabilities, look for a buyer, or break up the company into viable
parts. Possible strategies also include exchanging debt for equity, which allows the nancially
distressed rm to dispense with paying interest on debt, and at the same time gives the credi-
tor a stake in the company should it recover.
The legal agreement that details how the rms liabilities are to be restructured is known
as a company voluntary agreement (CVA). If creditors reject the CVA, or the company does
not submit a CVA to the court, the judge can give the corporation an extension, during which
it must come up with an acceptable plan or ask the creditors to come up with their own
reorganization plan. In most cases at least one extension is granted. Under UK bankruptcy
law a CVA will be accepted if at least 75 per cent of the companys claimholders, including
shareholders, vote in favour of it. Once accepted, the agreement is legally binding.
In Scotland bankruptcy law is slightly more complex. In addition to administration and
insolvency procedures, rms may also go into receivership. This is also a characteristic of
bankruptcy law in England and Wales for rms that have outstanding securities issued before
2003. The differences between administration and receivership are important. When in admin-
istration, the nancially distressed rm is legally protected from its creditors while a CVA is
prepared. An insolvency practitioner, such as an accounting rm, is normally appointed to
run the business while the agreement is being drawn up. A rm will go into receivership if
its creditors do not believe that the company can recover and repay its liabilities. A receiver,
again normally an accounting rm, will thus be appointed to sell the assets of the rm so
that the creditors can be paid.
EXAMPLE
30.2
Suppose B.O. Deodorant Co. decides to go into administration and reorganize. Generally,
senior claims are honoured in full before various other claims receive anything. Assume
that the going concern value of B.O. Deodorant Co. is 3 million, and that its statement
of nancial position is as shown:
()
Assets 3,000,000
Liabilities
Mortgage bonds 1,500,000
Subordinated debentures 2,500,000
Shareholders equity 1,000,000
The rm has proposed the following reorganization plan:
Old security
Old claim
()
New claim with
reorganization
plan ()
Mortgage bonds 1,500,000 1,500,000
Subordinated debentures 2,500,000 1,500,000
and a distribution of new securities under a new claim with this reorganization plan:
Old security Received under proposed reorganization plan
Mortgage bonds 1,000,000 in 9% senior debentures
500,000 in 11% subordinated debentures
Debentures 1,000,000 in 8% preference shares
500,000 in ordinary shares
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However, it will be difcult for the rm to convince secured creditors (mortgage bonds) to accept
unsecured debentures of equal face value. In addition, the rm may wish to allow the old shareholders
to retain some participation in the rm. Needless to say, this would be a violation of the absolute priority
rule, and the holders of the debentures would not be happy.
Bankruptcy in other countries Bankruptcy procedures in most countries follow the same
model as that in the United Kingdom. In the United States nancially distressed rms may
le for Chapter 11 bankruptcy (equivalent to administration) or for Chapter 7 bankruptcy
(equivalent to liquidation). All other aspects of the system are practically the same.
Countries in the European Union follow the 2002 Regulation on Insolvency Proceedings.
Some country level differences do exist, however. Under Spanish insolvency law a creditors
meeting is organized to form a CVA, and if it is not possible to come to an agreement, the
rm will be liquidated. France has a three-stage process. The rst stage involves pre-insolvency
hearings, which can occur if the rms auditor is concerned about the nancial health of the
rm. If the hearings cannot resolve the auditors concerns, a petition will be made to a com-
mercial court. The rm may at this point request a three-month window to draw up a CVA
that will be acceptable to all parties. If this is unsuccessful, the rm will be wound up. Finally,
although South Africa follows a similar system to other countries, there is no administration
process. Thus creditors, shareholders, or the company itself will go directly to the South African
High Court to request that the rm be placed in liquidation. The process is then worked
through the system, and restructuring or winding-up may be an outcome of this process.
In Their Own Words
edward I. Altman* on Corporate Financial Distress and
Bankruptcy
As we entered the new millennium, corporate distress and bankruptcy were no longer a niche
area of corporate evolution. The average company is far riskier today than it was just two
decades ago, and the roles of the bankruptcy courts and restructuring specialists have never
been more important. Financial distress of private and public entities throughout the world is
a frequent occurrence with important implications to their many stakeholders. While the role
of corporate bankruptcy laws is clear either to provide a legal procedure that permits rms,
which have temporary liquidity problems, to restructure and successfully emerge as continuing
entities or to provide an orderly process to liquidate assets for the benet of creditors before
asset values are dissipated bankruptcy laws differ markedly from country to country.
It is generally agreed that the US Chapter 11 provisions under the Bankruptcy Reform Act of
1978 provide the most protection for bankrupt rms assets and result in a greater likelihood
of successful reorganization than is found in other countries where liquidation and sale of the
assets for the benet of creditors is more likely the result. But the US codes process is usually
lengthy (averaging close to two years, except where a sufcient number of creditors agree in
advance via a prepackaged Chapter 11) and expensive, and the reorganized entity is not
always successful in avoiding subsequent distress. If the reorganization is not successful, then
liquidation under Chapter 7 will usually ensue.
Bankruptcy processes in the industrialized world outside the United States strongly favour
senior creditors who obtain control of the rm and seek to enforce greater adherence to debt
contracts. The UK process, for example, is speedy and less costly, but the reduced costs can
result in undesirable liquidations, unemployment, and underinvestment. The new bankruptcy
code in Germany attempts to reduce the considerable power of secured creditors but it is still
closer to the UK system.
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Private Workout or Bankruptcy: Which Is Best? 837
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Regardless of the location, one of the objectives of bankruptcy and other distressed workout
arrangements is that creditors and other suppliers of capital clearly know their rights and
expected recoveries in the event of a distressed situation. When these are not transparent and/
or are based on outdated processes with arbitrary and possibly corrupt outcomes, then the
entire economic system suffers and growth is inhibited. Such is the case in several emerging-
market countries. Revision of these outdated systems should be a priority.
* Edward I. Altman is Max L. Heine Professor of Finance, NYU Stern School of Business. He is widely
recognized as one of the worlds experts on bankruptcy and credit analysis, as well as the distressed debt
and high-yield bond markets.
30.4 Private Workout or Bankruptcy: Which Is Best?
A rm that defaults on its debt payments will need to restructure its nancial claims. The rm
will have two choices: formal bankruptcy or private workout. The previous section described
two types of formal bankruptcy: bankruptcy liquidation and bankruptcy reorganization. This
section compares private workouts with bankruptcy reorganizations. Both types of nancial
restructuring involve exchanging new nancial claims for old nancial claims. Usually senior
debt is replaced with junior debt, and debt is replaced with equity. Much recent academic
research has described what happens in private workouts and formal bankruptcies.
7
Historically, half of nancial restructurings have been private, but recently formal bank-
ruptcy has dominated.
Firms that emerge from private workouts experience share price increases that are much
greater than those for rms emerging from formal bankruptcies.
The direct costs of private workouts are much less than the costs of formal bankruptcies.
Top management usually loses pay and sometimes jobs in both private workouts and formal
bankruptcies.
These facts, when taken together, seem to suggest that a private workout is much better
than a formal bankruptcy. We then ask: Why do rms ever use formal bankruptcies to
restructure?
The Marginal Firm
For the average rm a formal bankruptcy is more costly than a private workout, but for
some rms formal bankruptcy is better. Formal bankruptcy allows rms to issue debt that is
senior to all previously incurred debt. This new debt is debtor in possession (DIP) debt. For
rms that need a temporary injection of cash, DIP debt makes bankruptcy reorganization
an attractive alternative to a private workout. There are some tax advantages to bankruptcy.
Firms do not lose tax carry-forwards in bankruptcy, and the tax treatment of the cancellation
of indebtedness is better in bankruptcy. Also, interest on pre-bankruptcy unsecured debt
stops accruing in formal bankruptcy.
holdouts
Bankruptcy is usually better for the equity investors than it is for the creditors. Using DIP debt
and stopping pre-bankruptcy interest on unsecured debt helps the shareholders and hurts
the creditors. As a consequence, equity investors can usually hold out for a better deal in
bankruptcy. The absolute priority rule, which favours creditors over equity investors, is usually
violated in formal bankruptcies. One recent study found that in 81 per cent of recent bank-
ruptcies the equity investor obtained some compensation.
8
When a rm is in administration,
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the creditors are often forced to give up some of their seniority rights to get management and
the equity investors to agree to a deal.
Complexity
A rm with a complicated capital structure will have more trouble putting together a private
workout. Firms with secured creditors and trade creditors will usually use formal bankruptcy,
because it is too hard to reach an agreement with many different types of creditor.
Lack of Information
There is an inherent conict of interest between equity investors and creditors, and the conict
is accentuated when both have incomplete information about the circumstances of nancial
distress. When a rm initially experiences a cash ow shortfall, it may not know whether
the shortfall is permanent or temporary. If the shortfall is permanent, creditors will push
for a formal reorganization or liquidation. However, if the cash ow shortfall is temporary,
formal reorganization or liquidation may not be necessary. Equity investors will push for this
viewpoint. This conict of interest cannot easily be resolved.
These last two points are especially important. They suggest that nancial distress will be
more expensive (cheaper) if complexity is high (low) and information is incomplete (complete).
Complexity and lack of information make cheap workouts less likely.
Institutional Factors
Most research on corporate bankruptcies has looked at single countries, such as the United
States and United Kingdom. However, an examination of only one country can mask the effect
of important institutional factors that relate to the legal and corporate system. Davydenko
and Franks (2008) look at the French, German and British systems of bankruptcy, and investigate
whether their country-specic regulations impact upon the likelihood of rms going into and
surviving formal administration.
9
The legal bankruptcy systems in France, Germany and the UK fall under the umbrella of
EU regulation. However, France and the UK represent two extremes in their approaches to
resolving bankruptcy. Whereas Frances approach focuses on the debtor or borrowing rm, the
UK is very much creditor- or lender-friendly. In France lenders have no input, beyond an
advisory role, into the reorganization plan. This contrasts with the situation in the UK, where
creditors can veto any reorganization plan that is put forward by the company. Germany is
somewhere in between these two extremes.
Davydenko and Franks found that banks required higher levels of collateral when lending
to French companies to offset the lower likelihood of receiving outstanding debts in the event
of a default. Moreover, recovery rates (i.e. the percentage of outstanding debts that are received
by creditors) are signicantly higher in the United Kingdom (92 per cent) than in Germany
(67 per cent) or France (56 per cent). Interestingly, British rms are more likely to survive
administration, because their creditors, normally banks, are more likely to work with the
nancially distressed company to see it through the administration period.
30.5 Predicting Financial Distress: The Z-Score Model
10
Many potential lenders use credit scoring models to assess the creditworthiness of prospective
borrowers. The general idea is to nd statistical factors that enable the lenders to discriminate
between good and bad credit risks. To put it more precisely, lenders want to identify attributes
of the borrower that can be used to predict default or bankruptcy.
Edward Altman has developed a model using nancial statement ratios and multiple dis-
criminant analyses to predict bankruptcy for publicly traded manufacturing rms. The resultant
model for US companies is of the form
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Predicting Financial Distress: The Z-Score Model 839
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Z = + 3.3
EBIT
Total assets
1.2
Net working capital
Tootal assets
1.0
Sales
Total assets
0.6
Market
+ +
vvalue of equity
Book value of debt
1.4
Accumul
+
aated retained earnings
Total assets
where Z is an index of bankruptcy.
A score of Z less than 2.675 indicates that a rm has a 95 per cent chance of becoming
bankrupt within one year. However, Altmans results show that in practice scores between 1.81
and 2.99 should be thought of as a grey area. In actual use, bankruptcy would be predicted if
Z 1.81 and non-bankruptcy if Z 2.99. Altman shows that bankrupt rms and non-bankrupt
rms have very different nancial proles one year before bankruptcy. These different nancial
prots are the key intuition behind the Z-score model, and are depicted in Table 30.3.
Altmans original Z-score model requires a rm to have publicly traded equity and be
a manufacturer. He uses a revised model to make it applicable for private rms and non-
manufacturers. The resulting model is this:

Z = + 6.56
Net working capital
Total assets
3.26
Accuumulated retained earnings
Total assets
+ 1.05
E
BBIT
Total assets
6.72
Book value of equity
Total
+
liabilities
where Z < 1.23 indicates a bankruptcy prediction, 1.23 Z 2.90 indicates a grey area, and
Z > 2.90 indicates no bankruptcy.
EXAMPLE
30.3
Consider the nancial accounts of Sano-Aventis SA from Chapter 26. The company is
publicly traded, but not a manufacturer, and so the modied Z-score model will be used.
The alert reader will notice that the model uses accounting variables that are found in US
accounting statements. International Financial Reporting Standards (IFRS) have slightly different
ways of presenting the information. For example, net working capital appears as current assets less current
liabilities, and accumulated retained earnings appears in notes to the statement of nancial position.
The rst step is to determine the value of each of the nancial statement variables and apply them
in the Z-score model. In $ millions:

Net working capital
Total assets
Current assets
=

=

Current liabilities
Total assets
12 553 9 669 , ,
71 994
0 040
,
. =

Accumulated retained earnings
Total assets
47,2
=
775
71,994
0.657 =

EBIT
Total assets 71,994
0.082 = =
5 911 ,

Book value of equity
Total liabilities
=
44 719
27
,
,1195
= 1.644
The next step is to calculate the revised Z-score:
Z = 6.56 0.040 + 3.26 0.657 + 1.05 0.082 + 6.72 1.644
= 11.05
Finally we determine that the Z-score is above 2.9, and we conclude that Sano-Aventis is a good credit risk.
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2012 McGraw-Hill
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Table 30.3 Financial statement ratios one year before bankruptcy: manufacturing rms
TABL E
30.3
Bankrupt rms Non-bankrupt rms

Net working capital
Total assets
6.1% 41.4%

Accumulated retained earnings
Total assets
62.6% 35.5%

eBIT
Total assets
31.8% 15.4%

Market value of equity
Total liabilities
40.1% 247.7%

Sales
Assets
150% 190%
Source: E.I. Altman, Corporate Financial Distress and Bankruptcy (New York: John Wiley & Sons,
1993), Table 3.1, p. 109.
The same alert reader will also wonder why US Z-score coefcients can be used for a rm
that is based in Europe. This would be a very good observation. In practice, banks use a variety
of propriety prediction models when assessing the credit-worthiness of potential borrowers,
and Altmans Z-score model is just one of these. Another approach is to use neural networks
to predict failure in borrowers. Irrespective of the model used, good-quality data on credit
defaults is required in order to calibrate the coefcients. The coefcients in any model will
clearly be a function of the borrower and lender demographics, institutional factors, and the
quality of data that the analyst has in her possession. In practice, each country will have its
own set of important variables and coefcients. All Altmans model does is provide a predic-
tion of failure, which is not a perfect prediction of the future. As a general indicator, the US
coefcients can be used to provide some insight into the bankruptcy risk of corporations in
other countries only dont take the outcome as particularly precise.
Summary and Conclusions
This chapter examined what happens when rms experience nancial distress.
Financial distress is a situation where a rms operating cash ow is not sufcient to cover 1
contractual obligations. Financially distressed rms are often forced to take corrective
action and undergo nancial restructuring. Financial restructuring involves exchanging
new nancial claims for old ones.
F 2 inancial restructuring can be accomplished with a private workout or formal bankruptcy.
Financial restructuring can involve liquidation or reorganization. However, liquidation is
not common.
Corporate bankruptcy involves liquidation or reorganization. An essential feature of bank- 3
ruptcy codes is the absolute priority rule. The absolute priority rule states that senior
creditors are paid in full before junior creditors receive anything. However, in practice the
absolute priority rule is often violated.
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Questions and Problems 841
___
___
Questions and Problems
Financial Distress 1 Dene nancial distress using the value-based and ow-based approaches.
What Happens in Financial Distress 2 Review the turnaround strategies that rms can
follow when in nancial distress. Which do you think are most effective? Why?
Bankruptcy Liquidation and Administration 3 What is the difference between admin-
istration and reorganization? What are some benets of nancial distress?
Private Workouts and Bankruptcy 4 Do you think country-level institutional factors
affect the turnaround strategies nancially distressed rms may adopt? Explain.
Predicting Financial Distress 5 Review the variables in Altmans Z-score model. Why do
you think these variables are important in predicting nancial distress?
F 6 inancial Distress Why doesnt nancial distress always cause rms to die?
APR 7 What is the absolute priority rule?
DIP Loans 8 What are DIP loans? Where do DIP loans fall in the APR?
Bankruptcy Ethics 9 Firms sometimes use the threat of a bankruptcy ling to force creditors
to renegotiate terms. Critics argue that in such cases the rm is using bankruptcy laws
as a sword rather than a shield. Is this an ethical tactic?
Bankruptcy Ethics 10 Several rms have entered bankruptcy, or threatened to enter bank-
ruptcy, at least in part, as a means of reducing labour costs. Whether this move is ethical,
or proper, is hotly debated. Is this an ethical use of bankruptcy?
Bankruptcy versus Private Workouts 11 Why do so many rms le for legal bankruptcy
when private workouts are so much less expensive?
Administration 12 When Beacon Computers entered insolvency, it had the following
balance sheet information:
Liquidating value () Claims ()
Trade credit 3,000
Secured mortgage notes 6,000
Senior debentures 5,000
Junior debentures 9,000
Total assets 15,500 Book equity 7,500
Assuming there are no legal fees associated with the bankruptcy, as trustee, what distribu-
tion of liquidating value do you propose?
Administration 13 When Masters Printing led for bankruptcy, it entered administration.
Key information is shown here:
Assets () Claims ()
Mortgage bonds 10,000
Senior debentures 6,000
Junior debentures 4,000
going concern value 15,500 Book equity 5,000
As trustee, what reorganization plan would you accept?
CONCEPT
15
REGULAR
611
CHALLENGE
1213
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2012 McGraw-Hill
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Practical Case Study
It is not difcult to nd rms that are in nancial distress. Download the nancial accounts
for ve rms in your country that have performed poorly over the last year. Carry out a
Z-score analysis for these companies. Now download the nancial accounts for ve rms
that performed strongly in the past year and carry out a similar analysis. Are the Z-scores
for the poor performance sample different from the good performance sample? Write a
report on your analysis.
Relevant Accounting Standards
Many nancially distressed rms choose to restructure their assets and sell off poorly per-
forming divisions. An important standard in this regard is IAS37 Provisions, Contingent Liabilities
and Contingent Assets. If rms wish to sell off divisions or non-current assets, they should
also be familiar with IFRS5 Non-Current Assets Held for Sale and Discontinued Operations.
Additional Reading
Financial distress is another topic that has taken on a new lease of life in recent years because of
the unprecedented events in the world economy. The literature can be separated into factors
that inuence nancial distress and turnaround strategies once a company is in trouble.
Predictors of Distress
Acharya, V.V., S.T. Bharath and A. Srinivasan (2007) Does industry-wide distress affect defaulted
rms? Evidence from credit recoveries, Journal of Financial Economics, vol. 85, no. 3,
pp. 787821. US.
Agarwal, V. and R. Tafer (2008) Comparing the performance of market-based and accounting-
based bankruptcy prediction models, Journal of Banking and Finance, vol. 32, no. 8,
pp. 15411551. UK.
Braun, M. and B. Larrain (2005) Finance and the business cycle: international, inter-industry
evidence, Journal of Finance, vol. 60, no. 3, pp. 10971127. International.
Campbell, J.Y., J. Hilscher and J. Szilagyi (2008) In search of distress risk, Journal of Finance,
vol. 63, no. 6, pp. 28992939. US.
Yang, L. (2008) The real determinants of asset sales, Journal of Finance, vol. 63, no. 5,
pp. 22312262. US.
Turnaround Strategies and the Bankruptcy Process
Bates, T.W. (2005) Asset sales, investment opportunities, and the use of proceeds, Journal of
Finance, vol. 60, no. 1, pp. 105135. US.
Bris, A., I. Welch and N. Zhu (2006) The costs of bankruptcy: Chapter 7 liquidation versus
Chapter 11 reorganization, Journal of Finance, vol. 61, no. 3, pp. 12531303. US.
Brown, D.T., B.A. Ciochetti and T.J. Riddiough (2006) Theory and evidence on the resolution
of nancial distress, Review of Financial Studies, vol. 19, no. 4, pp. 13571397. US.
Davydenko, S.A. and J.R. Franks (2008) Do bankruptcy codes matter? A study of defaults in
France, Germany and the UK, Journal of Finance, vol. 62, no. 2, pp. 565608. Europe.
Eckbo, B.E. and K. Thorburn (2009) Creditor nancing and overbidding in bankruptcy auc-
tions: theory and tests, Journal of Corporate Finance, vol. 15, no. 1, pp. 1029. Sweden.
Eisdorfer, A. (2008) Empirical evidence of risk shifting in nancially distressed rms, Journal
of Finance, vol. 62, no. 2, pp. 609637. US.
Faccio, M., R.W. Masulis and J.J. McConnell (2006) Political connections and corporate bailouts,
Journal of Finance, vol. 16, no. 6, pp. 25972635. International.
Ross_ch30.indd 842 6/11/09 10:33:04 AM
Finanza aziendale
2012 McGraw-Hill
endnotes 843
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Hillier, D., A. Marshall, P. McColgan and S. Werema (2007) Employee layoffs, shareholder
wealth and rm performance: evidence from the UK, Journal of Business Finance and
Accounting, vol. 34, nos. 3/4, pp. 467494. UK.
Jostarndt, P. and Z. Sautner (2008) Financial distress, corporate control, and management
turnover, Journal of Banking and Finance, vol. 32, no. 10, pp. 21882204. Germany.
Lee, E. and S. Lin (2008) Corporate sell-offs in the UK: use of proceeds, nancial distress and
the long-run impact on shareholder wealth, European Financial Management, vol. 14, no. 2,
pp. 222242. UK.
Other Relevant Research
Ongena, S., D.C. Smith and D. Michalsen (2003) Firms and their distressed banks: lessons
from the Norwegian banking crisis, Journal of Financial Research, vol. 67, no. 1, pp. 81112.
Norway.
Endnotes
1 This denition is close to the one used by K. Wruck, Financial distress: reorganization and organiza-
tion efciency, Journal of Financial Economics, vol. 27 (1990), p. 425.
2 Blacks Law Dictionary, 5th ed. (St. Paul, MN: West Publishing Company), p. 716.
3 Edward Altman was one of the rst to distinguish between stock-based insolvency and ow-based
insolvency. See E. Altman, Corporate Financial Distress: A Complete Guide to Predicting, Avoiding, and
Dealing with Bankruptcy, 2nd ed. (New York: John Wiley & Sons, 1993).
4 The bet was reported in Carl Has 9 Lives but He Is Betting up to 8, Business Week, 24 February
1992.
5 However, only less than 20 per cent of all rms (public or private) going through a bankruptcy are
successfully reorganized.
6 We are describing the standard events in a bankruptcy reorganization. The general rule is that a
reorganization plan will be accepted by the court if all of the creditor classes accept it, and it will be
rejected if all of the creditor classes reject it. However, if one or more (but not all) of the classes accept
it, the plan may be eligible for a cram down procedure. A cram down takes place if the bankruptcy
court nds a plan fair and equitable and accepts the plan for all creditors.
7 For example, see S. Gilson, Managing default: some evidence on how rms choose between workouts
and bankruptcy, Journal of Applied Corporate Finance (Summer 1991); and S.C. Gilson, K. John, and
L.N.P. Lang, Troubled debt restructuring: an empirical study of private reorganization of rms in
defaults, Journal of Financial Economics, vol. 27 (1990).
8 L.A. Weiss, Bankruptcy dissolution: direct costs and violation of priority and claims, Journal of
Financial Economics, vol. 23 (1990). However, W. Beranek, R. Boehmer and B. Smith, in Much ado
about nothing: absolute priority deviations in Chapter 11, Financial Management (Autumn 1996), nd
that 33.8 per cent of bankruptcy reorganizations leave shareholders with nothing.
9 S.A. Davydenko and J. Franks, Do bankruptcy codes matter? A study of defaults in France, Germany
and the UK, Journal of Finance, vol. 63 (2008).
10 E.I. Altman, Corporate Financial Distress and Bankruptcy (New York: John Wiley & Sons, 1993), Chapter 3.
To help you grasp the key concepts of this chapter check out
the extra resources posted on the Online Learning Centre at
www.mcgraw-hill.co.uk/textbooks/hillier
Among other helpful resources there are PowerPoint
presentations, chapter outlines and mini-cases.
Ross_ch30.indd 843 6/11/09 10:33:05 AM
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2012 McGraw-Hill

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