VMC: Distressed Firms
This is a Valuation Master Class student essay by Jana Kristofova from October 15, 2018. Jana wrote this essay in Module 3 and has since completed all five modules of the Valuation Master Class. The post was originally published here.
This paper focuses on distressed companies, bankruptcy processes, liquidation, and reorganization. The definition of distressed companies is well known. However, these companies can show one or multiple signs that a distressed situation is coming. A solution for distressed companies is either a reorganization process or a liquidation process.
Distressed Firms
Financial distress is a situation when a company cannot meet or has difficulties to pay off its financial obligations to its creditors. The reason for the inability is high fixed costs; illiquid assets or revenues sensitive do economic downturns (Financial Dictionary, 2012).
Stock prices of distressed companies are less informationally efficient prices (Chambers et al., 2015).
A distressed company usually deals with multiple signs (Yakola, 2014):
a) Working capital/ liquidity:
- Declining or negative free cash flow;
- Increase in accounts-receivable aging;
- Increase in outstanding accounts payable
b) Financial:
- Declining stock price and bond price;
- Inability to meet debt covenants;
- Diminishing liquidity and downgrades in debt ratings;
c) Profitability and industry outlook:
- Reduced capital-investment programs;
- Shrinking EBITDA margin;
- The adverse regulatory environment and regulatory inquiries,
d) Employees
- Large or unplanned reductions in the workforce;
- Management turnover;
- Disruptions in the unionized workforce;
Bankruptcy Process
The bankruptcy process refers to a series of actions that start with filing for bankruptcy and ends with bankruptcy resolution. The distribution of the firm’s assets to its stakeholders is done according to the priority, beginning with senior claims (e. g. wages).
Altmann Z-score can be used for calculating the probability of bankruptcy of a firm (Meeampol et al., 2014):
Z = 0.012×1 + 0.014×2 + 0.033×3 + 0.006×4 + 0.999×5
x1 = working capital divided by total assets. This ratio measures liquid assets in relation to the size of the company;
x2 = retained earnings divided by total assets. It measures profitability that reflects the company’s age and earning power;
x3 = earnings before interest and taxes to total assets. It measures operating efficiency apart from tax and leveraging factors. Furthermore, it recognizes operating earnings as being important for long-term viability;
x4 = book value of equity to total liabilities. This ratio adds a market dimension that can show stock price fluctuation as a possible red flag.
x5 = sales to total assets. This is the standard measure for total asset turnover (however, it varies from industry to industry).
The interpretation of Z-Score Model:
z-score > 2.99 “safe” zones,
1.81 < z-score < 2.99 “grey” zones,
z-score <1.81 “distress” zones (Meeampol et al., 2014).
The important question that management of a distressed company is facing is whether the company is “worth more dead than alive”, meaning if the business would be more valuable if it continued its operation after reorganization or if it was liquidated and sold off in pieces.
Liquidation
The liquidation process refers to the process of selling assets and allocating proceeds to equity and debt holders (according to the U. S. Chapter 7 bankruptcy).
Bankruptcy law recognizes 1) absolute priority doctrine (creditors should be compensated for their claims in rigid hierarchical order and all senior claims have to be fully paid before junior claims are treated); 2) relative priority doctrine (allows more flexibility in a reorganization and introduces a balanced approach to all claimants) (Financial Management – Theory and Practice, 2012).
The Process of Reorganization
The reorganization process enables firms to reorganize and successfully emerge from bankruptcy (according to the U.S. Chapter 11 bankruptcy).
If a fundamentally sound company faces some temporary financial difficulties, it can be solved by voluntary reorganization plans that are called workouts.
Reorganization requires some type of restructuring of the firm’s debt, either a) extension – postponing the date of required payment of past-due obligations; or b) composition – when creditors voluntarily reduce their claims on the debtor or the interest rate on their claims.
The purpose of the bankruptcy court in a reorganization process is to ensure fairness and feasibility of proposed reorganization plans. In the situation when reorganization plans are approved by the bankruptcy court but not accepted by some creditors or stockholders, the court can mandate a reorganization plan in spite of dissent. This is called a cramdown. A pre-packaged bankruptcy (or pre-pack) has gained some popularity in recent years. It refers to a new type of reorganization that combines the advantages of both – informal workout and formal (Chapter 11 reorganization). (Financial Management – Theory and Practice, 2012).
Remedies/ Actions to Betaken
Yakola (2014) provides ten tips for leading companies out of the crisis:
- Throw away your perceptions of a company in distress;
- Force yourself to periodically review your business plan;
- Expect more from your board of directors;
- Focus on cash and cash returns;
- Create a great change story;
- Treat every turnaround like a crisis;
- Build traction for change with quick wins;
- Throw out your old incentive plans;
- Replace a top-team member (or two top-team members);
- Find and retain talented people.
References
Chambers, D. R. et al. (2015). Alternative Investments: CAIA Level I. 3rd Edition, CAIA Association.
Financial Dictionary (2012) (accessed online on 15th October 2018)
Financial Management – Theory and Practice (2012). Chapter 24 – Bankruptcy, Reorganization and Liquidation. (accessed online on 15th October 2018).
Meeampol, S. et al. (2014). Applying Emerging Market Z-Score Model to Predict Bankruptcy: A Case Study of Listed Companies in the Stock Exchange of Thailand. (accessed online on 15th October 2018).
Yakola, D. (2014). Ten tips for leading companies out of crisis. (accessed online on 15th October 2018).
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DISCLAIMER: This content is for information purposes only. It is not intended to be investment advice. Readers should not consider statements made by the author(s) as formal recommendations and should consult their financial advisor before making any investment decisions. While the information provided is believed to be accurate, it may include errors or inaccuracies. The author(s) cannot be held liable for any actions taken as a result of reading this article.