Finanacial Restructuring 2

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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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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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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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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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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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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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



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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%



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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



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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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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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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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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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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.

Finanacial Restructuring 2

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