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Financial Distress - Overview and Models

The document discusses financial distress, including: 1) Definitions of financial distress and insolvency, such as when a firm's liabilities exceed its assets or cash flows are insufficient to cover obligations. 2) Common responses to financial distress, like selling assets, issuing new securities, or negotiating with creditors, with the goal of restructuring financially or operationally to address the distress. 3) Models for predicting financial distress, including univariate models using individual ratios and multivariate models combining multiple indicators into a composite score to assess bankruptcy risk.

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132 views

Financial Distress - Overview and Models

The document discusses financial distress, including: 1) Definitions of financial distress and insolvency, such as when a firm's liabilities exceed its assets or cash flows are insufficient to cover obligations. 2) Common responses to financial distress, like selling assets, issuing new securities, or negotiating with creditors, with the goal of restructuring financially or operationally to address the distress. 3) Models for predicting financial distress, including univariate models using individual ratios and multivariate models combining multiple indicators into a composite score to assess bankruptcy risk.

Uploaded by

fanuel kijoji
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Financial Distress

June 2019

FN301 - Financial Distress


Coverage
• Overview of Financial Distress

• Management of financial distress

• Models for Predicting financial distress

• Class exercise

• Conclusions
FN301 - Financial Distress 1
Definition of Financial Distress
• A situation where a firm’s operating cash flows are not sufficient to
satisfy current obligations and the firm is forced to take corrective
action.
• Financial distress may lead a firm to default on a contract, and it may
involve financial restructuring between the firm, its creditors, and its
equity investors.

FN301 - Financial Distress 2


Insolvency
• Stock-base insolvency; the value of the firm’s assets is less
than the value of the debt.

Solvent firm Insolvent firm

Debt Debt
Equity
Assets Assets
Equity Debt

Note the negative equity


FN301 - Financial Distress 3
Insolvency
• Flow-base insolvency occurs when the firms cash flows are
insufficient to cover contractually required payments.

Cash flow
shortfall
Contractual
obligations
Firm cash flow

Insolvency time

FN301 - Financial Distress 4


What happens when firm is in financial distress?

...?

FN301 - Financial Distress 5


What Happens in Financial Distress?
• Financial distress does not usually result in the firm’s death.
• Firms deal with distress by
• Selling major assets.
• Merging with another firm.
• Reducing capital spending and research and development.
• Issuing new securities.
• Negotiating with banks and other creditors.
• Exchanging debt for equity.
• Filing for bankruptcy.

FN301 - Financial Distress 6


What Happens in Financial Distress?
No financial
restructuring
49%

Financial Private
distress workout
47%
51%
Financial Reorganize
restructuring and emerge
83%
53%
Legal bankruptcy 7% Merge with
another firm

10%
Source: Karen H. Wruck, “Financial Distress: Reorganization and Organizational Efficiency,” Journal of Financial Economics
27 (1990), Figure 2. See also Stuart C. Gilson; Kose John, and Larry N.P. Lang, “Troubled Debt Restructurings: An Empirical
Study of Private Reorganization in Firms in Defaults,” Journal of Financial Economics 27 (1990); and Lawrence A. Weiss,
“Bankruptcy Resolution: Direct Costs and Violation of Priority Claims,” Journal of Financial Economics 27 (1990).
Liquidation

FN301 - Financial Distress 7


What do we learn from the figure above?

...?

FN301 - Financial Distress 8


Responses to Financial Distress
• Think of the two sides of the balance sheet.
• Asset Restructuring:
• Selling major assets.
• Merging with another firm.
• Reducing capital spending and R&D spending.
• Financial Restructuring:
• Issuing new securities.
• Negotiating with banks and other creditors.
• Exchanging debt for equity.
• Filing for bankruptcy.

FN301 - Financial Distress 9


Predicting financial distress
• Can we predict financial distress?

• Are there challenges to predicting financial distress?

FN301 - Financial Distress 10


Financial Distress Prediction Models
• Univariate model of financial distress prediction
• Single indicator consideration

• Multivariate model of financial distress prediction


• Multiple indicators consideration

FN301 - Financial Distress 11


Univariate Model of Financial Distress Prediction
• Beaver tested his model on 79 firms matched for industry and size
(failed and non-failed), tracking them over five years prior to failure
• He examined 7 financial ratios:
• Cashflow/total debt
• Net income/total assets
• Total debt/total assets
• Working capital/total assets
• Current ratio
• No-credit interval
• Total assets
• Distinct differences exist and clear trends are apparent in financial ratios
which makes them

FN301 - Financial Distress 12


Univariate Model of Financial Distress Prediction

FN301 - Financial Distress 13


Problems with Beaver’s Model
• Problems
• Absence of clear distinction between groups
• There exist more secure than failing firms
• Difficulties in identifying failed firms
• Single variable based prediction
• Financial ratios selection

• However,
• All ratios indicated some degree of predictability
• While appraising predictability of ratios … the cut-off points would vary
over time, sector and countries
• Some provides advance warning failure
• Rates of return and gearing ratios are better indicators

FN301 - Financial Distress 14


Multivariate Distress Prediction Model
• Achievement of more accurate predictions by combining
univariate (single) ratios?
• Financial distress = f (number of factors)
• Z-score = composite ratio with the most efficient weights such
that:
• Dispersion of Z is minimised for each category (failed and survived)
• Distance between mean Z for each group is maximised thereby
reducing chance of overlap

FN301 - Financial Distress 15


Multivariate Distress Prediction Model
• Altman’s Z Score Model (1968):
Z = 1.2x1 + 1.4x2 + 3.3x3 + 0.6x4 + 1.0x5
x1 = Working capital / Total assets (%)
x2 = Retained earnings / Total assets (%)
x3 = Earnings before interest and taxes / Total assets (%)
x4 = Market value of equity / Total liabilities (%)
x5 = Sales / Total assets (no.of times)

• IF Z < 1.81 serious credit problems


• IF Z > 2.99 healthy company
• IF 1.81<Z<2.99 zone of ignorance

FN301 - Financial Distress 16


Problem of Multivariate Distress Prediction Model
• Variables selected for their predictive performance, not from
underlying theory
• Definition of what constitutes a failed firm is dubious
• Variables in equation are accounting values
• Samples were not random/distribution problems

FN301 - Financial Distress 17


Class exercise
• LUHU Co. Ltd has applied to your bank for a loan. You have their financial
statements and a modified Z-score model of:

• Z = 6.56 (Net Working Capital/Total Assets) + 3.26 (Accumulated Retained


Earnings/Total Assets) + 1.05 (EBIT/Total Assets) + 6.72 (Book Value of
Equity/Total Liabilities)

• where: Z < 1.25 predicts bankruptcy. A Z-score between 1.25 and 2.95
indicates gray area. A Z-score greater than 2.95 indicates no bankruptcy.

• From the financial statements you gathered net working capital of Tshs.
475,000/=; accumulated retained earnings of Tshs. 240,000/=; book value
of equity of Tshs. 1,900,000/=; total assets of Tshs. 9,500,000/=; EBIT of
Tshs.525,000/=; and total liabilities of Tshs. 7,600,000/=. Should the bank
lend to LUHU Co. Ltd?
FN301 - Financial Distress 18
Conclusions
• Financial distress is a situation where a firm’s operating cash flow is
not sufficient to cover contractual obligations.
• Financial restructuring can be accomplished with a private workout
or formal bankruptcy.
• Financial restructuring can take a different forms
• Assets restructuring
• Portfolio restructuring
• Financial restructuring

FN301 - Financial Distress 19

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