FINANCIAL DISTRESS ANALYSIS

 Financial distress refers to a situation where a company or individual struggles to meet

financial obligations, such as paying debts or financing ongoing operations. It is
characterized by declining financial performance, liquidity issues, and an increased risk of
bankruptcy.
 Financial distress is 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.
A. Key Indicators of Financial Distress
1. Declining Revenues
A consistent decrease in sales or revenue over multiple periods can signal financial trouble.
2. Negative Cash Flow
Ongoing cash flow deficits indicate that a business is not generating enough cash to cover its
operating expenses and obligations.
3. High Debt Levels
An increasing debt-to-equity ratio or high levels of liabilities relative to assets can point to
financial distress.
4. Late Payments
Frequent delays in payments to suppliers or creditors can indicate cash flow issues.
5. Operational Losses
Continued net losses can erode equity and signal underlying operational inefficiencies.
6. Increased Inventory Levels
Excess inventory can indicate declining sales or inefficiencies in production and distribution.
7. Loss of Key Customers
Losing significant clients can drastically impact revenue and profitability.
8. Inability to Secure Financing
Difficulty obtaining loans or credit can indicate a lack of confidence from lenders and investors.
Example: Nakumatt Holdings (Kenya)
- Signs of distress included:
- Inability to pay suppliers, leading to empty shelves
 - Closure of multiple stores
- Mounting debt to creditors
B. 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.
Firms that cannot meet their obligations have two choices: liquidation or reorganization.
• Liquidation (Chapter 7) means termination of the firm as a going concern.
– It involves selling the assets of the firm for salvage value.
– The proceeds, net of transactions costs, are distributed to creditors in order of
priority.
• Reorganization (Chapter 11) is the option of keeping the firm a going concern.
– Reorganization sometimes involves issuing new securities to replace old ones.
C. Financial Ratio Analysis
Financial ratios provide quantitative insights into a company's financial health.
Financial ratio analysis can be used examine the current performance of your company in
comparison to past periods of time, from the prior quarter to years ago.
1. Liquidity Ratios
Liquidity ratios measure your company’s ability to cover its expenses. The two most common
liquidity ratios are the current ratio and the quick ratio.
a) Current Ratio
The current ratio is a reflection of financial strength. It is the number of times a company’s
current assets exceed its current liabilities, which is an indication of the solvency of the
business
 - Formula: Current Assets / Current Liabilities
- Ideal: > 1.5
- Example:
Company A: Current Assets = $100,000, Current Liabilities = $60,000
Current Ratio = 100,000 / 60,000 = 1.67 (Healthy)
A current ratio can be improved by increasing current assets or by decreasing current liabilities.
Steps to accomplish an improvement include:
• Paying down debt
• Acquiring a long-term loan (payable in more than 1 year’s time)
• Selling a fixed asset
• Putting profits back into the business
A high current ratio may mean cash is not being utilized in an optimal way. For example, the
excess cash might be better invested in equipment
b) Quick Ratio (Acid Test)
The quick ratio is also called the “acid test” ratio. That’s because the quick ratio looks only at a
company’s most liquid assets and compares them to current liabilities. The quick ratio tests
whether a business can meet its obligations even if adverse conditions occur.
- Formula: (Current Assets - Inventory) / Current Liabilities
- Ideal: > 1
- Example:
Company B: Current Assets = $80,000, Inventory = $30,000, Current Liabilities = $50,000
Quick Ratio = (80,000 - 30,000) / 50,000 = 1 (Borderline)
2. Profitability Ratios
Profitability ratios are financial metrics used by analysts and investors to measure and evaluate the
ability of a company to generate income (profit) relative to revenue, balance sheet assets, operating
costs, and shareholders’ equity during a specific period of time. They show how well a company
utilizes its assets to produce profit and value to shareholders
a) Return on Assets (ROA)
It is the relationship between the profits of the company and the total assets. It is a measure of how
effectively you utilized your company’s assets to make a profit. It is a common ratio used to
compare how well you performed in relationship to your peers in your industry.
 - Formula: Net Income / Total Assets
- Example:
Company C: Net Income = $5,000,000, Total Assets = $100,000,000
ROA = 5,000,000 / 100,000,000 = 0.05 or 5%
b) Gross Profit Margin
It shows how much profit a company makes after paying off its cost of goods sold (COGS). The
ratio indicates the percentage of each shilling of revenue that the company retains as gross profit,
so naturally a high gross margin ratio is desired.
- Formula: (Revenue - Cost of Goods Sold) / Revenue
- Example:
Company D: Revenue = $10,000,000, COGS = $7,000,000
Gross Profit Margin = (10,000,000 - 7,000,000) / 10,000,000 = 0.3 or 30%
Interpretation
A low gross margin ratio does not necessarily indicate a poorly performing company. It is
important to compare gross margin ratios between companies in the same industry rather than
comparing them across industries. For example, a legal service company reports a high gross
margin ratio because it operates in a service industry with low production costs. In contrast, the
ratio will be lower for a car manufacturing company because of high production costs
c) Return on Equity
It is a measure of a company’s annual return (net income) divided by the value of its total
shareholders’ equity, expressed as a percentage (e.g. 10%). Alternatively, ROE can also be derived
by dividing the firm’s dividend growth rate by its earnings retention rate (1-dividend payout ratio).
Interpretation
ROE provides a simple metric for evaluating returns. By comparing a company’s ROE to the
industry’s average, it is possible to pinpoint a company’s competitive advantage (or lack of
competitive advantage). As it uses net income as the numerator, return on equity (ROE) looks at
the firm’s bottom line to gauge overall profitability for the firm’s owners and investors. As an
investor, this is an essential ratio to look at as it ultimately determines how attractive an investment
is. Return on equity is a product of asset efficiency, profitability, and financial leverage.
d) Return on Capital Employed
It is a profitability ratio that measures how efficiently a company is using its capital to generate
profits. The return on capital employed is considered one of the best profitability ratios and is
commonly used by investors to determine whether a company is suitable to invest in.
Interpretation
The return on capital employed shows how much operating income is generated for each shilling
invested in capital. A higher ROCE is always more favorable as it implies that more profits are
generated per shilling of capital employed. As with any other financial ratios, calculating just the
ROCE of a company is not enough. Other profitability ratios such as return on assets, return on
invested capital, and return on equity should be used in conjunction with ROCE to determine
whether a company is truly profitable or not
3. Leverage Ratios
Leverage ratios measure the stability of a company and its ability to repay debt. These ratios are
of particular interest to bank loan officers. They should be of interest to you, too, since leverage
ratios give a strong indication of the financial health and viability of your business
a) Debt-to-Equity Ratio
The Debt-to-Worth Ratio (or Leverage Ratio) is a measure of how dependent a company is on debt
financing as compared to owner’s equity. It shows how much of a business is owned and how
much is owed
- Formula: Total Liabilities / Shareholders' Equity
- Example:
Company E: Total Liabilities = $40,000,000, Shareholders' Equity = $60,000,000
Debt-to-Equity = 40,000,000 / 60,000,000 = 0.67
b) Interest Coverage Ratio
- Formula: EBIT / Interest Expense
- Ideal: > 1.5
- Example:
Company F: EBIT = $5,000,000, Interest Expense = $2,000,000
Interest Coverage = 5,000,000 / 2,000,000 = 2.5 (Healthy)
4. Efficiency Ratios

a) Inventory Turnover
It measures the number of times inventory turned over or was converted to sales during a time
period. It may also be called the Cost of Sales to Inventory Ratio. It is a good indication of
purchasing and production efficiency. In general, the higher the ratio, the more frequently the
inventory turned over. You might expect a company with a perishable inventory, such as a grocery
store, to have a very high Inventory Turnover Ratio. Conversely, a furniture store might have a
low Inventory Turnover Ratio
- Formula: Cost of Goods Sold / Average Inventory
- Example:
Company G: COGS = $50,000,000, Average Inventory = $10,000,000
Inventory Turnover = 50,000,000 / 10,000,000 = 5 times per year
b) Accounts Receivable Turnover
The Accounts Receivable Turnover Ratio measures the number of time accounts receivable turned
over during a time period. A higher ratio indicates a shorter time between making a sale and
collecting the cash.
- Formula: Net Credit Sales / Net Accounts Receivable
- Example:
Company H: Net Credit Sales = $80,000,000, Average A/R = $20,000,000
A/R Turnover = 80,000,000 / 20,000,000 = 4 times per year

Formula Example Meaning

Current Ratio Current Assets/ 1.35 There is 1.35 in
current liabilities current assets to pay
every shs.1.00 in
current liabilities.
Quick Ratio Current Assets- 0.49 There is shs.0.49 in
Inventory / current quick assets (liquid)
liabilities to pay every shs.1.00
in current liabilities
Debt to Equity Ratio Total Liabilities / 0.45 The creditors have put
Equity shs.0.45 in the
business for every
shs.1.00 the owners
have put in
Gross profit margin Gross profit/ Sales 30.7% For every shs.1.00 of
sales there is
shs.0.307 in gross
profit
Pre- Tax Profit Profit before Taxes/ 0.15% For every shs.1.00 of
margin Sales sales there is
 shs.0.0015 in pre-tax
profit.
Sales to Assets Sales/ Total Assets 1.98 There is shs.1.98 in
sales for every
shs.1.00 in assets
employed in the
business.
Return on Assets Profit before taxes/ 0.3% There is shs.0.003 in
Total Assets profit for every
shs.1.00 in assets
employed in the
business.
Return on Equity Profit before taxes/ 0.8% There is shs.0.008 in
Equity profit for every
shs.1.00 in equity
invested in the
business.
Inventory turnover Cost of goods sold/ 4x On average, the
Inventory inventory turns over 4
times a year.
Inventory days 365 days/ Inventory 91 days On average, the
turnover inventory turns over
every 91 days.
Accounts Receivable Net credit Sales/ Net 10.9x On average, the
Turnover Accounts Receivable accounts receivable
turn over Turnover
10.9 times a year
Collection Period 365 days/ Accounts 33 days On average, the
Receivable turnover accounts receivable
turn over every 33
days.

3. Analyzing the Probability of Bankruptcy

Several models have been developed to assess the likelihood of bankruptcy.
a) Altman Z-Score Model

A numerical measurement used to predict the chances of a business going bankrupt in the next two
years.

The model was developed by Edward Altman in 1968

Altman’s Z-score model is considered an effective method of predicting the state of financial
distress of any organization by using multiple balance sheet values and corporate income.
Altman’s idea of developing a formula for predicting bankruptcy started at the time of the Great
Depression, when businesses experienced a sharp rise in incidences of default.

Altman’s Z-Score Model Formula

The Z-score model is based on five key financial ratios. It increases the model’s accuracy when
measuring the financial health of a company and its probability of going bankrupt.

The Altman’s Z-score formula is written as follows:

ζ = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:

 Zeta (ζ) is the Altman’s Z-score

 A is the Working Capital/Total Assets ratio
 B is the Retained Earnings/Total Assets ratio
 C is the Earnings Before Interest and Tax/Total Assets ratio
 D is the Market Value of Equity/Total Liabilities ratio
 E is the Total Sales/Total Assets ratio
What Z-Scores Mean

Interpretation:
- Z > 2.99: "Safe" Zone
- 1.81 < Z < 2.99: "Gray" Zone
- Z < 1.81: "Distress" Zone

Usually, the lower the Z-score, the higher the odds that a company is heading for bankruptcy. A
Z-score that is lower than 1.8 means that the company is in financial distress and with a high
probability of going bankrupt. On the other hand, a score of 3 and above means that the company
is in a safe zone and is unlikely to file for bankruptcy. A score of between 1.8 and 3 means that
the company is in a grey area and with a moderate chance of filing for bankruptcy.

Investors use Altman’s Z-score to make a decision on whether to buy or sell a company’s stock,
depending on the assessed financial strength. If a company shows a Z-score closer to 3, investors
may consider purchasing the company’s stock since there is minimal risk of the business going
bankrupt in the next two years.

However, if a company shows a Z-score closer to 1.8, the investors may consider selling the
company’s stock to avoid losing their investments since the score implies a high probability of
going bankrupt.

The Five Financial Ratios in Z-Score Explained

The following are the key financial ratios that make up the Z-score model:

1. Working Capital/Total Assets

Working capital is the difference between the current assets of a company and its current liabilities.
The value of a company’s working capital determines its short-term financial health. A positive
working capital means that a company can meet its short-term financial obligations and still make
funds available to invest and grow.

In contrast, negative working capital means that a company will struggle to meet its short-term
financial obligations because there are inadequate current assets.

2. Retained Earnings/Total Assets

The retained earnings/total assets ratio shows the amount of retained earnings or losses in a
company. If a company reports a low retained earnings to total assets ratio, it means that it is
financing its expenditure using borrowed funds rather than funds from its retained earnings. It
increases the probability of a company going bankrupt.

On the other hand, a high retained earnings to total assets ratio shows that a company uses its
retained earnings to fund capital expenditure. It shows that the company achieved profitability over
the years, and it does not need to rely on borrowings.

3. Earnings Before Interest and Tax/Total Assets

EBIT, a measure of a company’s profitability, refers to the ability of a company to generate profits
solely from its operations. The EBIT/Total Assets ratio demonstrates a company’s ability to
generate enough revenues to stay profitable and fund ongoing operations and make debt payments.

4. Market Value of Equity/Total Liabilities

The market value, also known as market capitalization, is the value of a company’s equity. It is
obtained by multiplying the number of outstanding shares by the current price of stocks.

The market value of the equity/total liabilities ratio shows the degree to which a company’s market
value would decline when it declares bankruptcy before the value of liabilities exceeds the value
of assets on the balance sheet. A high market value of equity to total liabilities ratio can be
interpreted to mean high investor confidence in the company’s financial strength.

5. Sales/Total Assets

The sales to total assets ratio shows how efficiently the management uses assets to generate
revenues vis-à-vis the competition. A high sales to total assets ratio is translated to mean that the
management requires a small investment to generate sales, which increases the overall profitability
of the company.

In contrast, a low or falling sales to total assets ratio means that the management will need to use
more resources to generate enough sales, which will reduce the company’s profitability.

Example:
Company X has the following data:
- Working Capital = $10M
- Total Assets = $100M
- Retained Earnings = $20M
- EBIT = $15M
- Market Value of Equity = $80M
- Total Liabilities = $50M
- Sales = $120M

Calculation:
A = 10/100 = 0.1
B = 20/100 = 0.2
C = 15/100 = 0.15
D = 80/50 = 1.6
E = 120/100 = 1.2

Z = 1.2(0.1) + 1.4(0.2) + 3.3(0.15) + 0.6(1.6) + 1.0(1.2)

Z = 0.12 + 0.28 + 0.495 + 0.96 + 1.2
Z = 3.055

Interpretation: With a Z-score of 3.055, Company X is in the "Safe" zone.

b) Springate Model
Developed by Gordon L.V. Springate in 1978, this model is used to predict the probability of
financial distress.

Formula:
S = 1.03A + 3.07B + 0.66C + 0.4D
Where:
- A = Working Capital / Total Assets
- B = Net Profit before Interest and Taxes / Total Assets
- C = Net Profit before Taxes / Current Liabilities
- D = Sales / Total Assets
Interpretation:
- S < 0.862: High probability of financial distress
- S > 0.862: Low probability of financial distress
c) Zmijewski Model
Developed by Mark E. Zmijewski in 1984, this model uses three financial ratios to predict
bankruptcy.
Formula:
X = -4.3 - 4.5A + 5.7B - 0.004C
Where:
- A = Net Income / Total Assets
- B = Total Liabilities / Total Assets
- C = Current Assets / Current Liabilities
Interpretation:
- If X > 0.5, the company is likely to go bankrupt
- If X < 0.5, the company is unlikely to go bankrupt

Case Study: Analysis of a Kenyan Company

Let's analyze Uchumi Supermarkets, a Kenyan retail chain that faced financial difficulties.
Financial data (hypothetical, based on publicly available information):
- Current Assets: KES 2 billion
- Current Liabilities: KES 4 billion
- Total Assets: KES 5 billion
- Total Liabilities: KES 6 billion
- Net Income: KES -500 million
- Sales: KES 10 billion

Calculations:
1. Current Ratio = 2B / 4B = 0.5 (Well below the ideal of > 1.5, indicating severe liquidity issues)
2. Debt-to-Equity Ratio = 6B / (5B - 6B) = -6 (Negative equity, extremely high financial risk)
3. Return on Assets = -500M / 5B = -0.1 or -10% (Indicating significant losses)
4. Altman Z-Score (simplified version for non-manufacturing firms):
Z = 6.56A + 3.26B + 6.72C + 1.05D
Where:
A = (Current Assets - Current Liabilities) / Total Assets = (2B - 4B) / 5B = -0.4
B = Retained Earnings / Total Assets (assume -1B) = -1B / 5B = -0.2
C = EBIT / Total Assets (assume -400M) = -400M / 5B = -0.08
D = Book Value of Equity / Total Liabilities = -1B / 6B = -0.167
 Z = 6.56(-0.4) + 3.26(-0.2) + 6.72(-0.08) + 1.05(-0.167)
Z = -2.624 - 0.652 - 0.5376 - 0.17535
Z = -3.98895
Interpretation: The Z-score of -3.98895 is well below 1.1, indicating a very high probability of
financial distress and potential bankruptcy.
This analysis aligns with Uchumi's real-world financial struggles, including multiple periods of
insolvency and attempts at restructuring and it eventually went under.