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7/28/2019 Finanacial Restructuring 2
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Financial Restructuring in
Corporations
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Why Do Firms Fail?
Corporate failure occurs when thefollowing performance patterns exist:
Firm performance never rises above a poor
level;
Firm shoots up to very high levels ofperformance before crashing down;
Firm performance partially collapses,followed by a relatively longer plateauperiod of sub-par performance, and thenrapid decline into insolvency.
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Processes Resulting inCorporate Failure
There are at least two primary failureprocesses:
Relatively long duration in which financialstress is evidentSTRESSED
A relatively rapid, unexpeced failure in whichfinancial stress (proxied by accounting numbers)
is not evident
UNSTRESSED
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Corporate Restructuring
There is always a step company makes beforefiling for bankruptcy. This step is calledcorporate restructuring.
The aim of corporate restructuring is to
rehabilitate financially distressed company. Corporate restructuring takes place through:
Government involvement by utilizing suchrestructuring vehicles as establishment of Asset
Management Companies, Deposit InsuranceCorporations, Corporate Restructuring Funds, etc.
Company management involvement by changingfirm's strategy and restructuring its financialstatements.
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Why Restructure?
Why does a firm face a need torestructure?
Firm is overleveraged
Firm is underleveraged
Firm faces sluggish sales
Firm faces seasonal sale problems
Firm faces externalities
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Review of Basic Ratios
Before proceeding with approaches andmethods to financial restructuring, letssummarize basic financial ratios:
Liquidityratios
Leverageratios
Activityratios
Profitabilityratios
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Leverage Ratios
Nine ratios describe leverage. They allare an indication of how a firm gets itsoperating 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
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Financial Leverage Ratios
Financial leverage ratios measure the fundssupplied by owners (equity) as compared withthe financing provided by the firms creditors(debt).
Financial leverage is the use of debt to magnifyreturn on equity (ROE) to shareholders.
Equity, or owner-supplied funds, provide amargin of safety for creditors. Thus, the lessequity, the more the risks of the enterprise to
the creditors. To understand financial leverage we need to
understand ratios between Debt to Total Assetsand Debt to Equity
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Sample Balance Sheet
Company X Balance SheetDecember 31, 2003 ($000)
Current Assets
Cash 200
Marketable Securities 350
Accounts Receivable200
Inventory 500Prepaid Expenses 250
Total Current Assets 1,500
Fixed Assets
Land 4,500
Plant 9,000Machinery and Equipment 6,000
Less: Acc. Depreciation 1,000
Total Fixed Assets 20,500
Total Assets 22,000
Liabilities
Accounts Payable 300
Notes Payable 300
Accrued Liabilities 100
ST Loans Payable 100Maturing Bonds 100
Bonds 2,000
Loans 5,100
Total Liabilities 8,000
Shareholders Equity 14,000
Total Liabilities and Equity 22,000
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Sample Income Statement
Company X Income StatementEnding December 31, 2003 ($000)
Net Sales 3,400
Other Income 100
Total Revenue 3,500
Cost of Goods Sold 1,000
Gross Profit 2,500
General Expenses 200
Administrative Expenses 250
Selling Expenses 50
Earnings Before Interest and Taxes (EBIT)2,000
Interest Expenses 500
Earnings Before Taxes (EBT) 1,500
Taxes 500
Earnings After Taxes (EAT) or Net Profit 1,000
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The debt ratio is the ratio of total debt to totalassets and measures the percentage of totalfunds provided by creditors:
DEBT RATIO =
Debt Ratio for Company X for the year 2003 iscalculated as follows
Debt Ratio = 8,000 / 22,000 = 0.36
Financial Leverage Ratios:Debt Ratio
TOTAL DEBT
TOTAL ASSETS
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Debt Ratio
To see whether Company Xs Debt Ratiois an indicator of its good performance,we need to look at: the historical trend of the ratio
A comparison of the companys performanceagainst other major players in the industry
If Debt Ratio is rising, the company isdeveloping a leverage problem
If the debt ratio is falling, the company isinvesting more of its own resources togenerate assets and is becoming lessdependent on debts
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Debt Ratio - Industry Graph
-
0.10
0.20
0.30
0.40
0.50
0.60
0.70
1997 1998 1999 2000 2001 2002 2003
Company X Company Y
Com pany Z Industry Average
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Example of Debt Ratio
Debt Ratio of Company X has been improvingfrom 1997 to 2003. It went down from 0.61 to0.36 which means the company is less relyingon debt to finance its assets.
Compared to the Industry in 2003, the CompanyX is almost on par with the industry averageDebt Ratio
Company X 0.36
Industry Average 0.37
Company X has performed relatively well in2003 than in previous years compared to othermajor players in the industry - Company Y andCompany Z.
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The debt to equity ratio compares the amount ofmoney borrowed from creditors to the amountof shareholders investment made within a firm
DEBT TO EQUITY RATIO =
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
Financial Leverage Ratios:Debt to Equity Ratio
TOTAL DEBT
TOTAL EQUITY
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Debt to Equity Ratio
To see whether Company Xs Debt toEquity Ratio is an indicator of its goodperformance, we need to look at: the historical trend of the ratio,
the company compared with other majorplayers in the industry
If Debt to Equity Ratio is rising, thecompany is developing a leverageproblem
If the debt ratio is falling, the company isinvesting more of its owners resources togenerate assets and is becoming lessdependent on creditors
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Debt to Equity Ratio - IndustryGraph
-
0.10
0.20
0.30
0.400.50
0.60
0.70
0.80
0.90
1997 1998 1999 2000 2001 2002 2003
Company X Company Y
Company Z Industry Average
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Example of Debt to EquityRatio
Debt to Equity Ratio of Company X hasbeen declining from 1997 to 2003 It went down from 0.79 to 0.57
This means the company has beenchanging its debt to equity mix withmoving away from heavy debt borrowingto raising capital from shareholders
The graph also shows that Company Xhas been overleveraged in 1997
f
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Example of Debt to EquityRatio
Compared to the Industry in 2003, theCompany X is performing slightly abovethe industry average, but has shown apersistent trend towards the industry
average Debt to Equity RatioCompany X 0.57
Industry Average 0.51
Company X has performed better thanCompany Y in 2003. Company Z showssigns of being underleveraged, whichcan be very risky
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Decisions about Leverage
Decisions about the use of leveragemust balance higher expected returnsagainst increased risk.
Debt funding enables the owners to maintaincontrol of the firm with a limited investment.
If the firm earns more on the borrowed fundsthan it pays in interest, the return to the
owners is magnified.
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Decisions about Leverage
Indicate less risk of loss when the economy is ina downturn, but lower expected returns when the
economy booms
LOW LEVERAGE RATIOS
Indicate the risk of large losses, but also have a
chance of gaining high profits
HIGH LEVERAGE RATIOS
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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 andmaximizes returns
E l f O l d
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Examples of Overleveragedand 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 costsare $40,000
We will look at three scenarios whereDebt to Equity ratios will be at 25%,100% and 400%
What should the debt and equity mix be, and what is itgoing to affect, and how?
E l f O l d
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Examples of Overleveragedand Underleveraged Firms
Debt to Equity Ratio 25% 100% 400%
Net sales 150,000 150,000 150,000COGS 90,000 90,000 90,000Fixed Costs 40,000 40,000 40,000Interest Expense 1,600 4,000 6,400Pretax Income 18,400 16,000 13,600Income tax (40%) 7,360 6,400 5,440Net Income 11,040 9,600 8,160
Return on Equity 13.8% 19.2% 40.8%
Debt (8% interest) 20,000 50,000 80,000Equity 80,000 50,000 20,000Total Capital 100,000 100,000 100,000
E l f O l d
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Examples of Overleveragedand Underleveraged Firms
By looking at debt and equity mix, it isclear that underleveraged companies:
Have low EBT
Pay less in taxes
Their net income is comparatively low
ROE is the highest, since there is anover-reliance on debt
Pay high interest expenses
E l f O l d
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Examples of Overleveragedand Underleveraged Firms
By looking at debt and equity mix, it isclear that overleveraged companies:
Have higher EBT
Pay higher dollars in taxes
Their net income is comparatively higher
ROE is the lowest, since there is an over-reliance on equity, and the net profit is not
commensurate to the amount of equity raised
Pay less in interest expenses
E l f O l d
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Examples of Overleveragedand Underleveraged Firms
Overleveraged companies also haveother obligations not shown here, suchas payment of dividends to shareholders
The more equity is raised throughshareholders (stocks issued), the morefirms have to pay out in dividends, thus
reducing their retained earnings that canlater be re-invested into businessexpansion
C f Fi i l
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Causes for FinancialRestructuring
There are several instances wherecompany management has to make adecision 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
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Overleveraged Firm
The problem of overleverage occurswhen a firm has overborrowed debt froma bank on a consistent basis
As a result, firm has a higher Debt toEquity Ratio
Using debt to run a firm is a commonpractice, however, sometimes there is anover-reliance on debt
Over-reliance on debt can be a factor inhurting the companys bottom line
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Overleveraged Firm
Overleveraging is acceptable in caseswhen a firm is undertaking expansionprojects (buying new plant andequipment, investing into newtechnologies) that have high probabilityof higher expected returns, profits, andthus ROA
When firms over-borrow debt on aconsistent basis, and thus haveprofitability issues, the management hasto consider Financial Restructuring
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Overleveraged Firm
If a firm is fully leveraged, it will not be able toborrow money
A lower debt-equity ratio will make for easierloan negotiations in the event a firm needs to
borrow money in the future Many financially distressed firms that
restructure their debts either file for bankruptcylater or experience financial distress again
This is because they remain overleveraged afterthe restructuring; out-of-court restructuringsleave firms with suboptimal capital structures
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Overleveraged Firm
Financial Restructuring in overleveragedfirm can be implemented through
Selling off unprofitable assets to pay off debt
Rent out equipment to pay off debt
Restructure debt (refinance LT debt with alower interest rate, if possible)
Issuing new stocks
Debt to equity swap
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Overleveraged Firm - Example
Issuing new stocks (issue $50,000 in stocksto pay off $50,000 in debt)
Before After
Total Assets $100,000 $102,400
Total Debt $80,000 $30,000
Total Equity $20,000 $72,400
Common Stocks $10,000 $60,000
Retained Earnings $10,000 $12,400
Net Profit $8,160 $10,560
Debt Ratio 80% 29%Debt to Equity Ratio 400% 41%
Return on Equity 41% 15%
Return on Assets 8% 10%
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Underleveraged Firm
The problem of underleverage arises when afirm has raised majority of its capital throughstocks
As a result, firm has a very low Debt to Equity
Ratio
With higher equity the firm has to improve itsperformance to keep the shareholders happy
If firm pays dividends, it has to constantlyallocate a portion of its profits towardsdividends payable to shareholders
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Underleveraged Firm
Financial Restructuring in underleveragedfirm can be implemented through
Buying back stocks for cash (if available)
Borrowing funds (debt) to buyback stocks toattain the best debt to equity mix
Selling off unprofitable assets to
buyback stocks
Renting out equipment to buyback stocks
Underleveraged Firm
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Underleveraged Firm -Example
Borrowing funds to buyback stocks(borrow$40,000 in debt to buy back $40,000 worth ofcommon shares)
Before After
Total Assets $100,000 $98,080Total Debt $10,000 $50,000
Total Equity $90,000 $48,080
Common Stocks $80,000 $40,000
Retained Earnings $10,000 $8,080
Net Profit $11,520 $9,600
Debt Ratio 10% 51%Debt to Equity Ratio 11% 104%
Return on Equity 13% 20%
Return on Assets 12% 10%
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Firm with Sluggish Sales
Sluggish sales can cause financial distress, as they affecta companys cash flow
Sluggish sales are influenced by the line of business a firmis in
Usually, firms face sluggish sales when they are into bigticket items sale, or when the economy is slow
As a result, companys working capital decreases causingcash deficit
One of the areas most affected by sluggish sales is pilingof accounts receivable and the problem of non-collection
Cash deficit forces firms management to take alternativesteps to raising cash through stock issuance, debt
borrowing or other
Firm with Sluggish Sales
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Firm with Sluggish Sales -Example
Decrease in sales by $25,000 and $35,000. Originalsales at $150,000.
Before After After(sales down (sales downby $25,000) by $35,000)
Total Assets $100,000 $94,000 $91,600Total Debt $50,000 $50,000 $50,000Total Equity $50,000 $44,000 $41,600
Common Stocks $40,000 $40,000 $40,000Retained Earnings $10,000 $4,000 $1,600
Net Profit $9,600 $3,600 $1,200Debt Ratio 50% 53% 55%
Debt to Equity Ratio 100% 114% 120%Return on Equity 19% 8% 3%Return on Assets 10% 4% 1%
Firm with Sluggish Sales
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Firm with Sluggish Sales -Example
The example showed that a slight drop insales might completely change thefinancial picture of a firm
Decline in profits causes drop in totalassets (decrease in cash inflow) andequity (decrease in retained earnings)
If not addressed timely, this might causea problem of overleveraged firm
Firm with Sluggish Sales
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Firm with Sluggish Sales -Example
Current Assets Current Liabilities(remain unchanged)
Fixed Assets Long Term Liabilities(remain unchanged) (remain unchanged)
Equity/Capital
TOTAL ASSETS TOTAL LIABILITIES + EQUITY
Working Capital = CA CL
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Firm with Sluggish Sales
Financial Restructuring in a firm with slow salescan be implemented through:
Different hedging techniques (to avoid or covercurrency 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, providingdiscounts, or demanding prepayment)
Diversification of line of business (producing fastselling products in parallel to compensate slow salesand raise additional cash to use as a working capital)
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Firm with Sluggish Sales
Why do companies attempt to hedge
Hedging is contingent on the preferences ofthe firm's shareholders
There are risks peripheral to the centralbusiness in which they operate
Companies do not exist in isolation; hedgingis also used to improve or maintain the
competitiveness of the firm
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Firm with Seasonal Sales
Seasonal sales are attributive to firms inseveral industries such as farming,construction, businesses highly dependenton holidays, etc.
The question is how to keep businessesviable when the season is out
Similar techniques can be adopted as withsluggish sales
In addition, firms with seasonal sales needto engage into other lines of businesses, todiversify and therefore reduce the risk, aswell as to have an additional source for cashinflow
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Firm with Seasonal Sales
Seasonal pattern in sales affectscompany profits, and therefore, causescash 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 showcompany sustainability
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Firm with Seasonal Sales
Financial Restructuring in a firm withseasonal sales can be implementedthrough Different hedging techniques
Borrowing funds on line of credit to coverworking capital gap during months ofinactivity
Diversification of line of business (producingproducts that have non-seasonal demand to
compensate seasonal sales and raiseadditional cash for covering working capitalgap)
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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
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Firm facing Externalities
There are several techniques thatcompanies can employ to reduce externalrisk
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
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Conclusion
Each firm is a unique entity, and there isno one road map for success
Management should be aware of differenttechniques available when a company is
in financial distress Each decision should be tailored to a firm
taking into account specificity of thebusiness
Management has to look at advantagesand disadvantages each decision has.