Financial Restructuring in Corporations

Why Do Firms Fail?

Corporate failure occurs when the following performance patterns exist:

Firm performance never rises above a poor level;

Firm shoots up to very high levels of performance before crashing down; Firm performance partially collapses, followed by a relatively longer plateau period of sub-par performance, and then rapid decline into insolvency.

Processes Resulting in Corporate Failure

There are at least two primary failure processes:

UNSTRESSED

A relatively rapid, unexpeced failure in which financial stress (proxied by accounting numbers) is not evident STRESSED Relatively long duration in which financial stress is evident

Corporate Restructuring

There is always a step company makes before filing for bankruptcy. This step is called corporate restructuring. The aim of corporate restructuring is to rehabilitate financially distressed company. Corporate restructuring takes place through:

Government involvement by utilizing such restructuring vehicles as establishment of Asset Management Companies, Deposit Insurance Corporations, Corporate Restructuring Funds, etc. Company management involvement by changing firm's strategy and restructuring its financial statements.

Why Restructure?

Why does a firm face a need to restructure?

Firm is overleveraged Firm is underleveraged Firm faces sluggish sales Firm faces seasonal sale problems

Firm faces externalities

Review of Basic Ratios

Before proceeding with approaches and methods to financial restructuring, lets summarize basic financial ratios: Liquidity ratios Activity ratios

Leverage ratios

Profitability ratios

Leverage Ratios

Nine ratios describe leverage. They all are an indication of how a firm gets its operating funds:

Collection Period Sales to Inventory Assets to Sales Sales to Net Working Capital Accounts Payable to Sales Debt to Equity Current Debt to Equity Interest Coverage Debt Services

Financial Leverage Ratios

Financial leverage ratios measure the funds supplied by owners (equity) as compared with the financing provided by the firms creditors (debt). Financial leverage is the use of debt to magnify return on equity (ROE) to shareholders. Equity, or owner-supplied funds, provide a margin of safety for creditors. Thus, the less equity, the more the risks of the enterprise to the creditors. To understand financial leverage we need to understand ratios between Debt to Total Assets and Debt to Equity

Sample Balance Sheet

Current Assets Cash Marketable Securities Accounts Receivable 200 Inventory Prepaid Expenses Total Current Assets 1,500

Company X Balance Sheet December 31, 2003 ($000)

200 350 Liabilities Accounts Payable Notes Payable Accrued Liabilities ST Loans Payable Maturing Bonds Bonds Loans
Total Liabilities Shareholders Equity 300 300 100 100 100 2,000 5,100 8,000 14,000

500 250

Fixed Assets Land Plant Machinery and Equipment Less: Acc. Depreciation Total Fixed Assets Total Assets

4,500 9,000 6,000 1,000 20,500 22,000

Total Liabilities and Equity

22,000

Sample Income Statement

Company X Income Statement Ending December 31, 2003 ($000)
Net Sales Other Income Total Revenue Cost of Goods Sold Gross Profit General Expenses Administrative Expenses Selling Expenses Earnings Before Interest and Taxes (EBIT) 2,000 Interest Expenses Earnings Before Taxes (EBT) Taxes 3,400 100 3,500 1,000

2,500
200 250 50

500 1,500 500

Earnings After Taxes (EAT) or Net Profit

1,000

Financial Leverage Ratios: Debt Ratio

The debt ratio is the ratio of total debt to total assets and measures the percentage of total funds provided by creditors: DEBT RATIO =
TOTAL DEBT TOTAL ASSETS

Debt Ratio for Company X for the year 2003 is calculated as follows
Debt Ratio = 8,000 / 22,000 = 0.36

Debt Ratio

To see whether Company Xs Debt Ratio is an indicator of its good performance, we need to look at:

the historical trend of the ratio A comparison of the companys performance against other major players in the industry

If Debt Ratio is rising, the company is developing a leverage problem If the debt ratio is falling, the company is investing more of its own resources to generate assets and is becoming less dependent on debts

Debt Ratio - Industry Graph

0.70 0.60 0.50 0.40 0.30 0.20 0.10 1997 1998 1999 2000 2001 2002 2003

Com pany X Com pany Z

Com pany Y Industry Average

Example of Debt Ratio

Debt Ratio of Company X has been improving from 1997 to 2003. It went down from 0.61 to 0.36 which means the company is less relying on debt to finance its assets. Compared to the Industry in 2003, the Company X is almost on par with the industry average Debt Ratio
Company X Industry Average 0.36 0.37

Company X has performed relatively well in 2003 than in previous years compared to other major players in the industry - Company Y and Company Z.

Financial Leverage Ratios: Debt to Equity Ratio

The debt to equity ratio compares the amount of money borrowed from creditors to the amount of shareholders investment made within a firm
TOTAL DEBT

DEBT TO EQUITY RATIO =

TOTAL EQUITY

Debt to Equity Ratio for Company X for the year 2003 is calculated as follows Debt To Equity Ratio = 8,000 / 14,000 = 0.57

Debt to Equity Ratio

To see whether Company Xs Debt to Equity Ratio is an indicator of its good performance, we need to look at:

the historical trend of the ratio, the company compared with other major players in the industry

If Debt to Equity Ratio is rising, the company is developing a leverage problem If the debt ratio is falling, the company is investing more of its owners resources to generate assets and is becoming less dependent on creditors

Debt to Equity Ratio - Industry Graph

0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 1997 1998 1999 2000 2001 2002 2003

Company X Company Z

Company Y Industry Average

Example of Debt to Equity Ratio

Debt to Equity Ratio of Company X has been declining from 1997 to 2003

It went down from 0.79 to 0.57

This means the company has been changing its debt to equity mix with moving away from heavy debt borrowing to raising capital from shareholders The graph also shows that Company X has been overleveraged in 1997

Example of Debt to Equity Ratio

Compared to the Industry in 2003, the Company X is performing slightly above the industry average, but has shown a persistent trend towards the industry average Debt to Equity Ratio
Company X 0.57 Industry Average 0.51

Company X has performed better than Company Y in 2003. Company Z shows signs of being underleveraged, which can be very risky

Decisions about Leverage

Decisions about the use of leverage must balance higher expected returns against increased risk.

Debt funding enables the owners to maintain control of the firm with a limited investment. If the firm earns more on the borrowed funds than it pays in interest, the return to the owners is magnified.

Decisions about Leverage

LOW LEVERAGE RATIOS Indicate less risk of loss when the economy is in a downturn, but lower expected returns when the economy booms HIGH LEVERAGE RATIOS Indicate the risk of large losses, but also have a chance of gaining high profits

Decisions about Leverage

Debt

Equity
Too much Debt = Overleveraged firm

Too much Equity = Underleveraged firm

The decision is a tradeoff between Risks and Returns. A firm should adopt a policy that minimizes risks and maximizes returns

Examples of Overleveraged and Underleveraged Firms

A firm needs to raise $100,000 in capital Company borrows at 8% per year Income taxes are at 40% COGS is 60% of sales, and fixed costs are $40,000

What should the debt and equity mix be, and what is it going to affect, and how?

We will look at three scenarios where Debt to Equity ratios will be at 25%, 100% and 400%

Examples of Overleveraged and Underleveraged Firms

Debt to Equity Ratio Net sales COGS Fixed Costs Interest Expense Pretax Income Income tax (40%) Net Income Return on Equity Debt (8% interest) Equity Total Capital 25% 150,000 90,000 40,000 1,600 18,400 7,360 11,040 13.8% 20,000 80,000 100,000 100% 150,000 90,000 40,000 4,000 16,000 6,400 9,600 19.2% 50,000 50,000 100,000 400% 150,000 90,000 40,000 6,400 13,600 5,440 8,160 40.8% 80,000 20,000 100,000

Examples of Overleveraged and Underleveraged Firms

By looking at debt and equity mix, it is clear that underleveraged companies:

Pay high interest expenses

Have low EBT Pay less in taxes

Their net income is comparatively low ROE is the highest, since there is an over-reliance on debt

Examples of Overleveraged and Underleveraged Firms

By looking at debt and equity mix, it is clear that overleveraged companies:

Pay less in interest expenses

Have higher EBT Pay higher dollars in taxes

Their net income is comparatively higher

ROE is the lowest, since there is an overreliance on equity, and the net profit is not commensurate to the amount of equity raised

Examples of Overleveraged and Underleveraged Firms

Overleveraged companies also have other obligations not shown here, such as payment of dividends to shareholders The more equity is raised through shareholders (stocks issued), the more firms have to pay out in dividends, thus reducing their retained earnings that can later be re-invested into business expansion

Causes for Financial Restructuring

There are several instances where company management has to make a decision about Financial Restructuring This includes cases when:

Firm is overleveraged Firm is underleveraged Firm faces sluggish sales Firm faces seasonal sale problems Firm faces externalities

Overleveraged Firm

The problem of overleverage occurs when a firm has overborrowed debt from a bank on a consistent basis As a result, firm has a higher Debt to Equity Ratio Using debt to run a firm is a common practice, however, sometimes there is an over-reliance on debt Over-reliance on debt can be a factor in hurting the companys bottom line

Overleveraged Firm

Overleveraging is acceptable in cases when a firm is undertaking expansion projects (buying new plant and equipment, investing into new technologies) that have high probability of higher expected returns, profits, and thus ROA When firms over-borrow debt on a consistent basis, and thus have profitability issues, the management has to consider Financial Restructuring

Overleveraged Firm

If a firm is fully leveraged, it will not be able to borrow money A lower debt-equity ratio will make for easier loan negotiations in the event a firm needs to borrow money in the future Many financially distressed firms that restructure their debts either file for bankruptcy later or experience financial distress again This is because they remain overleveraged after the restructuring; out-of-court restructurings leave firms with suboptimal capital structures

Overleveraged Firm

Financial Restructuring in overleveraged firm can be implemented through

Issuing new stocks Selling off unprofitable assets to pay off debt

Rent out equipment to pay off debt

Restructure debt (refinance LT debt with a lower interest rate, if possible) Debt to equity swap

Overleveraged Firm - Example

Issuing new stocks (issue $50,000 in stocks to pay off $50,000 in debt)
Before After $102,400 $30,000 $72,400 $60,000 $12,400 $10,560 29% 41% 15% 10%

Total Assets Total Debt Total Equity Common Stocks Retained Earnings Net Profit Debt Ratio Debt to Equity Ratio Return on Equity Return on Assets

$100,000 $80,000 $20,000 $10,000 $10,000 $8,160 80% 400% 41% 8%

Underleveraged Firm

The problem of underleverage arises when a firm has raised majority of its capital through stocks
As a result, firm has a very low Debt to Equity Ratio With higher equity the firm has to improve its performance to keep the shareholders happy If firm pays dividends, it has to constantly allocate a portion of its profits towards dividends payable to shareholders

Underleveraged Firm

Financial Restructuring in underleveraged firm can be implemented through

Buying back stocks for cash (if available) Borrowing funds (debt) to buyback stocks to attain the best debt to equity mix Selling off unprofitable assets to buyback stocks Renting out equipment to buyback stocks

Underleveraged Firm Example

Borrowing funds to buyback stocks (borrow $40,000 in debt to buy back $40,000 worth of common shares)
Before After
$98,080 $50,000 $48,080 $40,000 $8,080 $9,600 51% 104% 20% 10% $100,000 $10,000 $90,000 $80,000 $10,000 $11,520 10% 11% 13% 12%

Total Assets Total Debt Total Equity Common Stocks Retained Earnings Net Profit Debt Ratio Debt to Equity Ratio Return on Equity Return on Assets

Firm with Sluggish Sales

Sluggish sales can cause financial distress, as they affect a companys cash flow Sluggish sales are influenced by the line of business a firm is in

Usually, firms face sluggish sales when they are into big ticket items sale, or when the economy is slow
As a result, companys working capital decreases causing cash deficit One of the areas most affected by sluggish sales is piling of accounts receivable and the problem of non-collection Cash deficit forces firms management to take alternative steps to raising cash through stock issuance, debt borrowing or other

Firm with Sluggish Sales Example

Decrease in sales by $25,000 and $35,000. Original sales at $150,000.

Before After (sales down by $25,000) $94,000 $50,000 $44,000 $40,000 $4,000 $3,600 53% 114% 8% 4% After (sales down by $35,000) $91,600 $50,000 $41,600 $40,000 $1,600 $1,200 55% 120% 3% 1%

Total Assets Total Debt Total Equity Common Stocks Retained Earnings Net Profit Debt Ratio Debt to Equity Ratio Return on Equity Return on Assets

$100,000 $50,000 $50,000 $40,000 $10,000 $9,600 50% 100% 19% 10%

Firm with Sluggish Sales Example

The example showed that a slight drop in sales might completely change the financial picture of a firm

Decline in profits causes drop in total assets (decrease in cash inflow) and equity (decrease in retained earnings)
If not addressed timely, this might cause a problem of overleveraged firm

Firm with Sluggish Sales Example

Current Assets
Fixed Assets
(remain unchanged)

Current Liabilities
(remain unchanged)

Long Term Liabilities

(remain unchanged)

Equity/Capital
TOTAL ASSETS TOTAL LIABILITIES + EQUITY

Working Capital = CA CL

Firm with Sluggish Sales

Financial Restructuring in a firm with slow sales can be implemented through:

Different hedging techniques (to avoid or cover currency risk, interest rate risk, etc.) Borrowing funds on line of credit to cover working capital gap Selling off unprofitable assets to raise cash Renting out equipment to raise cash Selling techniques (such as selling on credit, providing discounts, or demanding prepayment) Diversification of line of business (producing fast selling products in parallel to compensate slow sales and raise additional cash to use as a working capital)

Firm with Sluggish Sales

Why do companies attempt to hedge

There are risks peripheral to the central business in which they operate Companies do not exist in isolation; hedging is also used to improve or maintain the competitiveness of the firm

Hedging is contingent on the preferences of the firm's shareholders

Firm with Seasonal Sales

Seasonal sales are attributive to firms in several industries such as farming, construction, businesses highly dependent on holidays, etc. The question is how to keep businesses viable when the season is out Similar techniques can be adopted as with sluggish sales In addition, firms with seasonal sales need to engage into other lines of businesses, to diversify and therefore reduce the risk, as well as to have an additional source for cash inflow

Firm with Seasonal Sales

Seasonal pattern in sales affects company profits, and therefore, causes cash flow deficit during later months Cash flow deficit causes working capital gap Working capital gap slows down company growth In order to raise cash the company can borrow long term debt or issue stocks; before doing so, however, it should show company sustainability

Firm with Seasonal Sales

Financial Restructuring in a firm with seasonal sales can be implemented through

Different hedging techniques Borrowing funds on line of credit to cover working capital gap during months of inactivity Diversification of line of business (producing products that have non-seasonal demand to compensate seasonal sales and raise additional cash for covering working capital gap)

Firm facing Externalities

Firms face externalities such as:

Changes in currency exchange rates Changes in global interest rates Fluctuations in prices for imported raw materials

This causes firms product prices to go up Pushing price increases to consumers usually affects the companys sales; resulting in sluggish sales

Firm facing Externalities

There are several techniques that companies can employ to reduce external risk This includes different techniques of hedging:

Buying raw materials in abundance to hedge price fluctuations of imported materials. Currency hedging Interest rate hedging Future and forward contracts

Conclusion

Each firm is a unique entity, and there is no one road map for success Management should be aware of different techniques available when a company is in financial distress Each decision should be tailored to a firm taking into account specificity of the business Management has to look at advantages and disadvantages each decision has.